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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
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[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDING SEPTEMBER 30, 1999
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM __________ TO __________.
COMMISSION FILE NUMBER 0-26825
N2H2, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
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WASHINGTON 91-1686754
(STATE OR OTHER JURISDICTION (I.R.S. EMPLOYER IDENTIFICATION NO.)
OF INCORPORATION OR ORGANIZATION)
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900 FOURTH AVENUE, SUITE 3400, SEATTLE, WA 98164
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES, INCLUDING ZIP CODE)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (206) 336-1501
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: COMMON STOCK,
WITHOUT PAR VALUE
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. Yes [X] No [ ]
As of December 17, 1999, the registrant had outstanding 21,162,737 shares
of common stock, no par value, and the aggregate market value of those shares
(based upon the closing price as reported by NASDAQ) held by non-affiliates was
approximately $151,063,850.
Documents incorporated by reference:
(1) Portions of the registrant's definitive 2000 Proxy Statement to be filed
with the Commission are incorporated by reference into Part III hereof.
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PART I
ITEM 1. BUSINESS.
The following discussion in this annual report on Form 10-K contains
forward-looking statements regarding the Company, its business, prospects and
results of operations that involve risks and uncertainties. The Company's actual
results could differ materially from the results that may be anticipated by such
forward-looking statements and discussed elsewhere herein. Factors that could
cause or contribute to such differences include, but are not limited to, those
discussed herein as well as those discussed under the captions "risk factors"
and "management's discussion and analysis of financial condition and results of
operations" as well as those discussed elsewhere throughout this annual report
on Form 10-K.
Forward-looking statements typically are identified by the use of such
terms as "may," "will," "expect," "believe," "anticipate," "estimate," "plan"
and similar words, although some forward-looking statements are expressed
differently.
Readers are cautioned not to place undue reliance on these forward-looking
statements, which speak only as of the date of this report. The Company
undertakes no obligation to revise any forward-looking statements in order to
reflect events or circumstances that may subsequently arise. Readers are urged
to carefully review and consider the various disclosures made by the Company in
this report and in the Company's other reports filed with the Securities and
Exchange Commission that attempt to advise interested parties of the risks and
factors that may affect the Company's business, prospects and results of
operations.
OUR BUSINESS
N2H2 is a leading Internet infrastructure company. We provide content
categorization of Internet Web sites, filtering of Internet content, and caching
services. We were the first company to offer a server-based Internet filtering
solution for a customer's computer network. With Bess, our flagship product, we
currently provide filtering services to approximately 8.5 million users in
approximately 8,750 schools in the United States and Canada. Our customers
include the statewide networks serving most of the public schools in Ohio,
Tennessee, Maine, Oklahoma, Wisconsin, Arkansas and Idaho as well as school
systems in areas such as Los Angeles County, Baltimore, Boston, Calgary,
Seattle, Stockton and Tampa.
In the quarter ending September 30, 1999, students and teachers accessed
approximately 1 billion Web pages through Bess. To better serve the needs of our
existing and potential school customers, we recently introduced Searchopolis as
an educational Internet portal. As a portal, Searchopolis is specifically
designed to maximize the educational potential of the Internet by aggregating
educational content in one place. It also links to other relevant Web sites and
provides safe access to Internet content using our award winning filtering
search technology. We are developing additional specialized communication tools
and services and plan to integrate them into Searchopolis, further enhancing its
capabilities as the portal of choice for the community of students, teachers,
parents and administrators. Searchopolis is available at www.searchopolis.com to
any Internet user who wants access to a safe, educationally-enriched Web portal.
We are actively extending our infrastructure services to corporations and
other organizations and, through approximately 210 Internet service providers,
into an increasing number of homes. We develop, market and support Internet
filtering solutions that enable businesses to increase productivity by limiting
the content that employees can access on the Internet without blocking material
that is useful for their jobs. Through our current Internet service provider
relationships, our filtering services are available to over 200,000 homes.
Our infrastructure services enable our school, business and other customers
to limit access to the Internet by allowing them to select from among 32 content
categories ranging from pornography, hate and bomb construction to gambling and
games. The key benefits of our services include:
- automated identification of potentially unsuitable Web sites backed by
human review to accurately place Internet content into our database of 32
categories,
- proprietary tools which enable customers to tailor their filtering
criteria to meet their specific needs,
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- minimal customer effort required for installation and maintenance,
- server-based filtering that is difficult to bypass, and
- daily electronic updating of the filtering database.
OUR MARKET OPPORTUNITY
We believe the school, home and corporate markets, both domestic and
international, present us with significant opportunities. According to Quality
Education Data, in the United States there are approximately 47 million students
in public schools grades K-12 within 16,000 school districts and approximately 5
million private school K-12 students. The Annenberg Public Policy Center
estimates that 60% of United States households with children aged 8 to 17 have
computers and 61% of those are connected to the Internet. International Data
Corporation estimates that medium and large businesses will account for 49
million Internet users worldwide by the year 2000. Without an effective Internet
content filtering system in place, educators and parents have to choose between
undesirable alternatives: prohibiting Internet access altogether or closely
supervising each student's use of the Internet. Corporations and other
organizations also face issues associated with unrestricted on-the-job access to
the Internet, including productivity losses caused by employees surfing the
Internet for personal reasons during work hours as well as potential liability
concerns.
INDUSTRY BACKGROUND
Growth of the Internet
The Internet has emerged as a critical global communications medium,
enabling millions of people to access and share information and conduct business
electronically. Industry analyst International Data Corporation estimates that
the number of Web users will grow from approximately 97 million worldwide in
1998 to approximately 320 million by the end of 2002. The rapidly increasing
volume of information available over the Internet has contributed to the
phenomenal growth in the number of users and hours spent online. The Internet
has become an invaluable tool for those who would otherwise not have access to
the rich data mine of information contained in libraries, databases and Web
sites around the world. As a result, schools, libraries, homes, corporations and
affinity groups, such as churches or associations, increasingly are connecting
to, and encouraging their users to access, the Internet.
Schools in the United States are rapidly expanding their computer networks
and adding Internet access with the help of a four year, $9 billion matching
funds program implemented by the Federal Communications Commission in January
1998. Both the Clinton Administration and the Department of Education have
announced long-term goals to provide Internet access to all students in the
nation's public schools. The Department of Education has recommended a target of
one computer workstation for every five students, up from one for about every 14
students currently.
The Need for Filtering
The introduction and expanded use of the Internet as an educational tool in
the classroom has prompted school board members, superintendents and teachers to
focus on protecting students from unsuitable Internet content. Parents have also
become increasingly concerned about children's access to various types of
content, ranging from pornography to bomb making instruction, among others.
Without an effective Internet content filtering system in place, educators and
parents have had to choose between undesirable alternatives: prohibiting
Internet access altogether or closely supervising each student's use of the
Internet. Prohibiting Internet access deprives students of the wealth of
beneficial information available on the Internet, while supervision can waste an
enormous amount of teacher or parent time.
Corporations also face issues associated with unrestricted on-the-job
access to the Internet, including productivity losses caused by employees
spending large amounts of time during the workday surfing the Internet for
personal reasons. In addition, corporations are exposed to many potential
liability issues relating to the misuse of and unlawful distribution of
Internet-based content.
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The Need for an Education Oriented Portal
The Internet has the potential to be a rich educational resource for K-12
students. However, most existing Internet portals are targeted to the needs of
an older audience and do not address the requirements of the growing school and
student Internet communities. In addition, current search engines and portals
are not formatted to meet the specific educational needs and interests of these
communities. This makes it difficult and inefficient for students, parents and
teachers to incorporate the Internet into the classroom and home.
The Development of Filtering
Early Internet filtering products were based on the use of keywords, often
four-letter or slang expressions for sex or body parts. These products scan the
text of a Web site and if designated keywords or phrases exist, access to the
particular Web site or partial Web site is blocked. Keyword blocking has
significant limitations in its ability to differentiate between acceptable and
potentially objectionable content, as it works on text only and relies on
scanning content without regard for context. For example, blocking anything with
"sex" in it blocks "Middlesex." It is impossible for a keyword blocking system
to block out all inappropriate content without simultaneously blocking a large
amount of useful information. In addition, much of the objectionable content on
the Internet consists of graphics, some of which have no text to scan for
keywords.
In addition, most of the keyword filter products on the market are
client-based software products. Because the software must be installed and
maintained on each individual workstation that requires filtering, these systems
have several significant limitations:
- users can more easily circumvent the filtering programs,
- product installation and maintenance can be time consuming and expensive,
and
- database updates require user input.
Many server-based filtering solutions suffer from some of the same
deficiencies as client-based software products. Some have limited databases that
may not be updated frequently, some are keyword based, some require extensive
administrative oversight and some are not easy to adapt to larger network
environments.
In addition to keyword filtering, access to Web sites can be blocked
through universal record locator lists and packet filtering. Universal record
locator blocking involves creating lists of Web addresses in a database, often
categorized as "allowed sites" or "blocked sites." Lists of blocked universal
record locators allow targeted content management by blocking only selected
portions of a given Web site, but require frequent updating to ensure the list
remains current. By comparison, packet filtering blocks access to entire
Internet servers, many of which contain multiple Web sites with both valuable
and inappropriate material. The potential benefits of packet filtering in terms
of speed and simplicity may be outweighed by its lack of precision.
THE N2H2 SOLUTION
N2H2 is a leading provider of Internet content filtering, serving schools,
homes and businesses. We develop, market and support technology services that
make the Internet a safe and educational resource for K-12 students at school
and at home. Our server-based Internet filtering solutions also enable
businesses to increase employee productivity by limiting the content employees
can access on the Internet. By using automated search technology backed by human
review to scan the Internet for potentially unsuitable material, we are able to
offer our customers a significant improvement over other Internet filtering
products. In addition, we offer Searchopolis, which addresses the need for a
content filtered, education focused Web portal that is easy to navigate and
provides communication tools to students, teachers and parents.
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Our Filtering Solution
In 1995, we introduced Bess, the first proxy server-based Internet
filtering solution. We believe our system provides our customers the following
key benefits:
- Thorough and accurate content analysis. Our proprietary Internet
screening technology continuously scans the Internet for content that
fits into one or more of 32 categories. Our staff then reviews this
content and places it in the appropriate categories. Use of human review
avoids overfiltering, which is often a disadvantage of fully automated
systems.
- Customer choice. We believe our proprietary search technology combined
with human review to categorize content enables our customers to
effectively tailor and control the Web sites and pages they make
available to their users. Our system requires minimal customer oversight
by a system administrator, teacher or parent, while allowing our
customers the flexibility to override specific Web site filtering,
customize filtered categories, select time schedules for various levels
of filtering and grant password-based override for authorized users.
- Protection of personal information. Our filtering solutions allow our
customers to protect students and children from inappropriate
solicitations of personal information. By identifying and categorizing
Web sites that seek access to confidential or personal information about
students and children or their parents or families, we are able to
address this growing concern about Internet access.
- Ease of installation and maintenance. Our proxy server-based filtering
solutions minimize customer need to support installation and maintenance
of equipment and software. Since our filtering product is network-based,
there is no need to install or maintain equipment or software at each
user's desktop. In addition, we provide full technical support to our
customers for our services.
- Difficult to bypass. Located on a customer's central network or at an
Internet service provider, our server-based filtering is an integral part
of each Internet access request. We believe, therefore, that it is
virtually impossible for the user to circumvent our filtering system.
- Continuous updating and caching. Our centrally managed system provides
our customers with a daily electronic update of our database of
categorized sites. As a result, our clients' filtering is kept current,
reflecting changes to sites on the Internet on a near real-time basis.
Our proxy servers are also equipped with caching capabilities that can
significantly speed classroom access and save our customers critical
telecommunication capacity and expense.
Searchopolis: Our Education Portal to the Internet
Searchopolis combines the following key features:
- Safe search. Searchopolis includes our pioneering, proprietary filtering
technology operated in conjunction with Inktomi's search technology.
Searchopolis enables the user to find educational resources quickly and
navigate safely through the Internet.
- Focused educational content. Teachers and students have limited class
time to access and use the Internet. Searchopolis enables instant access
to thousands of Web sites provided by our partner, Looksmart. These are
organized by subjects such as history, math and science and are
supplemented with learning tools such as a dictionary and news, sports
and weather reports provided by our partner, InfoSpace. By assembling
educational content in one place, making searches fast and relevant and
avoiding the need for supervision, we believe Searchopolis provides a
level of effectiveness unmatched by any other educational Web portal.
- Communication tools. We are developing enhanced features for Searchopolis
to provide specialized communication tools for teachers, students and
parents, including:
- access-controlled, filtered e-mail,
- an easy-to-use calendar linking schools, teachers, students and parents
in local communities,
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- a Virtual Locker to store students' favorite Internet sites, classroom
material and homework for access from the home, library or other
locations outside the classroom, and
- GradeChecker to provide parents, teachers and students Internet access
to grades and other classroom information.
N2H2'S STRATEGY
Our goal is to expand our presence in the school, home and corporate
markets and to make Searchopolis the leading education oriented Web portal for
K-12 students. We plan to achieve this goal through the following steps:
Aggressively expand our presence in schools. We plan to expand our
education user audience by building upon our reputation in the school market for
high-quality, effective Internet content filtering. Part of our strategy for
doing this is to make it easier for schools to purchase our services. Today,
schools are faced with many competing demands on their budgets, and we believe
they are open to proposals to assist them in meeting their educational goals
within their budgets. To more rapidly expand our filtering services and to take
advantage of advertising opportunities, we recently began offering alternate fee
structures to schools that allow us to sell sponsorship rights to advertisers
and to make Searchopolis the default search engine on these schools' networks.
Enhance content and communication features on Searchopolis. In June 1999,
we launched an enhanced Searchopolis portal which will feature specialized
communication tools customized for education, including access-controlled,
filtered e-mail, Virtual Locker, GradeChecker and a calendar. This new version
of Searchopolis will also feature a directory of useful Web sites classified by
educational topic and easier access to reference tools, curriculum materials and
other useful information. We plan to continue adding content features to
Searchopolis in the future and to build upon our existing agreements with
Inktomi, Looksmart, InfoSpace and Merriam-Webster, Incorporated.
Create advertising opportunities to reach the student market. We believe
our presence and continued growth in the education market will create a sizable
audience for advertisers trying to reach the 52 million public and private K-12
students in the United States. We expect to create the potential for high-value
advertising that will appeal to advertisers by differentiating students
according to school levels and geographic location.
Increase penetration of the home market. We believe parents familiar with
Bess and Searchopolis trust and value our services because we offer the content
filtering and search services used by their children's schools. We are expanding
the availability of our services to homes by making them available through
Internet service providers. We have approximately 210 Internet service provider
partners providing our services to over 200,000 homes in the United States and
are seeking additional relationships with Internet service providers throughout
the United States and abroad. Internet service providers may choose to either
include our services in their customers' basic monthly Internet access charge or
bill for it separately as an additional feature. We also target the home market
through affinity groups, such as churches and associations. These groups are
increasingly interested in filtered content tailored to their group's particular
needs. For example, the Church of Jesus Christ of Latter Day Saints, the Mormon
Church, which has ten million members, uses our filtering search technology on
its Website.
Expand our presence in the corporate and international markets. We are
pursuing marketing alliances with companies in the United States and overseas to
increase our penetration of the corporate market. We are also increasing our
direct sales efforts in the corporate marketplace.
Increase sales and marketing efforts and build brand awareness. We plan to
substantially increase our direct sales activities and our marketing
expenditures to penetrate the school, home, international and business filtering
markets and increase the use of Searchopolis. We also plan to devote substantial
resources and continue to work with our advertising sales partner 24/7 Media to
increase our advertising sales volume.
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Pursue additional strategic relationships. We intend to aggressively pursue
additional strategic relationships to expand our business in corporate, consumer
and international markets. We have customers in Canada, Australia, the United
Kingdom, Germany, Mexico, Chile, India and Bermuda and intend to expand
internationally by entering into additional overseas marketing relationships.
Where appropriate, we will consider the acquisition of businesses that can help
us provide specialized content, advanced service features, or expanded market
penetration.
SERVICES AND TECHNOLOGY
The N2H2 Filtering Service
We provide a complete filtering solution. Our filtering services enable our
school, library, corporate, home and other customers to limit access to
offensive or otherwise undesirable information on the Internet. Our on-site
proxy servers are shipped to customers ready to install into their networks. Our
proxy servers are a combination of readily available computer hardware,
including a high capacity hard drive and a high-speed modem, purchased from
outside suppliers. We configure these servers with software developed by us that
enables them to perform their filtering functions. We also monitor and maintain
all the software and hardware components necessary to meet our customers'
filtering needs remotely from our Seattle, Washington network facility. Once a
customer notifies us that it has installed our proxy server, we can put it in
service in less than two hours. Our filtering solutions are comprised of three
main components:
- a proxy server infrastructure,
- our advanced Internet content categorization system and
- tools for filter control, reporting and data collection
Proxy server infrastructure: configurations and caching. Rather than
installing a filter on every workstation as is necessary with client-based
products, our solution uses a proxy server that is usually installed on the
customer's network. Every networked workstation uses our filtering solution to
access the Internet.
Proxy server-based systems are secure and difficult to bypass because the
proxy server is installed directly in the network, thus making it virtually
impossible for users to access the Internet without passing through this server.
From a customer's point of view, a proxy-based system is easy and economical to
operate because it can be managed by us from one central site. Our customers'
systems are monitored, maintained and kept updated primarily from our
headquarters in Seattle. The parameters that our clients use to control the
filtering of their Internet content are stored by the proxy server located on
their networks and are based on information received from our central database
of categorized Web sites. This information is updated and sent to our customers'
proxy servers daily. In addition, we also send system upgrades and enhancements
to our customers' proxy servers via the Internet.
We provide two proxy server configurations to our clients:
- On-site configuration. In most cases, we install our proxy server on the
customer's network. Internet requests are routed directly through these
servers for filtering. In larger networks, we may deploy multiple
filtering servers to assure adequate capacity, redundancy and backup. Our
proxy server can also be configured to include a caching feature that can
significantly increase Internet access performance. Approximately 35% of
universal resource locators retrieved by servers in our system are
retrieved from cache. This caching feature substantially increases
performance of most networks. Our on-site configuration is most often
used by medium to large sized schools, school districts and state school
systems. It is also used by Internet service providers and corporations,
which are then able to provide filtered Internet services to their
individual users, business customers or employees.
- Remote or redirect configuration. For smaller networks, we offer a
"redirect" service that enables multiple customers to share one
regionally located proxy server. All of the customer's Internet requests
are routed via the Internet to an off-site proxy server where the content
is filtered and then returned to the customer. Smaller schools and
libraries have been the primary customers of our redirect service.
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While this configuration is more cost-effective for smaller networks, it
does not operate at the same speed as our on-site configuration because
it requires multiple routing steps and lacks caching.
Advanced Internet Content Categorization System
The selectable filtering criteria available to our clients are based on our
listing of Internet content categories. We believe we have created the most
extensive and accurate database and range of Website categories of any Internet
filtering company. In our Website categorization process we employ a multi-step
procedure using automated search technology backed by human review to place
Internet content into 32 distinct categories. Automated search is used to scan
the Internet on a continuous basis to quickly identify Web sites that
potentially fit into these categories. We employ a wide variety of techniques
for this part of our automated categorization process including keyword search
and site associations and linkages. Many of the techniques we use in our
automated search are proprietary and were developed by us. Once a Web site has
been identified as fitting into one or more of our 32 categories, it is stored
in a database and prioritized for human review. Our categories and the material
they cover are summarized below:
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CATEGORY MATERIAL
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Adults Only................................... Material labeled by its author or publisher as
being strictly for adults, such as, "Adults
only" or "You must be 18 to visit this site."
Alcohol....................................... Advocates or promotes recreational use of
alcohol.
Chat.......................................... Chat sites or services that allow short
messages to be sent to others in real time.
Drugs......................................... Advocates or promotes recreational use of any
controlled substances. (See Illegal)
Employment Search............................. Job-hunting and related employment resources.
Free Mail..................................... Sites that offer free Web e-mail accounts that
can expose users to unsuitable content
delivered via e-mail file attachments.
Free Home Pages............................... Sites where home page space is offered for
free. Individual pages that have been reviewed
by N2H2 on such sites are removed from this
category but filed under other categories as
appropriate.
Gambling...................................... Gambling services or information relevant to
gambling.
Games......................................... Computer games and related information.
Hate/Discrimination........................... Advocates discrimination against others based
on race, religion, gender, nationality or
sexual orientation.
Illegal....................................... Advocates or promotes illegal activities such
as bomb making, fraud and computer hacking.
Jokes......................................... Jokes and humor.
Lingerie...................................... Models in lingerie, except those classified as
Nudity.
Message/Bulletin boards....................... Sites that permit semi-permanent messages to
be posted and read by others.
Murder/Suicide................................ Information on committing murder or suicide
and crime scene photos.
News.......................................... News and current events.
Nudity........................................ Naked or visible genitalia, buttocks, female
breasts, etc.
Personal Information.......................... Sites that gather personal information,
including name, address and credit card
number.
Personals..................................... Personal advertisements, including "mail order
brides."
Pornography................................... Material intended to be sexually arousing or
erotic.
Profanity..................................... Crude, vulgar or obscene language or gestures.
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CATEGORY MATERIAL
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Recreation/Entertainment...................... Recreation and entertainment information,
other than Games, Jokes or Sports.
School Cheating Information................... Any site that promotes plagiarism or similar
cheating among students.
Sex........................................... Images or descriptions of sexual activity,
sexual merchandise or sexual fetishism.
Sports........................................ Sports information, especially professional
sports.
Stocks........................................ Stock trading, stock quotes and stock market
information.
Swimsuits..................................... Models in swimwear including fashion swimwear
photos.
Tasteless/Gross............................... Bodily functions, tasteless humor, graphic
medical photos and others.
Tobacco....................................... Advocating or promoting recreational use of
tobacco.
Violence...................................... Graphic images or written descriptions of
wanton violence or grave injury, including
graphically violent games.
Weapons....................................... Information on use of weapons, weapon
collecting or weapon making.
Not Categorized............................... Material reviewed but not otherwise
categorized.
</TABLE>
In addition to these 32 categories, we allow for exceptions to our
categorizations to permit access to useful content that would otherwise be
filtered under another category including:
- educational material such as sex education and public health information
that may contain sex, nudity or violence,
- historically significant material that may contain sex or violence and
- medical information that may contain nudity.
Our customers have the flexibility to select which, if any, of the
exceptions to these categories they wish to enable.
Categorized sites are stored in a proprietary database located at our
headquarters. The contents of this database are continuously updated using both
human and automated review and reflect the introduction of new sites on the
Internet and changes to sites we previously categorized. Each day, our customers
receive electronically an encrypted copy of the Web site categorization
information stored in this database.
Tools for Filter Control and Reporting. We provide our clients with a broad
range of tools that they can use to control and modify their own filtering
criteria as well as to monitor the filtering activity on their networks. These
tools are accessed through a simple Web-based interface called the control
center. The control center is password protected and currently includes the
following features:
- Statistics reporting. Enables the system administrator to configure
filtering reports in single day, multiple day and historical formats.
Summary data can be displayed on Web pages, distributed by e-mail and
exported to Excel spreadsheets.
- Authorized users. Used to create special accounts for specific users that
need to temporarily turn off filtering at their workstations.
- Local URL customization. Allows the system administrator to block
specific universal record locators that are not categorized by our system
or to allow access to universal record locators that we have categorized.
- Request site review. Web-based e-mail form that customers can submit to
us to request review of a site for blocking or unblocking.
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- Cache administration. Allows the user to control the storage criteria for
content in the proxy server cache.
- Cache-on-demand. Enables the administrator to set caching parameters.
Information preloaded in the proxy server cache can be retrieved
significantly faster, particularly when the customer's network is under
heavy use.
- Filter schedules. Used to schedule the time of day that specified
filtering rules will be put into effect. For example, filter schedules
can be preset to block game sites only during school hours.
- Filter builder. Customers use this feature to set up their own filtering
rules. They can begin this process by starting with one of our predefined
sets of rules or templates such as "Bess for Schools" or "Bess for
Libraries" and then make modifications as necessary.
- IP control. Enables the customer to define which workstations on their
network will have access to the proxy server for filtered Internet
service.
In addition, in the home and Internet service provider market, parents have
a password-based override allowing them unfiltered Internet access at any time.
Our central servers maintain a log of Internet data retrieval requests and
the workstations that originated the request. However, this process does not
provide us with information about the identity of the individual originating the
request. In some instances, our clients may maintain information regarding the
identity of users on a particular workstation at a given time.
Searchopolis: Our Education Portal to the Internet
Searchopolis is our comprehensive education portal, which includes our
pioneering filtering search technology. It incorporates what we believe to be
the most valuable educational resources found on the Internet and combines with
them a number of other features that are important and interesting to middle and
high school students. The Internet represents a huge educational resource, but
it is disorganized and a user must often invest significant time to locate
relevant material. By assembling educational content in one place, making
searches fast and relevant and minimizing the need for adult supervision,
Searchopolis makes the Internet a more effective educational resource. We intend
to make Searchopolis attractive to middle and high school students, their
teachers and parents by providing extensive content and content arrangement
features as well as specialized communication services. We believe that as
students grow accustomed to using Searchopolis at school, they will also use it
more frequently at home and increasingly appreciate its many useful features.
Content and content management features. We operate Searchopolis in
conjunction with partners including Infospace, LookSmart, Merriam-Webster and
Inktomi that provide us with their proprietary content or content management
services under advertising revenue sharing agreements.
Educational content directory links. Searchopolis contains links to
thousands of sites categorized by class subject, including math, history,
science, literature, civics, health and business, among others. Numerous
subcategories allow the users to focus their research quickly. These links are
organized and provided by Looksmart.
Filtered search. Our filtering search technology is operated in conjunction
with Inktomi. This search tool prohibits the user from accessing a subset of our
database of categorized sites selected for school use. It also prevents
references to such sites, which often contain lurid descriptive words designed
to attract searches, from appearing on search result lists. Other search engines
include such references on search result lists even if access to the underlying
site is blocked by another filtering product or source.
Reference tools. Our reference tools include a dictionary provided by
Merriam-Webster, a calculator, a thesaurus, a spell checker, maps and yellow and
white page directories.
News, sports and weather. Up-to-date news, sports and weather information
is provided by InfoSpace.
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General interest categories. Searchopolis also provides users with
organized links to sites in numerous general categories of interest to K-12
students. These include such categories as automotive, finance, computers and
Internet, home and family, sports and recreation, travel and vacation, shopping,
hobbies and entertainment. Searchopolis also provides daily features such as
"today's TV," "today's birthday" and "site of the day."
Tools to promote communication and community. We are enhancing Searchopolis
to provide specialized tools that promote communication for teachers, students
and parents including:
- Access-controlled filtered e-mail. Our proprietary e-mail service for
K-12 students will provide a number of special features important to the
school environment. For instance, this service allows group sign-ups for
all students in a class or school, while providing filtering of content
for profanity and permitting the restriction of e-mail transmissions to
specified recipients. This service will give schools the ability to
provide varying levels of e-mail service to students of different ages.
For example, a school district might permit second graders to exchange
e-mail only with other second graders at the same school. Sixth graders
might be allowed to exchange e-mail with anyone at their school. Eleventh
graders might be allowed to send e-mail to anyone, including
non-students.
- School calendar. Our easy-to-use proprietary calendar will link schools,
teachers, students and parents in local communities.
- Virtual Locker. Students will be provided with their own Web-based
Virtual Locker in which they can store their favorite Internet sites and
homework for later access from home, the library or other locations
outside the classroom.
- GradeChecker. GradeChecker will serve as our Web-based service allowing
parents, teachers and students direct and timely Internet access to a
student's grades and other classroom information.
Searchopolis is available on the Internet to anyone at
www.searchopolis.com. Our objective is to make Searchopolis the most used
Internet portal for students and teachers. Given the large potential volume of
Internet traffic associated with K-12 students, we believe Searchopolis could
generate significant revenues from advertisers. We expect our education portal
to be a targeted, premium rate Internet channel, which we will use to attract
major corporate advertisers.
SERVICE FEES
Our customers generally sign a 12-month subscription contract for our Bess
service that enables them to receive daily downloads of our categorized database
and to use our filtering and caching services. Our service delivery model is
similar for schools, Internet service providers, libraries, businesses and other
customers. We also charge our customers an initial set-up or installation fee.
Both the set-up fee and the subscription rate depend upon the size and
complexity of the system installed and the expected volume of use. Subscriptions
have generally been renewed by our customers at the same price as the original
monthly subscription, without the installation charge. We believe we have a high
degree of customer satisfaction, which has resulted in an almost 100%
subscription renewal rate by our school customers during the several years that
we have offered Bess.
We have begun offering schools and libraries an important choice of
alternate fee structures effective for fall 1999, including the Bess Partner
Program which is an advertising-based alternative with reduced rates or at no
charge. Since schools and libraries have limited budgets, our advertising-based
fee structures will enable schools to use their limited funding to rapidly
increase the number of computer workstations in their classrooms. At the time of
subscription or renewal, customers may choose to continue to pay our
subscription fees or, alternatively, to pay reduced or no subscription fees for
our Bess filtering service in exchange for allowing education-appropriate
advertising and for using Searchopolis as their default search technology. We
believe many schools will choose to lower their subscription fees, which we
expect to result in accelerated market adoption of our filtering services. We
anticipate, but cannot guarantee, a substantial increase in new customers and
revenues from installations.
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While our subscription revenues can be expected to decrease significantly,
we anticipate that they will be replaced, if not exceeded, by advertising
revenues. Historically, percentage increases in our subscription revenues have
not kept pace with the increased use of our systems. Our current fees are
proportional to the number of workstations on the customer network, not the
volume of Internet traffic generated through those workstations. Our alternate
fee structures, if adopted by our customers, will allow our revenues to grow at
a rate that corresponds with the increased use of our services. We believe the
combination of our new services, our alternate fee structures, continuation of
federal matching funds programs and the increasing use of Internet-based
curriculum will drive increased use of our Internet filtering services in
schools.
OPERATING INFRASTRUCTURE AND SECURITY
N2H2's operating infrastructure has been designed and implemented to
support the control and maintenance of thousands of servers handling millions of
user requests per day. Our systems can be easily configured and expanded to
accommodate a wide range of bandwidth and other performance requirements. For
example, our systems are currently used by a number of small organizations with
less than 100 Internet users as well as large state or county school systems.
Our proxy servers use standard hardware that is easily obtained from
commercial sources and equipped with our proprietary software. Our proxy servers
are compatible with a broad range of network platforms including Microsoft, Sun,
IBM, Apple, Macintosh and Novell. Our filtering servers run on the Linux
operating system and use custom-developed filtering proxy server software.
Internal servers run on Linux, Sun Solaris and Microsoft NT operating systems
and use custom-developed software in addition to Apache, Microsoft SQL Server
and Sybase Adaptive Server Enterprise.
Key attributes of our operating infrastructure include the ability to
support customer growth as well as performance, security and service
requirements. We maintain most of our proxy servers on our customers' premises.
We also maintain some proxy servers in our Seattle data center, and Exodus
maintains additional servers for us at their location. We house all of our
critical infrastructure servers in our Seattle data center. Our operations are
dependent upon each location's ability to protect its systems against damage
from fire, earthquake, power loss, telecommunications failure or physical
break-ins. Exodus provides comprehensive facilities management services for some
of our centralized servers, including human and technical monitoring of proxy
servers 24 hours per day, seven days per week. Exodus' facility is powered by
multiple uninterruptible power supplies. Any disruption in the Internet access
provided by Exodus could seriously harm our business, results of operations and
financial condition.
All of the information required to duplicate a customer's filtering server
is stored in a database in our Seattle data center. We back up on a daily basis
any information in this database that may change on a server in the field. This
process allows us to reconstruct any data that is lost by a server in the event
of catastrophic failure or other disaster.
Our internal servers are protected behind firewalls for security purposes
and do not allow outside access at the operating system level except via special
secure channels. Access to our remote servers requires a connection originating
from one of two servers in our data center which must be accompanied by a 1024
bit encryption key. Our servers use a highly secure operating system that is
difficult to override or bypass. Our security personnel follow CERT, BugTraq and
other security-related forums closely to ensure that any new threats are
identified and dealt with immediately. However, we cannot provide any assurance
that our operating infrastructure will not be affected by computer viruses,
electronic break-ins or other similar disruptions.
CUSTOMERS
We provide filtering services to a customer base that includes the
following:
Schools. Our school customers range from single schools to statewide
systems. Customers with thousands of workstations and multiple N2H2 servers
include Macomb School District in Michigan, Merrimack Education Center in the
Boston area, statewide networks for Ohio, Tennessee, Maine, Oklahoma
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and Wisconsin, plus Calgary and the Dufferin-Peel Roman Catholic school systems
in Canada. Over 8.5 million students in approximately 8,750 schools now use
Bess. Our customers are located in 47 states, Canada, Australia, United Kingdom,
Germany, Chile, Mexico, India and Bermuda. In the Quarter ending September 30,
1999, our customers used our filtering servers to receive approximately 1
billion Internet page views.
Homes. We currently provide our filtering services to homes through
approximately 210 Internet service providers. To date, over 200,000 homes have
elected to use our services. We recently entered the home market and we believe
our services will be used in more homes in the future. The charge for our
filtering service is typically added to the customer's monthly bill from its
Internet service provider. Internet service providers may also serve as
re-sellers of our services to small businesses and schools.
Affinity Groups. We provide our core technology for filtering, filtered
search and portal development to affinity groups, including the Mormon Church.
Affinity groups purchase our filtering services for their own members. They also
purchase from us filtered search services to include on their own affinity group
portal.
Corporate and International. Corporate and international customers are a
small but growing part of our customer base. We provide services to customers in
Canada, Australia, the United Kingdom, Germany, Chile, India, Mexico and
Bermuda. As corporate managers become increasingly concerned about productivity
and liability issues related to employee Internet usage, we believe the
corporate market will present us with significant opportunities.
SALES AND MARKETING
Organization
Our sales activities, which are now organized into three divisions, with
each consisting of sales representatives, marketing, product management and
support staff. These divisions are focused on the education, enterprise and
consumer markets worldwide.
- Education Division. The education group is our largest and is divided
into three areas, each focusing on customers of particular sizes and
needs.
- Our "key accounts" group focuses on sales of all our services to the
large educational service districts or statewide school networks.
- Our mid-tier education sales group sells our filtering and caching proxy
services, rating list subscriptions and search services to larger
schools and educational service districts that operate their own
networks, generally serving between 200 and 10,000 workstations.
- Finally, our small customer sales team sells our cache, filter and
search services on a redirect basis to smaller schools, educational
service districts and libraries that have anywhere from one to 200
workstations.
- Consumer Division. Our Internet service provider sales team concentrates
on selling our filtering and caching proxy servers, rating list
subscriptions and filtering search technology to regional and larger
Internet service providers throughout the world. We have senior sales
representatives dedicated to developing relationships with key national
and international Internet service providers and to virtual ISP groups.
- Enterprise Division. We have senior sales representatives dedicated to
developing sales in the corporate and international markets directly and
indirectly through our partnerships with major technology and marketing
companies. We anticipate increased demand for our services and products
as we expand our strategic alliances both domestically and abroad.
Advertising Sales
Although we have only recently begun receiving advertising revenues, we are
aggressively pursuing relationships with advertisers trying to reach K-12
students, particularly those in the 10-year to 18-year age
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group. This group, which constitutes the younger part of the 10 to 24 year old
age group known in the advertising industry as "Generation Y", has become the
subject of increasing focus among advertisers. It has been estimated that
Generation Y represents more than $150 billion in disposable income in the
United States annually. We believe that a higher percentage of people in this
age group have been introduced to computers at an earlier age than any previous
generation.
Internet advertising is now typically conducted through the use of
"click-through" advertising banners, by which users can access more information
about an advertised product or service by clicking on the banner. Contracts for
banner advertising are typically short-term in nature, and revenues are based
upon the number of page views, referred to as user impressions. This makes it
difficult to forecast revenues under Internet advertising contracts. We plan to
address this uncertainty by entering into long-term "sponsorship" arrangements
with advertisers that would call for a fixed fee for a specified time period.
We recently began receiving advertising-based revenue through 24/7 Media,
our advertising partner, and we plan to expand this relationship. These efforts
are intended to increase our visibility in the advertising and corporate
communities and to help us gain access to those individuals at major
corporations with decision-making authority over advertising expenditures. Our
advertising revenues from 24/7 Media are generated based on the number of
advertising impressions made on the Bess Partner Program traffic and on
Searchopolis.
Current sponsor sales include Nickelodeon, Toshiba and the Office of
National Drug Control Policy.
We are committed to ensure that the advertising offered is appropriate for
the education market.
Marketing
We advertise and market Bess, Searchopolis and our other services through a
variety of activities, including:
- Trade shows. We have increased our visibility at major educational
technology events in 1999, including those held in Atlantic City,
Orlando, Austin, Seattle and Baltimore. Management believes that trade
shows have historically generated significant sales leads.
- Print advertising. We will continue to maintain a steady presence in key
education technology journals, including eSchool News, Curriculum
Administrator and Technology & Learning. We believe that these
publications are regularly reviewed nationwide by education
administrators responsible for technology budgets and spending decisions.
- Direct mail. We regularly contact school administrators through direct
mail, such as sending product brochures to 13,000 education technology
specialists throughout the country.
- Online marketing. Our Website, www.n2h2.com, provides information about
our services, facilitates communication with our current and potential
customers and will provide links to Websites of our strategic partners.
In addition, we include links to Searchopolis in our Bess filtering
services.
We also market to and generate Searchopolis traffic from customers through:
- a link located on the tool bar appearing at the bottom of each page
viewed through Bess and
- requests for Web sites which are blocked by Bess return the user directly
to Searchopolis.
STRATEGIC RELATIONSHIPS
We have developed and intend to continue to develop strategic relationships
to offer services and products to a larger customer base than can be reached
through our direct sales efforts. We have a strategic relationship with Inktomi
for the operation of our filtering search technology. Under a Search Engine
Services Agreement, Inktomi provides us with search engine services that,
combined with our filtering technology and database of categorized Web sites,
form the basis of our filtering search technology. This agreement has a
three-year term
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and is terminable only upon a material breach of either party which is not
uncured within thirty days or in the event either party becomes insolvent or
bankrupt.
In addition, we also have strategic content and marketing relationships
with other companies, including Looksmart, WinStar Communications, Fortres Grand
and Netwave Technologies. Our agreements with Looksmart and InfoSpace have been
instrumental in assisting us in the assembly and presentation of educational
content through Searchopolis. We collaborate with a number of companies, such as
WinStar Communications and Fortres Grand Corporation, to make our Internet
filtering services available to an expanding customer base through redirect
arrangements. In other relationships, we provide filtering and caching services
to Internet browsers, such as NetWave's children's browser. Our plans for
increasing our corporate and international presence depend on our success in
establishing additional strategic relationships.
CUSTOMER SERVICE AND SUPPORT
We believe our high customer retention rate is evidence of our excellent
reputation for customer service. We respond to approximately 1,200 e-mails each
school day from our customers through a staff of reviewers dedicated solely to
that purpose. While some are from wishful students with requests such as "Please
unblock Playboy.com!", most provide useful feedback that helps us refine the
accuracy and relevance of our categorization determinations.
COMPETITION
We face a large number of competitors in the Internet filtering industry.
Some of the competing products, including NetNanny, SurfWatch and CyberPatrol,
are primarily client-based products that are sold directly to the end user.
While we believe that our comprehensive filtering services provide a solution
superior to these products, these products have generated significant name
recognition among parents and represent a significant competitive force in the
residential marketplace.
In addition, we have competitors that feature proxy server-based filtering
solutions using technology similar to ours, such as WebSENSE, Logon Data
Corporation's X-Stop and Unified Research Laboratories, Inc.'s I-Gear. We
believe, however, that none of these products is backed with the same level of
customer support and services as ours and that their filtering is accomplished
with less precision than ours.
Searchopolis, we believe, will represent the first widely available
integrated educational Web portal targeting K-12 students, and our alternate fee
structures will give schools the choice of paying our recurring subscriber fees
or receiving our subscription-based service at reduced rates or without charge
in exchange for allowing us to sell sponsorship rights to advertisers. We
believe these alternate fee structures should give us a significant competitive
advantage. However, a competitor with greater financial and human resources than
ours could introduce a competing product to the same market fairly quickly.
Accordingly, a significant component of our strategy will be to penetrate this
market rapidly, before competing products are able to gain significant market
share, name recognition or credibility. In particular, our potential competitors
include Web retrieval and other Web portal companies such as Excite, Infoseek,
Lycos, Yahoo! and Netscape, as well as Web sites targeted to educational and
family-oriented interests such as Disney.com and AOL.com.
INTELLECTUAL PROPERTY
Intellectual property is critical to our success, and we rely upon
trademark, copyright and trade secret laws in the United States and other
jurisdictions to protect our proprietary technology and brands. N2H2 and Bess
are registered United States trademarks. We have also applied to register
Searchopolis and Virtual Locker as trademarks. These trademark applications may
not be granted. In addition, any of our trademarks may be challenged by others
or invalidated through administrative process or litigation. None of our
technology is patented. Our proprietary search technology is protected by United
States trade secret and copyright law. We own and operate the servers that
provide our filtering services. We protect our proprietary rights through the
use of intellectual property agreements with employees and consultants which
cover confidentiality, nondisclosure and assignment of invention matters. Some
of our former employees and consultants who may have had access to our
proprietary information have not entered into these intellectual
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property agreements, although we believe that all intellectual property that is
material to our business is covered by signed agreements. If we are wrong in
this assessment, our business could be seriously harmed.
Trademark, copyright and trade secret protection may not be available to us
in every country in which our services are available. The laws of some foreign
countries may not be as protective of intellectual property rights as United
States laws, and mechanisms for enforcement of intellectual property rights may
be inadequate. Despite our efforts to protect our proprietary rights,
unauthorized parties may attempt to obtain, copy and use our proprietary
technology.
REGULATORY AND LEGISLATIVE ISSUES
As use of the Internet has become more prevalent and various negative
issues associated with the Internet have received increasing amounts of
publicity, there has been a correspondingly greater amount of governmental
attention directed to the Internet in the United States Congress and elsewhere.
While various pieces of legislation regulating different aspects of the Internet
and Internet-related activity have been proposed, to date there has been no
legislation enacted which places any direct and substantial regulatory burden on
N2H2. Nonetheless, we anticipate further attempts to regulate Internet-related
activity, some of which may impose substantial burdens on our ability to do
business.
We have never been party to a lawsuit regarding users acquiring
inappropriate content through our system. Management believes this is unlikely
in the future, partly because of the protections provided under Section 509 of
the Telecommunications Act of 1996 for organizations that provide filtering
tools or employ them. Our customer contracts do not provide for a guaranteed
level of filtering performance, and we do not intend to offer guarantees in the
future.
The United States Congress recently enacted the Children's Online Privacy
Protection Act of 1998. The principal provisions of the law become effective on
the later of (1) April 21, 2000, and (2) the date on which the Federal Trade
Commission issues a first ruling on applications for safe harbor treatment under
the Act if the Commission does not rule on the first such application by October
21, 1999, but in no case later than April 21, 2001. This act generally:
- makes it unlawful for an operator of a Web site or online service
directed to children under age 13, and any operator that has actual
knowledge that it is collecting personal information from such a child,
to collect personal information from the child without having obtained
verifiable parental consent and
- prohibits conditioning the participation of a child under age 13 in a
game, the offering of a prize or another activity on the child disclosing
more personal information than is reasonably necessary to participate in
such activity.
We do not believe that this Act will have a significant impact on our
business.
EMPLOYEES
As of September 30, 1999, we employed 179 full time equivalent staff. As
necessary, we supplement our regular employees with temporary and contract
personnel.
RISK FACTORS
You should carefully consider the following risk factors and all other
information contained in this Form 10-K before purchasing our common stock.
Investing in our common stock involves a high degree of risk. The risks
described below are not the only ones that we may face. Additional risks that
are not yet identified or that we currently think are immaterial may materially
adversely affect our business and financial condition in the future. Any of the
following risks could seriously harm our business, financial condition and
operating results and could result in a complete loss of your investment.
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WE HAVE A LIMITED OPERATING HISTORY AND A HISTORY OF LOSSES.
We have a limited operating history. Risks and uncertainties inherent in an
investment in N2H2 include, but are not limited to the following:
- we are an Internet company in the early stages of development,
- our limited history makes evaluation of our prospects difficult,
- our market is rapidly evolving and highly competitive and
- we have incurred net losses in each quarter since we incorporated in
1995.
We incurred net losses of $881,000 for 1997, $2.6 million for 1998 and $7.7
million for 1999. We anticipate that we will continue to incur net losses for
the foreseeable future.
WE INTEND TO SUBSTANTIALLY INCREASE OUR OPERATING EXPENSES, AND OUR FUTURE
OPERATING RESULTS ARE UNCERTAIN.
We intend to incur increased operating expenses before we receive any
revenues from these expenses. Increased operating expenses in 2000 and beyond
will include:
- sales and marketing costs, including expanding our direct sales force and
further developing our advertising sales force, indirect sales channels
and international sales presence,
- research and development costs, primarily through the hiring of
additional engineers and other technical staff,
- increased depreciation expenses related to installing additional servers
in customers' networks,
- increased depreciation expenses for equipment supporting Searchopolis and
Searchopolis communication tools,
- expanding our customer support and service operations.
We will need to significantly increase our revenues to achieve and maintain
profitability. Although our revenues have grown in recent quarters, we may not
be able to continue this growth or achieve or maintain profitability. We may
also fail to accurately estimate and assess increased operating expense
requirements as we grow. If we fail to achieve and maintain profitability, our
future capital raising efforts and planned growth of our business would be
seriously harmed.
WE OFFER SCHOOLS ALTERNATE FEE STRUCTURES, AND OUR FUTURE REVENUES FROM THESE
FEES ARE UNCERTAIN.
We have launched a new, untested, advertising based, fee structure. Our
alternate fee structure for school customers will reduce or eliminate
subscription fees, which have traditionally represented a significant portion of
our revenues. We have had limited advertising revenues to date, and we cannot
assure you that customers will accept our alternate fee structure. Even if they
accept the alternate fee structure, we cannot assure you that we will receive
enough advertising revenues to make up for lost subscription fees. At present we
do not have any contracts in place directly with advertisers.
Up to now, we have derived substantially all of our revenues through a
combination of subscription and installation fees for our filtering services.
Our subscription revenues were $548,000 for 1997, $1.7 million for 1998 and $3.8
million for 1999 and our installation revenues were $570,000 for 1997, $1.4
million for 1998 and $1.85 million for 1999. As a percentage of total revenues,
subscription revenues represented 49% for 1997 56% for 1998 and 60% for 1999.
THE MARKET FOR INTERNET ADVERTISING IS UNCERTAIN.
We expect to obtain a substantial amount of our revenues from Internet
advertising for the foreseeable future, but the demand and market acceptance for
Internet advertising are uncertain. No accepted standard currently exists to
measure the effectiveness of Internet advertising. Standard measurements may
need to be
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developed to support and promote the Internet as a significant advertising
medium. Also, a number of different pricing methods are used to sell advertising
on the Internet. We cannot predict which of those pricing methods, if any, will
emerge as the industry standard. Typically, Internet advertising is conducted
through the use of "click-through" advertising banners. Recent studies indicate
that click-through rates have declined over the past year. Future revenues and
the growth of our business will be seriously harmed if the market for Internet
advertising develops more slowly than expected or we are unable to adapt to new
forms of Internet advertising.
WE ARE UNABLE TO PREDICT OUR ADVERTISING REVENUES.
We have received insignificant advertising revenues to date and cannot
predict our future advertising revenues. We expect our Internet advertising
revenues will fluctuate significantly in the future as a result of a variety of
factors, many of which are outside our control. If we fail to obtain advertising
or sponsorship contracts, or if our contracts are cancelled or renewed at lower
rates, our business, financial condition and operating results will be seriously
harmed. These factors include:
- our ability to provide content attractive to our target audiences,
- the development of our brand,
- the level of user traffic on Bess and Searchopolis,
- demand for Internet advertising,
- the use of Internet advertising blocking software by customers and end
users,
- our ability to attract and retain advertisers,
- the mix of types of advertising we sell and
- the timing of initial set-up, engineering or development fees that may be
paid in connection with larger advertising arrangements.
ADVERTISING IN SCHOOLS IS CONTROVERSIAL.
Advertising in schools is controversial and may generate negative publicity
toward us and our sponsors. Some parents, teachers and public officials believe
that advertisements in schools compromise the integrity of the educational
environment. They argue that advertisements distract from learning and that
classroom audiences are overly susceptible to marketing and advertising
campaigns. We screen the advertisements generated through our contract with 24/7
Media which appear on Bess and Searchopolis in order to limit credit card and
other types of advertising which we believe are inappropriate for classrooms.
However, there can be no guarantee that we will succeed in preventing access to
undesirable advertisements. For example, we cannot screen advertisements
contained within Web pages retrieved through Bess or Searchopolis. The
appearance of controversial advertisements through our services may diminish
sponsors' interest in advertising with N2H2 and may result in significant
negative publicity toward us among parents, teachers and students.
Our alternate fee structure for schools is based upon offering schools the
choice between paying our current subscription fees or receiving our services at
reduced rates or without charge in exchange for allowing us to display
advertisements. It is possible that parents, teachers, students or the public at
large will object to Internet advertising. If they do, the resulting negative
publicity could limit our ability to offer advertising-based pricing in the
future, which would seriously limit the growth of our business and harm our
financial condition and results of operations.
OUR EXPANSION INTO THE WEB PORTAL MARKET INVOLVES A NUMBER OF RISKS.
Our future revenue growth is greatly dependent upon the success and market
acceptance of our current development efforts to enhance Searchopolis and our
ability to derive advertising or other revenue from Searchopolis. In addition,
we plan to market our enhanced version of Searchopolis to our existing and
potential filtering service customers. Existing and potential customers may not
use Searchopolis for a number
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of reasons, including an absence of desired capabilities or content or the
failure of Searchopolis to be competitive with other Internet searching
services. Also, we must overcome significant obstacles in our expansion into the
Web portal market, including:
- competitors such as Yahoo! Inc., America Online, Inc., Netscape
Communications Corporation, Lycos, Inc., Excite, Inc., Wired Digital,
Inc. (HotBot), Infoseek Corporation and others that have more experience,
better name recognition and greater resources,
- the limited experience of our sales personnel in the Web portal market
and
- our limited experience in obtaining revenues from developing and
marketing Internet filtering search technology.
OUR QUARTERLY FINANCIAL RESULTS FLUCTUATE AND MAY BE AFFECTED BY SEASONAL
VARIATIONS.
Our quarterly operating results have fluctuated significantly in the past
and will continue to fluctuate in the future. Operating results vary depending
on a number of factors, many of which are outside our control, including:
- our educational services customers typically budget and purchase goods
and services on a fiscal school year basis beginning in August of each
year,
- user traffic on our school customer systems has historically been lower
during the summer and during year end vacation and holiday periods, and
advertising revenues may be less during these periods,
- we typically receive subscription payments in advance of the costs
directly associated with delivery of monthly services over the term of
the 12 month contract, making it difficult to associate costs with cash
flows,
- quarterly cash flows from subscription payments are difficult to forecast
because the sales cycle, from initial evaluation to delivery of the
services, varies substantially between customers and
- as we expand our sales force, professional services personnel and
research and development staff, our operating expenses will continue to
rise.
Due to the combination of these and other factors, quarter to quarter
comparisons of operating results are not meaningful or indicative of future
performance. Further, it is possible that in some future quarter or quarters our
operating results will not meet or exceed the expectations of public market
analysts or investors. If that happens, or if adverse conditions prevail or are
perceived to prevail, either for our business or the market generally, the
market price of our common stock would be seriously harmed.
OUR SUCCESS DEPENDS ON CONTINUED MARKET ACCEPTANCE AND OPERATION OF OUR INTERNET
FILTERING SERVICES.
If we are unable to continue to solve our customers' Internet content
filtering problems, we will experience diminished revenues and the growth of our
business will be impaired. We currently receive, and expect to continue to
receive, a substantial portion of our revenues from our Internet filtering
services. Our future financial performance will depend, in part, upon the
successful development, introduction and customer acceptance of new and enhanced
versions of our Internet filtering services. We cannot assure you that we will
be successful in upgrading and continuing to sell our Internet filtering
services or that any new products or services that we may develop or acquire
will achieve market acceptance. Any failure to upgrade our services or products
or to maintain our market acceptance could seriously harm our business,
financial condition and results of operations.
OUR FILTERING CATEGORIZATIONS ARE SUBJECTIVE, AND WE MAY FAIL TO FILTER ALL
POTENTIALLY OBJECTIONABLE CONTENT.
We may not succeed in sufficiently filtering Internet content to meet our
customers' expectations. We rely upon a combination of automated filtering
technology and human review to categorize Web site content through our Bess
filtering services and on Searchopolis, our filtered Web portal. The total
number of Web sites
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and partial Web sites is growing rapidly. A partial Web site is a graphic image,
text or other visual appearing as a part of a full Webscreen display. We rely
upon our staff of reviewers to place Internet content into our 32 content
categories. We cannot assure you that our filtering technologies will
successfully block all potentially objectionable Internet content. Our
categorized database also may not contain substantially all of the material
available on the Internet fitting into any one of our content categories. In
addition, our customers may not agree with our categorization determinations.
Our failure to effectively categorize and filter Internet content according to
our customers' expectations would generate negative publicity which would impair
the growth of our business and our efforts to increase brand awareness.
OUR ABILITY TO MANAGE GROWTH IS UNPROVEN.
Our growth is likely to continue to place a significant strain on our
managerial, operational, financial and other resources. Our future success will
depend, in part, upon the ability of our senior management to manage growth
effectively. This will require us to:
- implement additional management information systems,
- develop further our operating, administrative, financial and accounting
systems and controls,
- hire additional personnel and
- locate additional office space in the United States and internationally.
WE MAY FAIL TO COMPETE SUCCESSFULLY WITH OTHER PROVIDERS OF INTERNET FILTERING
SERVICES.
The market for our services and products is intensely competitive and
rapidly changing. Many of our competitors are larger and have substantially
greater resources than us. Our primary competition comes from keyword, Universal
Resource Locator and packet filtering software applications. These products are
significantly less expensive than our filtering services and can often be
downloaded for free over the Internet.
We compete directly with a number of Internet content management firms,
including publishers and distributors of traditional media and general purpose
consumer online services such as America Online and Microsoft Network. Although
we believe the Internet provides opportunities for more than one provider of
content filtering services similar to ours, one or more of our competitors may
eventually dominate the sector. Further, we have only recently begun to provide
these services, and competitors' products and services may achieve greater
market acceptance than ours.
We also compete for users and advertisers with virtually all Web sites. Our
competitors for users and advertisers include:
- Web retrieval and other Web portal companies, such as Excite, Infoseek,
Lycos, Yahoo! and Netscape and
- Web sites such as Disney.com, AOL.com and others that provide education
and family oriented content.
We also compete with television, radio, cable and print media for a share
of total advertising budgets.
Increased competition could result in price reductions, reduced
profitability, or loss of market share, any of which would seriously harm our
business, financial condition and results of operations.
WE WILL NEED TO ESTABLISH AND MAINTAIN STRATEGIC RELATIONSHIPS.
We depend on strategic relationships to offer services and products to a
larger customer base than can be reached through our direct sales efforts. We
have a strategic relationship with Inktomi for operating our filtering search
technology. We also have other strategic content and marketing relationships
with companies, including Looksmart Ltd., WinStar Communications, Inc., Fortres
Grand Corporation and Netwave Technologies, Inc. Our plans for developing our
international business rely on additional strategic relationships. We
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<PAGE> 21
cannot assure you that we will be able to maintain and expand our strategic
relationships or enter into new strategic relationships or that these new
relationships will be on commercially reasonable terms.
If we are unable to maintain and expand our existing strategic
relationships or enter into new strategic relationships, we will need to use
substantially more resources to develop, distribute, sell and market our
services and products than planned. We would also lose the customer
introductions and co-marketing benefits that we anticipate from such strategic
relationships. Our success will depend both on the success of the other parties
to these relationships and on their ability to market our services and products
successfully. Most of these companies have multiple strategic relationships, and
we cannot assure you that they will regard their relationships with us as
significant for their own businesses. If any of these firms fail to effectively
promote our services or products, our business, financial condition and results
of operations will be seriously harmed through decreased growth opportunities.
WE ARE DEPENDENT ON KEY INDIVIDUALS WHO MAY BE SUBJECT TO CONFLICTING DEMANDS.
Our success depends on the performance of our senior management, including
Peter H. Nickerson, our President, Chief Executive Officer and Chairman of the
Board, David Arnold, Vice President and Chief Operating Officer, John Duncan,
Vice President and Chief Financial Officer and Kevin E. Fink, our Chief
Technology Officer. We have entered into employment agreements with members of
senior management of various terms. Mr. Nickerson is also a principal of
Nickerson & Associates, an econometric and data management consulting company,
and he performs consulting services for that firm that could impose conflicting
demands on his time.
OUR SUCCESS DEPENDS ON OUR ABILITY TO ATTRACT AND RETAIN QUALIFIED AND
EXPERIENCED EMPLOYEES.
We face a significant risk from a loss of any member of our senior
management team or any key employee, particularly if they join or form a
competitor. These risks relate mainly to:
- the loss of such individual's skills and talent,
- the resulting loss of existing or potential customers or
- the unauthorized disclosure or use of our technical knowledge, practices,
procedures or customer lists.
Loss of a key employee could seriously harm our business, financial
condition and results of operations. We cannot assure you that in such an event
we would be able to recruit personnel to replace our senior management in a
timely manner and on acceptable terms.
We expect there will continue to be competition for experienced
engineering, sales and consulting personnel, particularly in the Internet
market. Many of the companies we compete against for experienced personnel have
greater resources than us. Competition in the Seattle area for these personnel
is particularly intense, and we cannot assure you that we will be successful in
attracting and retaining qualified personnel. As a result, our growth could be
limited due to our lack of capacity to provide our services. We could also
experience deterioration in service levels or decreased customer satisfaction.
Either of these occurrences would seriously harm our business, financial
condition and results of operations through increased costs of doing business
and decreased demand for our services.
EXPANDING OUR INTERNATIONAL OPERATIONS EXPOSES US TO A NUMBER OF RISKS.
We currently have very limited international operations. Our installation
and subscription revenues from customers outside the United States, primarily in
the United Kingdom and Canada, represented approximately $84,000 in the fiscal
year ended September 30, 1998, and $158,125 for the year ended September 30,
1999. As a key component of our business strategy, we intend to expand our
international sales and support operations, and for that purpose we hired a
European operations director in June 1999 and created N2H2
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<PAGE> 22
Limited, a wholly-owned subsidiary formed under the laws of the United Kingdom,
in August 1999. Our ability to expand our international operations is subject to
a number of risks, including:
- our ability to customize services for local markets and foreign
languages,
- laws and business practices favoring local competitors,
- our dependence on local staff and vendors,
- compliance with multiple, conflicting and changing governmental laws and
regulations, including tax laws and regulations,
- longer sales cycles,
- possible delays or greater difficulty in accounts receivable collection,
- import and export restrictions and tariffs and
- uncertainties regarding transactions in foreign currencies.
Currently, we do not engage in or intend to engage in hedging. If we are
unable to successfully manage the risks associated with our international
operations, our international sales growth will be limited and our results of
operations will be seriously harmed.
OUR SERVICES MAY HAVE LIMITED INTEROPERABILITY AND MAY NOT KEEP PACE WITH RAPID
TECHNOLOGICAL CHANGES.
We may fail to develop filtering services compatible with future operating
systems, and we may not keep pace with technological advances. Our Internet
services are designed to operate with a variety of hardware and software used by
our customers. Our school customers may use older operating systems, however,
requiring us to maintain multiple service platforms at increased cost to us. In
addition, we must continuously modify and enhance our services to keep pace with
changes in hardware, software, communication, browser and database technology.
Uncertainties about the timing and nature of vendors' new product announcements
or their introduction or modification of operating systems would require
increased research and development expenses. The failure of our services to
operate effectively across existing and future versions of hardware and software
used by customers would limit or reduce the market for our services, result in
customer dissatisfaction and seriously harm our business, financial condition
and results of operations.
WE HAVE LIMITED PROTECTION OF OUR INTELLECTUAL PROPERTY AND PROPRIETARY
TECHNOLOGY.
We may fail to adequately protect our intellectual property and proprietary
technology. Intellectual property is critical to our success, and we rely upon
trademark, copyright and trade secret laws in the United States and other
jurisdictions to protect our proprietary technology and brands. N2H2 and Bess
are registered United States trademarks. We have also applied to register
Searchopolis and Virtual Locker as trademarks. These trademark applications may
not be granted. In addition, any of our trademarks may be challenged by others
or invalidated through administrative process or litigation. None of our
technology is patented. Our proprietary search technology is protected by United
States trade secret and copyright laws. We own and operate the servers that
provide our filtering services. We protect our proprietary rights through the
use of intellectual property agreements with employees and consultants covering
confidentiality, nondisclosure and assignment of invention matters. Some of our
former employees and consultants who may have had access to our proprietary
information have not entered into these intellectual property agreements,
although we believe that all intellectual property that is material to our
business is covered by signed agreements. If we are wrong in this assessment,
former employees could use our proprietary technology without our having an
effective remedy, and our business would be seriously damaged.
WE ARE SUBJECT TO RISKS OF INFRINGEMENT.
Trademark, copyright and trade secret protection may not be available to us
in every country in which our services are available. The laws of some foreign
countries may not be as protective of intellectual property
22
<PAGE> 23
rights as United States laws, and mechanisms for enforcement of intellectual
property rights may be inadequate. Despite our efforts to protect our
proprietary rights, unauthorized parties may obtain, copy and use our
proprietary technology. We expect that it will become more difficult to monitor
use of our services as we increase our international presence. We cannot assure
you that our means of protecting our proprietary technology and brands will be
adequate or that our competitors will not independently develop similar
technology.
WE ARE INVOLVED IN INTELLECTUAL PROPERTY DISPUTES AND CANNOT PREDICT THE
LIKELIHOOD OR IMPACT OF AN UNFAVORABLE OUTCOME.
We are a defendant in a lawsuit filed in California. The lawsuit, filed by
Spyglass, Inc. in June 1999, alleges patent infringement claims. We expect that
as competition in the market for Internet filtering increases and as the number
of patents continues to increase, the potential for intellectual property claims
against us will also increase. Prolonged litigation against us concerning
alleged infringement would likely result in significant expense to us and divert
the efforts of our management and development personnel, even if we are
successful in that litigation. In the event of an adverse result, we could be
required to do one or more of the following:
- pay substantial damages, including treble damages,
- permanently cease use of any infringing technology,
- obtain a license for the technology or expend significant resources to
develop noninfringing technology and
- attempt to redesign our filtering services to avoid the infringement or
to develop noninfringing technology.
Any limitation on our ability to market our services or products or any
incurrence of substantial costs and delays associated with redesigning our
services or products would seriously harm our business, financial condition and
results of operations.
THE YEAR 2000 MAY RESULT IN UNEXPECTED COMPUTER PROBLEMS.
We may face exposure and risk if the systems on which we depend to conduct
our operations are not year 2000 compliant. The principal year 2000 risks we
face include:
- a failure of the systems we use to run our business,
- a failure of systems and products used by our vendors or
- an extensive breakdown of the Internet and related loss of Internet
traffic due to telecommunications, energy or other infrastructure
failure.
A failure in any of these areas could temporarily shut down our operations
and seriously harm our business.
OUR SERVICES CREATE RISKS OF POTENTIAL NEGATIVE PUBLICITY AND LEGAL LIABILITY.
Because customers rely on our services for providing a content safe
Internet environment, any significant defects or errors in our services or
products may result in negative publicity or legal claims. This negative
publicity or any of these legal claims could seriously harm our business,
financial condition and results of operations. In addition, our ability to
maintain a log of Internet data retrieval requests and the workstations from
which they originated may result in negative publicity or claims based on
potential privacy violations. Although our agreements with customers typically
contain provisions designed to limit our exposure to potential legal liability,
these limitation of liability provisions may not be completely effective. We
have not experienced any liability claims to date, but we cannot assure you that
we will not face this type of claim in the future. We maintain errors and
omissions insurance, but we cannot assure you that this insurance coverage will
adequately cover us for any claims.
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<PAGE> 24
OUR SYSTEMS MAY BE VULNERABLE TO SECURITY RISKS OR SERVICE DISRUPTIONS THAT
COULD HARM OUR BUSINESS.
Our servers are vulnerable to physical or electronic break-ins and service
disruptions, which could lead to interruptions, delays, loss of data or the
inability to process user requests. Such events could be very expensive to
remedy and could damage our reputation, discouraging existing and potential
customers from using our services. In the past we have experienced unsuccessful
attempts at electronic break-ins but we may experience break-ins in the future.
Any such events could substantially harm our business, financial condition and
results of operations.
In August 1998, we entered into an Internet hosting agreement with Exodus
Communications, Inc., which will maintain some of our servers through August
1999, with automatic one year renewals. Our operations depend on Exodus's
ability to protect our systems against damage from fire, earthquake, power loss,
flood, telecommunications failures, vandalism and other malicious acts and
similar unexpected adverse events. Any major disruption in our services could
diminish revenues, decrease customer and user confidence in our services and
stunt the growth of our business.
WE MAY NOT BE ABLE TO DISTRIBUTE OUR SERVICES ABROAD DUE TO UNITED STATES EXPORT
LAWS.
The encryption technology contained in our services and products is subject
to United States export controls. Such export controls limit our ability to
distribute certain encrypted services and products outside of the United States.
While we take precautions against unlawful exportation, such exportation
inadvertently may have occurred in the past or may occur from time to time in
the future, subjecting us to potential liability. Future legislation or
regulation may further limit the use of encryption technology that we can
include in our services and products. In addition, foreign governments have
import and domestic use laws and regulations that restrict the types of
permitted encryption software distributed in their countries. Such regulations
could alter the design, production, distribution and use of our services and
products.
THE FUTURE ROLE OF THE INTERNET IN EDUCATION IS UNCERTAIN.
The success of our services and products will depend, in large part, on the
continued broad use and acceptance of the Internet as a source of information.
Schools, teachers and parents may cease to consider the Internet a viable
research tool due to concerns over the potential exposure of students to
unsuitable material, even with filtering services such as ours, or because of
inadequate development of telecommunications and networking systems. The
Internet could lose its viability due to delays in the development or adoption
of new standards and protocols to handle increased levels of Internet activity
or due to increased governmental regulation. Cutbacks in technology funding
could also limit use of the Internet in schools. If the necessary Internet
infrastructure and complementary products are not developed on a timely basis,
or if school use of the Internet experiences a significant decline, we may not
be successful in growing our business and our financial condition and results of
operations would be seriously harmed.
GOVERNMENT REGULATION AND LEGAL UNCERTAINTIES COULD ADD ADDITIONAL COSTS TO
DOING BUSINESS ON THE INTERNET.
Currently, few laws or regulations specifically govern communications or
commerce on the Internet. Laws and regulations may be adopted in the future
regarding user privacy, pricing and the characteristics and quality of products
and services. For example, the Telecommunications Act of 1996 sought to prohibit
transmitting various types of information and content over the Internet. Several
telecommunications companies have petitioned the Federal Communications
Commission to regulate Internet service providers and online service providers
in a manner similar to long distance telephone carriers and to impose access
fees on those companies. This could increase the cost of transmitting data over
the Internet.
WE MAY BE SUED FOR INFORMATION RETRIEVED FROM THE WEB.
We may be subject to claims relating to information available on our Web
site. These types of claims have been brought, sometimes successfully, against
online services. We could also be subject to claims based upon the content that
is accessible from our Web sites through links to other Web sites or through
content and
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<PAGE> 25
materials that may be posted by members in chat rooms or bulletin boards. We
also offer e-mail services, which may subject us to liabilities resulting from
unsolicited e-mail, lost or misdirected messages, illegal or fraudulent use of
e-mail or interruptions or delays in e-mail service. Our general commercial
liability insurance may not adequately protect us against these types of
potential claims.
OUR STOCK PRICE WILL BE VOLATILE.
The market price of our common stock has been and is likely to continue to
be highly volatile and could be subject to wide fluctuations in response to:
- quarterly variations in operating results,
- announcements of technological innovations or new services or products by
us or our competitors,
- changes in financial estimates by securities analysts,
- our failure to meet or exceed analyst estimates and
- other events or factors, many of which are beyond our control.
In addition, the stock market has experienced significant price and volume
fluctuations that have particularly affected the market prices of equity
securities of many Internet companies and that often have been unrelated or
disproportionate to the operating performance of these companies. A number of
publicly traded technology companies have current market prices below their
initial public offering price. Market fluctuations such as these may seriously
harm the market price of our common stock. In the past, following periods of
volatility in the marketplace for a company's securities, securities class
action litigation often has been instituted. We would incur substantial costs
and a diversion of management attention and resources resulting from such
litigation, which would seriously harm our business, financial condition and
results of operations.
OUR OFFICERS, DIRECTORS AND SIGNIFICANT SHAREHOLDERS HAVE VOTING CONTROL.
As of September 30, 1999 59.8% of our outstanding common stock will be
beneficially owned by our directors, executive officers and each person or group
that we know owns more than 5% of our common stock, together with the
individuals or entities affiliated with them, assuming no exercise of
outstanding warrants or stock options. These shareholders, if acting together,
are able to control substantially all matters requiring approval by our
shareholders, including the election of all directors and approval of
significant corporate transactions.
OUR FUTURE CAPITAL NEEDS ARE UNCERTAIN.
We may experience a material decrease in liquidity due to increased
operating expenses, unforeseen capital requirements or other events and
uncertainties. After that, we may need to raise additional funds, and additional
financing may not be available on favorable terms, if at all. Further, if we
issue additional equity securities, shareholders may experience dilution, and
the new equity securities may have rights, preferences or privileges senior to
those of existing holders of our common stock. If we cannot raise funds on
acceptable terms, we may not be able to develop or enhance our services, take
advantage of future opportunities or respond to competitive pressures or
unanticipated requirements. This may seriously harm our business and results of
operations.
WE HAVE IMPLEMENTED ANTI-TAKEOVER PROVISIONS.
Some provisions of our restated articles of incorporation and amended
bylaws, as well as provisions of Washington law, make it more difficult for a
third party to acquire us, even if doing so would be beneficial to our
shareholders.
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SUBSTANTIAL SALES OF SHARES MAY IMPACT THE MARKET PRICE OF OUR COMMON STOCK.
Sales of a substantial number of shares of common stock could cause the
market price of our common stock to fall. Such sales could make it more
difficult for us to raise capital through the sale of additional equity
securities. Most of our shareholders, option holders and warrant holders are
limited by lock-up agreements restricting their ability to sell their N2H2
common stock. They cannot sell or otherwise dispose of shares of our common
stock until January 26, 2000 without the written consent of CIBC World Markets
Corp. 15,460,965 shares may be eligible for sale when the lock-up agreements
expire.
WE DO NOT INTEND TO PAY DIVIDENDS.
We have never declared or paid any cash dividends on our common stock. We
currently intend to retain any future earnings for funding growth and,
therefore, do not expect to pay any dividends in the foreseeable future.
ITEM 2. PROPERTIES.
Our principal place of business is located in Seattle, Washington, where we
currently lease approximately 21,000 square feet of office space. Beginning
December 1, 1999 we increased our total leased space to approximately 30,000
square feet at the same location. Our principal lease expires in April 30, 2005
and includes during the term a right of first refusal on an additional
approximately 11,000 square feet of space at market rates. We are leasing
approximately 12,000 additional square feet on a month-to-month basis. Given our
anticipated growth, we may need to find suitable space in addition to the
increased space available under the right of first refusal, but we believe space
will be available as needed on commercially reasonable terms.
ITEM 3. LEGAL PROCEEDINGS.
The Company remains a defendant in the lawsuit described in its
registration statement filed on Form S-1 (File No. 333-78495) relating to
Spyglass, Inc.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
No matters were submitted to a vote of security holders during the fourth
quarter ended September 30, 1999.
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PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS.
Our Common Stock is traded on the Nasdaq National Market under the symbol
"NTWO." The following table sets forth the high and low closing prices as
reported by Nasdaq for the Common Stock of the Company since the initial public
offering for the quarters ended as follows. Such quotations represent inter-
dealer prices without retail markup, markdown or commission and may not
necessarily represent actual transactions.
<TABLE>
<CAPTION>
HIGH LOW
---- -----
<S> <C> <C>
FISCAL 1999
Fourth Quarter of 1999 -- July 30, 1999 through September
30, 1999.................................................... 13.5 7.125
</TABLE>
The effective date of our first registration statement, filed on Form S-1
under the Securities Act of 1993, as amended was July 29, 1999 (the
"Registration Statement"). The class of securities registered was Common Stock.
The offering commenced on July 30, 1999 and all securities were sold in the
offering.
During the fourth quarter of 1999, we began using proceeds from the initial
public offering. To date, offering proceeds have been used for working capital
and other general corporate purposes.
The remaining net proceeds have been invested in cash equivalents and
short-term securities. The use of proceeds from the offering does not represent
a material change in the use of proceeds described in the prospectus included as
part of the Registration Statement.
As of September 30, 1999, there were approximately 200 registered holders
of the Company's Common Stock which number does not include the number of
shareholders whose shares are held of record by a brokerage house or clearing
agency but does include such brokerage house or clearing agency as one record
holder. We believe that we have over 3,500 shareholders.
We have never declared or paid any cash dividends on our capital stock. We
currently intend to retain any future earnings to finance the growth and
development of its business and therefore do not anticipate paying any cash
dividends in the foreseeable future.
ITEM 6. SELECTED FINANCIAL DATA.
This section presents selected historical financial data of N2H2. You
should read carefully the financial statements included in this Form 10-K,
including the notes to the consolidated financial statements. The selected data
in this section is not intended to replace the financial statements.
We derived the statement of operations data for the fiscal years ended
September 30, 1996, 1997, 1998 and 1999 and balance sheet data as of September
30, 1996, 1997, 1998 and 1999, from the audited financial statements in this
Form 10-K. The selected balance sheet data found below for us as of September
30, 1996 is derived from our audited financial statements not included herein.
Those financial statements were audited by PricewaterhouseCoopers LLP,
independent accountants. The historical results are not necessarily indicative
of results to be expected for any future period. See "Item 7. Management's
Discussion and Analysis of Financial Condition and Results of Operations" for a
more complete discussion and analysis of the selected financial data presented
below.
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<TABLE>
<CAPTION>
FISCAL YEAR ENDED SEPTEMBER 30,
-------------------------------------------------
1996 1997 1998 1999
--------- --------- --------- ----------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Revenues..................................... $ 108 $ 1,118 $ 3,078 $ 6,357
Cost of revenue.............................. 78 236 963 2,325
--------- --------- --------- ----------
Gross profit................................. 30 882 2,115 4,032
Operating expenses:
Sales and marketing........................ 263 505 1,466 3,460
Research and development................... 91 271 328 2,101
General and administrative................. 493 868 2,631 6,340
--------- --------- --------- ----------
Total operating expenses........... 847 1,644 4,425 11,901
--------- --------- --------- ----------
Operating loss............................... (817) (762) (2,310) (7,869)
Interest income (expense), net............... (10) (119) (287) 148
--------- --------- --------- ----------
Net loss..................................... $ (827) $ (881) $ (2,597) $ (7,721)
========= ========= ========= ==========
Basic and diluted net loss per share......... $ (0.11) $ (0.10) $ (0.30) $ (0.57)
========= ========= ========= ==========
Basic and diluted weighted average shares
outstanding(1)............................. 7,317,000 8,390,000 8,687,000 13,620,000
</TABLE>
<TABLE>
<CAPTION>
SEPTEMBER 30,
--------------------------------------
1996 1997 1998 1999
----- ------- ------- -------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C>
BALANCE SHEET DATA:
Cash................................................. $ 128 $ 71 $ 121 $ 7,743
Working capital (deficit)............................ 27 (829) (2,234) 33,447
Property and equipment, net.......................... 163 453 1,271 3,990
Total assets......................................... 400 784 1,848 67,556
Long-term obligations, excluding current
portion(2)......................................... 544 826 1,942 1,255
Total shareholders' equity (deficit)................. (352) (1,201) (2,904) 61,498
</TABLE>
- -------------------------
(1) See Note 12 of the Notes to Financial Statements for an explanation of the
determination of the number of shares used in computing the share data.
(2) Includes capital lease obligations.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULT
OF OPERATIONS.
You should read this section together with the financial statements and
other financial information included in this Form 10-K. This discussion contains
forward-looking statements that involve risks and uncertainties. Our actual
results may differ materially from those indicated in these forward-looking
statements. Certain reclassifications of prior year balances have been made for
consistent presentation with the current year.
OVERVIEW
N2H2 is a leading Internet infrastructure company. We provide content
categorization of Internet Web sites, filtering of Internet content, and caching
services. Our services enable our customers to limit access to the Internet by
allowing them to select their own filter criteria from our 32 areas of
categorized Internet content. Our categories range from pornography, hate and
bomb construction to gambling and games. Our filtering solutions require minimal
customer effort for installation and maintenance. In addition, our proxy-server
based system updates our clients' filtering criteria on a daily basis to reflect
the continual addition or modification of new or existing Websites on the
Internet.
We introduced Searchopolis, our education oriented Internet portal, in
October 1998. We created Searchopolis to maximize the educational capabilities
of the Internet for students, teachers, parents and
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administrators by aggregating Internet based educational content in one place.
Searchopolis was designed to work in conjunction with our award winning
filtering search technology and is available at www.searchopolis.com to any
Internet user who wants access to a safe, educationally oriented Internet
portal.
We were incorporated in June 1995 and introduced the industry's first proxy
server based Internet filter in September 1995. As of September 30, 1999, we had
accomplished the following:
- provided filtering service to approximately 8.5 million users in
approximately 8,750 schools in the United States and Canada.
- individually reviewed over 3.6 million Web sites and partial Web sites,
- created a database of 32 categories of Internet content that can be
selected for filtering by our customers,
- had users access approximately one billion Web pages through our services
in the Quarter ending September 30, 1999,
- installed and shipped approximately 850 Internet proxy servers in the
United States, Canada, Australia, United Kingdom, Germany, Chile, Mexico,
India and Bermuda,
- introduced our education portal, Searchopolis.com,
- provided our services to approximately 200,000 homes through
approximately 210 Internet service providers,
- entered into strategic corporate relationships with Inktomi, Looksmart
and others and
- grown to 179 full time equivalent staff.
Since inception, we have derived substantially all of our revenues through
a combination of subscription and installation fees from our Internet services.
Customers pay a one-time installation fee and enter into a subscription
contract, which is typically 12 months in duration. We recognize installation
revenues upon installation of our servers and subscription revenues on a
straight line basis over the life of the subscription contract term.
We recently began to offer alternate fee structures to our school customers
that give them the choice of paying our recurring subscription fees or receiving
our filtering services at reduced rates or without charge in exchange for
allowing us to sell sponsorship rights to advertisers and to make Searchopolis
the default search engine on their networks. To the extent our customers do
choose to accept advertising from our sponsors, we will lose some or all of our
subscription and installation revenues from those customers. Our customers may
not accept our alternate fee structures, and the impact on our revenues is
unpredictable.
We are expanding our services to education and other markets with
Searchopolis. We expect Searchopolis to generate additional advertising revenues
as well from offering specialized communication features including
access-controlled, filtered e-mail, an easy-to-use calendar, Virtual Locker,
access to monitored chat rooms and various teacher tools including GradeChecker.
In the year ending September 30, 1999 we derived $752,000 in advertising
revenues from indirect sales of advertisements by our advertising partner, 24/7
Media, Inc. In the future, we expect to obtain a greater proportion of our
revenues from the direct and indirect sale of Internet advertising. We expect
that these sales will be made to companies that advertise their products and
services over the Internet to our target market of K-12 students. We currently
offer advertisers various sizes and types of advertising on Bess and
Searchopolis through 24/7 Media. In the future, we expect to offer additional
advertising as part of our marketing of our advanced communication tools. We
recognize advertising revenues in the period that the advertisement is
displayed. We intend to continue to increase the number and scope of our
relationships with advertising partners, such as 24/7 Media, as well as to
significantly increase the size of our internal advertising sales organization.
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We have a limited operating history and our prospects are subject to the
risks, expenses and difficulties encountered by companies in the new and rapidly
evolving Internet market. We have incurred significant net losses and negative
cash flows from operations since inception and, as of September 30, 1999, had
incurred operating losses of approximately $12 million from such time. These
losses have been funded primarily through the issuance of common stock and debt.
We intend to continue to invest heavily in sales and marketing, technology and
our operating infrastructure. As a result, we expect to incur substantial net
losses for the foreseeable future. Relatively low inflation rates over the past
three years have had an immaterial impact on our revenues and costs; neither our
prices nor those of our principal suppliers have changed significantly over the
past three years.
In view of the rapidly changing nature of our business and our limited
operating history, we believe that period-to-period comparisons of revenues and
operating results are not necessarily meaningful. You should not rely upon this
information as an indication of future performance.
Revenues. We generate our revenues from installation, subscription and
advertising fees. Our increasing revenues over the period to period comparisons
which follow have been due primarily to increased sales volume. While
installation revenues have been historically higher in the summer months, future
installation revenues may be lower as schools adopt advertising based filtering.
In addition, we expect advertising revenues to be negatively affected by the
reduction of Internet use by schools and K-12 students during the summer months.
User traffic on our school customer systems has historically been lower during
the summer and during year-end vacation and holiday periods, and advertising
revenues will likely be less during these periods.
Cost of revenues. Cost of revenues consists of the costs of Website review,
depreciation of servers which we own and are installed at customer locations,
technical installation and support and telecommunications costs. Since April
1999, we have included search processing and hosting fees as cost of revenues in
recognition of advertising revenues received. These costs consist of expenses
incurred with outside providers of search engine and Web hosting services,
including Inktomi and Exodus. We expect that our costs of revenues will vary
from period to period and may increase as a percentage of revenues in future
quarters as we expand our operations and offer alternate fee structures to our
school customers. Expanding our operations will also entail additional customer
support personnel and Web site review costs. We anticipate that our alternate
fee structures will increase Searchopolis traffic and require us to incur
additional search processing and hosting costs.
Sales and marketing. Sales expenses consist primarily of salaries,
commissions and bonuses. Marketing expenses consist primarily of salaries,
marketing brochures, trade shows, direct mailing programs, advertising, public
relations and travel. We believe that a significant increase in sales and
marketing efforts is essential for us to continue to improve our market
position. We anticipate that these increased sales and marketing efforts would
be carried out over the next two to three years.
Research and development. Research and development expenses consist
primarily of salaries and benefits for software developers, consulting fees,
facilities costs and equipment depreciation. In the development of new products
and enhancement of existing products, the technological feasibility of the
service is not established until substantially all product development is
complete. Accordingly, development costs and all costs related to internal
research and development have been expensed as incurred. We expect to continue
the hiring of additional engineers and other technical staff. Increased research
and development expenditures may be directed towards development of enhancements
of our filtering technologies, communications tools for Searchopolis and other
future service enhancements not presently defined.
General and administrative. General and administrative expenses consist
primarily of salaries, benefits and related costs for our executive, finance,
human resources and administrative personnel, third party professional service
fees and allocation of our facilities and depreciation expenses. We expect to
incur additional costs related to managing the financial, legal and
administrative aspects of our business. We also expect general and
administrative expenses to increase in the future, reflecting growth in our
operations and the costs associated with being a public company.
30
<PAGE> 31
Income Taxes. Prior to May 1999 we were an S corporation for federal income
tax purposes, and effective May 11, 1999, became a C corporation. As a C
corporation, we are subject to income tax at the corporate level to the extent
we have generated net income. Any operating losses we incur will result in net
operating loss carryforwards available to offset future taxable income. A full
valuation allowance has currently been recorded against any deferred tax assets
available to us for use in future periods because realization of these assets is
primarily dependent on generating taxable net income in the future. We do not
believe that the change to C corporation status will have a material impact on
our financial position, results of operations or liquidity in future periods.
FISCAL YEAR ENDED SEPTEMBER 30, 1999 COMPARED TO FISCAL YEAR ENDED SEPTEMBER 30,
1998
Revenues. Our revenues increased by $3.28 million, or 107%, to $6.36
million for the fiscal year ended September 30, 1999, from $3.1 million for the
fiscal year ended September 30, 1998. Installation and subscription revenues
accounted for 88% of the revenues for the fiscal year ended September 30, 1999.
Installation revenues increased $450,000, or 32%, to $1.85 million for the
fiscal year ended September 30, 1999, from $1.4 million for the fiscal year
ended September 30, 1998. Installation revenues accounted for 29% of total
revenues for the fiscal year ended September 30, 1999, compared to 45% for the
fiscal year ended September 30, 1998. Subscription revenues increased by $2.1
million, or 124%, to $3.8 million for the fiscal year ended September 30, 1999,
from $1.7 million for the fiscal year ended September 30, 1998. Subscription
revenues as a percentage of total revenues increased to 59% for the fiscal year
ended September 30, 1999, compared to 55% for the fiscal year ended September
30, 1998. Subscription revenues increased at a higher rate than installation
revenues primarily due to renewals of subscription contracts by existing
customers. Advertising revenues increased to $752,000 for the year ended
September 30, 1999.
Cost of revenues. Cost of revenues increased by $1.36 million, or 142%, to
$2.33 million for the fiscal year ended September 30, 1999, from $963,000 for
the fiscal year ended September 30, 1998. Cost of revenues as a percentage of
total revenues increased to 37% for the fiscal year ended September 30, 1999,
compared to 31% for the fiscal year ended September 30, 1998.
Sales and marketing. Sales and marketing expenses increased by $1.99
million, or 136%, to $3.46 million for the fiscal year ended September 30, 1999,
from $1.47 million for the fiscal year ended September 30, 1998. This increase
was primarily due to the hiring of additional sales and marketing personnel.
Sales and marketing expenses represented 55% of our total revenues for the
fiscal year ended September 30, 1999 and 48% of our total revenues for the
fiscal year ended September 30, 1998.
Research and development. Research and development expenses increased by
$1.77 million or 541%, to $2.10 million for the fiscal year ended September 30,
1999, from $328,000 for the fiscal year ended September 30, 1998. This increase
was primarily due to an increase in the number of software developers and
technical personnel supporting development of our filtering and Searchopolis
services. Our research and development expenses as a percentage of revenues
increased to 33% for the fiscal year ended September 30, 1999, from 11% for the
fiscal year ended September 30, 1998. This increase was due primarily to
increased spending on software developers.
General and administrative. General and administrative expenses increased
by $3.71 million or 141%, to $6.34 million for the fiscal year ended September
30, 1999, from $2.63 million for the fiscal year ended September 30, 1998. This
increase was primarily due to the addition of personnel to support the growth of
our business and non-cash deferred stock compensation costs in the amount of
$762,000 associated with warrants and options granted during the period. General
and administrative expenses as a percentage of revenues increased to 100% in the
fiscal year ended September 30, 1999, from 86% in the fiscal year ended
September 30, 1998. We expect that our general and administrative expenses will
continue to increase in amount in the future as we continue to build our
administrative staff and operating infrastructure.
FISCAL YEAR ENDED SEPTEMBER 30, 1998 COMPARED TO FISCAL YEAR ENDED SEPTEMBER 30,
1997
Revenues. Our revenues increased by $2.0 million, or 175%, to $3.1 million
for the fiscal year ended September 30, 1998, from $1.12 million for the fiscal
year ended September 30, 1997. Installation and
31
<PAGE> 32
subscription revenues accounted for substantially all the revenues for the
fiscal year ended September 30, 1998. Installation revenues increased $784,000,
or 138%, to $1.4 million for the fiscal year ended September 30, 1998, from
$570,000 for the fiscal year ended September 30, 1997. Installation revenues
accounted for 44% of total revenues for the fiscal year ended September 30,
1998, compared to 51% for the fiscal year ended September 30, 1997. The increase
in installation revenues was due primarily to sales to new customers.
Subscription revenues increased by $1.2 million, or 215%, to $1.7 million for
the fiscal year ended September 30, 1998, from $548,000 for the fiscal year
ended September 30, 1997. Subscription revenues as a percentage of total
revenues increased to 56% for the fiscal year ended September 30, 1998, compared
to 49% for the fiscal year ended September 30, 1997. Subscription revenues
increased at a higher rate than installation revenues primarily due to renewals
of subscription contracts by existing customers.
Cost of revenues. Cost of revenues increased by $727,000, or 308%, to
$963,000 for the fiscal year ended September 30, 1998, from $236,000 for the
fiscal year ended September 30, 1997. Cost of revenues as a percentage of total
revenues increased to 31% for the fiscal year ended September 30, 1998, compared
to 21% for the fiscal year ended September 30, 1997. The increase was due
primarily to increases in customer support personnel costs.
Sales and marketing. Sales and marketing expenses increased by $961,000, or
190%, to $1.47 million for the fiscal year ended September 30, 1998, from
$505,000 for the fiscal year ended September 30, 1997. This increase was
primarily due to the hiring of additional sales and marketing personnel. Sales
and marketing expenses represented 48% of our total revenues for the fiscal year
ended September 30, 1998 and 45% of our total revenues for the fiscal year ended
September 30, 1997.
Research and development. Research and development expenses increased by
$57,000 or 21%, to $328,000 for the fiscal year ended September 30, 1998, from
$271,000 for the fiscal year ended September 30, 1997. This increase was
primarily due to an increase in the number of software developers and technical
personnel supporting development of our filtering and Searchopolis services. Our
research and development expenses as a percentage of revenues decreased to 11%
for the fiscal year ended September 30, 1998, from 24% for the fiscal year ended
September 30, 1997. This decrease was due primarily to increased revenues.
General and administrative. General and administrative expenses increased
by $1.76 million, or 203%, to $2.63 million for the fiscal year ended September
30, 1998, from $868,000 for the fiscal year ended September 30, 1997. This
increase was primarily due to the addition of personnel to support the growth of
our business and non-cash deferred stock compensation costs in the amount of
$819,000 associated with warrants and options granted during the period. General
and administrative expenses as a percentage of revenues increased to 86% in the
fiscal year ended September 30, 1998, from 78% in the fiscal year ended
September 30, 1997. We expect that our general and administrative expenses will
continue to increase in amount in the future as we continue to build our
administrative staff and operating infrastructure.
LIQUIDITY AND CAPITAL RESOURCES
Since inception, we have funded our operations primarily through private
sales of equity securities, the use of short-term and long-term debt and capital
leases. As of September 30, 1999, we had cash and cash equivalents of $7.7
million, and short term investments of $27.9 million.
Our operating activities resulted in net cash outflows of $427,000 in 1997
and a net cash inflow of $286,000 in 1998. For the year ended September 30,
1999, our operating activities resulted in a net cash outflow of $5.99 million.
The operating cash outflow in 1997 resulted from net operating losses and
increases in accounts receivable due to increased sales. The operating cash
inflow in 1998 resulted primarily from increases in prepayment of subscription
fees, accounts payable and accrued liabilities. The operating cash outflow in
1999 resulted from net operating losses, increases in accounts receivable and
prepaid expenses and other assets.
Capital expenditures, excluding those under capital leases, totaled
$230,000 and $383,000 in 1997 and 1998 and $2.24 million in 1999. We anticipate
that we will continue to experience an increase in capital
32
<PAGE> 33
expenditures consistent with our anticipated growth in installations of new
proxy servers and purchases of equipment in support of our increasing
operations, administrative infrastructure and personnel.
Investment activities resulted in a cash outflow of $54.9 million in 1999.
This was the result of investing the proceeds of the Company's initial public
offering.
Our financing activities provided $600,000 in 1997 and $147,000 in 1998 and
$68.5 million in 1999. For 1997, cash provided by financing activities consisted
primarily of $631,000 in proceeds from long-term borrowings, reduced by $31,000
in payments on capital lease obligations. For 1998, cash provided by financing
activities consisted primarily of $210,000 in proceeds from long-term
borrowings, reduced by $63,000 in payments on capital lease obligations and
repayments of notes payable. For 1999, cash provided by financing activities
consisted primarily of $69.2 million received in connection with the sale of
common stock and warrants including our initial public offering of Common Stock
and $2.0 million in proceeds from long-term debt borrowings, less $1.1 million
of payments under capital lease obligations and $1.8 million of repayments on
notes payable.
On April 30, 1999, we entered into a term loan and revolving line of credit
agreement with Imperial Bank. The term loan is collateralized by a first
priority claim against all of our unpledged assets. The term loan provides for
maximum borrowings of $2.0 million if specified conditions are met. The
revolving line of credit provides for draws of 80% of accounts receivable
assigned as security up to a maximum short-term borrowing of $2.0 million if
specified conditions are met. As of September 30, 1999, the amount available for
borrowing under the term loan and revolving line of credit totaled $1.8 million.
Advances on the term loan bear interest on the outstanding daily balance at
N2H2's election at the rate of either (a) 1.0% above the prime rate as announced
by Imperial Bank or (b) at a rate equal to the LIBOR plus 400 basis points.
Advances on the revolving line of credit bear interest on the outstanding daily
balance at a rate of 0.5% above the prime rate as announced by Imperial Bank.
We intend to substantially increase our operating expenses in 2000 and
beyond as we:
- enter new markets with our services and further develop our sales
channels and international sales presence,
- expand implementation of Searchopolis with new communication tools and
incur increased depreciation costs for equipment supporting Searchopolis,
- incur increased depreciation expenses related to installing additional
servers in customer networks,
- hire additional software development, sales and marketing, and general
and administrative personnel,
- expand our customer support and service operations.
These increased operating expenses, together with capital expenditures
related to filtering servers and enhancement of Searchopolis, will consume a
significant amount of our cash resources, including a portion of the net
proceeds of this offering. We believe that our cash and short term investments
on hand, together with cash from operations, will be sufficient to meet our
anticipated cash needs 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 to obtain a larger credit facility.
The sale of additional equity or convertible debt securities would result in
additional dilution to our shareholders. The incurring of indebtedness would
result in increased fixed obligations and could result in covenants that would
restrict our operations. We have not made arrangements to obtain additional
financing and we cannot assure you that financing will be available in amounts
or on terms acceptable to us, if at all. See "Risk Factors -- Our Future Capital
Needs Are Uncertain" for a description of risks associated with a decrease in
liquidity.
RECENT ACCOUNTING PRONOUNCEMENTS
In March 1998, the Accounting Standards Executive Committee of the American
Institute of Certified Public Accountants issued SOP 98-1, Accounting for the
Costs of Computer Software Developed or Obtained for Internal Use. SOP 98-1
provides guidance for an enterprise on accounting for the costs of computer
33
<PAGE> 34
software developed or obtained for internal use. We adopted this statement in
1999 and, accordingly, we capitalized $485,000 in costs associated with
obtaining software for internal use.
In June 1998, the FASB issued Statement of Financial Accounting Standards
No. 133, "Accounting for Derivative Instruments and Hedging Activities." This
statement requires that all derivative instruments be recorded on the balance
sheet at their fair value. Changes in the fair value of derivatives are recorded
each period in current earnings or other comprehensive income, depending on
whether a derivative is designated as part of a hedge transactions and, if it
is, the type of hedge transaction. In July 1999, the FASB issued SFAS No. 137,
"Accounting for Derivative Instruments and Hedging Activities Deferral of the
Effective Date of FASB Statement No. 133." SFAS No. 137 deferred the effective
date of SFAS No. 133 until fiscal years beginning after June 15, 2000. We do not
use derivative instruments, therefore the adoption of this statement is not
expected to have any effect on the Company's results of operations or its
financial position.
In December 1999, SEC Staff Accounting Bulletin: No 101 -- Revenue
Recognition in Financial Statements (SAB 101), was issued. This pronouncement
summarizes certain of the SEC Staff's views on applying generally accepted
accounting principles to revenue recognition. SAB 101 is required to be adopted
by the Company for the year ended September 30, 2001. We are currently reviewing
the requirements of SAB 101 and assessing the impact on the financial
statements.
THE YEAR 2000
Background of year 2000 issues. Many currently installed computer systems
and software products are unable to distinguish between 20th century dates and
21st century dates because such systems were developed using two digits rather
than four to determine the applicable year. For example, computer programs that
have date-sensitive software may recognize a date using "00" as the year 1900
rather than the year 2000. This error could result in system failures or
miscalculations causing disruptions of operations, including, among other
things, a temporary inability to process transactions, send invoices or engage
in similar normal business activities. As a result, many companies' software and
computer systems may need to be upgraded or replaced to comply with "year 2000"
requirements.
Our internal systems. Our business is dependent on the operation of
numerous systems that could potentially be affected by year 2000 related
problems. Those systems include, among others, hardware and software systems
used by us to deliver products and services to our customers, communications
networks such as the Internet and private intranets, the internal systems of our
customers and suppliers, software portions of products licensed to customers,
the hardware and software systems used internally by us in the management of our
business and non-information technology systems and services used by us in the
management of our business, such as power, telephone systems and building
systems.
Our network is critical to providing top quality, reliable service to our
customers. Our goal is to maintain this quality and provide uninterrupted
service through the turn of the century. Our year 2000 program is
enterprise-wide and is focused on the following interrelated categories, which
include both software and hardware critical to maintaining uninterrupted service
to our customers:
- our own computer networks and proxy server equipment,
- applications, products and services we have developed,
- external interfaces of our networks and applications,
- our customers' information technology platforms that support our
applications,
- other information and computer systems which are essential to conduct
business but that do not affect our ability to provide services and
products to customers and
- our non-information technology infrastructure.
Our readiness. The key milestones to our year 2000 program have been
internal and external assessment, testing and repair. We have completed both our
internal and external year 2000 compliance assessment.
34
<PAGE> 35
We believe that we have identified and reviewed the internally and
externally developed software that supports the development and delivery of our
services and products or is necessary to maintain our administration, sales and
accounting functions. We have completed our assessment of this software and have
made the changes we consider necessary.
Costs of addressing year 2000 compliance. To date, we have spent an
immaterial amount on year 2000 compliance. We do not believe the cost of
preparing for year 2000 compliance will exceed $50,000, exclusive of labor costs
not specifically allocated to year 2000 compliance matters. If we are wrong, we
could face additional unexpected expenses to fix any year 2000 problems.
Our external products vendors and systems. We use third party equipment and
software that may not be year 2000 compliant. We have reviewed our externally
purchased network elements, including switches, routers, proxy servers and
network control points and do not believe they will be affected by year 2000
concerns. We identified our fax server software as noncompliant and have
replaced it with a compliant version. We have also reviewed other systems that
are important to our business such as telecommunications, energy and
environmental management. We identified no significant problems associated with
year 2000 issues in these systems. While not all our vendors have delivered
assurances that they will be year 2000 compliant, we have not encountered any
material year 2000 problems with servers, software or information systems
provided to us by third parties.
Contingency planning. We have not developed a formal year 2000 contingency
plan. Based on our assessment to date and our readiness activities, we do not
anticipate needing to develop such a plan. As part of the overall growth of our
network services, we have increased our telecommunication bandwidth capabilities
and purchasing and distributing servers to multiple locations. These plans,
while not specific to the year 2000 issue, could mitigate unforeseen year 2000
problems by establishing redundancy in our system.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Not applicable
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
<TABLE>
<S> <C>
Report of Independent Accountants........................... 36
Consolidated Balance Sheets as of September 30, 1999 and
1998........................................................ 37
Consolidated Statements of Operations for the Fiscal Years
Ended September 30, 1999, 1998 and 1997................... 38
Consolidated Statements of Changes in Shareholders' Equity
(Deficit) for the Fiscal Years Ended September 30, 1999,
1998 and 1997............................................. 39
Consolidated Statements of Cash Flows for the Fiscal Years
Ended September 30, 1999, 1998 and 1997................... 40
Consolidated Notes to Financial Statements.................. 41
</TABLE>
35
<PAGE> 36
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors
and Shareholders of
N2H2, Inc.
In our opinion, the consolidated financial statements listed in the index
appearing under Item 14(a)(1) present fairly, in all material respects, the
financial position of N2H2, Inc. and its subsidiary at September 30, 1999 and
1998, and the results of their operations and their cash flows for each of the
three years in the period ended September 30, 1999, in conformity with
accounting principles generally accepted in the United States. In addition, in
our opinion, the financial statement schedule listed in the index appearing
under Item 14(a)(2) presents fairly, in all material respects, the information
set forth therein when read in conjunction with the related consolidated
financial statements. 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 of these
statements in accordance with auditing standards generally accepted in the
United States which 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, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for the opinion expressed above.
PricewaterhouseCoopers LLP
Seattle, Washington
November 8, 1999
36
<PAGE> 37
N2H2, INC.
CONSOLIDATED BALANCE SHEETS
ASSETS
<TABLE>
<CAPTION>
SEPTEMBER 30,
---------------------
1999 1998
--------- --------
(IN THOUSANDS, EXCEPT
SHARE AMOUNTS)
<S> <C> <C>
Current assets
Cash and cash equivalents................................... $ 7,743 $ 121
Investments............................................... 27,937 --
Accounts receivable (net of $142 and $8 allowance in 1999
and 1998, respectively)................................ 1,434 321
Other current assets...................................... 1,136 37
-------- -------
Total current assets.............................. 38,250 479
Long-term investments....................................... 24,698 --
Property and equipment, net................................. 3,990 1,271
Other assets................................................ 618 98
-------- -------
Total assets...................................... $ 67,556 $ 1,848
======== =======
LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT)
Current liabilities
Accounts payable.......................................... $ 1,871 $ 451
Royalties payable......................................... 100 150
Accrued liabilities....................................... 1,062 461
Deferred revenue.......................................... 1,304 1,237
Current portion of long-term debt and notes payable....... -- 30
Current portion of capital lease obligations.............. 466 384
-------- -------
Total current liabilities......................... 4,803 2,713
Deferred revenue............................................ 303 97
Capital lease obligations................................... 952 524
Long-term debt and notes payable............................ -- 1,418
-------- -------
Total liabilities................................. 6,058 4,752
-------- -------
Commitments and contingencies (Notes 11 and 13)
Shareholders' equity (deficit)
Preferred stock, no par value; 50,000,000 shares
authorized, no shares issued and outstanding
Common stock, no par value; 250,000,000 shares authorized;
21,064,285 and 9,060,473 issued and outstanding,
respectively........................................... 75,528 1,440
Notes receivable from shareholders........................ (25) --
Deferred stock option compensation expense................ (1,940) --
Accumulated deficit....................................... (12,065) (4,344)
-------- -------
Total shareholders' equity (deficit).............. 61,498 (2,904)
-------- -------
Total liabilities and shareholders' equity
(deficit)........................................ $ 67,556 $ 1,848
======== =======
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
37
<PAGE> 38
N2H2, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
YEARS ENDED SEPTEMBER 30,
---------------------------------------
1999 1998 1997
----------- ---------- ----------
(IN THOUSANDS, EXCEPT SHARE AND
PER SHARE AMOUNTS)
<S> <C> <C> <C>
Revenues.............................................. $ 6,357 $ 3,078 $ 1,118
Cost of revenues...................................... 2,325 963 236
----------- ---------- ----------
Gross profit.......................................... 4,032 2,115 882
----------- ---------- ----------
Operating expenses:
Sales and marketing................................. 3,460 1,466 505
Research and development............................ 2,101 328 271
General and administrative.......................... 6,340 2,631 868
----------- ---------- ----------
Total operating expenses.................... 11,901 4,425 1,644
----------- ---------- ----------
Operating loss........................................ (7,869) (2,310) (762)
Interest income (expense), net........................ 148 (287) (119)
----------- ---------- ----------
Net loss.............................................. $ (7,721) $ (2,597) $ (881)
=========== ========== ==========
Basic and diluted net loss per common share........... $ (.57) $ (.30) $ (.10)
=========== ========== ==========
Basic and diluted weighted average shares
outstanding......................................... 13,620,000 8,687,000 8,390,000
=========== ========== ==========
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
38
<PAGE> 39
N2H2, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (DEFICIT)
<TABLE>
<CAPTION>
NOTE DEFERRED
COMMON STOCK RECEIVABLE STOCK OPTION
-------------------- FROM COMPENSATION ACCUMULATED
SHARES AMOUNT SHAREHOLDERS EXPENSE DEFICIT TOTAL
---------- ------- ------------ ------------ ----------- -------
(IN THOUSANDS, EXCEPT SHARE AMOUNTS)
<S> <C> <C> <C> <C> <C> <C>
Balance at September 30,
1996........................ 8,389,063 $ 514 $ -- $ -- $ (866) $ (352)
Issuance of common stock...... 297,348 --
Issuance of warrants.......... 32 32
Net loss...................... (881) (881)
---------- ------- ---- ------- -------- -------
Balance at September 30,
1997........................ 8,686,411 546 -- -- (1,747) (1,201)
Exercise of stock options..... 374,062 75 75
Compensation expense
recognized on issuance of
stock, stock options and
warrants.................... 819 819
Net loss...................... (2,597) (2,597)
---------- ------- ---- ------- -------- -------
Balance at September 30,
1998........................ 9,060,473 1,440 -- -- (4,344) (2,904)
Issuance of common stock,
private offering, net of
issuance costs of $243...... 4,131,245 10,788 10,788
Issuance of common stock,
public offering, net of
issuance costs of $1,409.... 4,950,000 58,436 58,436
Exercise of warrants.......... 6,342 20 20
Issuance of warrants.......... 77 77
Conversion of notes payable
into common stock........... 1,998,622 1,693 1,693
Exercise of stock options..... 792,603 156 (25) 131
Compensation expense
recognized on issuance of
common stock................ 125,000 216 216
Deferred compensation expense
relating to issuance of
stock options............... 2,702 (2,702) --
Amortization of deferred stock
option compensation
expense..................... 762 762
Net loss...................... (7,721) (7,721)
---------- ------- ---- ------- -------- -------
Balance at September 30,
1999........................ 21,064,285 $75,528 $(25) $(1,940) $(12,065) $61,498
========== ======= ==== ======= ======== =======
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
39
<PAGE> 40
N2H2, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
YEARS ENDED SEPTEMBER 30,
----------------------------
1999 1998 1997
-------- ------- -----
(IN THOUSANDS)
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss.................................................... $ (7,721) $(2,597) $(881)
Adjustments to reconcile net loss to net cash (used by)
provided by operating activities
Depreciation and amortization.......................... 1,262 346 147
Amortization of deferred stock compensation expense.... 762
Compensation expense on common stock and warrants...... 216 819
Notes payable issued for services...................... 98 65
Debt forgiven.......................................... (18)
Change in certain assets and liabilities
Accounts receivable.................................. (1,113) (62) (152)
Prepaid expenses and other assets.................... (1,619) (134)
Accounts payable..................................... 1,420 372 29
Royalties payable.................................... (50) 150
Accrued liabilities.................................. 601 364 66
Deferred revenue..................................... 273 930 299
-------- ------- -----
Net cash (used by) provided by operating
activities...................................... (5,987) 286 (427)
-------- ------- -----
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of investments.................................. (53,636)
Sales of investments...................................... 1,001
Additions to property and equipment....................... (2,240) (383) (230)
-------- ------- -----
Net cash used by investing activities............. (54,875) (383) (230)
-------- ------- -----
CASH FLOWS FROM FINANCING ACTIVITIES
Issuance of common stock, net............................. 69,224
Exercise of warrants...................................... 20
Exercise of stock options................................. 131
Payments under capital lease obligations.................. (1,128) (51) (31)
Borrowings under notes payable............................ 2,000 210 631
Repayments of notes payable............................... (1,763) (12)
-------- ------- -----
Net cash provided by financing activities......... 68,484 147 600
-------- ------- -----
Net increase (decrease) in cash and cash equivalents........ 7,622 50 (57)
Cash and cash equivalents, beginning of period.............. 121 71 128
-------- ------- -----
Cash and cash equivalents, end of period.................... $ 7,743 $ 121 $ 71
======== ======= =====
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
40
<PAGE> 41
N2H2, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 1999, 1998 AND 1997
1. DESCRIPTION OF BUSINESS
N2H2, Inc. (the Company) was incorporated on June 13, 1995 as an S
Corporation in the State of Washington. Effective May 11, 1999, the Company
became a C corporation. The Company develops and provides Internet filtering
services which screen for undesired content as specified by the end user. The
Company contracts its technology primarily to Internet service providers, school
districts, libraries and local and state government agencies.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The financial statements consolidate the accounts of N2H2, Inc. and its
wholly owned subsidiary, N2H2, Ltd. The companies are collectively hereinafter
referred to as the "Company". All intercompany transactions have been
eliminated.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents represent funds on deposit with banks or invested
in a variety of highly liquid short-term instruments with original maturities of
less than three months.
INVESTMENTS
The Company's investments are comprised primarily of debt securities which
are classified as held-to-maturity at purchase. Investments with remaining
maturities of less than twelve months from the balance sheet date are classified
as short-term investments. Investments with remaining maturities of more than
twelve months are classified as long-term investments. For the purpose of
computing realized gains and losses, costs are identified on a specific
identification basis.
PROPERTY AND EQUIPMENT
Property and equipment is recorded at cost for purchased assets.
Depreciation and amortization are recognized using the straight-line method over
the estimated useful lives of such assets. The useful lives of all property and
equipment, except leasehold improvements, are estimated to be three years.
Leasehold improvements are amortized over the lesser of the lease term or
estimated useful life. Software developed or obtained for internal use is
capitalized and amortized over a three year estimated useful life.
The cost of normal maintenance and repairs are charged to expense as
incurred and expenditures for major improvements are capitalized, at cost. Gains
or losses on the disposition of assets in the normal course of business are
reflected in the results of operations at the time of disposal.
IMPAIRMENT OF LONG-LIVED ASSETS
The Company evaluates its long-lived assets for impairment and continues to
evaluate them as events or changes in circumstances indicate that the carrying
amount of such assets may not be fully recoverable. The Company evaluates the
recoverability of long-lived assets by measuring the carrying amount of the
assets against the estimated undiscounted future cash flows associated with
these assets. At the time such evaluations indicate that the future undiscounted
cash flows of certain long-lived assets are not sufficient to recover the
carrying value of such assets, the assets are adjusted to their fair values.
41
<PAGE> 42
N2H2, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999, 1998 AND 1997
ROYALTIES PAYABLE
Royalties payable represent amounts payable to an independent provider of
Internet search content under a service agreement. Amortization is based on the
greater of amounts determined by the contractual royalty rates or amounts
computed on a straight-line basis over the terms of the agreement.
REVENUE RECOGNITION
Subscription and installation revenues are recognized when earned.
Installation revenues represent fees associated with the customization and
installation of the Company's software on the proxy servers which are sent to
the customer. Subscription revenues represent the fees associated with the right
to use the Company's software and hardware, access to filtering updates and
customer support. Subscription revenues are recognized over the life of the
subscription contract and installation revenues are recognized when the server
is installed by the end user, and when the criteria for revenue recognition
under Statement of Position No. 97-2, Software Revenue Recognition, is applied
and satisfied. The criteria include, but are not limited to, the existence of
vendor-specific objective evidence, delivery of the service to a customer, the
Company's lack of significant obligations to the customer and a determination
that collectibility of the amount due is probable. Subscription payments
received in advance of revenue recognition are recorded as deferred revenue.
Advertising revenue from impressions or click through based contracts is
recognized based on the number of guaranteed impressions or click throughs
delivered.
RESEARCH AND DEVELOPMENT COSTS
Research and development expenses consist principally of payroll and
related expenses for design and development of the Company's technologies.
Research and development costs related to these activities are expensed until
technological feasibility has been achieved. There were no capitalized software
development costs as of September 30, 1999 and 1998.
FEDERAL INCOME TAXES
Prior to May 1999, the Company was an S corporation for federal income tax
purposes. Effective May 11, 1999, the Company became a C corporation and
accounts for income taxes under the liability method of accounting. Under the
liability method, deferred income taxes are determined based on the difference
between the financial statement and tax bases of assets and liabilities at
enacted tax rates in effect in the year in which the differences are expected to
reverse. Valuation allowances are established, when necessary, to reduce
deferred tax assets to amounts expected to be realized.
ADVERTISING AND MARKETING EXPENSE
All costs related to marketing and advertising the Company's products are
expensed in the periods incurred. Advertising and marketing expenses were
$1,145,000, $120,000, and $80,000 for the years ended September 30, 1999, 1998
and 1997, respectively.
TRANSFER OF FINANCIAL INSTRUMENTS
In the fiscal year ended September 30, 1999, the Company terminated the
practice of factoring accounts receivable with the bank. Prior to that, the
Company did factor certain customer receivables with full recourse to a bank.
The transfer of accounts receivable was recorded by the Company as a sales
transaction under the provisions of Statement of Financial Accounting Standards
(SFAS) No. 125, Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities. The receivables were sold at a discount which
was recorded upon sale, and monthly finance charges were incurred based upon
average monthly
42
<PAGE> 43
N2H2, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999, 1998 AND 1997
balances outstanding with the factor. These monthly fees were recorded in the
period incurred. Customer accounts repurchased from the factor were included in
accounts receivable.
CONCENTRATION OF CREDIT RISK
Financial instruments that potentially subject the Company to concentration
of credit risk include primarily cash and cash equivalents and accounts
receivable. The Company places its cash deposits and certain short-term
investments in bank deposits and money market funds with high credit quality
financial institutions. At September 30, 1999, the Company had cash in one
financial institution that exceeded federally insured limits. Domestic accounts
receivable consists of account balances due from customers evenly dispersed
across the United States with industry concentrations in public institutions
such as federal and local governments and school districts. International
accounts receivable represent 7% and 3% of total accounts receivable at
September 30, 1999 and 1998, respectively, and are denominated primarily in
United States dollars. The Company performs ongoing credit evaluations of its
customer's financial condition and generally requires no collateral from its
customers.
No customer accounted for 10% or more of the Company's revenues in any year.
FAIR VALUE DISCLOSURES
Recorded amounts of cash and cash equivalents, receivables, capital lease
obligations, accounts payable and other amounts included in current liabilities
meeting the definition of financial instruments approximate fair value based on
the short-term maturity of those instruments. The carrying value of long term
debt is based on interest rates currently available to the Company and,
accordingly, approximates fair value. The carrying value of investments held
exceeded market value by $152,000 at September 30, 1999 (Note 3).
USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
STOCK OPTION PLAN AND STOCK PURCHASE WARRANTS
The Company has adopted Statement of Financial Accounting Standards (SFAS)
No. 123, Accounting for Stock-Based Compensation, which permits entities to
recognize as expense over the vesting period the fair value of all stock-based
awards on the date of grant. Alternatively, SFAS No. 123 also allows entities to
continue to apply the provisions of APB Opinion No. 25 (APB 25) for transactions
with employees and provide pro forma disclosures for employee stock option
grants as if the fair value-based method defined in SFAS No. 123 had been
applied to these transactions. The Company has elected to continue to apply the
provisions of APB 25 to these transactions and provide the pro forma disclosure
provisions of SFAS No. 123. Stock purchase warrants granted to non-employees are
recorded at fair value in accordance with SFAS No. 123.
NET LOSS PER SHARE
Statement of Financial Accounting Standards No. 128, "Earnings Per Share"
(SFAS) No. 128, issued in February 1997, requires presentation of earnings per
share on a basic and diluted earnings per share basis. Earnings per share for
all periods presented have been stated to reflect the adoption of SFAS No. 128.
43
<PAGE> 44
N2H2, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999, 1998 AND 1997
Under the provisions of SFAS No. 128, basic earnings per share is
calculated as income available to common shareholders divided by the
weighted-average number of common shares outstanding during the periods. Diluted
earnings per share is based on the weighted-average number of shares of common
stock and common stock equivalents outstanding during the periods, including
options and warrants computed using the treasury stock method. Basic and diluted
net loss per share are equal for all periods presented because the impact of
common stock equivalents is anti-dilutive.
RECENTLY ISSUED ACCOUNTING STANDARDS
In June 1997, the Financial Accounting Standards Board (the "FASB") issued
Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive
Income." This statement requires that changes in comprehensive income be shown
in a financial statement that is displayed with the same prominence as other
financial statements. The statement is effective for fiscal years beginning
after December 15, 1997. Reclassification for earlier periods is required for
comparative purposes. The Company does not have any material items of
comprehensive income, other than net loss, and accordingly, the statement does
not have material impact on the reported financial position or results of
operations.
In June 1997, the FASB issued Statement of Financial Accounting Standards
No. 131, "Disclosures About Segments of an Enterprise and Related Information."
This statement supersedes Statement of Financial Accounting Standards No. 14,
"Financial Reporting for Segments of a Business Enterprise." This statement
includes requirements to report selected segment information quarterly and
entity-wide disclosures about products and services, major customers, and
geographic areas in which the entity holds significant assets and reports
significant revenues. The statement is effective for fiscal year 1999. The
Company operates in one segment providing integrated Internet infrastructure
solutions.
In June 1998, the FASB issued Statement of Financial Accounting Standards
No. 133, "Accounting for Derivative Instruments and Hedging Activities." This
statement requires that all derivative instruments be recorded on the balance
sheet at their fair value. Changes in the fair value of derivatives are recorded
each period in current earnings or other comprehensive income, depending on
whether a derivative is designated as part of a hedge transactions and, if it
is, the type of hedge transaction. In July 1999, the FASB issued SFAS No. 137,
"Accounting for Derivative Instruments and Hedging Activities Deferral of the
Effective Date of FASB Statement No. 133." SFAS No. 137 deferred the effective
date of SFAS No. 133 until fiscal years beginning after June 15, 2000. The
Company does not use derivative instruments, therefore the adoption of this
statement is not expected to have any effect on the Company's results of
operations or its financial position.
In March 1998, the Accounting Standards Executive Committee of the American
Institute of Certified Public Accountants issued 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. This statement is effective for fiscal
years beginning after December 15, 1998. The Company adopted this statement in
1999 and, accordingly, the Company capitalized $485,000 in costs associated with
obtaining software for internal use.
In December 1999, SEC Staff Accounting Bulletin: No. 101 -- Revenue
Recognition in Financial Statements (SAB 101), was issued. This pronouncement
summarizes certain of the SEC Staff's views on applying generally accepted
accounting principles to revenue recognition. SAB 101 is required to be adopted
by the Company for the year ended September 30, 2001. The Company is currently
reviewing the requirements of SAB 101 and assessing the impact on the financial
statements.
44
<PAGE> 45
N2H2, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999, 1998 AND 1997
RECLASSIFICATIONS
Certain reclassifications of prior year balances have been made for
consistent presentation with the current year.
3. INVESTMENTS
The Company's investment portfolio includes held-to-maturity securities.
The following table summarizes the composition of the Company's held-to-maturity
short and long term investments at September 30, 1999.
<TABLE>
<CAPTION>
AMORTIZED AGGREGATE
COST BASIS FAIR VALUE
----------- -----------
<S> <C> <C>
U.S. Corporate Debt Securities............................ $26,390,000 $26,310,000
Negotiable CD's........................................... 14,350,000 14,293,000
Euro Dollar Bonds......................................... 3,895,000 3,880,000
Taxable Auction Securities................................ 8,000,000 8,000,000
----------- -----------
$52,635,000 $52,483,000
=========== ===========
</TABLE>
The contractual maturities of held-to-maturity investments at September 30,
1999 are as follows:
<TABLE>
<CAPTION>
AMORTIZED AGGREGATE
COST BASIS FAIR VALUE
----------- -----------
<S> <C> <C>
Due within one year....................................... $27,937,000 $27,828,000
Due after one year through five years..................... 24,698,000 24,655,000
----------- -----------
$52,635,000 $52,483,000
=========== ===========
</TABLE>
Net unrealized loss for held-to-maturity securities of $152,000 at
September 30, 1999 consisted of gross unrealized gains of $1,000 and gross
unrealized losses of $153,000.
4. PROPERTY AND EQUIPMENT
Property and equipment consists of the following:
<TABLE>
<CAPTION>
SEPTEMBER 30,
-------------------------
1999 1998
----------- ----------
<S> <C> <C>
Computer equipment......................................... $ 4,615,000 $1,637,000
Furniture and fixtures..................................... 376,000 42,000
Leasehold improvements..................................... 142,000 61,000
Internal use software...................................... 485,000 --
----------- ----------
5,618,000 1,740,000
Less: Accumulated depreciation and amortization............ (1,628,000) (469,000)
----------- ----------
$ 3,990,000 $1,271,000
=========== ==========
</TABLE>
Depreciation expense was approximately $1,159,000, $322,000 and $125,000
for the years ended September 30, 1999, 1998 and 1997.
5. RELATED PARTY TRANSACTIONS
In September 1998, the Company converted trade accounts receivable of
$30,000 from a related party into a note receivable bearing interest at 10.5%
per annum. The note was paid in full in December 1998. In August and September
of 1999, the Company entered into four separate recourse note receivable
agreements
45
<PAGE> 46
N2H2, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999, 1998 AND 1997
with employees totaling $25,000 in connection with the exercise of options. The
notes bear interest at 6% per annum and mature in February 2000.
6. INCOME TAXES
A provision for income taxes was not recorded for the period ended
September 30, 1999 due to taxable losses incurred during the period. A valuation
allowance has been recorded for deferred tax assets as it has been determined
that it is more likely than not that these deferred tax assets will not be
realized.
The provision for federal income tax differs from the amount computed by
applying the statutory federal income tax rate for the following reasons:
<TABLE>
<CAPTION>
SEPTEMBER 30,
1999
-------------
<S> <C>
Federal income tax benefit at statutory rate................ (34%)
Change tax status........................................... (45)
Other....................................................... 4
-----------
Change in valuation allowance............................... 75%
-----------
</TABLE>
Deferred tax assets and liabilities at September 30, 1999 consist of the
following:
<TABLE>
<CAPTION>
SEPTEMBER 30,
1999
-------------
<S> <C>
Deferred tax assets:
Net operating loss carryforwards............................ $ 1,618,000
Cash to accrual adjustment................................ 491,000
Allowance for doubtful accounts........................... 48,000
Accrued compensation and benefits......................... 104,000
Depreciation.............................................. 214,000
-----------
Total deferred tax assets......................... 2,475,000
Valuation allowance....................................... (2,475,000)
Net deferred tax asset.................................... $ 0
-----------
</TABLE>
As of September 30, 1999, the Company had net operating loss carryforwards
of approximately $4,758,000 to offset future taxable income for Federal income
tax purposes, which will expire through 2019 . Should certain changes in the
Company's ownership occur, there could be a limitation on the utilization of its
net operating losses.
7. LONG-TERM DEBT AND NOTES PAYABLE
In 1996, the Company entered into a loan and stock purchase warrant
agreement with a shareholder providing for maximum borrowings of $500,000. In
connection with this loan, the Company issued an option to purchase increments
of 2.2% of the Company's authorized common stock for each $100,000 of debt
outstanding. The options, in the aggregate, represented 11% of the Company's
common stock outstanding and were exercisable immediately. The agreement also
included anti-dilution provisions which provided the shareholder a 25% ownership
interest in the Company. The warrants and the debt were recorded at their fair
market values of $73,000 and $427,000, respectively. The original issue discount
was amortized annually through the maturity date of the debt on a basis which
approximated the interest method. These warrants were equivalent to 1,283,330
shares of the Company's common stock at September 30, 1998. Principal and
accrued interest under this obligation amounted to $594,000, net of original
issue discount of $26,000 at September 30, 1998. Effective December 31, 1998,
the Company converted the note principal and warrant into
46
<PAGE> 47
N2H2, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999, 1998 AND 1997
1,632,500 shares of common stock with an additional warrant to purchase up to
93,000 shares of the Company's common stock at an exercise price of $.004 per
share. This warrant was cancelled in connection with the Company's initial
public offering.
In April 1997, the Company entered into a notes payable agreement with a
shareholder for $400,000 which bore compounded interest at 12% per annum and was
collateralized by the Company's common stock. Principal and accrued interest
under this obligation amounted to $472,000 as of September 30, 1998. The
principal and interest on the note was repaid in full with the proceeds from the
Company's debt and equity financing in December 1998.
In January 1998, the Company issued $100,000 in notes to certain
shareholders which were repayable in either shares of common stock worth
$100,000 or cash. The notes and accrued interest were converted into 103,675
shares of common stock at $1.16 per share in December 1998 and January 1999.
Notes payable to shareholder at September 30, 1998 in the amount of
$185,000 consisted of unpaid salary at September 30, 1998 due to the shareholder
who is also a senior executive. The note was paid in full with proceeds from the
Company's debt and equity financing in December 1998.
On December 31, 1998, the Company received proceeds from a financing
arrangement in the amount of $4,200,000 in exchange for the issuance of
subordinated debt and common stock. The Company issued $2,000,000 of 11.5%
subordinated debentures maturing on the earlier of October 15, 1999, a change in
control of the Company, or upon an initial public offering. In conjunction with
the notes, the Company issued warrants to purchase up to 465,000 shares of
common stock at an exercise price of $3.14 per share. The debt and the warrants
were recorded at their fair market values of $1,923,000 and $77,000,
respectively. The original issue discount was amortized through the maturity
date of the debt on a basis which approximated the interest method.
Additionally, the Company issued 1,687,113 shares of common stock at $1.16 per
share, net of offering costs of $.14 per share. The principal and interest on
this note was repaid in full through a combination of cash and conversion to
common stock in connection with a private equity financing in May 1999.
Long term debt and notes payable consisted of the following at September
30, 1998:
<TABLE>
<S> <C>
Promissory note to shareholder.............................. $ 620,000
Promissory note to related parties.......................... 472,000
Promissory note............................................. 28,000
Convertible note to shareholders............................ 100,000
Promissory note............................................. 69,000
Promissory note to shareholder.............................. 185,000
----------
1,474,000
Less: Original issue discount............................... (26,000)
Less: Current portion....................................... (30,000)
----------
$1,418,000
==========
</TABLE>
On April 30, 1999, the Company entered into a term loan and revolving line
of credit agreement with Imperial Bank. The term loan is collateralized by a
first priority claim against all of the Company's unpledged assets. The term
loan provides for maximum borrowings of $2.0 million if specified conditions are
met. The revolving line of credit provides for draws of 80% of accounts
receivable assigned as security up to a maximum short-term borrowing of $2.0
million if specified conditions are met. As of September 30, 1999, the amount
available for borrowing under the term loan and revolving line of credit totaled
$1.8 million. Advances on the term loan bear interest on the outstanding daily
balance at the Company's election at the rate of either (a) 1.0% above the prime
rate as announced by Imperial Bank or (b) at a rate equal to the LIBOR plus 400
47
<PAGE> 48
N2H2, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999, 1998 AND 1997
basis points. Advances on the revolving line of credit bear interest on the
outstanding daily balance at a rate of 0.5% above the prime rate as announced by
Imperial Bank.
8. FACTORING AGREEMENT
During fiscal 1999, the Company terminated its factoring agreement with the
bank. Prior to that, pursuant to a factoring agreement entered into in September
1997 and amended July 14, 1998, the Company's bank acted as its factor for the
majority of its receivables, assigned on a pre-approved, full recourse basis, up
to $1,000,000. The Company sold its eligible receivables at a .3% discount to
face value and was charged 1.6% of uncollected assigned balances per month.
Pursuant to the agreement, the Company repurchased any assigned receivables
outstanding 90 days after the invoice date. Total interest paid on factored
receivables was $35,000, $86,000 and $2,000 during 1999, 1998 and 1997,
respectively.
9. STOCK OPTION PLAN AND STOCK PURCHASE WARRANTS
Pursuant to a management services agreement dated December 29, 1997, the
Company issued a warrant to allow the purchase of 2.5% of the Company's
outstanding common stock and equivalents for $250,000 through December 31, 2004.
As of the grant date, this warrant was the equivalent of 222,728 shares. The
warrant vested monthly over the first year of the agreement, and was exercisable
sooner in connection with certain significant corporate events. The fair market
value of these warrants on the date of grant was $12,000, which was amortized as
management service expense in the accompanying financial statements over the
vesting period of the warrants. On March 11, 1999, the Company redeemed the
outstanding warrant for 50,000 shares of its common stock, and recorded a
redemption charge of $185,000 for the year ended September 30, 1999.
The following summarizes stock purchase warrant activity:
<TABLE>
<S> <C>
Balance at September 30, 1996............................... 727,332
Warrants issued............................................. 555,998
----------
Balance at September 30, 1997............................... 1,283,330
Warrants issued............................................. 222,728
----------
Balance at September 30, 1998............................... 1,506,058
Warrants issued............................................. 558,000
Warrants canceled........................................... (1,599,058)
Warrants exercised.......................................... (6,342)
----------
Balance at September 30, 1999............................... 458,658
==========
</TABLE>
The Company recorded compensation expense of $0, $12,000 and $32,000 in
1999, 1998, and 1997, respectively, related to the issuance of these warrants.
Additionally, the Company has issued options to certain non-employees under the
1999 Stock Option Plan as described below.
During the year ended September 30, 1999, the Company settled a lawsuit
with a former employee terminated in fiscal 1998. In connection with the offer,
the Company extended the exercise period for stock options previously granted to
the employee. The Company recorded compensation expense of $530,000 related to
this transaction in the September 30, 1998 financial statements.
During the year ended September 30, 1999, the Company settled a lawsuit
with an employee terminated in fiscal 1998 for cash and stock with an aggregate
value of $332,000. The Company recorded compensation expense of $277,000
relating to the 75,000 shares issued as a part of this settlement. This charge
is included in the Company's financial statements for the year ended September
30, 1998.
48
<PAGE> 49
N2H2, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999, 1998 AND 1997
Effective September 30, 1997, the Company adopted the 1997 Stock Option
Plan (the 1997 Plan) for employees, directors, consultants or independent
contractors under which 2,187,500 shares of common stock are reserved for stock
option grants. Effective April 2, 1999, the Company adopted the 1999 Stock
Option Plan (the 1999 Plan) for employees, directors, consultants or independent
contractors under which 1,329,625 shares of common stock are reserved for stock
option grants. Effective September 14, 1999 the Company adopted the 1999/2000
Transition Plan (the 2000 Plan) for employees, consultants, and independent
contractors under which 750,000 shares of common stock are reserved for stock
options grants. Pursuant to all plans, the Board of Directors may grant
nonqualified and incentive stock options. The vesting period, exercise price and
expiration period of options are established at the discretion of the Board of
Directors, except that the exercise price of incentive stock options must equal
the fair market value of the underlying common stock on the date of the grant.
Option grants to date generally vest over a three or four-year period and expire
ten years from the date of grant.
Effective July 30, 1999 the Company adopted the Non-Employee Director Stock
Option Plan, under which the Board of Directors has provided for the automatic
grant of options to purchase shares of common stock to non-employee directors of
the Company. The Company has reserved a total of 87,500 shares of common stock
for issuance as nonqualified stock options to non-employee directors. The
options are priced based on the fair market value on the date of grant and
become fully exercisable following the sixth month after grant date. Options
granted under this plan are exercisable at any time prior to the expiration date
of the stock option or within three months after the date the grantee ceases to
be a director, whichever is shorter.
During 1999 the Company issued 900,000 options to employees outside of the
authorized plans referenced above which, when exercised, constitute securities
which have not been registered under the Securities Act of 1933, as amended. The
vesting period, exercise price and expiration period of these nonqualified
options are established at the discretion of the Board of Directors.
The following summarizes the activity under the Company's Stock Option
Plans:
<TABLE>
<CAPTION>
OPTIONS
ISSUED
1997 1999 DIRECTORS 2000 OUTSIDE
OPTIONS OUTSTANDING PLAN PLAN PLAN PLAN PLANS TOTAL
------------------- ---------- ---------- --------- ------- ------- ----------
<S> <C> <C> <C> <C> <C> <C>
Balance at September 30, 1996.... --
Options granted.................. 1,827,438 1,827,438
---------- ---------- ------ ------- ------- ----------
Balance at September 30, 1997.... 1,827,438 1,827,438
Options granted................ 696,500 696,500
Options exercised.............. (374,062) (374,062)
Options cancelled.............. (465,938) .......... (465,938)
---------- ---------- ------ ------- ------- ----------
Balance at September 30, 1998.... 1,683,938 1,683,938
Options granted................ 198,249 1,327,624 3,750 900,000 2,429,623
Options exercised.............. (792,603) (792,603)
Options cancelled.............. (83,500) (11,250) (94,750)
---------- ---------- ------ ------- ------- ----------
Balance at September 30, 1999.... 1,006,084 1,316,374 3,750 900,000 3,226,208
========== ========== ====== ======= ======= ==========
</TABLE>
49
<PAGE> 50
N2H2, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999, 1998 AND 1997
<TABLE>
<CAPTION>
OPTIONS
ISSUED
1997 1999 DIRECTORS 2000 OUTSIDE
OPTIONS AVAILABLE PLAN PLAN PLAN PLAN PLANS TOTAL
----------------- ---------- ---------- --------- ------- ------- ----------
<S> <C> <C> <C> <C> <C> <C>
Balance at September 30, 1996.... 2,187,500 2,187,500
Options granted.................. (1,827,438) (1,827,438)
---------- ---------- ------ ------- ------- ----------
Balance at September 30, 1997.... 360,062 360,062
Options granted................ (696,500) (696,500)
Options cancelled.............. 465,938 465,938
---------- ---------- ------ ------- ------- ----------
Balance at September 30, 1998.... 129,500 129,500
Shares authorized.............. 1,329,625 87,500 750,000 2,167,125
Options granted................ (198,249) (1,327,624) (3,750) (1,529,623)
Options cancelled.............. 83,500 11,250 94,750
---------- ---------- ------ ------- ------- ----------
Balance at September 30, 1999.... 14,751 13,251 83,750 750,000 861,752
========== ========== ====== ======= ======= ==========
</TABLE>
<TABLE>
<CAPTION>
OPTIONS
ISSUED
1997 1999 DIRECTORS 2000 OUTSIDE
WEIGHTED AVERAGE EXERCISE PRICES PLAN PLAN PLAN PLAN PLANS TOTAL
-------------------------------- ----- ----- --------- ------- ------- -----
<S> <C> <C> <C> <C> <C> <C>
Balance at September 30, 1996................... $ -- $ -- $ -- $ -- $ -- $ --
Options granted................................. 0.19 0.19
----- ----- ------ ------- ----- -----
Balance at September 30, 1997................... 0.18 $ -- $ -- $ -- $ -- $0.18
Options granted............................... 0.25 0.25
Options exercised............................. 0.20 0.20
Options cancelled............................. 0.18 0.18
----- ----- ------ ------- ----- -----
Balance at September 30, 1998................... $0.21 $ -- $ -- $ -- $ -- $0.21
Options granted............................... 1.46 3.08 11.00 9.48 5.33
Options exercised............................. 0.20 0.20
Options cancelled............................. 0.77 3.70 1.12
----- ----- ------ ------- ----- -----
Balance at September 30, 1999................... $0.42 $3.07 $11.00 $ $9.48 $4.04
----- ----- ------ ------- ----- -----
</TABLE>
The Company applies the accounting provisions prescribed in APB 25 and
related interpretations. In certain instances, the Company has issued stock
options with an exercise price less than the deemed fair value of the Company's
common stock at the date of grant. Accordingly, total compensation costs related
to these stock options of approximately $2,151,000 was deferred during fiscal
1999, and is being amortized over the vesting period of the options, generally
three or four years. Amortization of unearned compensation costs of
approximately $423,000 has been recognized as an expense for the year ended
September 30, 1999. Additionally, unearned compensation costs of $551,000 was
recorded on warrants issued to non-employees of which $339,000 was amortized for
the year ended September 30, 1999.
Pro forma information regarding net loss is required by SFAS No. 123, and
has been determined as if the Company had accounted for its stock options under
the minimum value method of that statement for all periods prior to the Company
becoming a public entity and fair value method of that statement for all periods
subsequent to the Company becoming a public entity. The fair value of each
option is estimated at the date of
50
<PAGE> 51
N2H2, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999, 1998 AND 1997
grant with the following weighted-average assumptions used for the years ended
September 30, 1999, 1998 and 1997:
<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30,
-----------------------------
1999 1998 1997
------- ------- -------
<S> <C> <C> <C>
Risk-free interest rate................................. 5.3% 4.8% 5.9%
Dividend yield.......................................... 0.0% 0.0% 0.0%
Expected term of option................................. 5 years 5 years 5 years
Volatility subsequent to initial public offering........ 95.3% -- --
</TABLE>
For purposes of pro forma disclosures, the estimated fair value of the
option is amortized over the options' vesting period. The Company's pro forma
net loss would have been as follows:
<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30,
---------------------------
1999 1998 1997
------- ------- -----
<S> <C> <C> <C>
Net loss as reported.................................... $(7,721) $(2,597) $(881)
Net loss pro forma...................................... (8,447) (2,623) (881)
Net loss per share as reported.......................... (0.57) (0.30) (0.10)
Net loss per share pro forma............................ (0.62) (0.30) (0.10)
</TABLE>
The weighted-average fair values and weighted-average exercise prices per
share at the date of grant for options granted for the years ended September 30,
1999, 1998 and 1997 were as follows:
<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30,
------------------------
1999 1998 1997
------ ------ ------
<S> <C> <C> <C>
Weighted-average fair value of options granted with exercise
prices equal to the market value of the stock at the date of
grant....................................................... $2.66 $0.05 $0.04
Weighted-average fair value of options granted with exercise
prices less than the market value of the stock at the date
of grant.................................................. 8.05 -- --
Weighted-average fair value of options granted with exercise
prices greater than the market value of the stock at the
date of grant............................................. 2.18 -- --
Weighted-average exercise price of options granted with
exercise prices equal to the market value of the stock at
the date of grant......................................... 3.59
Weighted-average exercise price of options granted with
exercise prices less than the market value of the stock at
the date of grant......................................... 9.30
Weighted-average exercise price of options granted with
exercise prices greater than the market value of the stock
at the date of grant...................................... 3.37
</TABLE>
The following table summarizes information about fixed-price options
outstanding at September 30, 1999 as follows:
<TABLE>
<CAPTION>
WEIGHTED- WEIGHTED- WEIGHTED-
AVERAGE AVERAGE AVERAGE
EXERCISE NUMBER REMAINING EXERCISE NUMBER EXERCISABLE
PRICES OUTSTANDING CONTRACTUAL LIFE PRICE EXERCISABLE PRICE
- -------------- ----------- ---------------- --------- ----------- -----------
<S> <C> <C> <C> <C> <C>
$0.18 - $ 0.27 860,083 8.48 $0.23 271,693 $0.20
$1.16 290,374 9.47 $1.16 -- --
$3.06 - $ 3.70 1,161,875 9.53 $3.29 12,500 $3.06
$9.06 - $11.00 913,876 9.93 $9.50 -- --
</TABLE>
51
<PAGE> 52
N2H2, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999, 1998 AND 1997
10. COMMON STOCK
On September 30, 1997, September 30, 1998, and July 8, 1999, the Board of
Directors declared a one hundred twenty five-for-one, a seven-for-one, and a
five-for-two stock split, respectively, on the Company's common stock effected
in the form of a stock dividend to holders of record on these dates. Common
stock issued and stock option information in these financial statements have
been restated to reflect these splits.
As of May 10, 1999, the Company amended its Articles of Incorporation to
authorize the issuance of 50,000,000 shares of preferred stock and 250,000,000
shares of common stock at no par value. The terms of the preferred stock are to
be set by the Board of Directors.
On May 11, 1999, the Company completed a private equity financing in which
2,443,215 shares of common stock were sold to investors at $3.70 per share for
an aggregate of $8,830,122, net of issuance costs. In connection with this
financing, the Company satisfied promissory notes plus accrued interest totaling
$970,005 by issuing 262,447 shares of common stock.
On July 29, 1999, the Company completed its initial public offering of
5,000,000 shares of common stock at a purchase price of $13.00 per share. Of the
shares sold, 4,950,000 were sold by the Company, and 50,000 were offered by a
group of selling shareholders. Net proceeds received by the Company were $58.4
million.
11. LEASE COMMITMENTS
The Company's property held under capital leases, which is included in
property and equipment on the balance sheet at September 30, 1999 and 1998,
consists primarily of computer equipment in the gross amount of $2,644,000 and
$1,006,000, respectively. Related accumulated amortization for those assets is
$675,000 and $189,000 for the years then ended. The Company is also committed
under operating leases for its headquarter facilities which includes a lease
escalation clause. Rent expense for the years ended September 30, 1999, 1998 and
1997 was $307,000, $188,000 and $46,000, respectively.
Minimum annual rental commitments on all leases at September 30, 1999 are
as follows:
<TABLE>
<CAPTION>
OPERATING CAPITAL
YEARS ENDING SEPTEMBER 30, LEASE LEASES
-------------------------- ---------- ----------
<S> <C> <C>
2000...................................................... $1,026,000 $ 779,000
2001...................................................... 1,238,000 619,000
2002...................................................... 1,291,000 338,000
2003...................................................... 1,334,000 36,000
2004...................................................... 1,375,000 --
Thereafter................................................ 833,000 --
---------- ----------
Total minimum lease payments...................... $7,097,000 1,772,000
==========
Less: Amount representing interest.......................... (354,000)
----------
Present value of capital lease obligation................... 1,418,000
Less: Current portion....................................... (466,000)
----------
Long-term obligations at September 30, 1999................. $ 952,000
==========
</TABLE>
52
<PAGE> 53
N2H2, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999, 1998 AND 1997
12. NET LOSS PER SHARE
Statement of Financial Accounting Standards No. 128, "Earnings Per Share"
(SFAS) No. 128, issued in February 1997, requires presentation of earnings per
share on a basic and diluted earnings per share basis. Earnings per share for
prior periods presented have been stated to reflect the adoption of SFAS No.
128. A reconciliation of the basic and diluted earnings per share to the shares
used is as follows:
<TABLE>
<CAPTION>
SEPTEMBER 30,
----------------------------------------
1999 1998 1997
----------- ----------- ----------
<S> <C> <C> <C>
Net loss..................................... $(7,721,000) $(2,597,000) $ (881,000)
Weighted-average shares
outstanding -- basic....................... 13,620,000 8,687,000 8,390,000
Weighted-effect of dilutive options and
warrants...................................
----------- ----------- ----------
Weighted-average shares
outstanding -- diluted..................... 13,620,000 8,687,000 8,390,000
=========== =========== ==========
Basic and diluted net loss per share......... $ (.57) $ (.30) $ (.10)
=========== =========== ==========
</TABLE>
The Company's outstanding options and warrants have not been considered in
calculating diluted earnings per share because their effect is anti-dilutive.
13. COMMITMENTS AND CONTINGENCIES
The Company is from time to time involved in various claims and legal
proceedings of a nature considered by management to be routine and incidental to
its business. In the opinion of the Company's management, after consultation
with outside legal counsel, the ultimate disposition of such matters is not
expected to have a material adverse effect on the Company's financial position,
results of operations or liquidity.
14. SUBSEQUENT EVENTS
Subsequent to the end of the fiscal year, the Company entered into reseller
agreements with British Telecom, PLC, AT&T and Inktomi. These agreements allow
these entities to sell the Company's filtering service to others. The Company
also entered into an agreement with OneName, Inc. which includes an investment
in OneName, a marketing agreement and a technology and patent license.
15. SUPPLEMENTAL CASH FLOW INFORMATION
Supplemental disclosure of cash flow information is summarized below for
the years ended September 30, 1999, 1998 and 1997:
<TABLE>
<CAPTION>
YEARS ENDED SEPTEMBER 30,
----------------------------------
1999 1998 1997
---------- -------- --------
<S> <C> <C> <C>
NONCASH INVESTING AND FINANCING ACTIVITIES:
Equipment obtained through capital lease........ $1,638,000 $757,000 $185,000
Value ascribed to warrants issued with note
payable...................................... 77,000
Conversion of notes payable to common stock..... 1,693,000 32,000
Notes payable surrendered for the exercise price
of stock options............................. 75,000
Note receivable from shareholder for exercise of
options...................................... 25,000
Unearned compensation........................... 2,702,000
Cash paid for interest.......................... 541,000 178,000 36,000
</TABLE>
53
<PAGE> 54
N2H2, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1999, 1998 AND 1997
(a)(2)
N2H2, INC.
VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
<TABLE>
<CAPTION>
BALANCE AT CHARGES TO BALANCE AT
BEGINNING OF COSTS & CHARGES TO END OF
DESCRIPTION FISCAL PERIOD EXPENSES OTHER ACCOUNTS FISCAL PERIOD
----------- ------------- ---------- -------------- ----------------
<S> <C> <C> <C> <C>
Year Ended September 30, 1997
Allowance for doubtful
accounts.................... -- --
Year Ended September 30, 1998
Allowance for doubtful
accounts.................... -- (8,000) (8,000)
Year Ended September 30, 1999
Allowance for doubtful
accounts.................... (8,000) (261,000) 127,000 (142,000)
Tax valuation allowance........ -- (2,475,000) (2,475,000)
</TABLE>
54
<PAGE> 55
PART III
ITEM 9.CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE.
Not applicable
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The information required by this item with respect to the Company's
directors and compliance with Section 16(a) of the Exchange Act is included in
the following sections of the Company's Proxy Statement for its 2000 Annual
Meeting of Shareholders which sections are incorporated by reference herein and
will be filed within 120 days after the end of the Company's fiscal year:
Executive Officers of the Company
Election of Directors
Compliance with Section 16(a) of the Exchange Act of 1934
ITEM 11. EXECUTIVE COMPENSATION.
The information required under this item is included in the following
sections of the Company's Proxy Statement for its 2000 Annual Meeting of
Shareholders, which sections are incorporated by reference herein and will be
filed within 120 days after the end of the Company's fiscal year:
Compensation of Executive Officers in the Year Ended September 30, 1999
Compensation Committee Report on Executive Compensation
Stock Price Performance
Director Compensation
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The information required under this item is included in the following
section of the Company's Proxy Statement for its 2000 Annual Meeting of
Shareholders, which section is incorporated by reference herein and will be
filed within 120 days after the end of the Company's fiscal year:
Security Ownership of Certain Beneficial Owners and Management
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The information required under this item is included in the following
sections of the Company's Proxy Statement for its 2000 Annual Meeting of
Shareholders, which sections are incorporated by reference herein and will be
filed within 120 days after the end of the Company's fiscal year:
Election of Directors
Transactions with Management, Certain Transactions
55
<PAGE> 56
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
a. The following documents are filed as part of this report under Item 8:
<TABLE>
<CAPTION>
PAGE
----
<S> <C> <C>
(1) Consolidated Financial Statements
Report of Independent Accountants 36
Consolidated Balance Sheets as of September 30, 1999
and 1998 37
Consolidated Statements of Operations for the Fiscal
Years Ended September 30, 1999,
1998 and 1997 38
Consolidated Statements of Changes in Shareholders'
Equity (Deficit) for the Fiscal
Years Ended September 30, 1999, 1998 and 1997 39
Consolidated Statements of Cash Flows for the Fiscal
Years Ended September 30, 1999,
1998 and 1997 40
Consolidated Notes to Financial Statements 41
(2) Financial Statement Schedule
Valuation and qualifying accounts and reserves
</TABLE>
b. Reports on Form 8-K
There were no reports on Form 8-K filed during the fourth quarter ended
September 30, 1999.
c. Exhibits. The following exhibits are filed or incorporated by reference
pursuant to Item 601 of Regulation S-K:
56
<PAGE> 57
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION OF DOCUMENT
------- -----------------------
<C> <S>
3.1+ Form of Restated Articles of Incorporation of the
registrant.(3.1)(1)
3.2+ Amended Bylaws of the registrant.(3.2)(1)
4.1+ Form of common stock certificate.(4.1)(1)
10.1+ Bank of California Center Lease dated August 31, 1995,
between Continental Seattle Partners Limited Partnership and
Toll-Free Cellular Inc.(10.1)(1)
10.2+ Assignment of Lease dated March 13, 1998, between
Continental Seattle Partners Limited Partnership, Toll-Free
Cellular Inc. and the registrant.(10.2)(1)
10.3+ Union Bank of California Center Office Lease dated March 12,
1999, between Walton Seattle Investors I, L.L.C. and the
registrant.(10.3)(1)
10.4+ Loan and Security Agreement dated April 30, 1999, between
Imperial Bank and the registrant, together with exhibits
thereto.(10.4)(1)
10.5+ 1997 Stock Option Plan, as amended.(10.5)(1)
10.6+ 1999 Stock Option Plan.(10.6)(1)
10.7+ 1999 Nonemployee Director Stock Option Plan.(10.7)(1)
10.8+ Search Engine Services Agreement dated January 19, 1998,
between Inktomi Corporation and the registrant.(10.8)(1)
10.9+ Employment Agreement of Peter H. Nickerson dated May 10,
1999.(10.9)(1)
10.10+ Employment Agreement of John F. Duncan dated May 10,
1999.(10.10)(1)
10.11+ Employment Agreement of Kevin E. Fink dated May 10,
1999.(10.11)(1)
10.12+ Registration Rights Agreement dated effective as of December
31, 1998.(10.12)(1)
10.13+ Internet Data Center Services Agreement dated effective
August 31, 1998, between Exodus Communications, Inc. and the
registrant.(10.15)(1)
10.14+ Amendment Agreement entered into June 30, 1999, to the
Search Engine Services Agreement dated January 19, 1999,
between Inktomi Corporation and the registrant.(10.16)(1)
10.15+ Information Services Agreement dated June 30, 1999, between
Inktomi Corporation and the registrant.(10.17)(1)
10.16 First Amendment, dated June 16, 1999, to Union Bank of
California Office Lease of March 12, 1999, between Walton
Seattle Investors I, L.L.C. and the registrant.(10.1)(2)
10.17 Second Amendment, dated August 10, 1999, to Union Bank of
California Center Office Lease of March 12, 1999, between
Walton Seattle Investors I, L.L.C and the
registrant.(10.2)(2)
10.18 Third Amendment, dated August 12, 1999, to Union Bank of
California Center Office Lease of March 12, 1999, between
Walton Seattle Investors I, L.L.C and the
registrant.(10.3)(2)
10.19 Employment Agreement of David W. Arnold dated August 23,
1999.(10.4)(2)
10.20 Option to purchase Common Stock issued August 24, 1999 to
David W. Arnold.(10.5)(2)
10.21 Employment Agreement of Eric H. Posner, dated September 9,
1999. (filed herewith)
10.22 Option to purchase Common Stock issued September 30, 1999 to
Eric H. Posner. (filed herewith)
10.23 Employment Agreement of William A. Golding, dated September
13, 1999. (filed herewith)
10.24 Option to purchase Common Stock issued September 30, 1999 to
William A. Golding. (filed herewith)
27.1 Financial Data Schedule. (filed herewith)
</TABLE>
- ---------------
(1) Incorporated by reference to the exhibit shown in the preceding parentheses
and filed with the registrant's Registration Statement on Form S-1 (File No.
333-78495).
(2) Incorporated by reference to the exhibit shown in the preceding parentheses
and filed with the registrant's Form 10-Q for the quarter ended September
30, 1999.
57
<PAGE> 58
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized, in the City of
Seattle, State of Washington, on December 29, 1999.
N2H2, Inc.
By: /s/ JOHN F. DUNCAN
------------------------------------
Vice President -- Chief Financial
Officer, Secretary and Treasurer
<TABLE>
<CAPTION>
SIGNATURE TITLE
--------- -----
<S> <C>
/s/ PETER H. NICKERSON President, Chief Executive Officer, Chairman
- ----------------------------------------------------- and Director (principal executive officer)
/s/ JOHN F. DUNCAN Vice President -- Chief Financial Officer,
- ----------------------------------------------------- Secretary and Treasurer (principal financial
and accounting officer)
/s/ HOLLIS R. HILL Director
- -----------------------------------------------------
/s/ MARK A. SEGALE Director
- -----------------------------------------------------
/s/ RICHARD R. ROWE Director
- -----------------------------------------------------
</TABLE>
58
<PAGE> 1
EXHIBIT 10.21
EXECUTIVE EMPLOYMENT AGREEMENT
THIS EMPLOYMENT AND NONCOMPETITION AGREEMENT (this "Agreement"), dated
as of September 9, 1999, is entered into by and between N(2)H(2), INC., a
Washington corporation (the "Company") and ERIC H. POSNER, a resident of the
State of Washington (the "Executive").
WHEREAS, the Company wishes to assure itself of the services of
Executive for the period provided in this Agreement; and
WHEREAS, Executive is willing to serve in the employ of the Company as
Vice President - Business Division of the Company for said period; and
WHEREAS, the parties desire by this writing to set forth the terms and
conditions of the employment relationship between the Company and Executive.
NOW, THEREFORE, in consideration of the mutual covenants contained
herein and other good and valuable consideration, the receipt and sufficiency of
which are hereby acknowledged, the parties hereto agree as follows:
1. Employment. The Company hereby employs Executive, and Executive
agrees to accept such employment, upon the terms and conditions herein set
forth.
2. Employment Period. The initial term of employment hereunder shall
commence on the date hereof and continue for a period of two (2) years ending on
September 8, 2001 (the "Initial Term"), subject to earlier termination as
provided herein. If Executive's employment is not earlier terminated, following
the Initial Term, this Agreement and Executive's employment hereunder shall
renew indefinitely until terminated by either party in accordance with Section 5
below (the "Employment Period").
3. Position and Duties. Executive hereby agrees to serve as an employee
of the Company as Vice President - Business Division. Executive shall report to
the Company's Chief Operating Officer (the "COO") for such other officer(s) as
designated by the Board of Directors of the Company (the "Board"). Executive
shall devote his best efforts and his full business time and attention to the
performance of services to the Company in accordance with the terms hereof and
as may reasonably be requested by the Board, the COO or other Board-designated
officer of the Company; provided that any permanent material reduction of
Executive's duties and responsibilities or a permanent change in Executive's
duties and responsibilities such that Executive's duties and responsibilities
are inconsistent with the type of duties and responsibilities of Executive in
effect immediately prior to such reduction or change shall constitute Good
Reason for voluntary termination by Executive.
<PAGE> 2
4. Compensation and Other Terms of Employment.
(a) Compensation. In consideration of the performance of his
duties hereunder, during the Employment Period, the Company agrees to pay
Executive during the Term of his employment at a base salary of One Hundred
Eighty Thousand and No/100 Dollars ($180,000.00) per annum (the "Base
Compensation"). All amounts payable to Executive under this Section 4(a) shall
be paid in accordance with the Company's regular payroll practices (e.g., timing
of payments and standard employee deductions, such as income tax, Social
Security and Medicare withholdings). Base Compensation shall increase by ten
percent (10%) during each twelve (12) month period beginning October 1, 2000 if
the Company's gross revenues reflected in its audited financial statements for
the fiscal year ending September 30, have increased by at least one hundred
percent (100%) over the gross revenues for the immediately preceding fiscal
year.
(b) Bonus. In addition to the Base Compensation described in
Section 4(a) above and any additional bonuses approved by the Board, Executive
shall receive a quarterly bonus in the amount equal to 1.0% of the increase, if
any, of the Company's Business Division's gross revenues during such quarter
over the gross revenues for the same quarter during the immediately preceding
year. For purposes of this Section 4(b), gross revenues shall be computed in
accordance with generally accepted accounting principles consistently applied.
Bonus compensation for any quarter shall be payable on the 15th day of the month
following the end of the quarter and shall be subject to standard employee
deductions.
(c) Business Expenses. During the Employment Period, upon
presentation of vouchers and similar receipts, Executive shall be entitled to
receive reimbursement in accordance with the policies and procedures of the
Company maintained from time to time for all reasonable business expenses
actually incurred in the performance of his duties hereunder.
(d) Vacation. During the Employment Period, Executive shall be
entitled to four (4) weeks paid annual vacation. Executive's vacation will be
scheduled at those times most convenient to the Company's business.
(e) Benefits. During the Employment Period, the Company shall
provide to Executive such other employment benefits as may from time to time, be
made generally available to executives of the Company, including, without
limitation, the opportunity to participate in a group health insurance plan
(including coverage of Executive's family) and other benefit plans, if any are
in existence, in accordance with the terms of such plans, which benefits are
intended to be substantially similar to those provided by the Company as of the
date hereof (assuming availability at costs consistent with and comparable to
those currently paid by the Company); provided, however, that the Company shall
not be required to establish, continue or maintain any benefit plans.
(f) Additional Benefits. The Company shall reimburse Executive
on a monthly basis for reasonable commuting costs, parking, health club dues and
high speed Internet access at home.
2
<PAGE> 3
5. Termination of Employment. Executive's employment shall be terminated
on any of the following occurrences:
(a) Executive's Permanent Disability. For purposes of this
Agreement, "Permanent Disability" means an illness, injury or other physical or
mental condition continuing for at least ninety (90) consecutive days, arising
at any time during the Employment Period, unless with reasonable accommodation
Executive could perform the essential functions of his position and making such
accommodation would not result in an undue hardship to the Company. If
Executive's employment is terminated because of Executive's Permanent
Disability, the Company shall continue to pay all Base Compensation and pro rata
bonus amounts accrued pursuant to Sections 4(a) and (b) for the longer of (i)
the remaining Initial Term of this Agreement or (ii) twelve (12) months.
(b) Executive's Death. If Executive's employment is terminated
because of Executive's death, the Company shall pay to Executive's personal
representative (on behalf of Executive's estate), within 60 days after the
Company receives written notice of such representative's appointment, all Base
Compensation and pro rata bonus amounts, if any, accrued pursuant to Sections
4(a) and 4(b) above through the date of termination, and shall continue to pay
all Base Compensation and pro rata bonus amounts, if any, accrued pursuant to
Sections 4(a) and (b) for the longer of (i) the remaining Initial Term of the
Agreement or (ii) twelve (12) months.
(c) For Cause. If Executive's employment is terminated with
Cause (as defined in Section 6(a) below), the Company shall pay to Executive all
Base Compensation accrued through the date of termination pursuant to Sections
4(a) and 4(b) above, whereupon the Company shall have no further obligations to
Executive under this Agreement. Executive and his dependents, if any, shall also
be entitled to any continuation health insurance coverage rights available under
applicable law. Without waiving any rights the Company may have hereunder or
otherwise, the Company hereby expressly reserves its rights to proceed against
Executive for damages in connection with any claim or cause of action that the
Company may have arising out of or related to Executive's employment hereunder.
(d) Termination By The Company Without Cause or Voluntary
Termination By Executive With Good Reason. If Executive's employment with the
Company is terminated by the Company without Cause, or is Voluntarily Terminated
(as defined in Section 6(b) below) by Executive with Good Reason (as defined in
Section 6(c) below), the Company shall pay to Executive all Base Compensation
and pro rata bonus amounts, if any, accrued pursuant to Sections 4(a) and 4(b)
above through the date of such termination and shall continue to pay Executive's
Base Compensation and bonus for a period eighteen months (18) months thereafter
(the "Severance Period"). Those unvested stock options which are scheduled to
vest between the date of termination and the end of the Severance Period shall
be deemed to vest immediately, except that if such termination occurs in
connection with a Change in Control (as defined in Section 6(d) below), then all
unvested stock options shall be deemed to vest immediately. Executive and his
dependents, if any, shall also be entitled to any continuation health insurance
coverage rights available under applicable law.
3
<PAGE> 4
(e) Voluntary Termination By Executive Without Good Reason. If
Executive's employment with the Company is Voluntarily Terminated by Executive
without Good Reason, the Company shall pay to Executive all Base Compensation
and bonus accrued through the date of termination pursuant to Sections 4(a) and
4(b) above, whereupon the Company shall have no further obligations to Executive
under this Agreement. Executive and his dependents, if any, shall also be
entitled to any continuation health insurance coverage rights available under
applicable law. Without waiving any rights the Company may have hereunder or
otherwise, the Company hereby expressly reserves its rights to proceed against
Executive for damages in connection with any claim or cause of action that the
Company may have arising out of or related to Executive's employment hereunder.
(f) Voluntary Termination By Executive Following Change in
Control. If Executive's employment with the Company is Voluntarily Terminated by
Executive within 30 days of a Change in Control (as defined in Section 6(d)
below), the Company shall pay to Executive all Base Compensation and bonus
amounts accrued pursuant to Sections 4(a) and 4(b) through a period equal to the
Severance Period. All unvested stock options shall be deemed to vest
immediately. Executive and his dependents, if any, shall also be entitled to any
continuation of health insurance coverage rights available under the applicable
law.
(g) Termination Obligations.
(i) Executive hereby acknowledges and agrees that all
personal property and equipment furnished to or prepared by Executive in the
course of or incident to his employment by the Company, belongs to the Company
and shall be promptly returned to the Company upon termination of the Employment
Period. "Personal property" includes, without limitation, all books, manuals,
records, reports, notes, contracts, lists, blueprints, and other documents, or
materials, or copies thereof (including computer files), and all other
proprietary information belonging, or relating to the business of, the Company
or any affiliate. Following termination, Executive will not retain any written
or other tangible materials containing any proprietary information of the
Company or any affiliate.
(ii) Upon termination of the Employment Period,
Executive shall be deemed to have resigned from all offices, directorships and
similar positions then held with the Company or any affiliate.
(iii) The representations and warranties contained
herein and Executive's obligations under Sections 9 and 10 shall survive
termination of the Employment Period and the expiration or termination of this
Agreement. Any provision hereof required to give meaning and effect to such
surviving provisions shall also survive the termination of the Employment Period
and the expiration or termination of this Agreement.
6. Definitions. For the purposes of this Agreement the following terms
and phrases shall have the following meanings:
(a) "Cause" shall mean a termination of Executive's employment
by the Company due to (i) Executive's failure or refusal to perform his duties,
responsibilities or
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obligations hereunder after at least fourteen (14) days' prior written notice
regarding any such failure or refusal, (ii) Executive's breach of any
noncompetition or confidentiality agreement with the Company; (iii) the willful
misappropriation of funds or property of the Company; (iv) use of alcohol or
drugs which interferes with performance of Executive's obligations under this
Agreement, continuing after at least thirty (30) days' prior written notice; (v)
conviction of a felony or of any crime involving moral turpitude, fraud or
misrepresentation; or (vi) the commission by Executive of any willful or
intentional act in disregard of the interests of the Company which could
reasonably be expected to materially injure the reputation, business or business
relationships of the Company, provided, however, that a good faith mistake in
the normal course of business shall not be considered "Cause" under this Section
6(a).
(b) "Voluntary Termination" shall mean the termination by
Executive of his employment by the Company by voluntary resignation or any other
means other than (i) death or Permanent Disability, (ii) simultaneous with
termination for Cause or (iii) simultaneous with or following an event which,
whether or not known to the Company at the time of such Voluntary Termination by
Executive, would constitute Cause.
(c) "Good Reason" shall mean, with respect to a Voluntary
Termination, (i) if (A) such Voluntary Termination occurs within the thirty (30)
day period immediately following a permanent material reduction of Executive's
duties and responsibilities or a permanent change in Executive's duties and
responsibilities such that Executive's duties and responsibilities are
inconsistent with the type of duties and responsibilities of Executive in effect
immediately prior to such reduction or change, (B) such Voluntary Termination
promptly follows a reduction in Executive's benefits, or (C) the President or
the Board otherwise determines that a Voluntary Termination by Executive is for
"Good Reason" under the circumstances then prevailing, and (ii) if Executive
provides written notice of such Good Reason to the Company and the Company does
not correct the circumstances giving rise to such Good Reason during the
following 30-day period. The Company's termination or material breach of this
Agreement without Cause shall constitute Good Reason.
(d) "Change In Control" means the occurrence of any one of the
following events:
(i) any recapitalization, consolidation or merger of the
Company in which the Company is not the continuing or surviving entity or which
contemplates that all or substantially all of the business and/or assets of the
Company shall be controlled by another person or entity other than the person or
entity which controlled the Company immediately prior to such recapitalization,
consolidation or merger;
(ii) any sale, lease, exchange or transfer (in one
transaction or series of related transactions) of all or substantially all of
the assets of the Company; or
(iii) approval by the members of the Company of any plan
or proposal for the liquidation or dissolution of the Company, unless such plan
or proposal is abandoned within 60 days following such approval.
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7. Stock Options. Subject to the discretion of the Company's Board of
Directors Executive shall be entitled to participate in any Company stock option
or stock purchase plan.
8. Records and Confidential Information.
(a) Executive acknowledges that, in connection with the
performance of his duties during the Term of this Agreement, the Company will
make available to Executive, or Executive will have access to, certain
Confidential Information (as defined below) and Trade Secrets (as defined by the
Uniform Trade Secrets Act) of the Company and its affiliates. Executive
acknowledges and agrees that any and all Confidential Information or Trade
Secrets of the Company learned or obtained by Executive during the course of his
employment by the Company or otherwise (including, without limitation,
information that Executive obtained through or in connection with his ownership
of and employment by the Company prior to the date hereof) whether developed by
Executive alone or in conjunction with others or otherwise, shall be and is the
property of the Company and its affiliates.
(b) Confidential Information and Trade Secrets of the Company
will be kept confidential by Executive, will not be used in any manner which is
detrimental to the Company, will not be used other than in connection with
Executive's discharge of his duties hereunder, and will be safeguarded by
Executive from unauthorized disclosure.
(c) Following Executive's termination hereunder, as soon as
possible after the Company's written request, Executive will return to the
Company all written Confidential Information and Trade Secrets of the Company
will have been provided to Executive, and Executive will destroy all copies of
any analyses, compilations, studies or other documents prepared by Executive or
for Executive's use containing or reflecting any Confidential Information or
Trade Secrets of the Company. Within 5 business days of the receipt of such
request by Executive, Executive shall, upon written request of the Company,
deliver to the Company a notarized document certifying that such written
Confidential Information and Trade Secrets of the Company have been returned or
destroyed in accordance with this Section.
(d) For the purposes of this Agreement, "Confidential
Information" shall mean all confidential and proprietary information to the
Company, and its affiliates, including, without limitation, the Company's
marketing strategies, pricing policies or characteristics, customers and
customer information, product or product specifications, designs, manufacturing
processes, manufacturing costs, cost of materials, customer lists, business or
business prospects, plans, proposals, codes, marketing studies, research,
reports, investigations, or other information of similar character. For purposes
of this Agreement, Confidential Information shall not include and Executive's
obligations under this Section shall not extend to (i) information which is
generally available to the public or within the industry, (ii) information
obtained by Executive from third persons not under agreement to maintain the
confidentiality of the same and (iii) information which is required to be
disclosed by law or legal process.
(e) This Section is not intended to, and does not, limit in any
way Executive's duties and obligations to the Company under statutory and common
law not to disclose or make personal use of any Confidential Information or
Trade Secrets of the Company.
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9. Assignment of Inventions.
(a) Definition of Inventions. "Inventions" means discoveries,
developments, concepts, ideas, methods, designs, improvements, inventions,
formulas, processes, techniques, programs, know-how and data, whether or not
patentable or registerable under copyright or similar statutes, except any of
the foregoing that (i) is not related to the business of the Company or its
affiliates, or the Company's (and its affiliates') actual or demonstrable
research or development (ii) does not involve the use of any equipment,
supplies, facility or Confidential Information of the Company, (iii) was
developed entirely on Executive's own time, and (iv) does not result from any
work performed by Executive for the Company.
(b) Assignment. Executive agrees to and hereby does assign to
the Company, without further consideration, all of his right, title and interest
in any and all Inventions he may make during the Term hereof.
(c) Duty to Disclose and Assist. Executive agrees to promptly
disclose in writing all Inventions to the Company, and to provide all assistance
reasonably requested by the Company in the preservation of the Company's
interests in the Inventions including obtaining patents in any country
throughout the world. Such services will be without additional compensation if
Executive is then employed by the Company and for reasonable compensation and
subject to his reasonable availability if he is not. If the Company cannot,
after reasonable effort, secure Executive's signature on any document or
documents needed to apply for or prosecute any patent, copyright, or other right
or protection relating to an Invention, whether because of his physical or
mental incapacity or for any other reason whatsoever, Executive hereby
irrevocably designates and appoints the Company and its duly authorized officers
and agents as his agent and attorney-in-fact, to act for and in his behalf and
in his name and stead for the purpose of executing and filing any such
application or applications and taking all other lawfully permitted actions to
further the prosecution and issuance of patents, copyrights, or similar
protections thereon, with the same legal force and effect as if executed by him.
(d) Ownership of Copyrights. Executive agrees that any work
prepared for the Company, which is eligible for copyright protection under the
laws of the United States or any other country, shall be a work made for hire
and ownership of all copyrights (including all renewals and extensions) therein
shall vest in the Company. If any such work is deemed not to be a work made for
hire for any reason, Executive hereby grants, transfers and assigns all right,
title and interest in such work and all copyrights in such work and all renewals
and extensions thereof to the Company, and agrees to provide all assistance
reasonably requested by the Company in the establishment, preservation and
enforcement of the Company's copyright in such work, such assistance to be
provided at the Company's expense but without any additional compensation to
Executive. Executive hereby agrees to and does hereby waive the enforcement of
all moral rights with respect to the work developed or produced hereunder,
including without limitation any and all rights of identification of authorship
and any and all rights of approval, restriction or limitation on use or
subsequent modifications.
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(e) Litigation. Executive agrees to render assistance and
cooperation to the Company at its request regarding any matter, dispute or
controversy with which the Company may become involved and of which Executive
has or may have reason to have knowledge, information or expertise. Such
services will be without additional compensation if Executive is then employed
by the Company and for reasonable compensation and subject to his reasonable
availability if he is not.
10. Covenants Not to Compete.
(a) Non-Interference with Customer Accounts. Executive covenants
and agrees that, during the Employment Period, and for a period of eighteen (18)
months after the date of termination of Executive's employment with the Company,
Executive shall not, directly or indirectly, personally or on behalf of any
other person, business, corporation, or entity, contact or do business with any
customer of the Company with respect to any Internet filtering product or
service which is competitive with any product or service which was sold,
provided, or under development by the Company at any time during the
twelve-month period prior to the date of termination of Executive's employment
with the Company. This covenant applies to those customers and the related
entities of those customers to which the Company sold its Internet filtering
products or services at any time during the twelve-month period prior to the
date of termination of Executive's employment with the Company, and those
prospective customers with which the Company actively pursued sales or the
provision of services at any time during the twelve-month period prior to the
date of termination of Executive's employment with the Company.
(b) Noncompetition. Executive covenants and agrees that, during
the Employment Period, and for a period of eighteen (18) months after the date
of termination of Executive's employment with the Company, Executive shall not,
directly or indirectly, own an interest in, operate, join, control, advise, work
for, serve as a director of, have a financial interest which provides any
control of, or participate in any corporation, partnership, proprietorship,
firm, association, person, or other entity (collectively, "Businesses")
producing, designing, providing, soliciting orders for, selling, distributing,
or marketing any Internet filtering products, goods, equipment, or services
which are similar to any Internet filtering products, goods, equipment or
services produced, sold or provided by the Company at any time during the
twelve-month period prior to the date of termination of Executive's employment
with the Company. THE PARTIES ACKNOWLEDGE THAT THE COMPANY PROVIDES SERVICES ON
A WORLD WIDE BASIS AND, ACCORDINGLY THAT IT IS NOT FAIR OR APPROPRIATE TO
RESTRICT THE FOREGOING COVENANT GEOGRAPHICALLY.
(c) This covenant does not prohibit the mere ownership of less
than two percent (2%) of the outstanding stock of any publicly traded
corporation as long as Executive is not otherwise in violation of this covenant.
(d) Non-Diversion. During the Employment Period, and for a
period of eighteen (18) months after the date of termination of Executive's
employment with the Company, Executive shall not divert or attempt to divert or
take advantage of or attempt to take advantage of any actual or potential
business or opportunities of the Company or its subsidiaries or affiliates which
Executive became aware of as the result of his employment with the Company.
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(e) Non-Recruitment. Executive agrees that the Company has
invested substantial time and effort in assembling its present workforce.
Accordingly, Executive agrees that during the Employment Period and for a period
of eighteen (18) months after the date of termination of Executive's employment
with the Company, Executive shall not (i) hire away any individuals who were
employed by the Company or its subsidiaries or affiliates during the
twelve-month period prior to the date of termination of Executive's employment
with the Company or (ii) directly or indirectly entice, solicit or seek to
induce or influence any such employees to leave their employment with the
Company or its subsidiaries or affiliates.
(f) Non-Disparagement. Executive and the Company mutually
covenant and agree that, during the Employment Period and for a period of
eighteen (18) months after the date of termination of Executive's employment
with the Company, neither shall, directly or indirectly disparage the other.
(g) Remedies. Both parties acknowledge that should they
materially breach this Agreement, it will be difficult to determine the
resulting damages to the non-breaching party, and, in addition to any other
remedies the non-breaching party may have, the non-breaching party shall be
entitled to temporary injunctive relief without being required to post a bond
and to permanent injunctive relief without the necessity of proving actual
damage. In the event of any action or proceeding to interpret or enforce this
Agreement, the prevailing party shall be entitled to recover its reasonable
attorneys' fees and costs, whether or not litigation is actually commenced and
including litigation of any appeal. Failure of either party to seek any or all
remedies in one case does not restrict that party from seeking any remedies in
another situation, and no such action shall not constitute a waiver of any of
the party's rights.
(h) Severability and Modification of Any Unenforceable Covenant.
It is the parties' intent that each of the covenants be read and interpreted
with every reasonable inference given to its enforceability. However, it is also
the parties' intent that if any term, provision or condition of the covenants is
held by a court of competent jurisdiction to be invalid, void or unenforceable,
the remainder of the provisions thereof shall remain in full force and effect
and shall in no way be affected, impaired or invalidated. Finally, it is also
the parties' intent that if a court should determine any of the covenants are
unenforceable because of over breadth, then the court shall modify said covenant
so as to make it reasonable and enforceable under the prevailing circumstances.
(i) Tolling. In the event of the breach by Executive of any
covenant the running of the period of restriction shall be automatically tolled
and suspended for the amount of time that the breach continues, and shall
automatically recommence when the breach is remedied so that the Company shall
receive the benefit of Executive's compliance with the covenants.
11. No Assignment. This Agreement and the rights and duties hereunder
are personal to Executive and shall not be assigned, delegated, transferred,
pledged or sold by Executive without the prior written consent of the Company.
Executive hereby acknowledges and agrees that the Company may assign, delegate,
transfer, pledge or sell this Agreement and the rights and duties hereunder (a)
to an affiliate of the Company or (b) to any third party acquiring through
merger,
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consolidation or purchase all or substantially all of the business and/or assets
of the Company. This Agreement shall inure to the benefit of and be enforceable
by the parties hereto, and their respective heirs, personal representatives,
successors and assigns.
12. Miscellaneous Provisions.
(a) Payment of Taxes. To the extent that any taxes become
payable by Executive by virtue of any payments made or benefits conferred by the
Company, the Company shall not be liable to pay or obligated to reimburse
Executive for any such taxes or to make any adjustment under this Agreement. Any
payments otherwise due under this Agreement to Executive, including, but not
limited to, the Base Compensation and any bonus, shall be reduced by any
required withholding for federal, state and/or local taxes and other appropriate
payroll deductions.
(b) Insurance. The Company may, from time to time, apply for and
take out, in its own name and at its own expense, life, health, accident,
disability or other insurance on Executive in any sum or sums that it may deem
necessary to protect its interests, and Executive shall aid and cooperate in all
reasonable respects with the Company in procuring any and all such insurance,
including, without limitation, submitting to the usual and customary medical
examinations, and by filling out, executing and delivering such applications and
other instruments in writing as may be reasonably required by an insurance
company or companies to which an application or applications for such insurance
may be made by or for the Company. In order to induce the Company to enter into
this Agreement, Executive represents and warrants to the Company that, to his
knowledge, Executive is insurable at standard (non-rated) premiums.
(c) Deceased Executive. In the event that Executive shall die
while entitled to benefits hereunder, the payment which would otherwise be made
to Executive, shall be made to the estate, or other appropriate legal
representative, of Executive.
(d) Notices. All notices, offers or other communications
required or permitted to be given pursuant to this Agreement shall be in writing
and shall be considered as properly given or made if (i) delivered personally,
(ii) mailed from within the United States by certified mail, return receipt
requested, postage prepaid, (iii) sent by prepaid telegram or facsimile
transmission (with written confirmation of receipt) or (iv) sent by overnight
delivery service. All notices given or made pursuant hereto shall be so given or
made to the parties at the following addresses, or to any other address the
addressee may have notified the sender beforehand referring to this Agreement,
and shall be deemed effective when so given or made at such address whether or
not the recipient still resides at that address or actually receives the notice:
If to Executive:
Eric H. Posner
8425 - NE 27th Place
Bellevue, Washington 98004
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If to the Company:
N(2)H(2), Inc.
900 4th Avenue
Suite 3400
Seattle, Washington 98164
Attn: President
With a copy to:
Lane Powell Spears Lubersky LLP
1420 Fifth Avenue, Suite 4100
Seattle, Washington 98101-2338
Attn: Jim D. Johnston
Facsimile: (206) 223-7107
(e) Severability. If any provision of this Agreement is held by
a court of competent jurisdiction to be invalid, illegal or unenforceable, such
provision shall be severed and enforced to the extent possible or modified in
such a way as to make it enforceable, and the invalidity, illegality or
unenforceability thereof shall not affect the validity, legality or
enforceability of the remaining provisions of this Agreement.
(f) Governing Law. This Agreement shall be governed by and
construed in accordance with the laws of the State of Washington applicable to
contracts executed in and to be performed entirely within that state, except
with respect to matters of law concerning the internal corporate affairs of any
corporate entity which is a party to or the subject of this Agreement, and as to
those matters, the law of the jurisdiction under which the respective entity
derives its powers shall govern.
(g) Counterparts. This Agreement may be executed in
counterparts, each of which shall be an original, but all of which shall
constitute one and the same instrument.
(h) Entire Understanding. This Agreement, including all Recitals
hereto which are incorporated herein by this reference, together with the other
agreements and documents being executed and delivered concurrently herewith by
Executive, the Company and certain of its affiliates, constitute the entire
understanding among all of the parties hereto and supersedes any prior
understandings and agreements, written or oral, among them respecting the
subject matter within.
(i) Pronouns and Headings. As used herein, all pronouns shall
include the masculine, feminine, neuter, singular and plural thereof wherever
the context and facts require such construction. The headings, titles and
subtitles herein are inserted for convenience of reference only and are to be
ignored in any construction of the provisions hereof.
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(j) Amendments. Except as specifically set forth herein, this
Agreement shall not be changed or amended unless in writing and signed by both
Executive and the President (or other officer of the Company designated by the
Board).
(k) Executive's Acknowledgment. Executive acknowledges (i) that
he has consulted with or has had the opportunity to consult with independent
counsel of his own choice concerning this Agreement and has been advised to do
so by the Company, and (ii) that he has read and understands this Agreement, is
fully aware of its legal effect, and has entered into it freely based on his own
judgment.
(l) Arbitration. It is understood and agreed between the parties
hereto that any claim of any nature whatsoever arising out of or connected with
Executive's employment with the Company, including but not limited to wrongful
termination, breach of contract, defamation, and claims of discrimination
(including age, disability, sex, religion, race, national origin, color, etc.)
or harassment, whether under federal, state or local laws, common law or in
equity, shall be decided by submission to final and binding arbitration. The
arbitrator shall be a retired or former superior court or appellate court judge.
This arbitration provision shall be governed by the Federal Arbitration Act the
arbitration shall be and pursuant to rules and procedures hereafter adopted by
the Company, and failing such adoption, the Federal Rules of Civil Procedure.
Any arbitration hereunder shall be conducted in Seattle, Washington. Judgment
shall be final upon the award rendered by the arbitrator and may be entered in
any court having jurisdiction thereof. It is further understood and agreed
between the parties hereto that actions seeking temporary injunctions are hereby
excluded from arbitration and, therefore, may be sought in a court of
appropriate jurisdiction without resort to arbitration, even though resolution
of the underlying claim must be submitted to arbitration. Provided: This Section
shall not govern any matter arising out of Executive's violation of, or
threatened violation of, the terms of the Employee Intellectual Property
Agreement attached hereto as Appendix A and incorporated herein by reference
("IP Agreement"), or Executive's violation of the covenants contained in
Sections 10 of this Agreement, in which event the Company shall be entitled to
seek injunctive or other equitable relief in any state or federal court located
in King County, Washington, and the parties agree to submit to the jurisdiction
of such court.
(m) Delivery by Facsimile. The parties agree that counterparts
of this Agreement may be executed and delivered by facsimile, followed by
regular mailing of original signed counterparts.
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IN WITNESS WHEREOF, this Agreement has been executed as of the date and
year first above written.
THE COMPANY:
N(2)H(2), INC.
By /s/ DAVID ARNOLD
----------------------------------
Its Vice President-
Chief Operating Officer
THE EXECUTIVE:
/s/ ERIC H. POSNER
------------------------------------
Eric H. Posner
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APPENDIX A
EMPLOYEE INTELLECTUAL PROPERTY AGREEMENT
BY and BETWEEN: N(2)H(2), INC. (the "COMPANY"), a Washington corporation
and ERIC H. POSNER ("EMPLOYEE").
In the course of employment with the Company, Employee has had and/or will have
access to information, products, processes, tools, know-how and other
intellectual properties that are confidential, proprietary or licensed to the
Company. There is currently an understanding and agreement between the Company
and Employee regarding these confidentiality and intellectual property matters,
which was documented in part by a certain N(2)H(2) Employee Confidentiality and
Nondisclosure Agreement. As a condition of Employee's continuing employment, the
parties now wish to have this Agreement supersede and replace all previous
agreements of the parties on matters of confidentiality and intellectual
property rights.
NOW THEREFORE, in consideration of the employment relationship between the
parties, the parties agree, promise and covenant to each other as follows:
1. SCOPE OF AGREEMENT.
(a) The parties acknowledge and agree that this Agreement addresses only
certain issues relating to patent, copyright, trade secret and other
intellectual property rights. This Agreement is not a contract of employment and
does not address or modify any of the terms and conditions of employment,
including but not limited to duration of employment, compensation, non-compete
covenants, and other employment-related issues.
(b) This Agreement and Executive Employment Agreement constitute the
entire agreement of the parties with respect to the subject matter thereof, and
may not be modified, amended or waived except in a writing signed by both
parties. In the event of any inconsistency between this Agreement and Executive
Employment Agreement, the provisions of this Agreement will control. This
Agreement shall be effective as of the beginning of the employment relationship
between the parties.
2. DEFINITIONS.
For purposes of this Agreement, the capitalized terms set forth below
shall have the meanings assigned to them as follows:
(a) "Development" shall mean any information, product, process, invention,
discovery, technique, idea, design, work of authorship, improvement or
modification, in whatever form and whether or not patentable, copyrightable or
otherwise protectable under law, that is created,
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made, conceived, developed, expressed in tangible form or reduced to practice by
Employee (either alone or with others).
(b) "Protected Development" shall mean any Development that:
(i) results from the use of equipment, supplies, facility, Protected
Information and any property or proprietary rights (whether tangible or
intangible) that are owned, leased or contracted for by the Company;
(ii) relates directly to the business of the Company, or to the
Company's actual or demonstrably anticipated research or development; or
(iii) results from any work or services performed by Employee for the
Company.
In particular, Protected Development shall include, without limitation,
any computer design, programming and documentation; source code and object code
for software; database, model, documentation, and information to whose creation
Employee contributes during the course of Employee's employment by the Company.
(c) "Protected Information" shall mean all information, in whatever form or
format, that is identified by the Company or is reasonably understood as private
or confidential, or that qualifies for protection under law as a trade secret or
proprietary information of the Company, its affiliated companies, its suppliers
or its customers. Protected Information shall include, but is not limited to:
(i) inventions, discoveries, ideas, techniques, drawings, specifications,
models, database, software, documentation; (ii) customer-related information;
(iii) sales and marketing plans, projections and analysis; (iv) any and all
information related to the business operations of the Company, its affiliated
companies, its suppliers or its customers; and (v) any and all information
provided to the Company by third parties which the Company is obligated to keep
confidential.
Notwithstanding the foregoing, Protected Information does not include any
information that is or becomes part of the public domain through no act or
failure to act on the part of Employee.
3. ASSIGNMENT OF INTELLECTUAL RIGHTS TO THE COMPANY.
(a) Subject to the limitation of Subsection 3(b), Employee hereby grants,
transfers and assigns to the Company all of the Employee's right, title, and
interest in or to: (i) the Protected Developments; and (ii) any proprietary
rights therefrom. Employee agrees that any copyrightable Protected Development,
to the extent created by Employee within the scope of Employee's employment with
the Company, shall be deemed to be a "work made for hire," pursuant to the
United States Copyright Act (17 U.S.C. Section 101).
(b) In compliance with Washington state law (RCW 49.44.140), Employee hereby
acknowledges that Employee has been advised and notified by the Company via this
Agreement that the Agreement does not apply to an invention for which no
equipment, supplies, facility, or trade secret information of the Company was
used and which was developed entirely on Employee's own time, unless: (i) the
invention relates (A) directly to the business of the
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Company, or (B) to the Company's actual or demonstrably anticipated research or
development; or (ii) the invention results from any work performed by Employee
for the Company.
(c) Employee shall promptly disclose all Developments to the Company and keep
records relating to the conception, tangible expression and reduction to
practice of all such Developments. Employee acknowledges and agrees that this
disclosure obligation applies to all Developments, whether or not they qualify
as Protected Developments, for the purpose of determining rights of Employee and
the Company in such inventions. Any and all disclosure records, to the extent
related to a Protected Development, shall remain the sole and exclusive property
of the Company, and the Employee shall surrender possession of such records to
the Company upon request or upon any suspension or termination of the Employee's
employment with the Company.
(d) Employee shall render and provide the Company with all information,
documentation and assistance, and shall sign and deliver all such assignments,
affidavits, declarations and other documents that the Company may request to
perfect, enforce, or defend any proprietary rights in or based on the Protected
Developments. The Company shall pay reasonable compensation for such
information, documentation and assistance if they are provided by Employee after
any suspension or termination of Employee's employment.
(e) The Company, in its sole discretion, shall determine the extent of the
proprietary rights, if any, to be protected in any Protected Development.
4. NONDISCLOSURE OF PROTECTED INFORMATION.
(a) Unless otherwise specified in writing, Employee shall assume that any and
all information disclosed by the Company to Employee, in whatever form, is
Protected Information, whether or not designated as private or confidential.
(b) During the period of employment and thereafter, Employee shall hold in trust
and the strictest confidence any and all Protected Information. Employee shall
not disclose any Protected Information to others without the prior written
permission of the Company, or use any Protected Information for any purpose
other than for the performance of services for the Company. In addition,
Employee shall take all necessary precautions to prevent any person or entity
with whom Employee comes into contact from acquiring, disclosing or using such
Protected Information.
(c) Employee hereby acknowledges and agrees that the obligations with respect to
any particular Protected Information shall be in force and binding as long as
such information qualifies as Protected Information under this Agreement,
regardless of any suspension or termination of employment relationship between
the parties, and regardless of any termination of this Agreement for any reason.
(d) All Protected Information is the Company's sole and exclusive property. Upon
request or upon any suspension or termination of Employee's employment, Employee
shall promptly return and surrender to the Company all items and materials in
Employee's possession or control, in
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<PAGE> 17
whatever form and medium and including any and all copies, which contain or
embody any Protected Information.
(e) Nothing contained in this Agreement shall be construed as granting to or
conferring on Employee any proprietary right or interest in any Protected
Information.
(f) Unless otherwise agreed in writing, the Company shall be free to use and to
disclose in any way it deems appropriate any information provided to the Company
by Employee. Employee agrees not to disclose to the Company any information
which is confidential or private to Employee or to any third party that Employee
does not want so used or disclosed.
5. MISCELLANEOUS PROVISIONS.
(a) Remedies. Employee acknowledges and agrees that any violation of this
Agreement will cause irreparable harm for which the Company may not be fully or
adequately compensated by recovery of monetary damages. Accordingly, in the
event of any such violation or threatened violation, the Company shall be
entitled to injunctive relief from a court of competent jurisdiction in addition
to any other remedy available at law or in equity.
(b) Attorney Fees. If any action at law or in equity is brought to enforce or
interpret the terms of this Agreement, the prevailing party shall be entitled to
recover, at trial and on appeal, in addition to any other relief that may be
granted, reasonable amounts of legal, accounting and other professional fees,
together with other allowable costs and expenses.
(c) Applicable Law and Jurisdiction. The parties agree that this Agreement will
be governed by the laws of the State of Washington, without regard to Washington
choice of law principles. Law suits relating to this Agreement shall be brought
in the appropriate court in the State of Washington, and the parties agree to
submit to the jurisdiction of such court.
(d) Amendment and Assignment. All modifications to this Agreement must be in
writing, signed by the parties hereto. Except by operation of law, neither party
shall assign or delegate its rights or duties under this Agreement without the
prior written consent of the other party.
(e) Independence of Provisions. Each provision herein shall be treated as a
separate and independent clause, and the invalidity or unenforceability of any
one clause shall in no way impair the validity or enforceability of any other
clauses herein.
(f) Successors and Assigns. This Agreement shall be binding on Employee's heirs,
executors, estate administrators and legal representatives and shall be for the
benefit of the Company, its successors or assigns.
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<PAGE> 18
IN WITNESS THEREOF, the parties hereby execute this Agreement.
The undersigned has read and understood the foregoing and agrees to be bound
thereby.
EMPLOYEE:
Signed: /s/ ERIC H. POSNER
-----------------------------
Print Name: Eric H. Posner
Date: September 8, 1999
The foregoing was executed by the Employee and accepted on behalf of the
Company.
N(2)H(2), INC.:
Signed: /s/ DAVID ARNOLD
-----------------------------
By: David Arnold
Title: Vice President-
Chief Operating Officer
Date: September 8, 1999
18
<PAGE> 1
EXHIBIT 10.22
TRIPLICATE ORIGINAL
September 30, 1999
NONQUALIFIED STOCK OPTION AGREEMENT
A STOCK OPTION for a total of 150,000 shares of common stock
(hereinafter the "Option"), of N(2)H(2), Inc., a Washington corporation (the
"Company"), is hereby granted to Eric H. Posner (the "Optionee"), at the price
and subject to the terms and provisions set forth below. For purposes of this
Agreement the term "shares" shall be deemed to apply to shares of common stock
of the Company as of the date hereof.
1. OPTION PRICE. The option price is $10.28125 for each share, being one
hundred percent (100%) of the fair market value based on the average closing
price of the prior 10 trading days of the Company's Common Stock on September
8, 1999, the date of hire.
2. VESTING AND EXERCISE OF OPTION. The Option shall vest and be
exercisable in accordance with the following provisions:
a. Schedule of Vesting and Rights to Exercise. The Option shall
be vested and exercisable as follows:
<TABLE>
<CAPTION>
Years Percent of Number of
Following Grant Option Vested Shares Exercisable
- --------------- ------------- ------------------
<S> <C> <C>
After One Year 25% 37,500
After Two Years 50% 75,000
After Three Years 75% 112,500
After Four Years 100% 150,000
</TABLE>
b. Method of Exercise. The Option shall be exercisable by a
written notice which shall:
i. state the election to exercise the Option, the number of
shares in respect of which it is being exercised;
ii. contain such representations and agreements as to the
holder's investment intent with respect to such shares of common stock,
acquired by exercise of the Option, as may be satisfactory to the
Company;
iii. be signed by the person entitled to the Option; and
iv. be in writing and delivered in person or by certified mail
to the President or Secretary of the Company.
<PAGE> 2
Payment of the purchase price of any shares with respect to which an
Option is being exercised shall be by check. The certificate or certificates for
shares of common stock as to which the Option shall be exercised shall be
registered in the name of the person exercising the Option. Options hereunder
may not at any time be exercised for a fractional number of shares.
c. Restrictions on Exercise. No Option may be exercised if the issuance
of the shares upon exercise would constitute a violation of any applicable
federal or state securities or other law or valid regulation. As a condition to
the exercise of this Option the Company may require the person exercising the
Option to make any representation and warranty to the Company as the Company's
counsel believes may be required by any applicable law or regulations.
The following legend will appear on all certificates for option shares:
THE SECURITIES REPRESENTED BY THIS CERTIFICATE HAVE NOT BEEN REGISTERED
UNDER THE SECURITIES ACT OF 1933, AS AMENDED, AND ARE ACQUIRED BY THE
REGISTERED HOLDER PURSUANT TO REPRESENTATION THAT THE HOLDER IS
ACQUIRING THESE SHARES FOR THE HOLDER'S OWN ACCOUNT, FOR INVESTMENT.
THESE SHARES MAY NOT BE PLEDGED, HYPOTHECATED, SOLD, TRANSFERRED OR
OFFERED FOR SALE IN THE ABSENCE OF AN EFFECTIVE REGISTRATION STATEMENT
AS TO THE SHARES UNDER THE SECURITIES ACT OF 1933, AS AMENDED, OR AN
EXEMPTION FROM SUCH REGISTRATION STATEMENT.
3. Non-Transferability of Option. Except as otherwise provided herein,
no Option may be sold, pledged, assigned or transferred in any manner, other
than by will or the laws of descent and distribution, and may be exercised
during the lifetime of the Optionee only by the Optionee or by the guardian or
legal representative of the Optionee. The terms of the Option shall be binding
upon the executors, administrators, heirs, successors, and assigns of the
Optionee.
4. Termination of Service to Company. An Option may only be exercised,
to the extent vested on the employee's last day of service to the Company as an
employee, for a period of one hundred (100) days after such last day of service,
but in no event later than ten (10) years after its grant.
5. Term of Option. No Option may be exercised more than ten (10) years
from the date of original grant, and may be exercised during such term only in
accordance with the terms of this agreement.
6. Adjustments Upon Changes in Capitalization. The number and kind of
shares of common stock subject to this Option shall be appropriately adjusted
along with a corresponding adjustment in the Option price to reflect any stock
dividend, stock split, split-up or any combination, exchange or change of
shares, however accomplished.
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<PAGE> 3
7. Accelerated Vesting. Notwithstanding any provision to the contrary,
in the event the Company or the shareholders of the Company enter into an
agreement to dispose of all or substantially all of the assets or Shares by
means of a sale, reorganization, liquidation, or otherwise, this Option shall
become immediately exercisable with respect to the full number of Shares subject
to this Option. If this Stock Option is not exercised prior to consummation of
any such agreement, it shall terminate. In addition, this Option shall vest and
become exercisable upon certain terminations of employment as set forth in that
certain Executive Employment Agreement of even date herein between the Optionee
and the Company
DATED: September 30, 1999 N(2)H(2), Inc.
By /s/ PETER NICKERSON
----------------------------------
Peter Nickerson
President
Optionee acknowledges and represents that he is familiar with the terms
and provisions of this Nonqualified Stock Option Agreement as set forth above
and hereby accepts this Option subject to all the terms and provisions hereof.
Optionee hereby agrees to accept as binding, conclusive and final all decisions
of the Compensation Committee of the Company's Board of Directors with respect
to the interpretation of any provision under this Nonqualified Stock Option
Agreement.
DATED: September 30, 1999
/s/ ERIC H. POSNER
------------------------------------
Eric H. Posner, Optionee
3
<PAGE> 1
EXHIBIT 10.23
EXECUTIVE EMPLOYMENT AGREEMENT
THIS EMPLOYMENT AND NONCOMPETITION AGREEMENT (this "Agreement"), dated
as of September 13 1999, is entered into by and between N(2)H(2), INC., a
Washington corporation (the "Company") and WILLIAM A. GOLDING, a resident of the
State of Washington (the "Executive").
WHEREAS, the Company wishes to assure itself of the services of
Executive for the period provided in this Agreement; and
WHEREAS, Executive is willing to serve in the employ of the Company as
Vice President and General Manager Consumer Division of the Company for said
period; and
WHEREAS, the parties desire by this writing to set forth the terms and
conditions of the employment relationship between the Company and Executive.
NOW, THEREFORE, in consideration of the mutual covenants contained
herein and other good and valuable consideration, the receipt and sufficiency of
which are hereby acknowledged, the parties hereto agree as follows:
1. Employment. The Company hereby employs Executive, and Executive
agrees to accept such employment, upon the terms and conditions herein set
forth.
2. Employment Period. The initial term of employment hereunder shall
commence on the date hereof and continue for a period of two (2) years ending on
September 13, 2001 (the "Initial Term"), subject to earlier termination as
provided herein. If Executive's employment is not earlier terminated, following
the Initial Term, this Agreement and Executive's employment hereunder shall
renew indefinitely until terminated by either party in accordance with Section 5
below (the "Employment Period").
3. Position and Duties. Executive hereby agrees to serve as an employee
of the Company as Vice President and General Manager Consumer Division.
Executive shall report to the Company's Chief Operating Officer (the "COO") and
such other officer(s) as designated by the Board of Directors of the Company
(the "Board"). Executive shall devote his best efforts and his full business
time and attention to the performance of services to the Company in accordance
with the terms hereof and as may reasonably be requested by the Board, the COO
or other Board-designated officer of the Company; provided that any permanent
material reduction of Executive's duties and responsibilities or a permanent
change in Executive's duties and responsibilities such that Executive's duties
and responsibilities are inconsistent with the type of duties and
responsibilities of Executive in effect immediately prior to such reduction or
change shall constitute Good Reason for voluntary termination by Executive.
<PAGE> 2
4. Compensation and Other Terms of Employment.
(a) Compensation. In consideration of the performance of his
duties hereunder, during the Employment Period, the Company agrees to pay
Executive during the Term of his employment at a base salary of One Hundred
Eighty Thousand and No/100 Dollars ($180,000.00) per annum (the "Base
Compensation"). All amounts payable to Executive under this Section 4(a) shall
be paid in accordance with the Company's regular payroll practices e.g., timing
of payments and standard employee deductions, such as income tax, Social
Security and Medicare withholdings). Base Compensation shall increase by ten
percent (10%) during each twelve (12) month period beginning October 1, 2000 if
the Company's gross revenues reflected in its audited financial statements for
the fiscal year ending September 30, have increased by at least one hundred
percent (100%) over the gross revenues for the immediately preceding fiscal
year.
(b) Bonus. In addition to the Base Compensation described in
Section 4(a) above and any additional bonuses approved by the Board, Executive
shall receive a quarterly bonus in the amount equal to 1.0% of the increase, if
any, of the Company's Consumer Division's gross revenues during such quarter
over the gross revenues for the same quarter during the immediately preceding
year. For purposes of this Section 4(b), gross revenues shall be computed in
accordance with generally accepted accounting principles consistently applied.
Bonus compensation for any quarter shall be payable on the 15th day of the month
following the end of the quarter and shall be subject to standard employee
deductions.
(c) Business Expenses. During the Employment Period, upon
presentation of vouchers and similar receipts, Executive shall be entitled to
receive reimbursement in accordance with the policies and procedures of the
Company maintained from time to time for all reasonable business expenses
actually incurred in the performance of his duties hereunder.
(d) Vacation. During the Employment Period, Executive shall be
entitled to four (4) weeks paid annual vacation. Executive's vacation will be
scheduled at those times most convenient to the Company's business.
(e) Benefits. During the Employment Period, the Company shall
provide to Executive such other employment benefits as may from time to time, be
made generally available to executives of the Company, including, without
limitation, the opportunity to participate in a group health insurance plan
(including coverage of Executive's family) and other benefit plans, if any are
in existence, in accordance with the terms of such plans, which benefits are
intended to be substantially similar to those provided by the Company as of the
date hereof (assuming availability at costs consistent with and comparable to
those currently paid by the Company); provided, however, that the Company shall
not be required to establish, continue or maintain any benefit plans.
(f) Additional Benefits. The Company shall reimburse Executive
on a monthly basis for reasonable commuting costs, parking, health club dues and
high speed Internet access at home.
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<PAGE> 3
5. Termination of Employment. Executive's employment shall be terminated
on any of the following occurrences:
(a) Executive's Permanent Disability. For purposes of this
Agreement, "Permanent Disability" means an illness, injury or other physical or
mental condition continuing for at least ninety (90) consecutive days, arising
at any time during the Employment Period, unless with reasonable accommodation
Executive could perform the essential functions of his position and making such
accommodation would not result in an undue hardship to the Company. If
Executive's employment is terminated because of Executive's Permanent
Disability, the Company shall continue to pay all Base Compensation and pro rata
bonus amounts accrued pursuant to Sections 4(a) and (b) for the longer of (i)
the remaining Initial Term of this Agreement or (ii) twelve (12) months.
(b) Executive's Death. If Executive's employment is terminated
because of Executive's death, the Company shall pay to Executive's personal
representative (on behalf of Executive's estate), within 60 days after the
Company receives written notice of such representative's appointment, all Base
Compensation and pro rata bonus amounts, if any, accrued pursuant to Sections
4(a) and 4(b) above through the date of termination, and shall continue to pay
all Base Compensation and pro rata bonus amounts, if any, accrued pursuant to
Sections 4(a) and (b) for the longer of (i) the remaining Initial Term of the
Agreement or (ii) twelve (12) months.
(c) For Cause. If Executive's employment is terminated with
Cause (as defined in Section 6(a) below), the Company shall pay to Executive all
Base Compensation accrued through the date of termination pursuant to Sections
4(a) and 4(b) above, whereupon the Company shall have no further obligations to
Executive under this Agreement. Executive and his dependents, if any, shall also
be entitled to any continuation health insurance coverage rights available under
applicable law. Without waiving any rights the Company may have hereunder or
otherwise, the Company hereby expressly reserves its rights to proceed against
Executive for damages in connection with any claim or cause of action that the
Company may have arising out of or related to Executive's employment hereunder.
(d) Termination By The Company Without Cause or Voluntary
Termination By Executive With Good Reason. If Executive's employment with the
Company is terminated by the Company without Cause, or is Voluntarily Terminated
(as defined in Section 6(b) below) by Executive with Good Reason (as defined in
Section 6(c) below), the Company shall pay to Executive all Base Compensation
and pro rata bonus amounts, if any, accrued pursuant to Sections 4(a) and 4(b)
above through the date of such termination and shall continue to pay Executive's
Base Compensation and bonus for a period eighteen months (18) months thereafter
(the "Severance Period"). Those unvested stock options which are scheduled to
vest between the date of termination and the end of the Severance Period shall
be deemed to vest immediately, except that if such termination occurs in
connection with a Change in Control (as defined in Section 6(d) below), then all
unvested stock options shall be deemed to vest immediately. Executive and his
dependents, if any, shall also be entitled to any continuation health insurance
coverage rights available under applicable law.
3
<PAGE> 4
(e) Voluntary Termination By Executive Without Good Reason. If
Executive's employment with the Company is Voluntarily Terminated by Executive
without Good Reason, the Company shall pay to Executive all Base Compensation
and bonus accrued through the date of termination pursuant to Sections 4(a) and
4(b) above, whereupon the Company shall have no further obligations to Executive
under this Agreement. Executive and his dependents, if any, shall also be
entitled to any continuation health insurance coverage rights available under
applicable law. Without waiving any rights the Company may have hereunder or
otherwise, the Company hereby expressly reserves its rights to proceed against
Executive for damages in connection with any claim or cause of action that the
Company may have arising out of or related to Executive's employment hereunder.
(f) Voluntary Termination By Executive Following Change in
Control. If Executive's employment with the Company is Voluntarily Terminated by
Executive within 30 days of a Change in Control (as defined in Section 6(d)
below), the Company shall pay to Executive all Base Compensation and bonus
amounts accrued pursuant to Sections 4(a) and 4(b) through a period equal to the
Severance Period. All unvested stock options shall be deemed to vest
immediately. Executive and his dependents, if any, shall also be entitled to any
continuation of health insurance coverage rights available under the applicable
law.
(g) Termination Obligations.
(i) Executive hereby acknowledges and agrees that all
personal property and equipment furnished to or prepared by Executive in the
course of or incident to his employment by the Company, belongs to the Company
and shall be promptly returned to the Company upon termination of the Employment
Period. "Personal property" includes, without limitation, all books, manuals,
records, reports, notes, contracts, lists, blueprints, and other documents, or
materials, or copies thereof (including computer files), and all other
proprietary information belonging, or relating to the business of, the Company
or any affiliate. Following termination, Executive will not retain any written
or other tangible materials containing any proprietary information of the
Company or any affiliate.
(ii) Upon termination of the Employment Period,
Executive shall be deemed to have resigned from all offices, directorships and
similar positions then held with the Company or any affiliate.
(iii) The representations and warranties contained
herein and Executive's obligations under Sections 9 and 10 shall survive
termination of the Employment Period and the expiration or termination of this
Agreement. Any provision hereof required to give meaning and effect to such
surviving provisions shall also survive the termination of the Employment Period
and the expiration or termination of this Agreement.
6. Definitions. For the purposes of this Agreement the following terms
and phrases shall have the following meanings:
4
<PAGE> 5
(a) "Cause" shall mean a termination of Executive's employment
by the Company due to (i) Executive's failure or refusal to perform his duties,
responsibilities or obligations hereunder after at least fourteen (14) days'
prior written notice regarding any such failure or refusal, (ii) Executive's
breach of any noncompetition or confidentiality agreement with the Company,
(iii) the willful misappropriation of funds or property of the Company, (iv) use
of alcohol or drugs which interferes with performance of Executive's obligations
under this Agreement, continuing after at least thirty (30) days' prior written
notice; (v) conviction of a felony or of any crime involving moral turpitude,
fraud or misrepresentation; or (vi) the commission by Executive of any willful
or intentional act in disregard of the interests of the Company which could
reasonably be expected to materially injure the reputation, business or business
relationships of the Company, provided, however, that a good faith mistake in
the normal course of business shall not be considered "Cause" under this Section
6(a).
(b) "Voluntary Termination" shall mean the termination by
Executive of his employment by the Company by voluntary resignation or any other
means other than (i) death or Permanent Disability, (ii) simultaneous with
termination for Cause or (iii) simultaneous with or following an event which,
whether or not known to the Company at the time of such Voluntary Termination by
Executive, would constitute Cause.
(c) "Good Reason" shall mean with respect to a Voluntary
Termination, (i) if (A) such Voluntary Termination occurs within the thirty (30)
day period immediately following a permanent material reduction of Executive's
duties and responsibilities or a permanent change in Executive's duties and
responsibilities such that Executive's duties and responsibilities are
inconsistent with the type of duties and responsibilities of Executive in effect
immediately prior to such reduction or change, (B) such Voluntary Termination
promptly follows a reduction in Executive's benefits, or (C) the President or
the Board otherwise determines that a Voluntary Termination by Executive is for
"Good Reason" under the circumstances then prevailing, and (ii) if Executive
provides written notice of such Good Reason to the Company and the Company does
not correct the circumstances giving rise to such Good Reason during the
following 30-day period. The Company's termination or material breach of this
Agreement without Cause shall constitute Good Reason.
(d) "Change In Control" means the occurrence of any one of the
following events:
(i) any recapitalization, consolidation or merger of the
Company inwhich the Company is not the continuing or surviving entity or which
contemplates that all or substantially all of the business and/or assets of the
Company shall be controlled by another person or entity other than the person or
entity which controlled the Company immediately prior to such recapitalization,
consolidation or merger;
(ii) any sale, lease, exchange or transfer (in one
transaction or series of related transactions) of all or substantially all of
the assets of the Company, or
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<PAGE> 6
(iii) approval by the members of the Company of any plan
or proposal for the liquidation or dissolution of the Company, unless such plan
or proposal is abandoned within 60 days following such approval.
7. Stock Options. Subject to the discretion of the Company's Board of
Directors Executive shall be entitled to participate in any Company stock option
or stock purchase plan.
8. Records and Confidential Information.
(a) Executive acknowledges that, in connection with the
performance of his duties during the Term of this Agreement, the Company will
make available to Executive, or Executive will have access to, certain
Confidential Information (as defined below) and Trade Secrets (as defined by the
Uniform Trade Secrets Act) of the Company and its affiliates. Executive
acknowledges and agrees that any and all Confidential Information or Trade
Secrets of the Company learned or obtained by Executive during the course of his
employment by the Company or otherwise (including, without limitation,
information that Executive obtained through or in connection with his ownership
of and employment by the Company prior to the date hereof) whether developed by
Executive alone or in conjunction with others or otherwise, shall be and is the
property of the Company and its affiliates.
(b) Confidential Information and Trade Secrets of the Company
will be kept confidential by Executive, will not be used in any manner which is
detrimental to the Company, will not be used other than in connection with
Executive's discharge of his duties hereunder, and will be safeguarded by
Executive from unauthorized disclosure.
(c) Following Executive's termination hereunder, as soon as
possible after the Company's written request, Executive will return to the
Company all written Confidential Information and Trade Secrets of the Company
will have been provided to Executive, and Executive will destroy all copies of
any analyses, compilations, studies or other documents prepared by Executive or
for Executive's use containing or reflecting any Confidential Information or
Trade Secrets of the Company. Within 5 business days of the receipt of such
request by Executive, Executive shall, upon written request of the Company,
deliver to the Company a notarized document certifying that such written
Confidential Information and Trade Secrets of the Company have been returned or
destroyed in accordance with this Section.
(d) For the purposes of this Agreement, "Confidential
Information" shall mean all confidential and proprietary information to the
Company, and its affiliates, including, without limitation, the Company's
marketing strategies, pricing policies or characteristics, customers and
customer information, product or product specifications, designs, manufacturing
processes, manufacturing costs, cost of materials, customer lists, business or
business prospects, plans, proposals, codes, marketing studies, research,
reports, investigations, or other information of similar character. For purposes
of this Agreement, Confidential Information shall not include and Executive's
obligations under this Section shall not extend to (i) information which is
generally available to the public or within the industry, (ii) information
obtained by Executive from third
6
<PAGE> 7
persons not under agreement to maintain the confidentiality of the same and
(iii) information which is required to be disclosed by law or legal process.
(e) This Section is not intended to, and does not, limit in any
way Executive's duties and obligations to the Company under statutory and common
law not to disclose or make personal use of any Confidential Information or
Trade Secrets of the Company.
9. Assignment of Inventions.
(a) Definition of Inventions. "Inventions" means discoveries,
developments, concepts, ideas, methods, designs, improvements, inventions,
formulas, processes, techniques, programs, know-how and data, whether or not
patentable or registerable under copyright or similar statutes, except any of
the foregoing that (i) is not related to the business of the Company or its
affiliates, or the Company's (and its affiliates') actual or demonstrable
research or development (ii) does not involve the use of any equipment supplies,
facility or Confidential Information of the Company, (iii) was developed
entirely on Executive's own time, and (iv) does not result from any work
performed by Executive for the Company.
(b) Assignment. Executive agrees to and hereby does assign to
the Company, without further consideration, all of his right, title and interest
in any and all Inventions he may make during the Term hereof.
(c) Duty to Disclose and Assist. Executive agrees to promptly
disclose in writing all Inventions to the Company, and to provide all assistance
reasonably requested by the Company in the preservation of the Company's
interests in the Inventions including obtaining patents in any country
throughout the world. Such services will be without additional compensation if
Executive is then employed by the Company and for reasonable compensation and
subject to his reasonable availability if he is not. If the Company cannot,
after reasonable effort, secure Executive's signature on any document or
documents needed to apply for or prosecute any patent, copyright, or other right
or protection relating to an Invention, whether because of his physical or
mental incapacity or for any other reason whatsoever, Executive hereby
irrevocably designates and appoints the Company and its duly authorized officers
and agents as his agent and attorney-in-fact, to act for and in his behalf and
in his name and stead for the purpose of executing and filing any such
application or applications and taking all other lawfully permitted actions to
further the prosecution and issuance of patents, copyrights, or similar
protections thereon, with the same legal force and effect as if executed by him.
(d) Ownership of Copyrights. Executive agrees that any work
prepared for or the Company, which is eligible for copyright protection under
the laws of the United States or any other country, shall be a work made for
hire and ownership of all copyrights (including all renewals and extensions)
therein shall vest in the Company. If any such work is deemed not to be a work
made for hire for any reason, Executive hereby grants, transfers and assigns all
right, title and interest in such work and all copyrights in such work and all
renewals and extensions thereof to the Company, and agrees to provide all
assistance reasonably requested by the Company in the establishment,
preservation and enforcement of the Company's copyright in such work, such
assistance to be
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<PAGE> 8
provided at the Company's expense but without any additional compensation to
Executive. Executive hereby agrees to and does hereby waive the enforcement of
all moral rights with respect to the work developed or produced hereunder,
including without limitation any and all rights of identification of authorship
and any and all rights of approval, restriction or limitation on use or
subsequent modifications.
(e) Litigation. Executive agrees to render assistance
and cooperation to the Company at its request regarding any matter, dispute or
controversy with which the Company may become involved and of which Executive
has or may have reason to have knowledge, information or expertise. Such
services will be without additional compensation if Executive is then employed
by the Company and for reasonable compensation and subject to his reasonable
availability if he is not.
10. Covenants Not to Compete.
(a) Non-Interference with Customer Accounts. Executive covenants
and agrees that, during the Employment Period, and for a period of eighteen (18)
months after the date of termination of Executive's employment with the Company,
Executive shall not, directly or indirectly, personally or on behalf of any
other person, business, corporation, or entity, contact or do business with any
customer of the Company with respect to any Internet filtering product or
service which is competitive with any product or service which was sold,
provided, or under development by the Company at any time during the
twelve-month period prior to the date of termination of Executive's employment
with the Company. This covenant applies to those customers and the related
entities of those customers to which the Company sold its Internet filtering
products or services at any time during the twelve-month period prior to the
date of termination of Executive's employment with the Company, and those
prospective customers with which the Company actively pursued sales or the
provision of services at any time during the twelve-month period prior to the
date of termination of Executive's employment with the Company.
(b) Noncompetition. Executive covenants and agrees that, during
the Employment Period, and for a period of eighteen (18) months after the date
of termination of Executive's employment with the Company, Executive shall not,
directly or indirectly, own an interest in, operate, join, control, advise, work
for, serve as a director of, have a financial interest which provides any
control of, or participate in any corporation, partnership, proprietorship,
firm, association, person, or other entity (collectively, "Businesses")
producing, designing, providing, soliciting orders for, selling, distributing,
or marketing any Internet filtering products, goods, equipment, or services
which are similar to any Internet filtering products, goods, equipment or
services produced, sold or provided by the Company at any time during the
twelve-month period prior to the date of termination of Executive's employment
with the Company. THE PARTIES ACKNOWLEDGE THAT THE COMPANY PROVIDES SERVICES ON
A WORLD WIDE BASIS AND, ACCORDINGLY THAT IT IS NOT FAIR OR APPROPRIATE TO
RESTRICT THE FOREGOING COVENANT GEOGRAPHICALLY.
(c) This covenant does not prohibit the mere ownership of less
than two percent (2%) of the outstanding stock of any publicly traded
corporation as long as Executive is not otherwise in violation of this covenant.
8
<PAGE> 9
(d) Non-Diversion. During the Employment Period, and for a
period of eighteen (18) months after the date of termination of Executive's
employment with the Company, Executive shall not divert or attempt to divert or
take advantage of or attempt to take advantage of any actual or potential
business or opportunities of the Company or its subsidiaries or affiliates which
Executive became aware of as the result of his employment with the Company.
(e) Non-Recruitment. Executive agrees that the Company has
invested substantial time and effort in assembling its present workforce.
Accordingly, Executive agrees that during the Employment Period and for a period
of eighteen (18) months after the date of termination of Executive's employment
with the Company, Executive shall not (i) hire away any individuals who were
employed by the Company or its subsidiaries or affiliates during the
twelve-month period prior to the date of termination of Executive's employment
with the Company or (ii) directly or indirectly entice, solicit or seek to
induce or influence any such employees to leave their employment with the
Company or its subsidiaries or affiliates.
(f) Non-Disparagement. Executive and the Company mutually
covenant and agree that, during the Employment Period and for a period of
eighteen (18) months after the date of termination of Executive's employment
with the Company, neither shall, directly or indirectly disparage the other.
(g) Remedies. Both parties acknowledge that should they
materially breach this Agreement, it will be difficult to determine the
resulting damages to the non-breaching party, and, in addition to any other
remedies the non-breaching party may have, the non-breaching party shall be
entitled to temporary injunctive relief without being required to post a bond
and to permanent injunctive relief without the necessity of proving actual
damage. In the event of any action or proceeding to interpret or enforce this
Agreement, the prevailing party shall be entitled to recover its reasonable
attorneys' fees and costs, whether or not litigation is actually commenced and
including litigation of any appeal. Failure of either party to seek any or all
remedies in one case does not restrict that party from seeking any remedies in
another situation, and no such action shall not constitute a waiver of any of
the party's rights.
(h) Severability and Modification of Any Unenforceable Covenant.
It is the parties' intent that each of the covenants be read and interpreted
with every reasonable inference given to its enforceability. However, it is also
the parties' intent that if any term, provision or condition of the covenants is
held by a court of competent jurisdiction to be invalid, void or unenforceable,
the remainder of the provisions thereof shall remain in full force and effect
and shall in no way be affected, impaired or invalidated. Finally, it is also
the parties' intent that if a court should determine any of the covenants are
unenforceable because of over breadth, then the court shall modify said covenant
so as to make it reasonable and enforceable under the prevailing circumstances.
(i) Tolling. In the event of the breach by Executive of any
covenant the running of the period of restriction shall be automatically tolled
and suspended for the amount of time that
9
<PAGE> 10
the breach continues, and shall automatically recommence when the breach is
remedied so that the Company shall receive the benefit of Executive's compliance
with the covenants.
11. No Assignment. This Agreement and the rights and duties hereunder
are personal to Executive and shall not be assigned, delegated, transferred,
pledged or sold by Executive without the prior written consent of the Company.
Executive hereby acknowledges and agrees that the Company may assign, delegate,
transfer, pledge or sell this Agreement and the rights and duties hereunder (a)
to an affiliate of the Company or (b) to any third party acquiring through
merger, consolidation or purchase all or substantially all of the business
and/or assets of the Company. This Agreement shall inure to the benefit of and
be enforceable by the parties hereto, and their respective heirs, personal
representatives, successors and assigns.
12. Miscellaneous Provisions.
(a) Payment of Taxes. To the extent that any taxes become
payable by Executive by virtue of any payments made or benefits conferred by the
Company, the Company shall not be liable to pay or obligated to reimburse
Executive for any such taxes or to make any adjustment under this Agreement. Any
payments otherwise due under this Agreement to Executive, including, but not
limited to, the Base Compensation and any bonus, shall be reduced by any
required withholding for federal, state and/or local taxes and other appropriate
payroll deductions.
(b) Insurance. The Company may, from time to time, apply for and
take out, in its own name and at its own expense, life, health, accident,
disability or other insurance on Executive in any sum or sums that it may deem
necessary to protect its interests, and Executive shall aid and cooperate in all
reasonable respects with the Company in procuring any and all such insurance,
including, without limitation, submitting to the usual and customary medical
examinations, and by filling out, executing and delivering such applications and
other instruments in writing as may be reasonably required by an insurance
company or companies to which an application or applications for such insurance
may be made by or for the Company. In order to induce the Company to enter into
this Agreement, Executive represents and warrants to the Company that, to his
knowledge, Executive is insurable at standard (non-rated) premiums.
(c) Deceased Executive. In the event that Executive shall die
while entitled to benefits hereunder, the payment which would otherwise be made
to Executive, shall be made to the estate, or other appropriate legal
representative, of Executive.
(d) Notices. All notices, offers or other communications
required or permitted to be given pursuant to this Agreement shall be in writing
and shall be considered as property given or made if (i) delivered personally,
(ii) mailed from within the United States by certified mail, return receipt
requested, postage prepaid, (iii) sent by prepaid telegram or facsimile
transmission (with written confirmation of receipt) or (iv) sent by overnight
delivery service. All notices given or made pursuant hereto shall be so given or
made to the parties at the following addresses, or to any other address the
addressee may have notified the sender beforehand referring to this
10
<PAGE> 11
Agreement, and shall be deemed effective when so given or made at such address
whether or not the recipient still resides at that address or actually receives
the notice:
If to Executive:
William A. Golding
P.O. Box 1110
Vashon Island, WA 98070
If to the Company:
N(2)H(2), Inc.
900 4th Avenue
Suite 3400
Seattle, Washington 98164
Attn: President
With a copy to:
Lane Powell Spears Lubersky LLP
1420 Fifth Avenue, Suite 4100
Seattle, Washington 98101-2338
Attn: Jim D. Johnston
Facsimile: (206) 223-7107
(e) Severability. If any provision of this Agreement is held by
a court of competent jurisdiction to be invalid, illegal or unenforceable, such
provision shall be severed and enforced to the extent possible or modified in
such a way as to make it enforceable, and the invalidity, illegality or
unenforceability thereof shall not affect the validity, legality or
enforceability of the remaining provisions of this Agreement.
(f) Governing Law. This Agreement shall be governed by and
construed in accordance with the laws of the State of Washington applicable to
contracts executed in and to be performed entirely within that state, except
with respect to matters of law concerning the internal corporate affairs of any
corporate entity which is a party to or the subject of this Agreement, and as to
those matters, the law of the jurisdiction under which the respective entity
derives its powers shall govern.
(g) Counterparts. This Agreement may be executed in
counterparts, each of which shall be an original, but all of which shall
constitute one and the same instrument.
(h) Entire Understanding. This Agreement, including all Recitals
hereto which are incorporated herein by this reference, together with the other
agreements and documents being executed and delivered concurrently herewith by
Executive, the Company and certain of its affiliates, constitute the entire
understanding among all of the parties hereto and supersedes any
11
<PAGE> 12
prior understandings and agreements, written or oral, among them respecting the
subject matter within.
(i) Pronouns and Headings. As used herein, all pronouns shall
include the masculine, feminine, neuter, singular and plural thereof wherever
the context and facts require such construction. The headings, titles and
subtitles herein are inserted for convenience of reference only and are to be
ignored in any construction of the provisions hereof.
(j) Amendments. Except as specifically set forth herein, this
Agreement shall not be changed or amended unless in writing and signed by both
Executive and the President (or other officer of the Company designated by the
Board).
(k) Executive's Acknowledgment. Executive acknowledges (i) that
he has consulted with or has had the opportunity to consult with independent
counsel of his own choice concerning this Agreement and has been advised to do
so by the Company, and (ii) that he has read and understands this Agreement, is
fully aware of its legal effect, and has entered into it freely based on his own
judgment.
(l) Arbitration. It is understood and agreed between the parties
hereto that any claim of any nature whatsoever arising out of or connected with
Executive's employment with the Company, including but not limited to wrongful
termination, breach of contract, defamation, and claims of discrimination
(including age, disability, sex, religion, race, national origin, color, etc.)
or harassment, whether under federal, state or local laws, common law or in
equity, shall be decided by submission to final and binding arbitration. The
arbitrator shall be a retired or former superior court or appellate court judge.
This arbitration provision shall be governed by the Federal Arbitration Act the
arbitration shall be and pursuant to rules and procedures hereafter adopted by
the Company, and failing such adoption, the Federal Rules of Civil Procedure.
Any arbitration hereunder shall be conducted in Seattle, Washington. Judgment
shall be final upon the award rendered by the arbitrator and may be entered in
any court having jurisdiction thereof. It is further understood and agreed
between the parties hereto that actions seeking temporary injunctions are hereby
excluded from arbitration and, therefore, may be sought in a court of
appropriate jurisdiction without resort to arbitration, even though resolution
of the underlying claim must be submitted to arbitration. Provided: This Section
shall not govern any matter arising out of Executive's violation of, or
threatened violation of, the terms of the Employee Intellectual Property
Agreement attached hereto as Appendix A and incorporated herein by reference
("IP Agreement"), or Executive's violation of the covenants contained in
Sections 10 of this Agreement, in which event the Company shall be entitled to
seek injunctive or other equitable relief in any state or federal court located
in King County, Washington, and the parties agree to submit to the jurisdiction
of such court.
(m) Delivery by Facsimile. The parties agree that counterparts
of this Agreement may be executed and delivered by facsimile, followed by
regular mailing of original signed counterparts.
12
<PAGE> 13
IN WITNESS WHEREOF, this Agreement has been executed as of the date and
year first above written.
THE COMPANY:
N(2)H(2), INC.
BY /s/ PETER NICKERSON
---------------------------------
ITS President
THE EXECUTIVE:
/s/ WILLIAM A. GOLDING
------------------------------------
William A. Golding
13
<PAGE> 14
APPENDIX A
EMPLOYEE INTELLECTUAL PROPERTY AGREEMENT
BY and BETWEEN: N(2)H(2), INC. (the "COMPANY"), a Washington corporation
and WILLIAM A. GOLDING ("EMPLOYEE").
In the course of employment with the Company, Employee has had and/or will have
access to information, products, processes, tools, know-how and other
intellectual properties that are confidential, proprietary or licensed to the
Company. There is currently an understanding and agreement between the Company
and Employee regarding these confidentiality and intellectual property matters,
which was documented in part by a certain N(2)H(2) Employee Confidentiality and
Nondisclosure Agreement. As a condition of Employee's continuing employment, the
parties now wish to have this Agreement supersede and replace all previous
agreements of the parties on matters of confidentiality and intellectual
property rights.
NOW THEREFORE, in consideration of the employment relationship between the
parties, the parties agree, promise and covenant to each other as follows:
1. SCOPE OF AGREEMENT.
(a) The parties acknowledge and agree that this Agreement addresses only
certain issues relating to patent, copyright, trade secret and other
intellectual property rights. This Agreement is not a contract of employment and
does not address or modify any of the terms and conditions of employment,
including but not limited to duration of employment, compensation, non-compete
covenants, and other employment-related issues.
(b) This Agreement and Executive Employment Agreement constitute the
entire agreement of the parties with respect to the subject matter thereof, and
may not be modified, amended or waived except in a writing signed by both
parties. In the event of any inconsistency between this Agreement and Executive
Employment Agreement, the provisions of this Agreement will control. This
Agreement shall be effective as of the beginning of the employment relationship
between the parties.
2. DEFINITIONS.
For purposes of this Agreement, the capitalized terms set forth below
shall have the meanings assigned to them as follows:
(a) "Development" shall mean any information, product, process, invention,
discovery, technique, idea, design, work of authorship, improvement or
modification, in whatever form and
14
<PAGE> 15
whether or not patentable, copyrightable or otherwise protectable under law,
that is created, made, conceived, developed, expressed in tangible form or
reduced to practice by Employee (either alone or with others).
(b) "Protected Development" shall mean any Development that:
(i) results from the use of equipment, supplies, facility, Protected
Information and any property or proprietary rights (whether tangible or
intangible) that are owned, leased or contracted for by the Company;
(ii) relates directly to the business of the Company, or to the
Company's actual or demonstrably anticipated research or development; or
(iii) results from any work or services performed by Employee for the
Company.
In particular, Protected Development shall include, without limitation,
any computer design, programming and documentation; source code and object code
for software; database, model, documentation, and information to whose creation
Employee contributes during the course of Employee's employment by the Company.
(c) "Protected Information" shall mean all information, in whatever form or
format, that is identified by the Company or is reasonably understood as private
or confidential, or that qualifies for protection under law as a trade secret or
proprietary information of the Company, its affiliated companies, its suppliers
or its customers. Protected Information shall include, but is not limited to:
(i) inventions, discoveries, ideas, techniques, drawings, specifications,
models, database, software, documentation; (ii) customer-related information;
(iii) sales and marketing plans, projections and analysis; (iv) any and all
information related to the business operations of the Company, its affiliated
companies, its suppliers or its customers; and (v) any and all information
provided to the Company by third parties which the Company is obligated to keep
confidential.
Notwithstanding the foregoing, Protected Information does not include any
information that is or becomes part of the public domain through no act or
failure to act on the part of Employee.
3. ASSIGNMENT OF INTELLECTUAL RIGHTS TO THE COMPANY.
(a) Subject to the limitation of Subsection 3(b), Employee hereby grants,
transfers and assigns to the Company all of the Employee's right, title, and
interest in or to: (i) the Protected Developments; and (ii) any proprietary
rights therefrom. Employee agrees that any copyrightable Protected Development,
to the extent created by Employee within the scope of Employee's employment with
the Company, shall be deemed to be a "work made for hire," pursuant to the
United States Copyright Act (17 U.S.C. Section 101).
(b) In compliance with Washington state law (RCW 49.44.140), Employee hereby
acknowledges that Employee has been advised and notified by the Company via this
Agreement that the Agreement does not apply to an invention for which no
equipment, supplies, facility, or
15
<PAGE> 16
trade secret information of the Company was used and which was developed
entirely on Employee's own time, unless: (i) the invention relates (A) directly
to the business of the Company, or (B) to the Company's actual or demonstrably
anticipated research or development; or (ii) the invention results from any
work performed by Employee for the Company.
(c) Employee shall promptly disclose all Developments to the Company and keep
records relating to the conception, tangible expression and reduction to
practice of all such Developments. Employee acknowledges and agrees that this
disclosure obligation applies to all Developments, whether or not they qualify
as Protected Developments, for the purpose of determining rights of Employee and
the Company in such inventions. Any and all disclosure records, to the extent
related to a Protected Development, shall remain the sole and exclusive property
of the Company, and the Employee shall surrender possession of such records to
the Company upon request or upon any suspension or termination of the Employee's
employment with the Company.
(d) Employee shall render and provide the Company with all information,
documentation and assistance, and shall sign and deliver all such assignments,
affidavits, declarations and other documents that the Company may request to
perfect, enforce, or defend any proprietary rights in or based on the Protected
Developments. The Company shall pay reasonable compensation for such
information, documentation and assistance if they are provided by Employee after
any suspension or termination of Employee's employment.
(e) The Company, in its sole discretion, shall determine the extent of the
proprietary rights, if any, to be protected in any Protected Development.
4. NONDISCLOSURE OF PROTECTED INFORMATION.
(a) Unless otherwise specified in writing, Employee shall assume that any and
all information disclosed by the Company to Employee, in whatever form, is
Protected Information, whether or not designated as private or confidential.
(b) During the period of employment and thereafter, Employee shall hold in trust
and the strictest confidence any and all Protected Information. Employee shall
not disclose any Protected Information to others without the prior written
permission of the Company, or use any Protected Information for any purpose
other than for the performance of services for the Company. In addition,
Employee shall take all necessary precautions to prevent any person or entity
with whom Employee comes into contact from acquiring, disclosing or using such
Protected Information.
(c) Employee hereby acknowledges and agrees that the obligations with respect to
any particular Protected Information shall be in force and binding as long as
such information qualifies as Protected Information under this Agreement,
regardless of any suspension or termination of employment relationship between
the parties, and regardless of any termination of this Agreement for any reason.
16
<PAGE> 17
(d) All Protected Information is the Company's sole and exclusive property. Upon
request or upon any suspension or termination of Employee's employment, Employee
shall promptly return and surrender to the Company all items and materials in
Employee's possession or control, in whatever form and medium and including any
and all copies, which contain or embody any Protected Information.
(e) Nothing contained in this Agreement shall be construed as granting to or
conferring on Employee any proprietary right or interest in any Protected
Information.
(f) Unless otherwise agreed in writing, the Company shall be free to use and to
disclose in any way it deems appropriate any information provided to the Company
by Employee. Employee agrees not to disclose to the Company any information
which is confidential or private to Employee or to any third party that Employee
does not want so used or disclosed.
5. MISCELLANEOUS PROVISIONS.
(a) Remedies. Employee acknowledges and agrees that any violation of this
Agreement will cause irreparable harm for which the Company may not be fully or
adequately compensated by recovery of monetary damages. Accordingly, in the
event of any such violation or threatened violation, the Company shall be
entitled to injunctive relief from a court of competent jurisdiction in addition
to any other remedy available at law or in equity.
(b) Attorney Fees. If any action at law or in equity is brought to enforce or
interpret the terms of this Agreement, the prevailing party shall be entitled to
recover, at trial and on appeal, in addition to any other relief that may be
granted, reasonable amounts of legal, accounting and other professional fees,
together with other allowable costs and expenses.
(c) Applicable Law and Jurisdiction. The parties agree that this Agreement will
be governed by the laws of the State of Washington, without regard to Washington
choice of law principles. Law suits relating to this Agreement shall be brought
in the appropriate court in the State of Washington, and the parties agree to
submit to the jurisdiction of such court.
(d) Amendment and Assignment. All modifications to this Agreement must be in
writing, signed by the parties hereto. Except by operation of law, neither party
shall assign or delegate its rights or duties under this Agreement without the
prior written consent of the other party.
(e) Independence of Provisions. Each provision herein shall be treated as a
separate and independent clause, and the invalidity or unenforceability of any
one clause shall in no way impair the validity or enforceability of any other
clauses herein.
(f) Successors and Assigns. This Agreement shall be binding on Employee's heirs,
executors, estate administrators and legal representatives and shall be for the
benefit of the Company, its successors or assigns.
17
<PAGE> 18
IN WITNESS THEREOF, the parties hereby execute this Agreement.
The undersigned has read and understood the foregoing and agrees to be bound
thereby.
EMPLOYEE:
Signed: /s/ WILLIAM A. GOLDING
----------------------------
Print Name: William A. Golding
Date: September 13, 1999
The foregoing was executed by the Employee and accepted on behalf of the
Company.
N(2)H(2), INC.:
Signed: /s/ PETER NICKERSON
-----------------------------
By:
Title:
Date: September 21, 1999
18
<PAGE> 1
EXHIBIT 10.24
TRIPLICATE ORIGINAL
September 30, 1999
NONQUALIFIED STOCK OPTION AGREEMENT
A STOCK OPTION for a total of 150,000 shares of common stock
(hereinafter the "Option"), of N(2)H(2), Inc., a Washington corporation (the
"Company"), is hereby granted to William A. Golding (the "Optionee"), at the
price and subject to the terms and provisions set forth below. For purposes of
this Agreement the term "shares" shall be deemed to apply to shares of common
stock of the Company as of the date hereof.
1. OPTION PRICE. The option price is $10.3125 for each share, being one
hundred percent (100%) of the fair market value, as determined by the Board of
Directors, of the Company's Common Stock on September 30, 1999, the date of
grant.
2. VESTING AND EXERCISE OF OPTION. The Option shall vest and be
exercisable in accordance with the following provisions:
a. Schedule of Vesting and Rights to Exercise. The Option shall
be vested and exercisable as follows:
<TABLE>
<CAPTION>
Years Percent of Number of
Following Grant Option Vested Shares Exercisable
- --------------- ------------- ------------------
<S> <C> <C>
After One Year 25% 37,500
After Two Years 50% 75,000
After Three Years 75% 112,500
After Four Years 100% 150,000
</TABLE>
b. Method of Exercise. The Option shall be exercisable by a
written notice which shall:
i. state the election to exercise the Option, the number of
shares in respect of which it is being exercised;
ii. contain such representations and agreements as to the
holder's investment intent with respect to such shares of common stock,
acquired by exercise of the Option, as may be satisfactory to the
Company;
iii. be signed by the person entitled to the Option; and
iv. be in writing and delivered in person or by certified mail
to the President or Secretary of the Company.
<PAGE> 2
Payment of the purchase price of any shares with respect to which an
Option is being exercised shall be by check. The certificate or certificates for
shares of common stock as to which the Option shall be exercised shall be
registered in the name of the person exercising the Option. Options hereunder
may not at any time be exercised for a fractional number of shares.
c. Restrictions on Exercise. No Option may be exercised if the
issuance of the shares upon exercise would constitute a violation of any
applicable federal or state securities or other law or valid regulation. As a
condition to the exercise of this Option the Company may require the person
exercising the Option to make any representation and warranty to the Company as
the Company's counsel believes may be required by any applicable law or
regulations.
The following legend will appear on all certificates for option
shares:
THE SECURITIES REPRESENTED BY THIS CERTIFICATE HAVE NOT BEEN REGISTERED
UNDER THE SECURITIES ACT OF 1933, AS AMENDED, AND ARE ACQUIRED BY THE
REGISTERED HOLDER PURSUANT TO REPRESENTATION THAT THE HOLDER IS
ACQUIRING THESE SHARES FOR THE HOLDER'S OWN ACCOUNT, FOR INVESTMENT.
THESE SHARES MAY NOT BE PLEDGED, HYPOTHECATED, SOLD, TRANSFERRED OR
OFFERED FOR SALE IN THE ABSENCE OF AN EFFECTIVE REGISTRATION STATEMENT
AS TO THE SHARES UNDER THE SECURITIES ACT OF 1933, AS AMENDED, OR AN
EXEMPTION FROM SUCH REGISTRATION STATEMENT.
3. Non-Transferability of Option. Except as otherwise provided herein,
no Option may be sold, pledged, assigned or transferred in any manner, other
than by will or the laws of descent and distribution, and may be exercised
during the lifetime of the Optionee only by the Optionee or by the guardian or
legal representative of the Optionee. The terms of the Option shall be binding
upon the executors, administrators, heirs, successors, and assigns of the
Optionee.
4. Termination of Service to Company. An Option may only be exercised,
to the extent vested on the employee's last day of service to the Company as an
employee, for a period of one hundred (100) days after such last day of service,
but in no event later than ten (10) years after its grant.
5. Term of Option. No Option may be exercised more than ten (10) years
from the date of original grant, and may be exercised during such term only in
accordance with the terms of this agreement.
6. Adjustments Upon Changes in Capitalization. The number and kind of
shares of common stock subject to this Option shall be appropriately adjusted
along with a corresponding adjustment in the Option price to reflect any stock
dividend, stock split, split-up or any combination, exchange or change of
shares, however accomplished.
2
<PAGE> 3
7. Accelerated Vesting. Notwithstanding any provision to the contrary,
in the event the Company or the shareholders of the Company enter into an
agreement to dispose of all or substantially all of the assets or Shares by
means of a sale, reorganization, liquidation, or otherwise, this Option shall
become immediately exercisable with respect to the full number of Shares subject
to this Option. If this Stock Option is not exercised prior to consummation of
any such agreement, it shall terminate. In addition, this Option shall vest and
become exercisable upon certain terminations of employment as set forth in that
certain Executive Employment Agreement of even date herein between the Optionee
and the Company
DATED: September 30, 1999 N(2)H(2), Inc.
By /s/ PETER NICKERSON
---------------------------------
Peter Nickerson
President
Optionee acknowledges and represents that he is familiar with the terms
and provisions of this Nonqualified Stock Option Agreement as set forth above
and hereby accepts this Option subject to all the terms and provisions hereof.
Optionee hereby agrees to accept as binding, conclusive and final all decisions
of the Compensation Committee of the Company's Board of Directors with respect
to the interpretation of any provision under this Nonqualified Stock Option
Agreement.
DATED: September 30, 1999
/s/ WILLIAM A. GOLDING
------------------------------------
William A. Golding, Optionee
3
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM CONSOLIDATED
BALANCE SHEETS AND CONSOLIDATED STATEMENT OF OPERATIONS AND IS QUALIFIED IN ITS
ENTIRETY BY REFERENCE TO SUCH FORM 10-K FILED DECEMBER 29, 1999.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> SEP-30-1999
<PERIOD-START> OCT-01-1998
<PERIOD-END> SEP-30-1999
<CASH> 7,743
<SECURITIES> 27,937
<RECEIVABLES> 1,434
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 38,250
<PP&E> 3,990
<DEPRECIATION> 0
<TOTAL-ASSETS> 67,556
<CURRENT-LIABILITIES> 4,803
<BONDS> 0
0
0
<COMMON> 75,528
<OTHER-SE> (14,030)
<TOTAL-LIABILITY-AND-EQUITY> 67,556
<SALES> 6,357
<TOTAL-REVENUES> 6,357
<CGS> 2,325
<TOTAL-COSTS> 2,325
<OTHER-EXPENSES> 11,901
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 148
<INCOME-PRETAX> (7,721)
<INCOME-TAX> 0
<INCOME-CONTINUING> (7,721)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (7,721)
<EPS-BASIC> (.57)
<EPS-DILUTED> (.57)
</TABLE>
