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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
(Mark One)
X ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended February 29, 2000
OR
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to .
Commission File Number: 0-26281
RED HAT, INC.
(Exact name of registrant as specified in its charter)
Delaware
(State of Incorporation)
06-1364380
(I.R.S. Employer Identification No.)
2600 Meridian Parkway, Durham, North Carolina 27713
(Address of principal executive offices, including Zip Code)
(919) 547-0012
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(g) of the Act: Common Stock,
$.0001 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 the 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.
Aggregate market value of the voting stock held by non-affiliates of the
Registrant as of April 28, 2000 was approximately $1,440,975,186, based on the
closing price of $25.06 for our common stock as reported by The Nasdaq National
Market on April 28, 2000. There were 155,200,547 shares of common stock
outstanding as of April 28, 2000.
DOCUMENTS INCORPORATED BY REFERENCE
Registrant intends to file a definitive Proxy Statement pursuant to Regulation
14A within 120 days of the end of the fiscal year ended February 29, 2000.
Portions of such Proxy Statement are incorporated by reference in Part III
hereof.
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PART I
ITEM 1 - BUSINESS
General
We are the leader in open source solutions for Internet computing, delivering on
the promise of open source from small embedded devices to the most prodigious
enterprise. We apply our technological leadership to create open source
solutions for Internet infrastructure and post-PC environments, offer services
backed by the best understanding of open source and the most comprehensive
resources, deliver the brand of a widely trusted open source leader and
corporate partner, and persist in an indelible commitment to the virtues of open
source to lead a revolution in the computing industry. Our services include
technical support and maintenance, developer support, custom development,
consulting, training and education and hardware certification.
Our web site, redhat.com, is a leading destination for open source software
users and developers and serves as the primary delivery mechanism and customer
interface for many of our offerings. redhat.com also offers extensive news and
information for the open source community, an important forum for open source
software development, a commerce site and priority access for software downloads
and upgrades. We are committed to serving the interests and needs of open
source software users and developers and to sharing our product developments
with the open source community.
Red Hat, Inc. was incorporated in Connecticut in March 1993 as ACC Corp., Inc.
In September 1995, ACC Corp., Inc. changed its name to Red Hat Software, Inc. In
September 1998, Red Hat Software, Inc. reincorporated in Delaware. In June 1999,
Red Hat Software, Inc. changed its name to Red Hat, Inc. In August 1999 we sold
13,800,000 shares of common stock to the public in our initial public offering.
In January 2000, we acquired Cygnus Solutions in a transaction accounted for as
a pooling of interests. As a result of this acquisition, our historical
financial statements have been restated to include the results of operations and
accounts of Cygnus for all periods presented. Cygnus is an open source software
company that provides custom engineering services to develop end-to-end software
solutions primarily for use in the UNIX and Linux markets and then provides
ongoing support and maintenance services for these custom developed software
solutions. In addition, Cygnus has developed a suite of software development
tools that are sold through their web site and through various distributors.
Cygnus has offices in the United States, United Kingdom and Japan.
Industry Background
Growth of open source software
The Internet has accelerated the development of open source software. Open
source software has its origins in the academic and research environments and is
based on an open, collaborative approach to the development and distribution of
software, whereby multiple groups of developers collaborate on specific projects
from remote locations around the globe. Developers can write code alone or in
groups, make their code available over the Internet, give and receive comments
on other developers' code and modify it accordingly. The growth of the Internet
has greatly increased the scale and efficiency of open source development
through the availability of collaborative technologies such as e-mail lists,
news groups and web sites. These technologies have enabled increasingly large
communities of independent developers to collaborate on more complex open source
projects.
Open source software has emerged as a viable alternative to traditional
proprietary software. Under the proprietary model of software development, a
software developer generally licenses to the user only the object, or binary
code. Binary code consists of the 1's and 0's that only computers understand.
By contrast, under the open source development model, the software developer
provides the user with
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access to both the binary code and the source code. Source code is the language
used by the developers. As compared to the proprietary model, the open source
model:
. allows a company's in-house development team to collaborate with a
global community of independent developers;
. provides the user access to both binary and source code, and the
rights to copy, modify, alter and redistribute the software; and
. permits the user ongoing access to improvements made to the software
by others.
We believe open source software offers many potential benefits for software
customers, users and vendors. Customers and users are able to acquire the
software at little or no cost, install the software on as many computing devices
as they wish, and customize the software to suit their particular needs. In
addition, customers and users can obtain software updates, improvements and
support from multiple vendors, reducing reliance on any single vendor. Vendors
are able to leverage the community of open source developers, allowing them to
reduce development costs and decrease their time to market. Vendors are also
able to distribute their products freely over the Internet, enabling them to
create large global user bases quickly.
Participants in open source development can generate revenue in a variety of
ways, including:
. making their own open source products widely available, and then
offering technical support, custom development, and related services
to customers;
. meeting consumer demand for convenience and quality by selling their
open source products to customers in shrink-wrapped packaging
accompanied by user manuals and other related documentation and access
to services and technical support offerings;
. using open source products as a means of attracting visitors to their
web sites, which in turn can result in the sale of other products,
services, and advertising; and
. developing brand loyalty and a reputation for quality by providing
technically superior open source software products, which they can
leverage to sell additional products and services to customers.
Just as the open source model has benefited from the success of the Internet, it
has also greatly contributed to the Internet's success. Open source software
comprises much of the Internet's infrastructure, from domain name server
software to web servers and e-mail router software. Open source software is
particularly well-suited to the Internet. With access to the source code, system
administrators and developers can collaborate to debug, fix and optimally
configure their software on a real-time basis. This enables them to improve
performance and keep data flowing continually across the Internet, minimizing
the disruptions and downtime common with proprietary software.
One of the better known open source products is the Linux kernel, the engine of
Linux-based operating systems. An operating system is the software that allows
a computer and its various hardware and software components to interact.
Operating systems based on the Linux kernel are robust and dynamic. Thousands of
developers worldwide continually collaborate on improving Linux-based operating
systems and update them on a regular basis.
Some of the benefits enjoyed by users of Linux-based operating systems include:
. reduced licensing costs;
. flexibility resulting from access to and legal right to modify source
code;
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. stability and high performance;
. comprehensive Internet support;
. compliance with standards; and
. multi-platform capability.
Since 1991, the use of Linux-based operating systems has grown rapidly.
According to IDC, Linux-based operating systems represented 24.6% of all new
license shipments of server operating systems in 1999. Linux-based operating
systems are now the most commonly used operating system for web sites,
representing approximately 33% of all installations, according to the April 2000
Netcraft Web Server Survey.
Open source opportunities beyond servers
The growth of the Internet, together with the reduction in cost and increase in
performance of computing platforms, has also stimulated the demand for computing
devices that provide low-cost, easy access to the Internet. These devices
include mobile computing devices, such as personal digital assistants, wireless
telephones, television set-top boxes, kiosks and game consoles, as well as
special-purpose server devices such as routers, switches and dedicated file and
e-mail servers. According to IDC, whereas in 1997 personal computers accounted
for 96% of Internet access devices shipped in the U.S., by 2002 mobile computing
devices are expected to account for nearly 50% of unit shipments in the U.S. In
addition, IDC predicts that from 1998 through 2002 shipments of these devices
will increase 76% annually, that by 2002 there will be more than 55 million
mobile computing devices, and that, by 2005, shipments of these devices will
exceed shipments of personal computers.
Manufacturers of mobile computing devices and other special-purpose server
devices need flexible, robust and sophisticated operating systems to power these
devices to take advantage of common application interfaces from desktop
computing environments. Many of these manufacturers have, therefore, turned to
open source solutions. In addition, many software developers rely upon open
source tools, such as libraries, compilers and debuggers, to create software for
these devices. Microprocessor vendors also use open source development tools
and real time operating systems to design reference platforms for integrated
device manufacturers.
Challenges to the widespread adoption of open source
Despite a strong initial market acceptance of Linux-based operating systems and
other open source products, there exists a number of obstacles to widespread
adoption within the enterprise, including:
. lack of service and support;
. scarcity of applications supporting Linux-based operating systems; and
. lack of well-financed, viable open source industry participants.
The ability of a Linux-based operating system to penetrate large businesses on
an enterprise-wide basis and to gain widespread acceptance as a viable
alternative to operating systems developed under the proprietary software model,
depends, in large part, on the emergence of a proven leader in the open source
community. This open source leader must demonstrate to the business enterprise,
as well as to the community of application developers upon whom the business
enterprise relies, a successful business model and the ability to support and
service its products at a consistently high level.
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The Red Hat Solution
To address the challenges facing the open source software market, our products
and services offer the following features and benefits:
Superior product offerings
We engineer what we believe to be the most technically advanced open source
operating system, Red Hat Linux. Red Hat Linux is comprised of more than 700
separate software packages, including compilers and web servers, e-mail servers,
file transfer protocol servers and file servers. Red Hat Linux is:
. flexible and scalable - capable of running a single desktop machine or
the entire network of a large business enterprise;
. functional - able to handle discrete or multiple applications accessed
by multiple users;
. modular - allowing the user to install only those applications that
are desired by the user;
. adaptable - allowing the user to modify the software to meet
particular needs and requirements; and
. reliable - constantly monitored and fine-tuned by thousands of
developers worldwide.
As a result, Red Hat accounted for 55% of new license shipments of Linux-based
server operating systems in the U.S. in 1998 and was the most popular system,
preferred by 68% of U.S. users, according to IDC. In addition, Red Hat Linux
has won numerous awards, including Info World Magazine's "Operating System
Product of the Year" four years in a row in 1996, 1997, 1998 and 1999.
We also engineer, through our subsidiary, Cygnus, superior software development
tools. Our GNUPro software development tools are based on the leading open
source GNU standards and feature a compiler, debugger, various additional
libraries and utilities, including advanced source code browsing and editing
technology. We believe that Cygnus has been responsible for over 75% of the
changes in GNU compiler source code over the past two years. We make regular,
supported releases of our GNUPro software across a broad range of computing
platforms that support all significant operating system environments.
Consequently, these tools have won numerous awards including "Show Favorite" at
the August 1999 Linux World show and Linux Journal's 1999 award for "Best New
Application-Software Development".
Comprehensive open source solutions
Our market leadership in open source operating systems and development tools
enables us to deliver end-to-end solutions for software developers and
enterprise customers from servers to mobile computing devices. We employ many
of the top contributors to the development and maintenance of the Linux kernel
and GNU tools. With this expertise, we are better able to encourage software
developers to rapidly develop applications across a broad range of computing
platforms and port these applications for use on the Red Hat Linux operating
system. We are also positioned to attract enterprise customers and expand the
adoption of open source solutions within these companies.
Extensive professional services
We also offer a broad range of professional services relating to the development
and use of open source products. These services include technical support and
maintenance, developer support, custom development, consulting, training and
education and hardware certification. We provide our customers and the open
source community with a respected and reliable technology partner, one that is
available to help with the purchase, deployment, customization and maintenance
of open source solutions. We also provide custom solutions for key integrated
device manufacturers and develop new technologies that meet their business
objectives. We provide engineering services and developer support to
microprocessor and product manufacturing partners to ensure that our development
tools provide functionality and flexibility that we believe are unmatched by any
proprietary tools vendor. We believe that providing these services
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and establishing ourselves as our customers' technology development partner will
allow us to facilitate the widespread adoption of Red Hat Linux and other open
source solutions as full scale enterprise solutions.
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A leading online destination for the open source community
We are dedicated to serving the interests and needs of open source software
users and developers online. redhat.com serves as our primary customer
interface and delivery mechanism for many of our solutions. redhat.com also
serves as a comprehensive resource for the latest information related to open
source initiatives. It contains news of interest to open source users and
developers, features for the open source community, a commerce site and priority
access for software downloads and upgrades. Visitors to our site can organize
and participate in user groups, make available bug fixes and incremental code
improvements and share knowledge regarding the use and development of open
source software.
By acting as a clearinghouse of open source and Linux-related information and by
facilitating the interaction of developers, businesses and technology
enthusiasts, our web site has become a community center for the open source
movement.
Commitment to the open source model
Red Hat has fully embraced the open source model in its products and services.
Whereas others have incorporated certain aspects of this model into their
businesses while retaining various features of the proprietary model, our
product offerings are true open source offerings. We share our improvements to
the Linux kernel and other open source products with the development community.
In this way, we benefit independent developers by making our products more
useful for them in their own development projects. We have also sponsored the
creation of the Red Hat Center for Open Source, Inc., a non-profit foundation
dedicated to the promotion of open source activities and ideals. Furthermore,
in addition to the open source software we develop ourselves, we help fund a
broad range of open source software projects and organizations, including the
XFree86 group, the linuxconf open source software product and the Free Software
Foundation.
Strategic relationships
In an effort to increase the market acceptance of open source software in
general, and the Red Hat Linux operating system in particular, we have
established development, marketing or distribution relationships with leading
technology companies, including Cisco, Compaq, Computer Associates, Dell,
Hewlett-Packard, IBM, Intel, Nokia, Nortel, Oracle, SAP, and Sony Computer
Entertainment. Further, with our acquisition of Cygnus, we are positioned to
partner with many of the world's leading microprocessor companies to provide
open source software technologies on the latest computing platforms. In
addition, we share our development efforts with and commit resources to third
party developers and vendors in order to expand the number of applications
available for Linux-based and other open source-based operating systems. By
establishing and maintaining these relationships, we are able to increase market
awareness of open source software, gather industry support for our products and
penetrate new markets.
Business Strategy
Our objective is to enhance our position as the leader in open source solutions
for Internet computing, via both traditional channels and the Internet. The key
elements of our strategy are:
Increase the adoption of open source software across all computing platforms
Although recent years have seen a substantial increase in the market acceptance
of Linux-based operating systems and other open source software, we intend to
promote further acceptance of open source software through a variety of means,
including strengthening our existing alliances with other information technology
companies, establishing new alliances and sharing our development efforts with
third-party developers. The strength of these relationships is crucial to the
expansion of the open source community, the technical advancement and widespread
distribution of open source products and the development of third-party
applications suitable for Linux-based operating systems.
By aligning ourselves with companies widely regarded as producing high quality
and highly reliable software developed under the traditional software
development model, we expect to bridge the gap
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between the open source community and those customers who are currently
skeptical or unaware of the benefits of open source software.
Our acquisition of Cygnus has broadened the market for our open source products
and solutions by permitting us to forge relationships with manufacturers of
mobile computing devices such as wireless phones and digital personal organizers
and special purpose server devices, such as routers and phone switches. With
our broad selection of open source products and our comprehensive array of
professional services, we believe that we can quickly and effectively penetrate
this market, expand our presence and increase the market acceptance for open
source solutions within it.
Additional means of increasing the market acceptance for Linux-based operating
systems and other open source software include maintaining and improving our
relationship with third-party developers and the open source community,
encouraging the development of open source applications and publicizing success
stories.
Continue to enhance our web site
We are continuing to enhance our web site in an effort to create a definitive
online destination for open source software products, software updates, news,
and other content related to Linux-based operating systems and other open source
projects. At redhat.com, people from around the world can obtain updates to
open source software, purchase a wide array of open source products and
services, access and copy code for their own programming efforts, read news
related to topics of interest to the community and interact with other community
members. We have recently added such enhancements as software update
notification and automatic software updating for those who want it. New
features we anticipate adding to our web site include:
. registries and hosting of open source web sites and projects;
. open source classifieds (including products for sale and employment
listings);
. event calendars; and
. virtual trade shows.
By adding these features to our web site, we believe that our visitors will
continue to visit on a regular basis and that we will attract an increasing
number of new visitors. In addition, we believe that these new features and
offerings will keep visitors on our site for longer periods of time.
Expand our presence in the enterprise market
Historically, enterprise customers had to obtain open source operating systems
from one source and application development tools from another source. With our
acquisition of Cygnus, we are now positioned to provide comprehensive open
source solutions. We intend to expand our service offerings, including
training, consulting, custom development and web-based services that customers
have come to expect from information technology providers, which will increase
their confidence in open source products and providers. We are currently
expanding our professional services organization to enhance our ability to
provide such services. We believe that as our user base grows, more of our
customers, particularly our larger customers, will look to us to help them
customize their operating systems and our development tools to perform optimally
within their particular computing environments across all of their computing
platforms. We also expect that more of our services will be provided as
subscription services accessed through our web site. We believe that many of
our larger customers will also expect us to assume the role of their technology
partner and perform on-site consulting services such as large-scale system
assessments and enterprise-wide system enhancements. We believe that by
increasing our capacity to offer such services, we will be able to significantly
increase our services revenue and establish ourselves as the premier open source
service provider.
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Continue to pursue strategic acquisitions and alliances
We intend to pursue a selective acquisition strategy as opportunities arise to
complement our product offerings, extend our service capabilities and expand the
features on our web site. We also intend to create strategic alliances where it
is beneficial to our business model. Our acquisition of Cygnus allows us to
expand the market for our products and foster the rapid development of open
source applications. In addition, we believe that our strategic relationships
with Cygnus' large corporate customers will encourage the wide-spread acceptance
of open source operating systems beyond the traditional workstation and desktop
computing environments. Our acquisition of Hell's Kitchen Systems, Inc. ("HKS")
in January 2000 will help us expand our web site and provide open source e-
commerce solutions to our business partners.
Increase our penetration into international markets
We have only recently commenced operations in Europe, Asia and Australia, but we
are rapidly expanding worldwide. Since August 1999, we have established
subsidiaries in France, Italy, Japan and Australia. While we have a significant
installed base of international users, we intend to increase our overseas
presence in the near future by establishing additional foreign offices or
subsidiaries. We offer Red Hat Linux in English, French, German, Italian, and
Japanese, and plan to introduce it in other languages in the future.
Continue to invest in the development of open source technology
We intend to continue to invest significant resources in the development of new
open source technology, capitalizing on our extensive experience working within
the open source model. We expect this continued investment to take the form of
increased expenditures on internal development efforts, including our Red Hat
Advanced Development Laboratory, as well as continued funding of third-party
open source projects. We also plan to continue our financial support of the
development efforts of many of the top-tier engineers in the open source
community. This support will be directed towards an array of projects, ranging
from:
. the development of open source embedded operating systems and
software, which we believe will take Red Hat Linux from the personal
computer to the mobile computing device; and
. the design of new networking and scalability features, which are
expected to make Red Hat Linux more attractive as a server operating
system.
In particular, we have sponsored the Red Hat Center for Open Source, Inc., a
foundation which promotes open source projects and ideals. We expect that,
through our continued efforts, we will be able not only to foster the
advancement of open source technology, but also to enhance our relationship with
the open source community.
Products and Services
Our product offerings include Red Hat Linux and related tools, open source
software applications, documentation, manuals and general merchandise. Our
professional services offerings, principally directed towards our larger
corporate customers and strategic partners, include technical support and
maintenance, custom development, consulting, training and education, developer
support and hardware certification.
Our shrink-wrapped products come with a limited subscription service. Users of
these services are entitled to priority downloads of products, access to
developer pages on our web site and are e-mailed news relating to developments
within the open source community.
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Red Hat Linux and related software
Official Red Hat Linux 6.2. Official Red Hat Linux is our principal product. We
first released Official Red Hat Linux in October 1994, and began shipping the
latest release, Version 6.2, in March 2000. Official Red Hat Linux is available
for the Intel, Sun SPARC and Compaq Alpha platforms. We offer the product in
three versions:
. Standard - the basic collection of Red Hat Linux software includes a
documentation CD, printed installation guide, limited installation
technical support, and priority access to software updates;
. Deluxe - includes the components of Standard, plus E-commerce credit
card verification software, additional software applications we
license from third parties, an additional printed manual, and limited
telephone technical support; and
. Professional - includes the components of Deluxe, plus additional
software applications and technical support, and cryptography software
we license from RSA Data Security, Inc. used to create a secure web
server suitable for conducting secure transactions via the Internet.
This is a successor to our product previously known as the Red Hat
Secure Web Server.
Official Red Hat Linux provides everything the user needs to perform a wide
variety of server functions, including setting-up a web, e-mail, file or print
server as well as using a computer as a general purpose desktop workstation to
perform virtually any computing function.
Other Red Hat products include:
Red Hat Linux Enterprise Edition. As part of our enterprise product strategy,
we work with top software vendors to provide tested and integrated total Red Hat
Linux solutions for business critical, high-volume, e-business and enterprise
environments. The Red Hat Linux Enterprise Edition product line features
enterprise-class support from Red Hat's worldwide support solutions centers.
Linux Applications Library. The Linux Applications Library is a collection of
applications developed by third parties that are designed to run on Red Hat
Linux. These products do not include printed documentation or technical
support.
RMS Linux. RMS Linux is a special collection of Red Hat Linux operating system
and applications containing only open source software, and does not include
technical support or printed documentation. Red Hat donates a portion of the
proceeds from the sale of this product to the Free Software Foundation.
CCVS. Credit Card Verification System (CCVS) is transaction-processing software
that is embeddable and portable to most UNIX and Linux systems. CCVS may be
used for credit card authorization and settlement, as well as check
verification. CCVS is certified with the major clearing house protocols and
supports e-commerce applications ranging from a single web page or billing
application, to a payment gateway server supporting thousands of merchants. We
acquired this product with our acquisition of HKS.
Software for special-purpose client and server devices
With our acquisition of Cygnus, we are now able to provide a wide array of
products that enable application scalability and portability across a range of
computing platforms. Cygnus engineers operating systems and tools which are
used for applications development and deployment across a broad range of
computing platforms. These products reduce the complexity of cross-platform
application development and deployment by allowing a single body of source code
to be developed on or targeted toward a wide range of computing platforms.
These products include:
GNUPro ETS and GNUPro Plus. GNUPro ETS and GNUPro Plus are collections of
software development tools based on the popular GNU standard. We intend to sell
GNUPro bundled with a
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subscription service that includes regular software upgrades and developer
support services for rapid response and resolution of technical questions or
problems.
eCos. eCos, the "embedded Cygnus operating system", is a real-time operating
system targeted at special-purpose client device environments such as consumer
electronics, wireless telephones, set top boxes, and Internet appliances. This
highly configurable and scalable product is currently bundled with host tools
that allow for rapid operating system configuration.
EL/IX. EL/IX brings a consistent application programming interface to
developers who wish to target Linux as a host operating system, Linux as an
embedded operating system, or eCos as a deeply embedded operating system. Use
of EL/IX provides developers with the ease of developing Linux applications
natively and redeploying them to a variety of targets and applications,
including special-purpose server and client applications that are running any
EL/IX-compliant operating system.
EDK. EDK, the "Red Hat embedded DevKit", is an integrated development
environment, based on GNUPro tools and Source Navigator for embedded Linux
development. Professional support packages are available to ensure the highest
possible support from the principal innovators in both Linux and GNU tools.
Subscription access to the new development packages will ensure timely
notification of the latest modifications and enhancements as they become
available.
Cygwin. Cygwin allows Linux/UNIX developers to compile their applications
easily for the Windows platform, without any substantial rewriting of the source
code.
Source-Navigator 4.5. Source-Navigator 4.5 is a tool for software developers,
enabling them to quickly understand and re-engineer complex code.
Professional services
With our acquisition of Cygnus, we have significantly expanded the scope of our
service offerings and professional services staff, and currently offer the
following services:
Technical support and maintenance and developer support. We offer technical
support and maintenance to a broad range of customers ranging from individual
users to large corporations. We deliver installation, incident-based and
developer support via our web site, e-mail and telephone. We have a highly-
trained and skilled staff of technical support engineers to provide these
services to our customers. In addition, we maintain relationships with several
third-party support providers in order to enhance and expand our technical
support and maintenance capabilities.
Custom development and consulting. We offer consulting and custom development
services for enterprise customers seeking to deploy Red Hat Linux and open
source applications. We also offer advanced assistance to third-party software
developers working to develop applications that run on Red Hat Linux. In
addition, we offer specific consulting and custom development services for key
integrated device and microprocessor manufacturers seeking to utilize embedded
open source operating systems on their devices.
Training and education. We provide training and educational programs to those
customers who want to learn how to optimize their use of Red Hat Linux. The
most popular of these programs is the "Red Hat Certified Engineer" course that
we offer at sites around the world. We also conduct on-site training for
customers. We work with third-party training and educational program providers
to develop and offer additional training courses on a variety of topics related
to Red Hat Linux, our open source tools and other open source software.
Hardware certification. We perform testing and certification services for
hardware vendors seeking to market their products to Red Hat Linux users.
Hardware vendors submit their products to us and, in exchange for a fee, we test
the hardware to determine whether it is compatible with Red Hat Linux. Products
meeting our performance criteria are certified as Red Hat Linux compatible.
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Production and fulfillment
We outsource the physical production, packaging and order fulfillment of our
products to third parties when it is cost effective to do so. To the extent
possible, we limit our internal production activities to such tasks as
scheduling, quality inspection and testing. We currently have arrangements for
production, packaging and fulfillment with JVC Disc America Co., and Saturn
Fulfillment Services Limited. We believe that our existing production
arrangements are sufficient to accommodate potential increases in sales volume
for the foreseeable future.
redhat.com
Our web site, redhat.com, serves as the primary delivery mechanism and customer
interface for many of our offerings. We offer extensive resources for the open
source community, software updates and downloads and a commerce site for our
shrink-wrapped products and support offerings. redhat.com also offers users
access to broad and authoritative content on open source software including
news, documentation, educational materials and case studies. Our web site
serves the interests and needs of a wide spectrum of open source software users,
from system administrators to developers to academics to mainstream technology
users.
The redhat.com audience is highly focused and technically sophisticated,
representing an attractive target market of computing professionals for
advertisers and merchants. We offer a number of advertising and sponsorship
programs to our partners and others seeking to reach this market.
Since August 1999, significant enhancements include:
. Red Hat Developer Network - The Red Hat Developer Network is a
collection of technical and business resources for developing software
that runs on Red Hat Linux. It includes news about recent open source
software developments, guidance on how to develop new applications
that will run optimally on Red Hat Linux, technical documentation and
other resources, and links to other resources that may be of interest
to software developers. It is targeted at a range of software
developers, including third parties that develop their own software
application products, enterprise developers, web application
developers and open source software developers. We plan to expand the
Developer Network to include a variety of partnership programs, co-
marketing opportunities and specialized support service offerings.
. Agent Update - We offer customers the ability to receive electronic
notification of the release of new open source products or product
upgrades. In addition, at their option, we can automatically download
new or upgraded products to the customers' computers when released.
. Red Hat Store - We intend to continue building the redhat.com store
into the most comprehensive open source shopping resource for
corporate enterprise buyers. Offerings and upsell opportunities will
be presented throughout the site in a context-relevant manner.
Sales, Marketing and Distribution
Software Products
We sell our products worldwide through direct sales, telesales campaigns and our
web site, and indirectly through distributors, retailers, catalogs and original
equipment manufacturers. Our direct sales force is dedicated to increasing
worldwide sales through our retail, distribution and original equipment
manufacturer channels. As of February 29, 2000, our indirect distribution
channel was comprised of eight
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distributors, over 100 retailers with thousands of locations and 50 original
equipment manufacturers. We have recently begun to focus our sales efforts more
aggressively on the business enterprise market.
Our agreements with our distributors typically are not exclusive, have no stated
minimum purchase or license obligations and may be terminated by either party
without cause. We believe that in the event of the termination of our
relationship with one or more of our indirect channel partners, we could enter
into replacement agreements with new partners.
We permit original equipment manufacturers to distribute Red Hat Linux with
their own hardware in exchange for royalty payments to us. We currently have
original equipment manufacturer agreements in place with Dell, Compaq, IBM,
Siemens and others. These agreements are not exclusive, have no stated minimum
purchase or license obligations, and generally may not be terminated prior to
the expiration of their terms.
Services
We sell our service offerings worldwide directly to individuals and companies
through our sales force, direct sales, telesales and our web site, and
indirectly through joint marketing alliances with companies such as Compaq, IBM
and Intel. Our direct sales force concentrates primarily on selling custom
development and technical support and maintenance contracts to our enterprise
customers worldwide. Our acquisition of Cygnus added 28 sales professionals to
our direct sales organization.
We have established joint marketing relationships with a number of leading
technology companies including Compaq, Hewlett-Packard, IBM, Intel and Oracle.
These agreements generally have one- or two-year terms and may be terminated
prior to the expiration of their terms by either party with prior notice.
Our direct sales efforts support our sales and distribution efforts through
participation in industry trade shows, targeted advertising, channel sales
programs, public relations campaigns, retail promotions, customer surveys and
the promotion of our products through our web site. In addition, we offer our
software products for free download from redhat.com and other Internet sites
worldwide.
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Competition
In the market for operating systems, we compete with a limited number of large
and well-established companies that have significantly greater financial
resources, larger development staffs and more extensive marketing and
distribution capabilities. These competitors include Microsoft, Novell, IBM,
Sun Microsystems and The Santa Cruz Operation, all of which offer hardware-
independent multi-user operating systems for Intel platforms, and AT&T, Compaq,
Hewlett-Packard, Olivetti and Unisys, each of which, together with IBM and Sun
Microsystems, offers its own version of the UNIX operating system. Many of
these competitors bundle competitive operating systems with their own hardware
offerings, thereby making it more difficult for us to penetrate their customer
bases.
In the rapidly evolving open source and Linux-based operating system market, we
compete with a number of well-respected vendors and development projects. These
competitors have established stable customer bases and continue to attract new
customers. We also compete for services revenue with a number of companies that
provide technical support and other professional services to users of Linux-
based operating systems, including some original equipment manufacturers with
which we have agreements. Many of these companies have larger and more
experienced services organizations than we do currently. In addition, we face
potential competition from several companies devoted to providing open source-
based products and services, such as VA Linux Systems, a provider of hardware
pre-installed with open source software, and Corel Corp., a developer of open
source applications, each of which has indicated a growing interest in the
Linux-based operating systems market.
With our acquisition of Cygnus, we now face competition in the market for
software development tools and operating systems for special-purpose computing.
Our main competitors in this market include Wind River Systems, Integrated
Systems Incorporated, Green Hills Software, and the Metrowerks subsidiary of
Motorola. These companies are well established and have greater financial
resources and larger direct sales staffs than we do. Some of these companies
currently produce or use open source software as part of their product
offerings.
The open source solutions market is not characterized by the traditional
barriers to entry that are found in most other markets, due to the nature of our
products. For example, anyone can copy, modify and redistribute Red Hat Linux
and most of our other open source products themselves. Accordingly, it is
possible that new competitors or alliances among competitors may emerge and
rapidly acquire significant market share.
We believe that the major factors affecting the competitive landscape for our
products include:
. name and reputation of vendor;
. product performance, reliability, functionality and price;
. strength of relationships in the open source community;
. availability of user applications;
. ease of use;
. networking capability;
. breadth of hardware compatibility;
. quality of support and customer services;
. distribution strength; and
. alliances with industry partners.
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Although we believe that we compete favorably with many of our competitors in a
number of respects, including product performance, functionality and price,
networking capability, and breadth of hardware compatibility, we believe that
many of our competitors have superior distribution capabilities and offer more
extensive support services than we currently do. In addition, there are
significantly more user applications available for competing operating systems,
such as Windows NT and UNIX, than there are for Linux-based operating systems.
An integral part of our strategy in the near future, however, is to address
these shortcomings by, among other things, strengthening our existing strategic
relationships and entering into new ones in an effort to expand our distribution
capabilities, continuing to expand into the special-purpose computing device
market and attracting more attention to the open source movement, which in turn
should create additional incentives for software developers to write more
applications for Red Hat Linux.
In the market for advertising revenue, we compete with other online content
providers and traditional forms of media such as newspapers, magazines, radio
and television. We believe that the principal competitive factors in attracting
advertisers include the amount of traffic on redhat.com, brand recognition,
customer service and support, the demographics of our users and visitors, our
ability to offer targeted audiences and the overall cost-effectiveness of the
advertising medium that we offer.
Software Engineering and Development
We have invested, and intend to continue to invest, significant resources in
product and technology development. We focus and modify our product development
efforts based on the needs of users and changes in the marketplace. We are
currently focusing our development efforts on improving the Linux kernel, as
well as commercializing our software innovations into new products and product
enhancements that are easier to use and provide greater functionality. Our
software engineers collaborate with open source software development teams
working across the Internet. This involvement enables us to remain abreast of
and lead technical advances, plans for development of new features and timing of
releases, as well as other information related to the development of the Linux
kernel and other open source projects.
Our software engineers have contributed to the development and maintenance of
some of the most important components of the Red Hat Linux operating system,
including the installation program and the package management program. The
installation program provides users with a single method to install the hundreds
of separate software programs that are included with Red Hat Linux so that from
the user's perspective, the hundreds of programs appear as one. This simplified
process sharply reduces the time and effort required to install a Linux-based
operating system, as compared to the alternative of gathering the hundreds of
programs one by one via the Internet. The installation program provides default
settings for the user depending upon whether the user wishes to use Red Hat
Linux as a server operating system or as a workstation operating system. The
installation also provides advanced users with the ability to customize the
programs that are installed, allowing for significant flexibility and control
over the operating system. The installation also automatically detects the type
of hardware that comprises the user's computer, in order to ensure that all
programs necessary for Red Hat Linux to work on the hardware are properly
installed.
Our software development engineers perform extensive testing of Red Hat Linux to
ensure that it is properly assembled and works as a coherent whole from the
user's perspective. We use industry standard methods of quality assurance
testing to ensure that Red Hat Linux is solidly engineered and ready for use by
our customers when shipped. We also operate an extensive beta testing program
for Red Hat Linux. Under this program, we post a beta or test version of the
operating system on the Internet. Developers and users around the world then
suggest improvements and identify bugs. Each suggestion is circulated over the
Internet in an attempt to encourage others to assist in the programming of a
solution. In this way, Red Hat Linux users are treated as co-developers. Bug
fixes and enhancements are tested by other users and our engineers, and when
corrected, added to the next release. When the beta version is viewed as stable
and complete, it becomes the next production version, and a new beta cycle
begins.
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Our web development team consists of engineers with considerable experience in
developing scalable web-based applications. We continue to develop applications
on redhat.com for user registration, commerce, and content management and
publication. We rigorously test these programs and have built in the software
necessary to ensure high quality visits to our web site.
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Intellectual Property
Red Hat Linux and our other open source products have been developed and made
available for licensing under the GNU General Public License and similar
licenses. These licenses generally permit anyone to copy, modify and distribute
the software, subject only to the restriction that any resulting or derivative
work is made available to the public under the same terms. Therefore, although
we retain the copyrights to the code that we develop ourselves, due to the open
source nature of our software products and the licenses under which we develop
and distribute them, our most valuable intellectual property is our collection
of trademarks. We rely primarily on a combination of trademarks and copyrights
to protect our intellectual property. We also enter into confidentiality and
nondisclosure agreements with our employees and consultants, and generally
control access to and distribution of our documentation and other proprietary
information.
We pursue registration of some of our trademarks in the United States and in
other countries. We have registered the trademark "Red Hat" in the United
States, Australia, and the European Union, and have registrations pending in
many other countries, including Canada and Japan. We have registered the Red
Hat "Shadow Man" logo in the U.S., European Union and Australia and have
registrations pending for it in many other countries, including Canada and
Japan. Other trademarks we have registered or have registrations pending in the
United States include Red Hat Certified Engineer, RHCE, Wide Open, Always Open,
Red Hat Ready and the Red Hat Ready logo. Other trademarks Cygnus registered or
for which it has registrations pending in the United States include Cygnus
Solutions, GNUPro, Code Fusion, eCos, eCosystem, SourceNavigator and Cygwin.
Despite our efforts to protect our trademark rights, unauthorized third parties
have in the past attempted and in the future may attempt to misappropriate our
trademark rights. We cannot be certain that we will succeed in preventing the
continued misappropriation of our tradename and trademarks in these
circumstances or that we will be able to prevent this type of unauthorized use
in the future. The laws of some foreign countries do not protect our trademark
rights to the same extent as do the laws of the United States. In addition,
policing unauthorized use of our trademark rights is difficult, expensive and
time consuming. The loss of any material trademark or trade name could have a
material adverse effect on our business, operating results and financial
condition.
Although we do not believe that our products infringe the rights of third
parties, third parties have in the past asserted, and may in the future assert
infringement claims against us which may result in costly litigation or require
us to obtain a license to third-party intellectual rights. There can be no
assurance that such licenses will be available on reasonable terms or at all,
which could have a material adverse effect on our business, operating results
and financial condition.
Employees
As of April 30, 2000, we had a total of 435 employees. From time to time we
also employ independent contractors to support our professional services,
product development, sales, marketing and business development organizations.
Our employees are not represented by any labor union and are not organized under
a collective bargaining agreement, and we have never experienced a work
stoppage. We believe our relations with our employees are good.
Recent Developments
On April 17, 2000, we executed a definitive agreement to acquire all of the
outstanding common stock and preferred stock and assume all of the outstanding
options of Bluecurve, Inc., a performance management solutions company, in
exchange for up to 1,257,862 shares of our common stock. This acquisition will
be accounted for using the purchase method of accounting and is expected to
close on or before June 30, 2000.
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Executive Officers and Directors of Red Hat
The following table sets forth the name, age, and position of each of the
persons who are serving as executive officers and directors of Red Hat as of
April 30, 2000:
<TABLE>
<CAPTION>
Name Age Position
- ---- --- --------
<S> <C> <C>
Executive Officers and Directors
Robert F. Young............................... 45 Chairman of the Board of Directors
Matthew J. Szulik............................. 43 Chief Executive Officer, President and Director
Michael Tiemann............................... 35 Chief Technology Officer
Timothy J. Buckley............................ 48 Senior Vice President and Chief Operating Officer
Harold L. Covert.............................. 53 Chief Financial Officer and Secretary
Marc Ewing.................................... 30 Director
Kevin Harvey (1)(2)........................... 35 Director
William S. Kaiser (1)(2)...................... 44 Director
Eric Hahn (1)(2).............................. 39 Director
</TABLE>
_______________
(1) Member of Compensation Committee.
(2) Member of Audit Committee.
Robert F. Young co-founded Red Hat and served as its President and a Director
from its inception until November 1998. In November 1998, he was elected as
Chief Executive Officer and Chairman of the Board of Directors. In November
1999, he resigned as Chief Executive Officer and currently serves as the
Chairman of the Board of Directors.
Matthew J. Szulik has served as Chief Executive Officer of Red Hat since
November 1999, as President since November 1998 and as a Director since April
1999. Mr. Szulik also served as Chief Operating Officer of Red Hat from
November 1998 to April 1999. Prior to joining Red Hat, from September 1997 to
October 1998, Mr. Szulik served as President of Relativity Technologies, a
computer software company. From February 1996 to May 1997, Mr. Szulik served as
President of Sapiens International, a computer software company. Prior to that,
from January 1993 to December 1995, he served as Senior Vice President in charge
of sales and marketing for MapInfo Corp., a computer software company.
Michael Tiemann has served as Red Hat's Chief Technology Officer since January
2000. Prior to joining Red Hat, he was a co-founder of Cygnus in 1989, and held
various positions with Cygnus, including President, Director of Business
Development and Director of Technical Marketing.
Timothy J. Buckley has served as Senior Vice President and Chief Operating
Officer of Red Hat since April 1999. Prior to joining Red Hat, from October
1997 until April 1999, Mr. Buckley was Senior Vice President of Worldwide Sales
at Visio Corp., a business software company. Mr. Buckley joined Visio in
November 1993 and served as Visio's Vice President of Worldwide Sales until his
promotion in October 1997.
Harold L. Covert has served as Red Hat's Chief Financial Officer since March
2000. Prior to joining Red Hat, from April 1998 to March 2000, Mr. Covert was
Senior Vice President and Chief Financial Officer of Adobe Systems, Inc. From
July 1997 to April 1998, Mr. Covert was Vice President and Chief Financial
Officer of Philips Components NAFTA, an operating entity of Philips Electronic
NV. From January 1991 to June 1997, Mr. Covert was a Partner in the firm of DHJ
& Associates, Inc., Consultants and Certified
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Public Accountants. During the last two and a half years of this period, he
acted in a full time capacity as Chief Financial Officer for two companies.
Prior to that time, Mr. Covert held senior financial management positions with
ISC Systems Corporation and Northern Telecom, Inc.
Marc Ewing co-founded Red Hat and has served as a Director of Red Hat since its
inception. He also served as its Executive Vice President and Chief Technology
Officer from inception until January 2000. Mr. Ewing participated in the design
and development of Red Hat Linux and founded Red Hat Advanced Development
Laboratories to develop open source graphical desktop applications for Linux in
cooperation with the open source development community. Prior to founding Red
Hat, for various periods from January 1991 to August 1992, Mr. Ewing worked as a
systems programmer for IBM.
Kevin Harvey has served as a Director of Red Hat since August 1999. Mr. Harvey
has been a Managing Member of the general partner of Benchmark Capital Partners,
a venture capital firm, since January 1995. From July 1993 to January 1995, Mr.
Harvey served as General Manager for Lotus Development Corporation, a software
company. Mr. Harvey is also a director of Silicon Gaming, Inc., Critical Path,
Inc. and several privately held companies.
William S. Kaiser has served as a Director of Red Hat since September 1998. Mr.
Kaiser has been employed by Greylock Management Corporation, a venture capital
firm, since May 1986 and has been a general partner of the Greylock Limited
Partnerships since January 1988. Mr. Kaiser is also a director of Open Market
Inc., Clarus Corporation and Student Advantage, Inc.
Eric Hahn has served as a Director of Red Hat since April 1999. Mr. Hahn is a
founding partner of Inventures Group, a leading "mentor investment" venture
capital firm. He served as Executive Vice President and Chief Technology
Officer of Netscape from November 1996 until June 1998. Prior to serving as
Netscape's Chief Technology Officer, from November 1995 to November 1996, Mr.
Hahn was general manager of Netscape's Server Products Division, overseeing
product development for Netscape's enterprise, Internet and extranet servers.
Mr. Hahn joined Netscape following its acquisition of Collabra Software, Inc.,
which Mr. Hahn founded in February 1993.
ITEM 2 - PROPERTIES
Our headquarters are currently located in a leased facility in Durham, North
Carolina, consisting of approximately 51,800 square feet under a five year lease
that will expire on January 14, 2004. The annual rental expense under this
lease is approximately $900,000. We also have major offices in Sunnyvale,
California and in the United Kingdom. We believe that additional space will be
required as our business expands and will be available on acceptable terms.
ITEM 3 - LEGAL PROCEEDINGS
We are not a party to any material legal proceedings. We may from time to time
become a party to various legal proceedings arising in the ordinary course of
our business.
ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matter was submitted to a vote of the Company's stockholders, through the
solicitation of proxies or otherwise, during the fourth quarter of fiscal year
2000.
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PART II
Item 5 - MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Market Information
The Company's common stock is traded on The Nasdaq National Market under the
symbol "RHAT". The chart below sets forth the high and low bid information for
the quarters of the fiscal year ended February 29, 2000 in which the Company was
publicly traded, taking into account the 2-for-1 stock splits affected by the
Company on August 11, 1999 and January 7, 2000.
2000
----------------
Quarter High Low
------- ---- ---
Second (commencing August 11, 1999)................. $ 45.34 $20.00
Third............................................... $127.00 $36.00
Fourth.............................................. $151.31 $60.50
The closing price for our common stock as reported by The Nasdaq National Market
on May 23 was $16.75 per share.
Holders
The Company has never declared or paid any cash dividends on its common stock.
The Company anticipates that all of its earnings will be retained for the
operation and expansion of the Company's business and does not anticipate paying
any cash dividends in the foreseeable future.
Sales of Unregistered Securities
In the three years preceding the filing of this Annual Report, the registrant
has sold the following securities that were not registered under the Securities
Act:
On August 15, 1997, the registrant sold an aggregate of 6,801,400 shares of its
Series A convertible preferred stock to one investor at a price of $.294057 per
share.
On September 29, 1998, the registrant sold an aggregate of 8,116,550 shares of
its Series B convertible preferred stock to five investors at a price of $.857
per share.
During the period between February 25, 1999 and April 1, 1999, the registrant
sold an aggregate of 2,054,776 shares of its Series C convertible preferred
stock to ten investors at a price of $3.141 per share.
From September 4, 1998 through August 11, 1999, the registrant granted options
to purchase an aggregate of 11,656,176 shares of common stock under the 1998
Stock Option Plan, as amended, exercisable at a weighted average price of $1.542
per share.
From August 11, 1999 through December 31, 1999, the registrant granted options
to purchase an aggregate of 837,800 shares of common stock under the 1999 Stock
Option and Incentive Plan, exercisable at a weighted average price of $41.72 per
share.
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<PAGE>
On January 6, 2000, in connection with the acquisition of HKS, the registrant
issued shares of common stock to 30 shareholders of HKS. The registrant issued
478,004 shares to such shareholders upon the closing of the acquisition and
318,666 shares may be issued at certain dates over a period of three years based
on continued employment with the registrant and designated performance targets.
Such sales were made in reliance upon the exemption provided by Section 4(2) of
the Securities Act for transactions not involving a public offering and/or Rule
701 under the Securities Act.
On January 7, 2000, in connection with the acquisition of Cygnus, the registrant
issued an aggregate of 10,867,966 shares of common stock. These shares do not
include 2,380,722 shares of common stock which were issuable as of the closing
upon the exercise of options granted under the Cygnus 1995 Stock Plan, the
Cygnus 1997 Stock Plan and the Cygnus 1998 Executive Stock Plan, which options
have been assumed by Red Hat. The offering and sale of the shares in the
transaction were made in reliance upon the exemption provided by Section
3(a)(10) of the Securities Act.
On January 17, 2000, the registrant issued 3,781 shares of its common stock as
part of the purchase price for the entire capital stock of Sistemi Research
Laboratories s.r.l., a limited liability company organized under the laws of
Italy. The registrant issued such shares pursuant to the exemption from
registration provided by Regulation S promulgated under the Securities Act. The
directed selling efforts were made by the registrant. The offering restrictions
specified under Rule 903 of Regulation S were implemented in connection with the
issuance of such shares. The registrant also agreed to issue an additional
1,512 of its shares of common stock on December 31, 2000 if sales of Red Hat
Linux products and services in the Italian market prior to that date exceed a
specified dollar target and the individual to whom the shares were issued is
still employed by the registrant or one of its affiliates.
No underwriters were involved in the foregoing sales of securities.
Use of Proceeds
On August 11, 1999 the Securities and Exchange Commission declared effective the
Company's Registration Statement on Form S-1 (File number 333-80051), relating
to the initial public offering of the Company's Common Stock, $.0001 par value.
The offering commenced on August 11, 1999 and all shares covered by the
Registration Statement were sold. The proceeds to the Company, net of
underwriting discounts and costs, was approximately $88.5 million. The following
are the uses of such proceeds from the effective date of the registration
statement (August 11, 1999) through February 29, 2000:
Cash and cash equivalents: $71,929,498
Working capital: $16,537,431
None of the net proceeds from the IPO were used to pay, directly or indirectly,
directors, officers, persons owning ten percent or more of the Company's equity
securities, or affiliates of the Company.
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<PAGE>
ITEM 6 - SELECTED FINANCIAL DATA
The following selected financial data is derived from the Consolidated Financial
Statements of the Company. The data should be read in conjunction with the
Consolidated Financial Statements, related notes, and other financial
information included herein.
<TABLE>
<CAPTION>
Year Ended
----------
(in thousands, except per share data)
-----------------------------------
February February February February February
-------- -------- -------- -------- --------
29, 2000 28, 1999 28, 1998 28, 1997 29, 1996
-------- -------- -------- -------- --------
<S> <C> <C> <C> <C> <C>
SELECTED STATEMENT OF OPERATIONS DATA
Total revenue ............................................ $ 42,428 $ 33,032 $ 22,643 $ 15,129 $ 9,292
Gross profit ............................................. 19,590 20,316 14,195 9,350 5,344
Income (loss) from operations ............................ (43,913) (5,105) (3,116) (1,461) 845
Net income (loss) ........................................ (39,842) (5,788) (2,966) (1,511) 453
Net income (loss) per common share (a):
Basic.................................................... (0.3968) (0.1224) (0.0631) (0.0322) 0.0100
Diluted.................................................. (0.3968) (0.1224) (0.0631) (0.0322) 0.0097
Number of weighted average shares
outstanding (a):
Basic.................................................... 100,610 47,628 47,000 47,000 45,251
Diluted.................................................. 100,610 47,628 47,000 47,000 46,700
BALANCE SHEET DATA
Working capital .......................................... $250,287 $ 14,894 $ 1,777 $ 4,614 $ 69
Total assets ............................................. 423,535 32,731 16,913 14,668 5,694
Long-term debt, net of current maturities ................ 231 1,399 194 1,201 30
Stockholders' equity (deficit) ........................... 393,447 (711) (3,330) (784) 1,001
</TABLE>
___________________
(a) All share and per share information has been retroactively restated to
reflect the two-for-one splits of common stock on each of August 11, 1999
and January 7, 2000. See Note 12 of Notes to Consolidated Financial
Statements.
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<PAGE>
ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Forward-looking statements in this Annual Report on Form 10-K are made pursuant
to the safe harbor provisions of Section 21E of the Securities Exchange Act of
1934. Investors are cautioned that statements in this Annual Report on Form 10-
K that are not strictly historical statements, including, without limitation,
statements regarding current or future financial performance, management's plans
and objectives for future operations, product plans and performance,
management's assessment of market factors, and statements regarding the strategy
and plans of Red Hat and its strategic partners, constitute forward-looking
statements. These forward-looking statements are not guarantees of Red Hat's
future performance and are subject to a number of risks and uncertainties that
could cause Red Hat's actual results in the future materially to differ from the
forward-looking statements. These risks and uncertainties include, without
limitation, the risks detailed below and in Red Hat's other filings with the
Securities and Exchange Commission, copies of which may be accessed through the
SEC's web site at http://www.sec.gov.
------------------
Overview
We are a leading global developer and provider of open source software and
solutions, and have built a comprehensive web site dedicated to the open source
software community. We were incorporated in Connecticut in March 1993 as ACC
Corp., Inc. In September 1995, we changed our name to Red Hat Software, Inc.
In September 1998, we reincorporated in Delaware. In June 1999, we changed our
name to Red Hat, Inc. We have financed our activities to date through proceeds
from the sale of equity securities and cash flow from operations.
In January 2000, we acquired Cygnus in a transaction accounted for as a pooling
of interests. As a result of this acquisition, our historical financial
statements have been restated to include the results of operations and accounts
of Cygnus for all periods presented. In January 2000, we acquired HKS in a
transaction accounted for in accordance with the purchase method of accounting.
As a result, our results of operations include the results of operations of HKS
from the date of the acquisition.
Sales of Official Red Hat Linux have historically represented our principal
source of revenue. We derive our subscription revenue primarily from the sale of
software products and technical support contracts:
. through distributors to enterprise and retail accounts;
. directly to individual users and enterprises through our redhat.com
web site, our call center, and our direct sales force; and
. from original equipment manufacturers which license our software and
support services directly.
We recognize revenue from software product sales to distributors and original
equipment manufacturers for which no technical support is provided at the time
our products are shipped, net of a reserve for estimated sales returns. This
reserve is recognized based on our historical experience with these
distributors' rates of sell-through to the end user. Revenue from the sale of
software products to individual users and enterprises for which no technical
support is provided is recognized on the date we ship the software products.
Upon the release of Version 6.0 of Red Hat Linux in May 1999, we began selling
Official Red Hat Linux and Red Hat Secure Web Server with 30 days of free
telephone technical support, 90 days of free e-mail technical support and 180
days of subscription services. In accordance with the provisions of Statement
of Opinion No. 97-2 "Software Revenue Recognition", we are recognizing all of
the revenue from the sale of Versions 6.0 and 6.1 of Official Red Hat Linux
ratably over the period that the technical support and subscription services are
provided in proportion to the costs incurred to provide such technical support
and subscription services as compared to estimated total costs to be incurred.
Cygnus recognized revenue on the sale of its software products at the date such
products were shipped
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<PAGE>
to the distributor or customer net of a reserve for estimated sales returns.
This reserve was recognized based on each individual distributor's right of
return under the distribution agreement and Cygnus' historical experience of
sales returns of its software products. Cygnus used the same method of revenue
recognition for product sales for which no technical support is provided as we
do, and we have continued to use this method for these sales.
We have recently added new features to our redhat.com web site and intend to
develop additional features which we believe will result in an increase in both
the number of visitors who access our web site and in revenue generated through
our web site, including through
. the sale of our own software and solutions;
. the sale of third-party products;
. the sale of products co-branded or bundled with third-party products;
and
. the sale of advertising.
Web revenue is currently derived principally from short-term advertising
contracts in which we typically guarantee a minimum number of impressions to be
delivered to users over a specified period of time for a fixed fee. Advertising
rates are typically measured on a cost per thousand impressions basis.
Advertising revenue is recognized ratably in the period in which the
advertisement is displayed, provided that we have no significant remaining
obligations, at the lesser of the ratio of impressions delivered over total
guaranteed impressions or the straight line basis over the term of the contract.
If we do not meet minimum guaranteed impressions requirements, we defer
recognition of the corresponding revenue until the minimum number of guaranteed
impressions is achieved. We did not generate revenue from the sale of
advertising on our web site until the first quarter of the fiscal year ending
February 29, 2000.
Prior to March 1999, we provided only minimal service offerings to our
customers. In March 1999, we developed and expanded our service offerings to
include comprehensive technical support and maintenance, developer support,
custom development, consulting, training and education and hardware
certification services. Revenue from technical support and maintenance
arrangements is deferred and recognized ratably over the term of the related
agreement, which is typically one year. Revenue from custom development,
consulting, training and education services, developer support and hardware
certification services, is recognized as the services are provided.
Cygnus provides custom development services for integrated device manufacturers
and also provides engineering services and developer support services for
microprocessor and product manufacturing companies. Cygnus recognizes revenue
on its service arrangements on the percentage of completion method over the term
of the related development agreement. These custom development arrangements
generally have a term of three to six months. Support and maintenance
arrangements typically have terms of three months to two years. Revenue from
ongoing technical support and maintenance services was recognized ratably over
the term of the related technical support and maintenance agreement. We have
continued to use this method of revenue recognition for these services.
Our software products are sold worldwide. For the fiscal year ended February
28, 1999, all of our revenue from sale of our software products came from North
America, except for royalties received from international sources, which totaled
less than $50,000. In August 1999, we established international operations for
the sale of Official Red Hat Linux and related service offerings, and for the
fiscal year ended February 29, 2000, when combined with Cygnus, we derived $10.7
million in total revenue from sales outside of North America.
We have historically experienced fluctuations in our results of operations
related to the release of new versions of Red Hat Linux. We believe our
customers' anticipation of the release of these new versions has historically
resulted in, and will continue to result in, a decline in sales for several
months prior to the release and an increase in sales immediately following the
release. Prior to our release of Version 6.0 of
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Official Red Hat Linux in May 1999 and of Version 6.1 of Official Red Hat Linux
in October 1999, software product sales decreased, but after each release we
experienced an immediate significant increase in both the volume and dollar
amount of software product sales. In addition, we believe that revenue from the
sale of Official Red Hat Linux and related products will decline as a percentage
of total revenue in the future as we continue to expand our services offerings
and execute our web initiatives.
25
<PAGE>
Results of Operations
The following table sets forth the results of operations for Red Hat expressed
as a percentage of total revenue.
<TABLE>
<CAPTION>
Year Ended
-----------------------------------------------
February 29, February 28, February 28,
2000 1999 1998
------------ ------------ ------------
<S> <C> <C> <C>
Revenue:
Subscription 56.5% 66.9% 58.3%
Services 40.4% 33.1% 41.7%
Web 3.1% 0.0% 0.0%
------------ ------------ ------------
Total revenue 100.0% 100.0% 100.0%
------------ ------------ ------------
Cost of revenue
Subscription 30.8% 20.2% 16.2%
Services 21.4% 18.3% 21.1%
Web 1.6% 0.0% 0.0%
------------ ------------ ------------
Total cost of revenue 53.8% 38.5% 37.3%
------------ ------------ ------------
Gross profit 46.2% 61.5% 62.7%
------------ ------------ ------------
Operating expense:
Sales and marketing 53.2% 33.6% 39.9%
Research and development 25.8% 25.3% 20.4%
General and administrative 21.5% 17.4% 16.2%
Amortization of goodwill and intangibles 7.3% 0.0% 0.0%
Stock-based compensation 11.9% 0.7% 0.0%
Mergers, acquisitions and other 30.0% 0.0% 0.0%
------------ ------------ ------------
Total operating expense 149.7% 77.0% 76.5%
------------ ------------ ------------
Loss from operations (103.5%) (15.5%) (13.8%)
------------ ------------ ------------
Other income (expense), net 10.3% 0.1% 1.7%
------------ ------------ ------------
Loss before income taxes (93.2%) (15.4%) (12.1%)
Provision for income taxes 0.7% 2.1% 1.0%
------------ ------------ ------------
Net Loss (93.9%) (17.5%) (13.1%)
Accretion of mandatorily redeemable preferred stock (0.2%) (0.1%) 0.0%
----------- ----------- -----------
Net loss available to common stockholders (94.1%) (17.6%) (13.1%)
=========== =========== ===========
</TABLE>
Years Ended February 29, 2000 and February 28, 1999
Total revenue
Total revenue increased 28.4% to $42.4 million in the year ended February 29,
2000 from $33.0 million in the year ended February 28, 1999. Revenue from
international operations totaled $10.7 million during the year ended February
29, 2000. We established international operations for sale of our software
products in August 1999. Prior to August 1999, our international revenue was
limited to revenue generated from custom development services performed for
international customers.
Subscription revenue
Subscription revenue is comprised primarily of revenue from sales of Official
Red Hat Linux and related software products, sales of publications about
Linux-based operating systems, sales of software development tools, and
technical support and maintenance. Subscription revenue increased 8.4% to $23.9
million in the year ended February 29, 2000 from $22.1 million in the year ended
February 28, 1999. This increase was primarily due to the release of Version 6.0
of Official Red Hat Linux in May 1999, the release of Version 6.1 of Official
Red Hat Linux in October 1999 and, to a lesser extent, to the initial release of
our software development tools in July 1999. As a percentage of total revenue,
subscription revenue decreased to 56.5% in the year ended February 29, 2000 from
66.9% in the year ended February 28, 1999. The decrease in subscription revenue
as a percentage of total revenue is primarily a result of the expansion of our
service offerings and web initiatives.
Services revenue
Services revenue is primarily comprised of custom development fees, training and
education fees, and short-term consulting contracts. Services revenue increased
57% to $17.2 million in the year ended February 29, 2000 from $10.9 million in
the year ended February 28, 1999. As a percentage of total revenue, services
revenue increased to 40.4% in the year ended February 29, 2000 from 33.1% in the
year ended February 28, 1999. The increase in services revenue in total and as a
percentage of total revenue resulted primarily from an increase in custom
development revenue due to an increase in the number, size and scope of custom
development contracts, an increase in training and education revenue as we began
offering these services in the first quarter of the fiscal year ended February
28, 1999, and an increase in training and education revenue due to the expansion
of our course offerings in the year ended February 29, 2000.
Web revenue
Web revenue is comprised primarily of fees generated from contracts with
advertisers to display advertisements on our web site. Web revenue increased to
$1.3 million in the year ended February 29, 2000 from zero in the year ended
February 28, 1999. As a percentage of total revenue, web revenue increased to
3.1% in the year ended February 29, 2000. These increases were due to the
commencement of our web initiatives during the fiscal year ending February 29,
2000. We expect web revenue to increase as a percentage of revenue in the future
as advertising revenue and revenue from the sale of third-party products and
products co-branded or bundled with third-party products continues to grow.
26
<PAGE>
Cost of revenue
Cost of subscription revenue
Cost of subscription revenue primarily consists of expenses we incur to
manufacture, package and distribute our products and related documentation.
These costs include expenses for physical media, literature and packaging,
fulfillment and shipping, and labor related costs to provide technical support
and maintenance. Also included are royalties we pay for licensing third-party
applications included in our software products. Cost of subscription revenue
increased 96.4% to $13.1 million in the year ended February 29, 2000 from $6.7
million in the year ended February 28, 1999. This increase was directly related
to the increase in costs to provide telephone support and subscription services
upon the release of Version 6.0 of Official Red Hat Linux and the increase in
sales volumes. As a percentage of subscription revenue, cost of subscription
revenue increased to 54.5% in the year ended February 29, 2000 from 30.1% in the
year ended February 28, 1999. This increase was due to the offering of technical
support and subscription services with the sale of Version 6.0 of Official Red
Hat Linux released in May 1999 and Version 6.1 of Official Red Hat Linux
released in October 1999. This increase was also due to higher costs associated
with the initiation of product sales by our international operations in the
fiscal quarter ended November 30, 1999. We expect the costs of subscription
revenue of our international operations to decrease as a percentage of revenue
in the future as sales volumes increase.
Cost of services revenue
Cost of services revenue is primarily comprised of salaries and related costs
incurred for custom development, training and education, and hardware
certification services. We incur no direct costs related to royalties received
from the licensing of our trademarks to third parties. Cost of services revenue
increased 49.7% to $9.1 million in the year ended February 29, 2000 from $6.1
million in the year ended February 28, 1999. This increase was primarily due to
the addition of personnel to provide custom development, training and education,
and hardware certification services, and the development of our services
organization. As a percentage of services revenue, cost of services revenue
decreased to 52.9% in the year ended February 29, 2000 from 55.4% in the year
ended February 28, 1999. This decrease was primarily due to higher utilization
of staff resources.
We expect cost of services to increase as we further expand our service
offerings. Cost of services as a percentage of services revenue is expected to
vary significantly from period to period depending upon:
. the mix of services we provide;
. the number and scope of custom development contracts;
. whether such services are provided by us or third-party partners and
contractors;
. the overall utilization rate of our services staff; and
. the use of our redhat.com web site to deliver these services
Cost of web revenue
Cost of web revenue includes the cost of developing advertising on our web site.
Cost of web revenue increased to $0.7 million in the year ended February 29,
2000 from zero in the year ended February 28, 1999. As a percentage of web
revenue, cost of web revenue was 53.3% in the year ended February 29, 2000.
These increases were due to the development of our web advertising group and our
offering of web advertising for the first time during the fiscal year ended
February 29, 2000. We expect cost of web revenue to decrease as a percentage of
revenue as this business becomes more established.
27
<PAGE>
Gross Profit
Gross profit decreased 3.6% to $19.6 million in the year ended February 29, 2000
from $20.3 million in the year ended February 28, 1999. As a percentage of total
revenue, gross profit decreased to 46.2% in the year ended February 29, 2000
from 61.5% in the year ended February 28, 1999. These decreases were the result
of the increase in costs related to our custom development services, the
expansion, development and marketing of the infrastructure for our technical
support and maintenance offerings during the fiscal year ending February 29,
2000 and higher costs associated with our international software product
revenue. These cost increases were partially offset by increased sales of our
software products, which were primarily a result of the release of Version 6.0
in May 1999 and Version 6.1 of Official Red Hat Linux in October 1999, and, to a
lesser extent, increased revenue from sales of software development tools.
Operating expense
Sales and marketing
Sales and marketing expense consists primarily of salaries and other related
costs for sales and marketing personnel, sales commissions, travel, public
relations and marketing materials and tradeshows. Sales and marketing expense
increased 103.5% to $22.6 million in the year ended February 29, 2000 from $11.1
million in the year ended February 28, 1999. As a percentage of total revenue,
sales and marketing expense increased to 53.2% in the year ended February 29,
2000 from 33.6% in the year ended February 28, 1999. These increases were due
primarily to higher advertising and promotional costs incurred to promote the
release of Versions 6.0 and 6.1 of Official Red Hat Linux, our web advertising
and service offerings and, to a lesser extent, our new software development
tools. In addition, we incurred a significant amount of sales and marketing
expense related to our international subscription operations which were
established in August 1999 and international promotion of Version 6.1 of
Official Red Hat Linux in the year ended February 29, 2000. These increases were
also due to higher costs resulting from joint marketing arrangements with
distributors. We expect sales and marketing expense to continue to increase in
dollar amount as we promote the expansion of our services offerings and web site
and expand our international subscription operations.
Research and development
Research and development expense consists primarily of personnel and related
costs for development of our software products and web site. Research and
development expense increased 30.7% to $10.9 million in the year ended February
29, 2000 from $8.4 million in the year ended February 28, 1999. As a percentage
of total revenue, research and development expense increased to 25.8% in the
year ended February 29, 2000 from 25.3% in the year ended February 28, 1999. The
increase in research and development expense resulted from increased spending
related to the development of our web initiatives and costs incurred to complete
the development of Versions 6.0 and 6.1 of Official Red Hat Linux, partially
offset by a decrease in spending related to the development of software
development tools as these products were completed during the year ended
February 29, 2000. We expect research and development expense to continue to
increase in dollar amount as we continue to add content to our web site and
create additional features for Red Hat Linux.
General and administrative
General and administrative expense consists primarily of personnel and related
costs for general corporate functions, including finance, accounting, legal,
human resources, facilities and information systems expenses. General and
administrative expense increased 59.4% to $9.1 million in the year ended
February 29, 2000 from $5.7 million in the year ended February 28, 1999. This
increase resulted from:
28
<PAGE>
. an increase in payroll costs due to an increase in the number of general
and administrative personnel to support the growth of our business;
. an increase in legal and accounting costs due to our initial public
offering and our geographic expansion; and
. an increase in insurance costs as a result of our becoming a public
company.
As a percentage of total revenue, general and administrative expense increased
to 21.5% in the year ended February 29, 2000 from 17.4% in the year ended
February 28, 1999. We expect general and administrative expense to continue to
increase in dollar amount as we add administrative personnel to support our
business expansion.
Amortization of goodwill and intangibles
Amortization of goodwill and intangibles expense consists of the amortization of
goodwill and other intangible assets. Goodwill, which represents the excess of
acquisition cost over the net assets acquired in business combinations, is
amortized over its estimated useful life which is three years. Costs incurred
for acquiring trademarks, copyrights and patents are capitalized and amortized
using the straight line method over their estimated useful lives, which range
from 5 to 15 years. Amortization of goodwill and intangibles expense increased
to $3.1 million in the year ended February 29, 2000 from zero in the year ended
February 28, 1999. As a percentage of total revenue, amortization of goodwill
and intangibles expense was 7.3% in the year ended February 29, 2000. These
increases were primarily due to the acquisition of HKS in January 2000.
29
<PAGE>
Stock-based compensation
Stock-based compensation expense consists of the amortization of deferred
compensation related to stock options granted to employees, primarily new
members of our management team that were recruited immediately prior to our
initial public offering in August 1999, with an exercise price below the fair
market value of our common stock at the date of grant. Deferred compensation is
amortized over the vesting period of the related stock options, which is
generally four years. Stock-based compensation also includes the amortization of
deferred compensation related to the value of certain shares of common stock to
be issued to certain HKS shareholders contingent on their continued employment
with the Company for a period of three years after the date of acquisition, as
well as, the employer portions of tax liabilities paid upon exercise of non-
qualified stock options and warrants. Stock-based compensation expense increased
to $5.1 million in the year ended February 29, 2000 from $0.2 million in the
year ended February 28, 1999. As a percentage of total revenue, stock based
compensation expense increased to 11.9% in the year ended February 29, 2000.
Stock-based compensation is expected to be approximately $12.7 million, 12.0
million, and 10.4 million in fiscal years 2001, 2002, and 2003, respectively.
Mergers, acquisitions, and other
Mergers, acquisitions and other expense consists of costs incurred in connection
with investigating potential acquisitions and the cost of acquisitions accounted
for using the pooling of interests method of accounting. Mergers, acquisitions
and other expense increased to $12.7 million in the year ended February 29, 2000
from zero in the year ended February 28, 1999. As a percentage of total revenue,
mergers, acquisitions and other expense increased to 30.0% in the year ended
February 29, 2000. These increases were primarily due to the acquisition of
Cygnus in January 2000, which was accounted for using the pooling of interests
method of accounting.
30
<PAGE>
Other income (expense), net
Other income (expense), net consists of interest income earned on cash deposited
in money market accounts and other short-term investments, net of interest
expense incurred on capital leases. Other income (expense), net increased to
income of $4.4 million in the year ended February 29, 2000 from income of
$39,000 in the year ended February 28, 1999. As a percentage of total revenue,
other income (expense), net increased to 10.3% in the year ended February 29,
2000 from 0.1% in the year ended February 28, 1999. These increases resulted
from higher average cash and investment balances in the year ended February 29,
2000 as compared to the year ended February 28, 1999 due primarily to the
receipt of proceeds from the sale of preferred stock in September 1998 and in
February, March, April and May 1999, and proceeds from the sale of common stock
in our initial and secondary public offerings in August 1999 and February 2000,
respectively.
Provision for income taxes
Provision for income taxes decreased to $0.3 million for the year ended February
29, 2000 from $0.7 million in the year ended February 28, 1999. This decrease
resulted from the decrease in our taxable income in the year ended February 29,
2000 as compared to the year ended February 28, 1999. Our taxes, for the year
ended February 29, 2000, were related to certain foreign income tax expenses.
Accretion of mandatorily redeemable preferred stock
Accretion of mandatorily redeemable preferred stock increased to $82,000 in the
year ended February 29, 2000 from $39,000 for the year ended February 28, 1999
due to the fact that prior to September 1998 we had no outstanding mandatorily
redeemable preferred stock. Accretion of mandatorily redeemable preferred stock
ceased with the completion of our initial public offering in August 1999 when
all outstanding mandatorily redeemable preferred stock converted to common
stock.
Years Ended February 28, 1999 and 1998
Total revenue
Total revenue increased 45.9% to $33.0 million in the year ended February 28,
1999 from $22.6 million in the year ended February 28, 1998. Our international
revenue totaled $13.1 million in the year ended February 28, 1999.
Subscription revenue
Subscription revenue increased 67.4% to $22.1 million in the year ended February
28, 1999 from $13.2 million in the year ended February 28, 1998. As a percentage
of total revenue, subscription revenue increased to 66.9% in the year ended
February 28, 1999 from 58.3% in the year ended February 28, 1998. These
increases were primarily due to higher sales of Official Red Hat Linux and, to a
lesser extent, to the initial release of our software development tools. We met
the higher demand for Official Red Hat Linux by establishing a relationship with
a major distributor in November 1998 and subsequently adding prominent national
computer and software retailers.
Services revenue
Services revenue increased 15.7% to $10.9 million in the year ended February 28,
1999 from $9.4 million in the year ended February 28, 1998. This increase was
the result of an increase in the number, size and scope of our custom
development arrangements and an increase in technical support and maintenance
revenue on custom development projects. As a percentage of total revenue,
services revenue decreased to 33.1% in the year ended February 28, 1999 from
41.7% in the year ended February 28, 1998. The decrease in services revenue as a
percentage of total revenue is primarily the result of the increase in
31
<PAGE>
subscription revenue.
Cost of revenue
Cost of subscription revenue
Cost of subscription revenue increased 81.0% to $6.7 million in the year ended
February 28, 1999 from $3.7 million in the year ended February 28, 1998. The
increase in cost of subscription revenue was directly related to the increase in
subscription revenue. As a percentage of subscription revenue, cost of
subscription revenue increased to 30.1% in the year ended February 28, 1999 from
27.8% in the year ended February 28, 1998. This increase was due to increased
costs on a per unit basis.
Cost of services revenue
Cost of services revenue increased 27.0% to $6.1 million in the year ended
February 28, 1999 from $4.8 million in the year ended February 28, 1998. This
increase was primarily due to greater costs associated with the expansion of our
service offerings through the hiring of additional personnel and to increased
costs related to our custom development and technical support and maintenance
services. As a percentage of services revenue, cost of services revenue
increased to 55.4% in the year ended February 28, 1999 from 50.5% in the year
ended February 28, 1998. This increase was primarily due to services revenue
increasing at a higher rate than the cost of services revenue.
Gross profit
Gross profit increased 43.1% to $20.3 million in the year ended February 28,
1999 from $14.2 million in the year ended February 28, 1998. This increase was
primarily due to increased revenue from custom development and technical support
and maintenance services and an increase in royalties received for licensing our
trademarks to third parties of $0.7 million in the year ended February 28, 1999
for which we incurred no direct costs. As a percentage of total revenue, gross
profit decreased to 61.5% in the year ended February 28, 1999 from 62.7% in the
year ended February 28, 1998. This decrease was primarily the result of a
decrease in gross profit on services revenue.
Operating expense
Sales and marketing
Sales and marketing expense increased 23.1% to $11.1 million in the year ended
February 28, 1999 from $9.0 million in the year ended February 28, 1998. This
increase was primarily due to extensive public relations activities in the year
ended February 28, 1999 to promote our brand and software products, costs of
marketing our software development tools and greater costs attributable to
cooperative marketing arrangements with distributors. As a percentage of total
revenue, sales and marketing expense decreased to 33.6% in the year ended
February 28, 1999 from 39.9% in the year ended February 28, 1998. This decrease
was primarily due to a significant increase in total revenue.
Research and development
Research and development expense increased 80.9% to $8.4 million in the year
ended February 28, 1999 from $4.6 million in the year ended February 28, 1998.
As a percentage of total revenue, research and development expense increased to
25.3% in the year ended February 28, 1999 from 20.4% in the year ended February
28, 1998. These increases resulted from expenditures incurred in the development
of a software emulation product that began in the year ended February 28, 1999,
an increase in the number of research and development personnel necessary to
support both expanded functionality and ease of use of Official Red Hat Linux,
costs of personnel involved in the GNOME graphical user interface project, and
increases in quality assurance and technical documentation projects.
32
<PAGE>
General and administrative
General and administrative expense increased 56.1% to $5.7 million in the year
ended February 28, 1999 from $3.7 million in the year ended February 28, 1998.
As a percentage of total revenue, general and administrative expense increased
to 17.4% in the year ended February 28, 1999 from 16.2% in the year ended
February 28, 1998. These increases resulted from:
. an increase in payroll costs due to an increase in the number of general
and administrative personnel at February 28, 1999 as compared to
February 28, 1998;
. an increase in legal and accounting costs in the year ended February 28,
1999 incurred in connection with establishment of new business
activities; and
. to a lesser extent, due to costs incurred associated with relocating our
offices in January 1999.
Stock-based compensation
Stock-based compensation expense increased to $0.2 million in the year ended
February 28, 1999 from zero in the year ended February 28, 1998. As a percentage
of total revenue, stock based compensation expense increased to 0.7% in the year
ended February 28, 1999 from zero in the year ended February 28, 1998.
Other income (expense), net
Other income (expense), net decreased to income of $39,000 in the year ended
February 28, 1999 from income of $0.4 million in the year ended February 28,
1998. As a percentage of total revenue, other income (expense), net decreased to
0.1% in the year ended February 28, 1999 from 1.7% in the year ended February
28, 1998. These decreases resulted from increased interest expense on our line
of credit due to a higher average outstanding balance in the year ended February
28, 1999 as compared to the year ended February 28, 1998. This was partially
offset by an increase in interest income as a result of higher average cash and
cash equivalents and short term investment balances in the year ended February
28, 1999 compared to the year ended February 28, 1998 due to receipt of proceeds
from the sale of preferred stock and the repayment of outstanding notes payable
during the year ended February 28, 1998.
Provision for income taxes
Provision for income taxes increased to $0.7 million in the year ended February
28, 1999 from $0.2 million in the year ended February 28, 1998. This increase
resulted from the growth in our taxable income in the United States and
withholding taxes on our foreign source income.
Accretion of mandatorily redeemable preferred stock
Accretion of mandatorily redeemable preferred stock of $39,000 in the year ended
February 28, 1999 was a result of the issuance of mandatorily redeemable
preferred stock in September 1998. Accretion of mandatorily redeemable preferred
stock ceased with the completion of our initial public offering in August 1999
when all outstanding mandatorily redeemable preferred shares converted into
common stock.
33
<PAGE>
Historical Liquidity and Capital Resources
We have historically derived a significant portion of our liquidity and
operating capital from the sale of equity securities, including private sales of
preferred stock and the sale of common stock in our initial and secondary public
offerings, and from cash flows from operations.
At February 29, 2000, cash and cash equivalents totaled $242.4 million, an
increase of $222.9 million as compared to February 28, 1999. The increase in
cash and cash equivalents resulted from the receipt of $337.1 million in net
proceeds from the issuance of common stock in August 1999 and February 2000,
$8.2 million in proceeds from issuance of preferred stock in March, April, and
June 1999, $2.7 million in proceeds from receipt of repayment of stockholders'
notes receivable, and $3.9 million in proceeds from exercise of stock options
and warrants. This was partially offset by the purchase of net investments in
debt and equity securities of $101.9 million, cash used by operations of $17.1
million, repayments of notes payable of $2.4 million, and $6.7 million for the
purchase of office and computer equipment.
Cash used by operations of $17.1 million in the year ended February 29, 2000,
represented the net loss of $39.8 million, an increase in accounts receivable of
$2.5 million, an increase in intangibles and other assets of $1.8 million and an
increase in prepaid expenses of $1.0 million, partially offset by an increase in
accounts payable and accrued expenses of $12.0 million, an increase in deferred
revenue of $4.9 million, and net non cash charges of 11.7 million. The increase
in accounts receivable, accounts payable, accrued expenses and deferred revenue
resulted from the release of Versions 6.0 of Official Red Hat Linux to our
distributors in late April 1999 and Version 6.1 of Official Red Hat Linux in
early October 1999. These releases resulted in increased sales which resulted in
higher amounts of accounts receivable from distributors and deferred revenues at
February 29, 2000.
Cash used in investing activities was comprised of the purchase of investments
in debt securities, net of maturities, of $101.9 million and purchases of
property and equipment totaling $6.7 million.
Cash from financing activities of $349.1 million for the year ended February 29,
2000 was comprised of $8.2 million in net proceeds from the sale of our
preferred stock, $3.9 million in proceeds from the exercise of stock options and
warrants, $2.7 million in proceeds from receipt of repayment of stockholders'
notes receivable, and $337.1 million in net proceeds from the sale of our common
stock in August 1999 and February 2000. This was partially offset by repayments
of notes payable of $2.4 million.
At February 28, 1999, cash and cash equivalents totaled $19.5 million, an
increase of $13.7 million as compared to February 28, 1998. The increase in cash
and cash equivalents resulted primarily from $16.8 million of net proceeds from
issuance of preferred stock during the year ended February 28, 1999 and $2.4
million in proceeds from notes payable. These amounts were partially offset by
$3.1 million in cash used in operations, $0.9 million of cash used to purchase
short-term debt securities, net of maturities, and $2.0 million of additions to
property and equipment.
Cash used by operations of $3.1 million for the year ended February 28, 1999
resulted primarily from an increase in accounts payable and accrued liabilities
of $1.9 million, net non cash charges to income of $3.1 million, partially
offset by our net loss of $5.8 million, a decrease in deferred revenue of $1.5
million, and an increase in accounts receivable of $0.4 million.
Cash used in investing activities of $2.9 million was used to purchase $0.9
million of short-term debt securities, net of maturities, and office and
computer equipment totaling $2.0 million.
Cash from financing activities totaled $19.7 million in the year ended February
28, 1999 as a result of $16.8 million in net proceeds received from sales of
preferred stock, $2.4 million in proceeds from notes payable, and $0.5 million
in proceeds from the exercise of stock options and warrants.
We have experienced a substantial increase in our operating expenses since our
inception in connection with the growth of our operations and staffing and the
expansion of our services operation and web initiatives. Our capital
requirements during the year ending February 28, 2001 depend on numerous
34
<PAGE>
factors including the amount of resources we devote to:
. fund our domestic and international expansion;
. enhance our redhat.com web site;
. improve and extend our service offerings;
. pursue strategic acquisitions and alliances;
. make possible investments in businesses, products and technologies; and
. expand our sales and marketing programs and conduct more aggressive
brand promotions.
We believe that the net proceeds from our public offerings of common stock in
August 1999 and February 2000, together with cash flow from operations, will be
sufficient to meet our anticipated cash needs for working capital and capital
expenditures for at least the next 12 to 18 months. We may need to raise
additional funds, however, in order to fund more rapid expansion. We may seek to
sell additional equity or debt securities or to obtain a credit facility. The
sale of additional equity or debt securities, if convertible, could result in
additional dilution to our stockholders. The incurrence of indebtedness would
result in increased fixed obligations and could result in operating covenants
that would restrict our operations. We cannot guarantee that financing will be
available in amounts or on terms acceptable to us, if at all.
Recent Accounting Pronouncements
In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative Instruments
and Hedging Activities". This statement establishes accounting and reporting
standards for derivative instruments, including certain derivative instruments
embedded in other contracts, and for hedging activities. Statement of Financial
Accounting Standards No. 133 as amended by Statement of Financial Accounting
Standards No. 137, is effective for all fiscal quarters of all fiscal years
beginning after June 15, 2000, with earlier application encouraged. We do not
currently, nor do we intend in the future, to use derivative instruments and
therefore do not expect that the adoption of Statement of Financial Accounting
Standards No. 133 will have any impact on our financial position or results of
operations.
In December 1998, the Accounting Standards Executive Committee of the American
Institute of Certified Public Accountants issued Statement of Position No. 98-9,
"Modification of Statement of Position No. 97-2, Software Revenue Recognition,
with Respect to Certain Transactions". Statement of Position No. 98-9 amends
Statement of Position No. 97-2 to require recognition of revenue using the
"residual method" in circumstances outlined in Statement of Position No. 98-9.
Under the residual method, revenue is recognized as follows:
. the total fair value of undelivered elements, as indicated by vendor
specific objective evidence is deferred and subsequently recognized in
accordance with the relevant sections of Statement of Position No. 97-
2; and
. the difference between the total arrangement fee and the amount
deferred for the undelivered elements is recognized as revenue related
to the delivered elements.
Statement of Position No. 98-9 is effective for transactions entered into in
fiscal years beginning after March 15, 1999. Also, the provisions of Statement
of Position No. 97-2 that were deferred by Statement of Position No. 98-4 will
continue to be deferred until the date Statement of Position No. 98-9 becomes
effective. We do not expect that the adoption of Statement of Position No. 98-9
will have any impact on our financial position or results of operations.
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In December 1999, the Securities and Exchange Commission issued Staff Accounting
Bulletin No. 101, "Revenue Recognition in Financial Statements" ("SAB 101")
which addresses certain criteria for revenue recognition. SAB 101 is required to
be adopted for reporting periods beginning after January 15, 2000. The adoption
of SAB 101 is not expected to have a material impact on our consolidated
financial position or results of operations.
Year 2000 Compliance
Year 2000 Readiness Disclosure
By the end of 1999, we had evaluated our Year 2000 readiness in preparation for
issues that could result from computer programs being written using two digits
to define the applicable year rather than four to define the applicable year and
century. We believe that we were prepared for the transition to the Year 2000
and did not experience any significant Year 2000 problems with respect to our
products, third party products that we bundle with official Red Hat Linux or our
internal management information systems or other systems, applications or
infrastructure.
Since January 1, 2000, our internal management information systems and non-
information systems have functioned properly. In addition, we have not
experienced any material Year 2000 issues related to our interaction with third
parties. We have not experienced any material disruption in our ability to
provide our products and services to our customers, collect payments or report
accurate data to management or any other business interruptions due to Year 2000
issues. While we will continue to monitor our products and systems and those of
third parties with whom we have material business relationships to ensure that
no unexpected Year 2000 issues develop, we have no reason to expect any of these
issues.
Factors Affecting Future Results
Risks Related to our Linux-based Open Source Business Model
Our business may not succeed because open source software business models
are unproven
We have not demonstrated the success of our open source business model, which
gives our customers the right to freely copy and distribute our software. No
other company has built a successful open source business. Few open source
software products have gained widespread commercial acceptance partly due to the
lack of viable open source industry participants to offer adequate service and
support on a long term basis. In addition, open source vendors are not able to
provide industry standard warranties and indemnities for their products, since
these products have been developed largely by independent parties over whom open
source vendors exercise no control or supervision. If open source software
should fail to gain widespread commercial acceptance, we would not be able to
sustain our revenue growth and our business could fail.
Our reliance on the support of Linus Torvalds and other prominent Linux
developers could impair our ability to release major product upgrades and
maintain market share
We may not be able to release major product upgrades of Red Hat Linux on a
timely basis because the heart of Red Hat Linux, the Linux kernel, is maintained
by third parties. Linus Torvalds, the original developer of the Linux kernel and
a small group of independent engineers are primarily responsible for the
development and evolution of the Linux kernel. If this group of developers fails
to further develop the Linux kernel or if Mr. Torvalds or other prominent Linux
developers, such as Alan Cox, David Miller or Stephen Tweedie, were to join one
of our competitors or no longer work on the Linux kernel, we will have to either
rely on another party to further develop the kernel or develop it ourselves. We
cannot predict whether enhancements to the kernel would be available from
reliable alternative sources. We could be forced to rely to a greater extent on
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our own development efforts, which would increase our development expenses and
may delay our product release and upgrade schedules. In addition, any failure on
the part of the kernel developers to further develop and enhance the kernel
could stifle the development of additional Linux-based applications.
We may not be able to effectively assemble and test our software because it
consists largely of code developed by independent third parties over whom we
exercise no control, which could result in unreliable products and damage to our
reputation
Red Hat Linux, in compressed form, consists of approximately 546 megabytes of
code. Of that total, approximately 500 megabytes have been developed by
independent third parties, including approximately 10 megabytes of code
contained in the Linux kernel. Included within the 546 megabytes of code are
approximately 700 distinct software components developed by thousands of
individual programmers which we must assemble and test before we can release a
new version of Red Hat Linux. If these components are not reliable, Red Hat
Linux could fail, resulting in serious damage to our reputation and potential
litigation. Although we attempt to assemble only the best available components,
we cannot be sure that we will be able to identify the highest quality and most
reliable components or to successfully assemble and test them. In addition, if
these components were no longer available, we would have to develop them
ourselves, which would significantly increase our development expenses.
The scarcity of software applications for Linux-based operating systems could
prevent commercial adoption of our products
Our products will not gain widespread commercial adoption until there are more
third-party software applications designed to operate on Linux-based operating
systems. These applications include word processors, databases, accounting
packages, spreadsheets, e-mail programs, Internet browsers, presentation and
graphics software and personal productivity applications. We intend to encourage
the development of additional applications that operate on Linux-based operating
systems by attracting third-party developers to the Linux platform, by providing
open source tools to create these applications and by maintaining our existing
developer relationships through marketing and technical support for third-party
developers. If we are not successful in achieving these goals, however, our
products will not gain widespread commercial acceptance and we will not be able
to maintain our product sales growth.
We may not be able to generate revenue from sales of Official Red Hat Linux if
users can more quickly download it from the Internet
Anyone can download a free copy of Red Hat Linux from the Internet. However,
because this download can take up to 36 hours using a standard telephone
connection, many of our users choose to buy the shrink-wrapped version of
Official Red Hat Linux. If hardware and data transmission technology advances in
the future to the point where increased bandwidth allows users to more quickly
download our products from the Internet, users may no longer choose to purchase
Official Red Hat Linux. This could lead to a significant loss of product
revenue.
We may not succeed in shifting our business focus from traditional shrink-
wrapped software sales to offering subscription-based product and services
offerings
We have recently begun to focus our sales and marketing efforts on providing
subscription-based products and services as opposed to relying on sales of
shrink-wrapped software. This change has required us to expend significant
financial and managerial resources and may ultimately not prove successful. The
failure to successfully implement this transition of our sales model could
materially adversely affect our operating results.
Our customers may find it difficult to install and implement Red Hat Linux,
which could lead to customer dissatisfaction and damage our reputation
Installation and implementation of Red Hat Linux often involves a significant
commitment of resources, financial and otherwise, by our customers. This process
can be lengthy due to the size and complexity of our
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products and the need to purchase and install new applications. The failure by
us to attract and retain services personnel to support our customers, the
failure of companies with which we have strategic alliances to commit sufficient
resources towards the installation and implementation of our products, or a
delay in implementation for any other reason could result in dissatisfied
customers. This could damage our reputation and the Red Hat brand, resulting in
decreased revenue.
We may be unable to predict the future course of open source technology
development, which could reduce the market appeal of our products and damage our
reputation
We do not exercise control over many aspects of the development of open source
technology. Historically at times different groups of open source software
programmers have competed with each other to develop new technology. Typically
one of those groups develops the technology that becomes more widely used than
that developed by others. If we adopt new technology and incorporate it into our
products, and competing technology becomes more widely used, the market appeal
of our products may be reduced, which could harm our reputation, diminish the
Red Hat brand and result in decreased revenue.
Risks Related to our Financial Results and Condition
Our limited operating history in the new and developing market for Linux-based
operating systems makes it difficult to evaluate our business
Red Hat was formed in March 1993. We began offering Red Hat Linux in October
1994. Our limited operating history makes it difficult to evaluate the risks and
uncertainties that we face. Our failure to address these risks and uncertainties
could cause our business results to suffer and result in the loss of all or part
of your investment.
We have no combined operating history with Cygnus and HKS and may have
difficulty integrating these businesses
The successful integration of the operations, products, services and personnel
of Red Hat, Cygnus and HKS is important to the future financial performance of
the combined enterprise. The anticipated benefits of these acquisitions may not
be achieved unless, among other things, the operations, products, services and
personnel of Cygnus and HKS are successfully combined with those of Red Hat in a
timely and efficient manner. Integration of the three companies' operations,
products, services and personnel may be hampered because, among other things,
. the products and services offered by Cygnus, HKS and Red Hat are highly
complex and have been developed independently;
. integration of Cygnus, HKS and Red Hat product lines will require the
coordination of separate development and engineering teams from each
company; and
. Cygnus, which is headquartered in Sunnyvale, California, HKS, which is
headquartered in Pittsburgh, Pennsylvania, and Red Hat, which is
headquartered in Durham, North Carolina, are located in disparate
geographical regions.
In addition, the costs associated with integrating these companies' operations,
products, services and personnel may be substantial and could include, among
other things:
. employee redeployment or relocation; and
. the combination of research and development teams and processes.
Any of these difficulties and costs encountered in the transition process, could
divert the attention of management, and could have an adverse impact on the
revenues and operating results of the combined enterprise.
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We expect to incur substantial losses for the foreseeable future
We have incurred operating losses in five of our previous six fiscal years,
including our most recent fiscal year ended February 29, 2000. We expect to
incur significant losses for the foreseeable future, as we substantially
increase our sales and marketing, research and development and administrative
expenses. In addition, we are investing considerable resources in our web
initiative and to expand our professional services offerings. As a result, we
cannot be certain when or if we will achieve sustained profitability. Failure to
become and remain profitable may adversely affect the market price of our common
stock and our ability to raise capital and continue operations.
You should not rely on our quarterly results of operations as an indication of
our future results because they fluctuate significantly and are difficult to
forecast
Due to our limited combined operating history and the unpredictability of our
business, our revenue and operating results may fluctuate significantly from
quarter to quarter and are difficult to forecast. We base our current and
projected future expense levels in part on our estimates of future revenue. Our
expenses are to a large extent fixed in the short term. We may not be able to
adjust our spending quickly if our revenue falls short of our expectations.
Accordingly, a revenue shortfall in a particular quarter would have a
disproportionate adverse effect on our operating results for that quarter. You
should not rely on quarter-to-quarter comparisons of our results of operations
as an indication of our future performance. Our future operating results may
fall below expectations of securities analysts or investors, which would likely
cause the market price of our common stock to decline significantly.
We may not be able to effectively attract additional enterprise customers and
preserve relationships with current enterprise customers, which could adversely
affect revenue
Historically, we focused our sales and marketing efforts on product sales to
individuals. We have recently, however, begun to focus our efforts on expanding
our enterprise customer base. To this end, we have invested extensively to
attract enterprise customers. In addition, we have gained a significant number
of enterprise customers through our acquisition of Cygnus. These enterprise
customers expect diverse and extensive service programs, and if we are unable to
continue to successfully expand and enhance our service offerings, we may not be
able to meet these customers' needs or attract new customers, and, consequently,
our revenue would suffer.
Our failure to update and modernize our internal systems, procedures and
controls may prevent the implementation of our business strategies in a rapidly
evolving market and may retard our future growth
Our operational and financial systems, procedures and controls, which are
adequate for a small private company, are becoming outdated as we grow. During
this fiscal year, from March 1, 1999 to February 29, 2000, we have increased the
number of employees more than tenfold. To accommodate this growth, we have
evaluated our financial and operational systems, procedures and controls.
Although we have revised and updated most of them, if we continue our rapid
growth, we may not be able to improve our transaction processing and reporting
systems and procedures, or expand and train our expanding workforce quickly
enough to maintain a competitive position in our markets. In addition, failure
to quickly replace obsolete systems, procedures and controls could impede our
management's decision-making abilities. This, in turn, may impair our ability to
pursue business opportunities and may hamper future growth.
Because our headquarters are not located in a major metropolitan area, we may
not be able to recruit and retain qualified professionals, who are currently in
high demand and whose numbers are limited
We compete intensely with other software companies nation-wide to recruit and
hire from a limited pool of qualified personnel. Because our headquarters are
not located in a major metropolitan area, many qualified candidates may be
unwilling to relocate to North Carolina and work for Red Hat. If we cannot
attract and hire additional qualified sales and marketing, professional services
and software engineering and development
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personnel, our business results will suffer.
We may not be able to generate enough additional revenue from our planned
international expansion to offset the costs associated with establishing and
maintaining foreign operations
A key component of our growth strategy is to expand our presence in foreign
markets. We have recently established subsidiaries or offices in Ireland, the
UK, Germany, Italy, Japan, France and Australia, and are considering further
expansion worldwide. We may also enter other markets as opportunities arise. It
will be costly to establish international facilities and operations, promote our
brand internationally, and develop localized web sites and other systems.
Revenue from international activities may not offset the expense of establishing
and maintaining these foreign operations. In addition, because we have little
experience in marketing and distributing products or services for these markets,
we may not benefit from any first-to-market advantages.
Our management team may not be able to successfully implement our business
strategies because it has only recently begun to work together
Our business is highly dependent on the ability of our management to work
together effectively to meet the demands of our growth. Several members of our
senior management, including our Chief Executive Officer and President, Matthew
Szulik, our Chief Operating Officer, Tim Buckley and our Chief Financial
Officer, Harold Covert, have been employed by us for a relatively short period
of time. These individuals have not previously worked together as a management
team. In addition, the members of our management team who have been with us
since 1997 or earlier have had only limited experience managing a rapidly
growing company on either a public or private basis. The failure of our
management team to work together effectively could prevent efficient decision-
making by our executive team, affecting product development and sales and
marketing efforts, which would negatively impact our operating results.
We could lose Robert Young, Matthew Szulik, Harold Covert and Tim Buckley or
other key personnel, which could prevent us from executing our business
strategies
Our future success depends on the continued services of a number of key
directors and officers, including our Chairman, Robert Young, our Chief
Executive Officer and President, Matthew Szulik, our Chief Financial Officer,
Harold Covert, and our Chief Operating Officer, Tim Buckley. The loss of the
technical knowledge and industry expertise of any of these people could
seriously impede our success. Moreover, the loss of one or a group of our key
employees, particularly to a competitor, and any resulting loss of customers
could reduce our market share and diminish the Red Hat brand.
We may lack the financial and operational resources needed to increase our
market share and compete effectively with Microsoft, other established operating
systems developers, software development tools developers and other service and
support providers
In the market for operating systems, we face significant competition from larger
companies with greater financial resources and name recognition than we have.
These competitors, which offer hardware-independent multi-user operating systems
for Intel platforms and/or UNIX-based operating systems, include Microsoft,
Novell, IBM, Sun Microsystems, The Santa Cruz Operation, AT&T, Compaq, Hewlett-
Packard, Olivetti and Unisys. Some of these competitors currently, or may in the
future, produce and market open source operating systems.
With our acquisition of Cygnus, we now face competition in the market for
software development tools and operating systems for special purpose computing.
Our competitors in this market, some of which have greater market share than we
do, include Wind River Systems, Integrated Systems Incorporated, Green Hills
Software, and the Metrowerks subsidiary of Motorola. Some of these companies
currently produce or use open source software as part of their product
offerings. We may not be able to compete effectively in this market if customers
choose proprietary solutions. If the demand for open source solutions in this
market expands, however, we could lose market share as existing competitors
reposition or new companies emerge to address the opportunity.
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As we increase our services offerings, we may face competition from larger and
more capable companies that currently service and support other operating
systems, particularly UNIX-based operating systems, due to the fact that Linux-
and UNIX-based operating systems share many common features. These companies may
be able to leverage their existing service organizations and provide higher
levels of support on a more cost-effective basis than we can. We may not be able
to compete successfully with these current or potential competitors.
We may not be able to match the promotional activities and pricing policies
offered by other suppliers of Linux-based and other open source operating
systems, which could result in a loss of market share
In the new and rapidly-evolving market for Linux-based operating systems, we
face intense competition from a number of other suppliers of Linux-based
operating systems. We also face competition to a lesser extent from developers
of non-Linux-based open source operating systems such as BSD-based operating
systems. BSD-based operating systems such as FreeBSD, NetBSD and OpenBSD are
open source operating systems produced by communities of developers working
together via the Internet, and which are published and distributed by Walnut
Creek CD-ROM, among others. We expect competition in broader open source
operating systems and the Linux-based operating systems market to intensify. In
addition, companies like Sun Microsystems and Corel, which are more established
and have larger customer bases than we do, have indicated a growing interest in
the market for Linux-based operating systems. These companies may be able to
undertake more extensive promotional activities, adopt more aggressive pricing
policies, and offer more attractive terms to their customers than we can.
Furthermore, because Linux-based operating systems can be downloaded from the
Internet for free or purchased at a nominal cost and modified and re-sold with
few restrictions, traditional barriers to entry are minimal. Accordingly, it is
possible that new competitors or alliances among existing competitors may emerge
and rapidly acquire significant market share.
If we fail to establish and maintain strategic distribution and other
collaborative relationships with industry-leading companies, we may not be able
to attract and retain a larger customer base
Our success depends on our ability to continue to establish and maintain
strategic distribution and other collaborative relationships with industry-
leading hardware manufacturers, distributors, software vendors and enterprise
solutions providers. These relationships allow us to offer our products and
services to a much larger customer base than we would otherwise be able to
through our direct sales and marketing efforts. We may not be able to maintain
these relationships or replace them on attractive terms.
In addition, our existing strategic relationships do not, and any future
strategic relationships may not, afford us any exclusive marketing or
distribution rights. As a result, the companies with which we have strategic
alliances are free to pursue alternative technologies and to develop alternative
products and services in addition to or in lieu of our products and services,
either on their own or in collaboration with others, including our competitors.
Moreover, we cannot guarantee that the companies with which we have strategic
relationships will market our products effectively or continue to devote the
resources necessary to provide us with effective sales, marketing and technical
support.
Any disruption in our relationships with our two largest distributors, on whom
we rely for a significant percentage of our product revenue, could cause our
revenue to decline
We are highly dependent on revenue from sales to our two largest distributors,
Frank Kasper & Associates and Ingram Micro, who together accounted for a
significant percent of our total revenue for the fiscal year ended February 29,
2000. These distributors are not obligated to purchase products from us and the
loss of one or both of these distributors, or a reduction in the amount of
product sales generated by them, could significantly reduce our product revenue.
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We may not be able to meet the operational and financial challenges that we will
encounter as our international operations expand
As we expand our international operations, we will face a number of additional
challenges associated with the conduct of business overseas. For example:
. we may have difficulty managing and administering a globally-dispersed
business;
. fluctuations in exchange rates may negatively affect our operating
results;
. we may not be able to repatriate the earnings of our foreign operations;
. we have to comply with a wide variety of foreign laws with which we are
not familiar;
. we may not be able to adequately protect our trademarks overseas due to
the uncertainty of laws and enforcement in certain countries relating to
the protection of intellectual property rights;
. reductions in business activity during the summer months in Europe and
certain other parts of the world could negatively impact the operating
results of our foreign operations;
. export controls could prevent us from shipping our products into and
from some markets;
. multiple and possibly overlapping tax structures could significantly
reduce the financial performance of our foreign operations;
. changes in import/export duties and quotas could affect the competitive
pricing of our products and services and reduce our market share in
some countries; and
. economic or political instability in some international markets could
result in the forfeiture of some foreign assets and the loss of sums
spent developing and marketing those assets.
Expanding our services business will be costly and may not result in any
benefit to us
We have recently expanded our strategic focus to place additional emphasis on
consulting, custom engineering and development, education and support services,
from which we have historically derived an insignificant amount of revenue. We
cannot be certain that our customers will engage our professional services
organization to assist with support, consulting, custom development, training
and implementation of our products. We also cannot be certain that we can
attract or retain a sufficient number of the highly qualified services personnel
that the expansion of our services business will need. In addition, this
expansion has required, and will continue to require, significant additional
expenses and development, financial and operational resources. The need for
these additional resources will place further strain on our management,
financial and operational resources and may make it more difficult for us to
achieve and maintain profitability.
Attempts to expand by means of business combinations and strategic alliances may
not be successful and may harm our operational efficiency, financial performance
and relationships with employees and third parties
We may continue to expand our operations or market presence by entering into
additional business combinations, investments, joint ventures or other strategic
alliances with hardware manufacturers, software vendors, Internet companies,
open source software developers or other companies both in the United States and
internationally. Our ability to expand in this way may be limited due to the
many financial and operational risks accompanying these transactions. For
example:
. we may have difficulty assimilating the operations, technology and
personnel of the combined companies;
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. our business may be disrupted by the allocation of resources to
consummate these transactions;
. we may have problems retaining key technical and managerial personnel
from acquired companies;
. we may experience one-time in-process research and development charges
and ongoing expenses associated with amortization of goodwill and
other purchased intangible assets;
. our stockholders will suffer dilution if we issue equity to fund these
transactions;
. acquired businesses may initially be unprofitable resulting in our
assumption of operating losses and increased expenses;
. our reputation may be harmed if the open source development community
does not approve of these transactions;
. our relationships with existing employees, customers and business
partners may be weakened or terminated as a result of these
transactions; and
. our investment activities, particularly with respect to emerging-
growth technology companies, are inherently risky and we may not
realize any benefit from such activities.
Risks Related to our Internet Strategy
We may fail to promote and enhance our web site effectively, which may prevent
us from attracting new visitors, advertisers or electronic commerce partners to
our web site
Enhancing the redhat.com web site is critical to our ability to increase our
revenue. In order to attract and retain Internet users, advertisers and
electronic commerce partners, we intend to substantially increase our
expenditures for enhancing and further developing our web site. Our success in
promoting and enhancing the redhat.com web site will also depend on our ability
to provide high quality content, features and functionality. If we fail to
promote our web site successfully or if visitors to our web site or advertisers
do not perceive our services to be useful, current or of high quality, our
ability to generate revenue from our web site will be significantly impaired.
Visitors to our web site could experience delays and decreased performance
during periods of heavy traffic, which could result in dissatisfaction with our
web site and damage to our reputation
Our web site must accommodate a high volume of traffic and deliver frequently
updated information. Our web site has in the past experienced slower response
times or decreased traffic for a variety of reasons. These occurrences have not
had a material impact on our business. These types of occurrences in the future,
however, could materially adversely affect our reputation and brand name and
could cause users to perceive our web site as not functioning properly. Under
these circumstances, our users might choose another web site or other methods to
obtain Linux-based operating systems or Linux-related information.
Because there is no industry standard for the measurement of the effectiveness
of Internet advertising, advertisers may not increase or even maintain their
current levels of Internet advertising, which would prevent us from generating a
significant amount of revenue from our web site
As we execute our Internet strategy, we expect to derive an increasing
percentage of our revenue from sponsorships and advertising on our web site. We
may not generate these revenues if advertisers do not maintain or increase their
current levels of Internet advertising. As there is no industry standard for the
measurement of the effectiveness of Internet advertising, advertisers that
currently advertise on the Internet may reduce or eliminate this form of
advertising and advertisers that have traditionally relied upon other
advertising media may be reluctant to begin to advertise on the Internet.
Moreover, widespread adoption of
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currently available software programs that limit or prevent advertisements from
being delivered to an Internet user's computer would negatively affect the
commercial viability of Internet advertising and would further deter advertisers
from increasing or maintaining current levels of Internet advertising. Our
ability to successfully execute our Internet strategy will be adversely affected
if the market for Internet advertising fails to develop or develops more slowly
than expected.
We may not be able to respond quickly to new pricing models for advertising,
which could prevent us from attracting quality sponsors to our web site
Different pricing models are used to sell advertising on the Internet. It is
difficult to predict which, if any, will emerge as the industry standard. If we
cannot quickly and successfully respond to changes in pricing models for
Internet advertising, or identify and adopt any industry standards that may
emerge, we will not be able to attract a sufficient number of quality sponsors
and our Internet advertising strategy will fail.
We may be unable to adequately measure the demographics of visitors to our web
site, which is critical to our ability to attract advertising revenue
We expect that it will be important to our advertisers that we accurately
measure the demographics of the visitors to our web site. While we have not
committed significant resources to the measurement of demographics to date, we
are currently implementing systems designed to record demographic data on our
web site's visitors. This implementation may be costly, and if not done
effectively, may not permit us to accurately measure the demographic
characteristics of our web site's visitors. Until these new systems are
functional, we will continue to rely on third parties to provide some of these
measurement services. If these parties were unable to provide these services, we
would need to obtain them from other providers, which might not be readily
available. Companies may choose not to advertise on our web site or may pay
less for advertising if they do not perceive our measurements or measurements
made by third parties to be reliable.
Our Internet strategy will fail if the infrastructure of the Internet is not
continually developed and maintained
The success of our Internet strategy will depend in large part on the continued
development and maintenance of the infrastructure of the Internet. Because
global commerce and the online exchange of information is new and evolving, we
cannot predict with any certainty that the Internet will be a viable commercial
marketplace in the long term. The Internet has experienced, and we expect it to
continue to experience, significant growth in the number of users and amount of
traffic. If the Internet continues to experience an increased number of users,
frequency of use or increased bandwidth requirements of users, it may not be
able to support the demands placed upon it by this growth, and its performance
and reliability may suffer. Furthermore, the Internet has experienced a variety
of outages and other delays as a result of damage to portions of its
infrastructure, and could face similar outages and delays in the future. Any
outage or delay could affect the level of Internet usage, as well as the volume
of traffic on our web site. In addition, the Internet could lose its viability
due to increased governmental regulation and delays in the development or
adoption of new standards and protocols to handle increased levels of activity.
If the necessary infrastructure, standards or protocols or complementary
products, services or facilities are not developed, or if the Internet does not
become a viable commercial marketplace, our Internet strategy will not succeed.
We are vulnerable to unexpected network interruptions caused by system failures,
which may result in reduced visitor traffic on our web site, decreased revenue
and harm to our reputation
Substantially all of our communications hardware and other hardware related to
our web site is located at our facilities, although we have back-up and co-
location hardware for our web site located at third-party facilities. Fire,
floods, hurricanes, tornadoes, earthquakes, power loss, telecommunications
failures, break-ins and similar events could damage these systems. In addition,
although we have implemented network security measures, our servers are
vulnerable to computer viruses, electronic break-ins, human error and other
similar disruptive problems which could adversely affect our systems and web
site. Although we try to prevent unauthorized access to our systems, we cannot
eliminate this risk entirely. We could lose revenue and suffer damage to our
reputation if our systems were affected by any of these occurrences. Our
insurance
44
<PAGE>
policies may not adequately compensate us for any losses that may occur due to
failures or interruptions in our systems. We do not presently have any secondary
"off-site" systems or a formal disaster recovery plan.
Risks Related to Legal Uncertainty
We could be prevented from selling or developing our products if the GNU General
Public License and similar licenses under which our products are developed and
licensed are not enforceable
The Linux kernel and the Red Hat Linux operating system have been developed and
licensed under the GNU General Public License and similar licenses. These
licenses state that any program licensed under them may be liberally copied,
modified and distributed. We know of no circumstance under which these licenses
have been challenged or interpreted in court. Accordingly, it is possible that a
court would hold these licenses to be unenforceable in the event that someone
were to file a claim asserting proprietary rights in a program developed and
distributed under them. Any ruling by a court that these licenses are not
enforceable, or that Linux-based operating systems, or significant portions of
them, may not be liberally copied, modified or distributed, would have the
effect of preventing us from selling or developing our products.
Our products may contain defects that may be costly to correct, delay market
acceptance of our products and expose us to litigation
Despite testing by us and our customers, errors have been and may continue to be
found in our products after commencement of commercial shipments. This risk is
exacerbated by the fact that most of the code in our products is developed by
independent parties over whom we exercise no supervision or control. If errors
are discovered, we may have to make significant expenditures of capital to
eliminate them and yet may not be able to successfully correct them in a timely
manner or at all. Errors and failures in our products could result in a loss of,
or delay in, market acceptance of our products and could damage our reputation
and our ability to convince commercial users of the benefits of Linux-based
operating systems and other open source software products.
In addition, failures in our products could cause system failures for our
customers who may assert warranty and other claims for substantial damages
against us. Although our license agreements with our customers typically contain
provisions designed to limit our exposure to potential product liability claims,
it is possible that these provisions may not be effective or enforceable under
the laws of some jurisdictions. Our insurance policies may not adequately limit
our exposure to this type of claim. These claims, even if unsuccessful, could be
costly and time consuming to defend.
We are vulnerable to claims that our products infringe third-party intellectual
property rights particularly because our products are comprised of many distinct
software components developed by thousands of independent parties
We may be exposed to future litigation based on claims that our products
infringe the intellectual property rights of others. This risk is exacerbated by
the fact that most of the code in our products is developed by independent
parties over whom we exercise no supervision or control. Claims of infringement
could require us to reengineer our products or seek to obtain licenses from
third parties in order to continue offering our products. In addition, an
adverse legal decision affecting our intellectual property, or the use of
significant resources to defend against this type of claim, could place a
significant strain on our financial resources and harm our reputation.
Our efforts to protect our trademarks may not be adequate to prevent third
parties from misappropriating our intellectual property rights
Our most valuable intellectual property is our collection of trademarks. The
protective steps we have taken in the past have been, and may in the future
continue to be, inadequate to deter misappropriation of our trademark rights.
Although we do not believe that we have suffered any material harm from
misappropriation to date, we may be unable to detect the unauthorized use of, or
take appropriate steps to enforce, our
45
<PAGE>
trademark rights. We have registered some of our trademarks in the United
States, Europe and Australia and have other trademark applications pending in
the United States, Europe, Australia, Canada, Europe and Japan. Effective
trademark protection may not be available in every country in which we offer or
intend to offer our products and services. Failure to adequately protect our
trademark rights could damage or even destroy the Red Hat brand and impair our
ability to compete effectively. Furthermore, defending or enforcing our
trademark rights could result in the expenditure of significant financial and
managerial resources.
We may be sued as a result of information published or posted on or accessible
from our redhat.com web site
We may be subjected to claims for defamation, negligence, copyright or trademark
infringement or other claims relating to the information we publish on our web
site. These types of claims have been brought, sometimes successfully, against
online services in the past, and can be costly to defend. We may also be
subjected to claims based on content that is accessible from our web site
through links to other web sites or through content and materials that may be
posted by visitors to our web site. We believe that the scope and amount of our
commercial and general liability insurance is appropriate, given our current
financial position. However, this insurance may not adequately protect us
against these types of claims. We have not been a party to any lawsuit of this
type to date.
Risks Related to the Market for Our Common Stock
Our stock price has been extremely volatile and you may not be able to resell
your shares at or above the offering price
The trading 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 factors
such as:
. actual or anticipated variations in quarterly operating results;
. new products or services offered by Red Hat or our competitors;
. changes in financial estimates by securities analysts;
. conditions or trends in the Internet, Linux and software industries;
. changes in the economic performance and/or market valuations of other
Internet, Linux and software industries;
. announcements by us or our competitors of significant acquisitions,
strategic partnerships, joint ventures or capital commitments;
. additions or departures of key personnel;
. sales of common stock; and
. other events or factors, many of which are beyond our control.
In addition, the stock market in general, and the Nasdaq National Market and the
market for Internet-related and technology companies in particular, has
experienced extreme price and volume fluctuations that have often been unrelated
or disproportionate to the operating performance of such companies. The trading
prices of many technology companies' stocks, including our common stock, are at
or near historical highs and these trading prices and multiples are
substantially above historical levels. These trading prices and multiples may
not be sustained. In addition, broad market and industry factors may materially
adversely affect the market price of our common stock, regardless of our actual
operating performance. In the past, following periods of volatility in the
market price of a company's securities, securities class-action litigation has
often been instituted against such companies. Such litigation, if instituted,
could result in substantial costs and a diversion of management's attention and
resources, which would materially adversely affect our business, financial
condition and operating results.
46
<PAGE>
Item 7a. Quantitative and Qualitative Disclosures about Market Risk
Interest Rate Risk
The primary objective of Red Hat's investment activities is to preserve
principal while at the same time maximizing yields without significantly
increasing risk. To achieve this objective, the Company maintains its portfolio
of cash equivalents, short-term and long-term investments in a variety of
securities, including both government and corporate obligations and money market
funds. The following table presents the fair value balances of the Company's
cash equivalents and short-term and long-term investments that are subject to
interest rate risk by year of expected maturity and average interest rates as of
February 29, 2000:
Year Ended
(in thousands)
February February February
-------- -------- --------
28, 2001 28, 2002 28, 2003 Total
-------- -------- -------- -----
Cash equivalents............... 242,426 242,426
Average interest rate.......... 6.0%
Investments.................... 27,460 69,219 3,135 99,814
Average interest rates......... 6.1% 6.7% 7.26%
Red Hat did not hold derivative financial instruments as of February 29, 2000,
and has never held such investments in the past.
Foreign Currency Risk
Approximately 25% of the Company's fiscal 2000 revenues were generated by sales
outside the United States. The Company is exposed to significant risks of
foreign currency fluctuation primarily from receivables denominated in foreign
currency and are subject to transaction gains and losses, which are recorded as
a component in determining net income. Additionally, the assets and liabilities
of the Company's non-U.S. operations are translated into U.S. dollars at
exchange rates in effect as of the applicable balance sheet dates, and revenue
and expense accounts of these operations are translated at average exchange
rates during the month the transactions occur. Unrealized translation gains and
losses will be included as an adjustment to stockholders' equity.
Based upon the foregoing, the Company began hedging its foreign currency
receivables in the third quarter of 1999 in an effort to reduce its exposure to
currency exchange rates. However, as a matter of procedure, the Company will not
invest in speculative financial instruments as a means of hedging against such
risk. The Company has no outstanding foreign currency hedging contracts at
February 29, 2000. The Company's accounting policies for these contracts are
based on the Company's designation of the contracts as hedging transactions. The
criteria the Company uses for designating a contract as a hedge include the
contract's effectiveness in risk reduction and one-to-one matching of derivative
instruments to underlying transactions. Gains and losses on forward foreign
exchange contracts are recognized in income in the same period as gains and
losses on the underlying transactions. If an underlying hedged transaction is
terminated earlier than initially anticipated, the offsetting gain or loss on
the related forward exchange contract would be recognized in income in the same
period. In addition, since the Company enters into forward contracts only as a
hedge, any change in currency rates would not result in any material net gain or
loss, as any gain or loss on the underlying foreign currency denominated balance
would be offset by the gain or loss on the forward contract. Information
regarding the Company's foreign currency forward exchange contracts is set forth
in Note 13 of Item 14(a)(1) of this Annual Report on Form 10-K and is
incorporated herein by reference.
47
<PAGE>
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
Page
----
<S> <C>
Financial Statements:
Report of Independent Accountants 49
Consolidated Balance Sheets at February 29, 2000 and February 28, 1999 50
Consolidated Statements of Operations for the years ended February 29, 2000
and February 28, 1999 and 1998 51
Consolidated Statements of Stockholders' Equity (Deficit) for the years ended
February 29, 2000 and February 28, 1999 and 1998 52
Consolidated Statements of Cash Flows for the years ended February 29, 2000
and February 28, 1999 and 1998 53
Notes to Consolidated Financial Statements 54
</TABLE>
48
<PAGE>
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of
Red Hat, Inc.
In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of operations, of stockholders' equity (deficit), and of
cash flows present fairly, in all material respects, the financial position of
Red Hat, Inc. and its subsidiaries at February 29, 2000 and February 28, 1999,
and the results of their operations and their cash flows for the years ended
February 29, 2000 and February 28, 1999 and 1998, in conformity with accounting
principles generally accepted in the United States. 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 audits 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
Raleigh, North Carolina
March 24, 2000
49
<PAGE>
<TABLE>
<CAPTION>
RED HAT, INC.
CONSOLIDATED BALANCE SHEETS
ASSETS
February 29, February 28,
2000 1999
----------------- ----------------
<S> <C> <C>
Current assets:
Cash and cash equivalents $ 242,426,032 $ 19,485,586
Short-term investments 27,460,222 2,037,992
Accounts receivable, net 7,893,936 5,895,173
Inventory 488,977 345,630
Prepaid expenses and other current assets 1,874,973 812,665
------------- ------------
Total current assets 280,144,140 28,577,046
Property and equipment, net 7,909,103 3,921,798
Goodwill and intangibles, net 58,267,419 154,249
Long-term investments 72,354,212 --
Other assets, net 4,859,958 78,130
------------- ------------
Total assets $ 423,534,832 $ 32,731,223
============= ============
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Accounts payable $ 10,774,546 $ 2,584,489
Royalties payable 115,117 144,074
Accrued expenses 7,571,058 3,209,080
Deferred revenue 11,030,337 6,096,465
Short term notes payable -- 1,509,936
Current portion of capital lease obligations 366,062 139,112
------------- ------------
Total current liabilities 29,857,120 13,683,156
Capital lease obligations 230,516 482,796
Long term notes payable -- 916,667
Commitments and contingencies (Note 15) -- --
Mandatorily redeemable preferred stock:
Series A, 0 and 6,801,400 shares authorized, issued and outstanding
at February 29, 2000 and February 28, 1999, respectively -- 1,992,184
Series B, 0 and 8,116,550 shares authorized, issued and outstanding
at February 29, 2000 and February 28, 1999, respectively -- 6,919,644
Series C, 0 and 1,797,929 shares authorized at February 29, 2000 and
February 28, 1999, respectively; 0 and 1,027,388 shares issued and
outstanding at February 29, 2000 and February 28, 1999, respectively -- 3,195,591
Series B Cygnus, 0 and 1,042,000 shares authorized, issued and
outstanding at February 29, 2000 and February 28, 1999, respectively -- 6,252,000
Stockholders' equity (deficit):
Preferred stock, 5,000,000 shares authorized, none outstanding -- --
Preferred stock -- 7,728,094
Common stock, $.0001 par value, 225,000,0000 shares authorized,
153,333,621 and 48,865,107 shares issued and outstanding
at February 29, 2000 and February 28, 1999, respectively 15,334 4,887
Additional paid-in capital 477,781,234 5,265,667
Shareholder receivables (66,899) (2,857,355)
Deferred compensation (35,159,127) (1,188,155)
Accumulated deficit (48,607,478) (9,663,953)
Accumulated other comprehensive income (loss) (515,868) --
------------- ------------
Total stockholders' equity (deficit) 393,447,196 (710,815)
------------- ------------
Total liabilities and stockholders' equity (deficit) $ 423,534,832 $ 32,731,223
============= ============
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
50
<PAGE>
RED HAT, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
Year Ended
----------------------------------------------------
February 29, February 28, February 28,
2000 1999 1998
-------------- ---------------- --------------
<S> <C> <C> <C>
Revenue:
Subscription $ 23,960,187 $ 22,102,923 $ 13,200,623
Services 17,160,678 10,928,759 9,442,827
Web 1,306,638 - -
------------- ---------------- --------------
Total revenue 42,427,503 33,031,682 22,643,450
------------- ---------------- --------------
Cost of revenue:
Subscription 13,069,831 6,655,685 3,676,338
Services 9,071,079 6,059,904 4,771,812
Web 696,259 - -
------------- ---------------- --------------
Total cost of revenue 22,837,169 12,715,589 8,448,150
------------- ---------------- --------------
Gross profit 19,590,334 20,316,093 14,195,300
------------- ---------------- --------------
Operating expense:
Sales and marketing (excludes $1,450,058 in stock-based
compensation for the year ended February 29, 2000) 22,584,069 11,098,616 9,016,388
Research and development (excludes $1,191,810 and $227,261
in stock-based compensation for the years ended February 29, 2000
and February 28, 1999, respectively) 10,929,815 8,363,087 4,622,409
General and administrative (excludes $2,409,875 in stock-based
compensation for the year ended February 29, 2000) 9,135,199 5,732,225 3,672,167
Amortization of goodwill and intangibles 3,074,307 - -
Stock-based compensation 5,051,743 227,261 -
Mergers, acquisitions and other 12,727,945 - -
------------- ---------------- --------------
Total operating expense 63,503,078 25,421,189 17,310,964
------------- ---------------- --------------
Loss from operations (43,912,744) (5,105,096) (3,115,664)
------------- ---------------- --------------
Other income (expense):
Interest income 4,923,029 376,039 509,558
Interest expense (558,326) (336,672) (144,392)
------------- ---------------- --------------
Other income (expense), net 4,364,703 39,367 365,166
------------- ---------------- --------------
Loss before income taxes (39,548,041) (5,065,729) (2,750,498)
Provision for income taxes 294,325 722,216 215,348
------------- ---------------- --------------
Net loss (39,842,366) (5,787,945) (2,965,846)
Accretion of mandatorily redeemable preferred stock (82,473) (39,356) -
------------- ---------------- --------------
Net loss available to common stockholders $ (39,924,839) $ (5,827,301) $ (2,965,846)
============= ================ ==============
Net loss per common share:
Basic ($0.3968) ($0.1224) ($0.0631)
Diluted ($0.3968) ($0.1224) ($0.0631)
Weighted average shares outstanding:
Basic 100,610,498 47,628,096 47,000,000
Diluted 100,610,498 47,628,096 47,000,000
</TABLE>
The accompanying notes are an integral part of these consolidated
financial statements.
51
<PAGE>
RED HAT, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
<TABLE>
<CAPTION>
Preferred Stock Common Stock
------------------------------- --------------------------------
Shares Amount Shares Amount
------------- ---------------- --------------- ---------------
<S> <C> <C> <C> <C>
Balance at February 28, 1997 5,845,509 $ 310,957 47,000,000 $ 4,700
Exercise of common stock options and warrants - - - -
Issuance of Series A preferred stock from options 288,455 117,555 - -
Repurchase and retirement of preferred stock (48,884) (16,821) - -
Net loss - - - -
------------- ---------------- --------------- ---------------
Balance at February 28, 1998 6,085,080 411,691 47,000,000 4,700
Exercise of common stock options and warrants - - 1,865,107 187
Tax benefit on exercise of common stock warrants - - - -
Issuance of Series A preferred stock from options 205,812 165,586 - -
Issuance of Series C preferred stock, net 709,555 6,760,594 - -
Repurchase and retirement of preferred stock (141,386) (44,357) - -
Deferred compensation - - - -
Amortization of deferred compensation - - - -
Stock options issued for services - 434,580 - -
Accretion of mandatorily redeemable preferred stock - - - -
Net increase in shareholder notes receivable - - - -
Net loss - - - -
------------- ---------------- --------------- ---------------
Balance at February 28, 1999 6,859,061 7,728,094 48,865,107 4,887
Net loss
Adjustment for inclusion of Cygnus September 1999 net
loss in results of operations twice - - - -
Other comprehensive income:
Unrealized loss on investments in marketable
securities - - - -
Foreign currency translation adjustment - - - -
Other comprehensive income - - - -
Conversion of preferred stock into common stock - - 67,890,904 6,789
Sale of common stock in public offerings, net - - 16,550,000 1,655
Exercise of common stock options and warrants - - 10,031,741 1,003
Repurchase and retirement of preferred stock (7,372) (1,119) - -
Issuance of Series A preferred stock from exercise of options 530,357 93,899 - -
Issuance of Series C preferred stock, net 524,160 4,973,882 - -
Conversion of convertible preferred stock to common stock (7,906,206) (12,794,756) 9,500,084 950
Common stock issued for acquisitions - - 495,785 50
Deferred compensation related to acquisitions - - - -
Deferred compensation related to stock options - - - -
Amortization of deferred compensation - - - -
Stock options issued for services - - - -
Net decrease in shareholder notes receivable - - - -
Accretion of mandatorily redeemable preferred stock - - - -
------------- ---------------- --------------- ---------------
Balance at February 29, 2000 - $ - 153,333,621 $ 15,334
============= ================ =============== ===============
Additional Shareholder
Paid-In Deferred Notes
Capital Compensation Receivable
--------------- ------------------ -----------------
<S> <C> <C> <C>
Balance at February 28, 1997 $ 261,300 $ - $ (178,961)
Exercise of common stock options and warrants - - (22,500)
Issuance of Series A preferred stock from options - - -
Repurchase and retirement of preferred stock - - 30,671
Net loss - - -
--------------- ------------------ -----------------
Balance at February 28, 1998 261,300 - (170,790)
Exercise of common stock options and warrants 3,121,860 - (2,745,901)
Tax benefit on exercise of common stock warrants 163,831 - -
Issuance of Series A preferred stock from options - - -
Issuance of Series C preferred stock, net - - -
Repurchase and retirement of preferred stock - - 72,877
Deferred compensation 1,415,416 (1,415,416) -
Amortization of deferred compensation - 227,261 -
Stock options issued for services 303,260 - -
Accretion of mandatorily redeemable preferred stock - - -
Net increase in shareholder notes receivable - - (13,451)
Net loss - - -
--------------- ------------------ -----------------
Balance at February 28, 1999 5,265,667 (1,188,155) (2,857,355)
Net loss
Adjustment for inclusion of Cygnus September 1999 net
loss in results of operations twice - - -
Other comprehensive income:
Unrealized loss on investments in marketable
securities - - -
Foreign currency translation adjustment - - -
Other comprehensive income - - -
Conversion of preferred stock into common stock 15,363,730 - -
Sale of common stock in public offerings, net 337,051,328 - -
Exercise of common stock options and warrants 3,619,356 - 127,670
Repurchase and retirement of preferred stock - - -
Issuance of Series A preferred stock from exercise of options - - -
Issuance of Series C preferred stock, net - - -
Conversion of convertible preferred stock to common stock 19,045,806 - -
Common stock issued for acquisitions 59,658,465 - -
Deferred compensation related to acquisitions 28,835,350 (28,835,350) _
Deferred compensation related to stock options 8,928,009 (8,928,009) _
Amortization of deferred compensation - 3,792,387 -
Stock options issued for services 13,523 - -
Net decrease in shareholder notes receivable - - 2,662,786
Accretion of mandatorily redeemable preferred stock - - -
--------------- ------------------ -----------------
Balance at February 29, 2000 $ 477,781,234 $ (35,159,127) $ (66,899)
=============== ================== =================
Accumulated
Other Total
Accumulated Comprehensive Stockholders'
Deficit Income (Loss) Equity (Deficit)
--------------- ------------------ -----------------
<C> <C> <C>
Balance at February 28, 1997 $ (870,806) $ - $ (472,810)
Exercise of common stock options and warrants - - (22,500)
Issuance of Series A preferred stock from options - - 117,555
Repurchase and retirement of preferred stock - - 13,850
Net loss (2,965,846) - (2,965,846)
--------------- ------------------ -----------------
Balance at February 28, 1998 (3,836,652) - (3,329,751)
Exercise of common stock options and warrants - - 376,146
Tax benefit on exercise of common stock warrants - - 163,831
Issuance of Series A preferred stock from options - - 165,586
Issuance of Series C preferred stock, net - - 6,760,594
Repurchase and retirement of preferred stock - - 28,520
Deferred compensation - - -
Amortization of deferred compensation - - 227,261
Stock options issued for services - - 737,840
Accretion of mandatorily redeemable preferred stock (39,356) - (39,356)
Net increase in shareholder notes receivable - - (13,451)
Net loss (5,787,945) - (5,787,945)
--------------- ------------------ -----------------
Balance at February 28, 1999 (9,663,953) - (710,815)
Net loss (39,842,366) (39,842,366)
Adjustment for inclusion of Cygnus September 1999 net
loss in results of operations twice 981,314 - 981,314
Other comprehensive income:
Unrealized loss on investments in marketable
securities - (575,647)
Foreign currency translation adjustment - 59,779
-----------------
Other comprehensive income - (515,868) (515,868)
Conversion of preferred stock into common stock - - 15,370,519
Sale of common stock in public offerings, net - - 337,052,983
Exercise of common stock options and warrants - - 3,748,029
Repurchase and retirement of preferred stock - - (1,119)
Issuance of Series A preferred stock from exercise of options - - 93,899
Issuance of Series C preferred stock, net - - 4,973,882
Conversion of convertible preferred stock to common stock - - 6,252,000
Common stock issued for acquisitions - - 59,658,515
Deferred compensation related to acquisitions - - -
Deferred compensation related to stock options - - -
Amortization of deferred compensation - - 3,792,387
Stock options issued for services - - 13,523
Net decrease in shareholder notes receivable - - 2,662,786
Accretion of mandatorily redeemable preferred stock (82,473) - (82,473)
--------------- ------------------ -----------------
Balance at February 29, 2000 $ (48,607,478) $ (515,868) $ 393,447,196
=============== ================== =================
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
52
<PAGE>
RED HAT, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
Year Ended
----------------------------------------------------
February 29, February 28, February 28,
2000 1999 1998
---------------- --------------- ----------------
<S> <C> <C> <C>
Cash flows from operating activities:
Net loss $ (39,842,366) $ (5,787,945) $ (2,965,846)
Adjustments to reconcile net loss to net cash used in operating activities:
Effect on net loss of inclusion of Cygnus September
1999 results of operations twice 981,314 -- --
Depreciation and amortization 5,941,261 1,600,919 1,085,106
Stock-based compensation expense 3,792,387 227,261 --
Tax benefit on exercise of common stock options and warrants -- 163,831 --
Noncash management compensation expense 13,523 737,840 --
Provision for doubtful accounts 504,246 185,092 38,141
Provision for inventory obsolescence 481,280 182,509 --
Loss on sale of property and equipment -- 46,058 116,063
Deferred revenue 4,921,154 (1,496,319) 2,731,660
Changes in operating assets and liabilities:
Accounts receivable (2,503,009) (419,316) (2,302,497)
Inventory (624,627) (386,963) (84,507)
Prepaid expenses (981,239) 18,801 53,402
Intangibles and other assets (1,787,033) 64,280 242,021
Accounts payable 8,142,195 999,591 500,200
Royalties payable (28,957) (103,249) (785,649)
Accrued expenses 3,891,610 865,620 526,848
---------------- --------------- ----------------
Net cash used in operating activities (17,098,261) (3,101,990) (845,058)
---------------- --------------- ----------------
Cash flows from investing activities:
Purchase of investment securities (275,926,085) (1,966,600) (150,000)
Proceeds from sales and maturities of investment securities 174,073,991 1,065,526 5,769,921
Cost of acquisitions, net of cash and cash equivalents acquired (600,000) -- --
Purchase of property and equipment (6,655,301) (1,986,887) (2,139,445)
Proceeds from sale of equipment -- -- 24,272
---------------- --------------- ----------------
Net cash (used in) provided by investing activities (109,107,395) (2,887,961) 3,504,748
---------------- --------------- ----------------
Cash flows from financing activities:
Decrease in stockholders' notes receivable 2,662,786 14,978 13,850
Repayments of borrowings from stockholders -- -- (86,243)
Proceeds from notes payable -- 2,416,667 239,214
Repayments of notes payable (2,426,603) (39,409) (279,019)
Repurchase of restricted stock (1,119) -- --
Proceeds from issuance of mandatorily redeemable preferred stock, net 3,180,628 10,084,854 1,983,209
Proceeds from issuance of preferred stock 4,962,507 6,760,594 --
Proceeds from issuance of common stock in public offerings, net 337,052,983 -- --
Proceeds from exercise of common stock options and warrants 3,853,302 541,731 95,055
Payments on capital lease obligations (198,161) (55,998) (22,569)
---------------- --------------- ----------------
Net cash provided by financing activities 349,086,323 19,723,417 1,943,497
---------------- --------------- ----------------
Effect of foreign currency exchange rates on cash and cash equivalents 59,779 -- --
Net increase in cash and cash equivalents 222,940,446 13,733,466 4,603,187
Cash and cash equivalents at beginning of the year 19,485,586 5,752,120 1,148,933
---------------- --------------- ----------------
Cash and cash equivalents at end of year $ 242,426,032 $ 19,485,586 $ 5,752,120
================ =============== ================
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
53
<PAGE>
RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1-Organization
Red Hat, Inc. and its subsidiaries ("Red Hat" or the "Company") is a leading
developer and global provider of open source software products and services, and
has built a comprehensive web site dedicated to the open source software
community. Red Hat, Inc. was incorporated in Connecticut in March 1993 as ACC
Corp., Inc. In September 1995 ACC Corp., Inc. changed its name to Red Hat
Software, Inc. In September 1998, Red Hat Software, Inc. reincorporated in
Delaware. In June 1999, Red Hat Software, Inc. changed its name to Red Hat, Inc.
On January 7, 2000, Red Hat acquired Cygnus Solutions, Inc. in a transaction
accounted for using the pooling of interests method of accounting (See NOTE 3).
All prior period financial statements of Red Hat have been restated to reflect
this combination.
NOTE 2-Summary of Significant Accounting Policies
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of the
Company and all of its wholly-owned subsidiaries. All significant intercompany
accounts and transactions are eliminated in consolidation.
Use of Estimates
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States 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.
Cash and Cash Equivalents
The Company considers investments purchased with a maturity period of three
months or less at the date of purchase to be cash equivalents.
Accounts Receivable
The Company's receivables include $2,433,095 and $557,014 in unbilled
receivables at February 29, 2000 and February 28, 1999, respectively. Unbilled
receivables arise as revenues for custom development services are recognized
under the percentage-of-completion method. These amounts are billable at
specified dates, which do not necessarily coincide with timing of revenue
recognition.
Investments
The Company's investments at February 29, 2000 are in debt securities which are
classified as available for sale and carried at market value in accordance with
Statement of Financial Accounting Standards No. 115 "Accounting for Certain
Investments in Debt and Equity Securities" ("SFAS 115"). The Company's
investments are considered available for sale as these securities could
potentially be sold in response to needs for liquidity, changes in the
availability of and the yield on alternative instruments or changes in funding
sources or terms. The Company has an unrealized loss of $575,647 related to
these investments at February 29, 2000, which is recorded as other comprehensive
income (loss), a separate component of stockholders' equity.
The Company's investments at February 28, 1999 were in debt securities which
were classified as held-to-maturity and were carried at amortized cost in
accordance with SFAS 115, as the Company had both the positive intent and
ability to hold them to maturity. During the year ended February 29, 2000, all
of these investments matured or were sold and reinvested in new securities. The
Company's net gain/(loss) on sale of these investments prior to their respective
maturity dates was deminimis.
54
<PAGE>
RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Inventory
The costs incurred for duplicating the computer software, documentation, and
training materials sold by the Company from the product masters and for
packaging the product for distribution are capitalized as inventory using the
weighted average method and charged to cost of sales when revenue from the sale
of units is recognized. Management periodically evaluates the realizability of
inventory based on planned release dates of product updates and records a
reserve for obsolescence when necessary. The reserve for inventory obsolescence
was $335,000 and $182,509 at February 29, 2000 and February 28, 1999,
respectively.
Capitalized Software Costs
Capitalization of software development costs begins upon the establishment of
technological feasibility and ceases when the product is available for general
release. The establishment of technological feasibility and the ongoing
assessment of recoverability of capitalized software development costs requires
considerable judgment by management concerning certain external factors
including, but not limited to, technological feasibility, anticipated future
gross revenue, estimated economic life and changes in software and hardware
technologies. As a result of the Company's practice of releasing source code
that it has developed on a weekly basis for unrestricted download on the
Internet, there is generally no passage of time between achievement of
technological feasibility and the availability of the Company's product for
general release. Therefore, the Company has no capitalized software development
costs at February 29, 2000 and February 28, 1999.
Property and Equipment
Property and equipment is primarily comprised of furniture and computer
equipment which are recorded at cost and depreciated using the straight-line
method over their estimated useful lives which range from 3 to 10 years.
Expenditures for maintenance and repairs are charged to operations as incurred;
major expenditures for renewals and betterments are capitalized and depreciated.
Property and equipment acquired under capital leases are being depreciated over
their estimated useful lives or the respective lease term, if shorter.
Goodwill and Intangibles
Goodwill and intangible assets, which represent the excess of acquisition cost
over the tangible net assets acquired in business combinations, is amortized
over its estimated useful life which is three years. Costs incurred for
acquiring certain intangible assets such as trademarks, copyrights and patents
are capitalized and amortized using the straight-line method over their
estimated useful lives, which range from 5 to 15 years.
Other Assets
Other assets includes security deposits which are expected to be refunded to the
Company upon termination of certain leases, investments in other companies
accounted for using the cost method of accounting and the long-term portion of
the Company's prepaid directors' and officers' insurance premiums, which is
amortized to general and administrative expense over the term of the insurance
policy.
Impairment of Long-Lived Assets
The Company evaluates the recoverability of its property and equipment, and
other assets in accordance with Statement of Financial Accounting Standards No.
121, "Accounting for the Impairment of Long-Lived Assets to be Disposed of"
("SFAS 121"). SFAS 121 requires recognition of impairment of long-lived assets
in the event the net book value of such assets exceeds the estimated future
undiscounted cash flows attributable to such assets or the business to which
such intangible assets relate. No impairments were required to be recognized
during the years ended February 29, 2000 and February 28, 1999 and 1998.
55
<PAGE>
RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Revenue Recognition
Revenues from the sale of software products for which no technical support is
provided are generally recognized upon shipment of the products, net of
estimated returns. A reserve for sales returns is recognized for sales of
software products to distributors, who have a right of return, based on the
Company's historical experience of sell-through to the end user by the
distributor. The Company recognizes revenues from the sale of software products
to new distributors of its software products based upon sell-through to the end
user until the Company has sufficient historical experience with the distributor
to allow the accurate estimation of sales returns.
Upon the release of Version 6.0 of Official Red Hat Linux in May 1999, the
Company began providing certain telephone and e-mail technical support services
with Official Red Hat Linux and Red Hat Secure Web Server for a period of 90
days from the date of registration of the software products for no additional
fee. In June 1999, the Company also began to provide to purchasers of Official
Red Hat Linux and Red Hat Secure Web Server subscription services for a period
of six months from the date of registration of the software products. In October
1999, the Company released Version 6.1 of Red Hat Linux and began to include the
Secure Web Server product in the "professional" version of Version 6.1 of
Official Red Hat Linux. In accordance with the provisions of Statement of
Opinion No. 97-2, "Software Revenue Recognition" ("SOP 97-2") as amended by SOP
98-4 and SOP 98-9, the Company is recognizing all of the revenue from the sale
of Versions 6.0 and 6.1 Official Red Hat Linux over the period that the
technical support and subscription services are provided as the Company does not
sell these technical support and subscription services separately and therefore
does not have vendor specific objective evidence of the fair value of these
services. These revenues are recognized ratably over the period that the
technical support and subscription services are provided in proportion to the
costs incurred to provide such technical support and subscription services as
compared to estimated total costs to be incurred. Revenue from sale of books
published by the Company, which is included in subscription revenue, is
recognized at the date of shipment, net of estimated returns.
Service revenues consist of revenue for technical support and maintenance
services, other than installation support, and customer training and education,
revenue for software compiling, debugging and optimization contracts
("Development Contracts") and royalty revenue. Revenue for technical support
and maintenance services, other than installation support, is deferred and
recognized ratably over the term of the agreement, which is typically twelve
months. Revenues for development contracts are recognized on the percentage-of-
completion method provided that the fee for such engineering services is fixed
or determinable and the collection of the resulting receivable is probable.
Revenue from customer training and education and other services is recognized at
the date the services are performed. Losses on development contracts are
recognized when estimable.
Royalty revenue, which is included in services revenue, is comprised primarily
of royalties received from the sale of rights to the Company's brand and
trademark and royalties received from international distributors of the
Company's products. Royalty revenue is recognized when received.
Web revenue related to advertising is recognized ratably in the period in which
the advertisement is displayed, provided that the Company has no significant
remaining obligations, at the lesser of the ratio of connections to the
advertiser's website delivered over total guaranteed connections to the
advertiser's website or the straight line basis over the term of the contract.
If minimum guaranteed connections are not met, the Company defers recognition of
the corresponding revenue until the guaranteed connections are achieved.
56
<PAGE>
RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Royalty Costs
Royalties that the Company is required to pay on applications licensed from
third parties that are a component of the software products sold by the Company
are expensed as cost of sales on a per unit basis as software products are sold.
Royalties paid in advance of the sale of the Company's software products are
included in prepaid expenses and recorded as expense when the related software
products are sold.
Stock-Based Compensation
The Company accounts for stock-based compensation based on the provisions of
Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to
Employees" ("APB 25"), which states that no compensation expense is recorded for
stock options or other stock-based awards to employees that are granted with an
exercise price equal to or above the estimated fair value per share of the
Company's common stock on the grant date. In the event that stock options are
granted with an exercise price below the estimated fair market value of the
Company's common stock at the grant date, the difference between the fair market
value of the Company's common stock and the exercise price of the stock option
is recorded as deferred compensation. Deferred compensation is amortized to
compensation expense over the vesting period of the stock option. Stock-based
compensation also includes the amortization of deferred compensation related to
the value of certain shares of common stock to be issued to certain HKS
shareholders contingent on their continued employment with the Company for a
period of three years after the date of acquisition (See NOTE 3). The Company
recognized $3,792,387 and $227,261 in non-cash compensation expense related to
amortization of deferred compensation during the years ended February 29, 2000
and February 28, 1999, respectively. In addition, the Company also classifies
the employer portion of tax liabilities paid upon exercise of non-qualified
stock options and warrants as stock-based compensation. The Company has adopted
the disclosure requirements of Statement of Financial Accounting Standards No.
123, "Accounting for Stock-Based Compensation" ("SFAS 123"), which requires
compensation expense to be disclosed based on the fair value of the options
granted at the date of the grant.
Sales and Marketing Expenses
Sales and marketing expenses consist primarily of costs, including salaries and
sales commissions, of all personnel involved in the sales process and related
expenses. Sales and marketing expenses also include costs of advertising and
trade shows. All costs of advertising, including cooperative marketing
arrangements, the software products, books and related services offered by the
Company are expensed as incurred. Advertising expense totaled $2,735,418,
$1,003,517 and $434,094 for the years ended February 29, 2000 and February 28,
1999 and 1998, respectively.
Research and Development Expenses
Research and development expenses include all direct costs, primarily salaries
for Company personnel and outside consultants, related to the development of new
products and significant enhancements to existing products and are charged to
operations as incurred until such time as technological feasibility is achieved
and ending when a product is available for general release to customers.
Income Taxes
The Company accounts for income taxes using the liability method which requires
the recognition of deferred tax assets or liabilities for the temporary
differences between financial reporting and tax bases of the Company's assets
and liabilities and for tax carryforwards at enacted statutory tax rates in
effect for the years in which the differences are expected to reverse. The
effect on deferred taxes of a change in tax rates is recognized in income in the
period that includes the enactment date. In addition, valuation allowances are
established when necessary to reduce deferred tax assets to the amounts expected
to be realized.
57
<PAGE>
RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Foreign Currency Translation
The majority of the Company's international sales are currently denominated in
U.S. dollars. The U.S. dollar has been determined to be the functional currency
for the Company's European operations and local currencies have been determined
to be the functional currencies for the Company's Asian operations. Foreign
exchange gains and losses, which result from the process of remeasuring foreign
currency financial statements into U.S. dollars are included in the statements
of operations. Foreign exchange gains and losses which result from the
translation of foreign currency financial statements into U.S. dollars where the
local currency is the functional currency is included as a separate component of
stockholders' equity.
Significant Customers and Credit Risk
Financial instruments which potentially subject the Company to concentrations of
credit risk consist principally of temporary cash investments and trade
receivables. The Company primarily places its temporary cash investments with
high-credit quality financial institutions which invest primarily in U.S.
Government instrumentalities, commercial paper of prime quality and certificates
of deposit guaranteed by banks which are members of the FDIC. Cash deposits are
primarily in financial institutions in the United States, however, cash from
monthly operating costs of international operations are deposited in banks
outside the United States. The Company performs ongoing credit evaluations to
reduce credit risk and requires no collateral from its customers. Management
estimates the allowance for uncollectible accounts based on their historical
experience and credit evaluation. Sales to one distributor comprised $7,110,391
or 17% and $3,719,162 or 11% of total revenue for the years ended February 29,
2000 and February 28, 1999, respectively. In addition, the Company generated
services revenue from a single customer which comprised 16% and 13% of total
revenue for the years ended February 28, 1999 and 1998, respectively.
Receivables from one distributor and one other customer comprised 14% and 10%,
respectively, of net accounts receivable at February 28, 1999.
Cash Flows
The Company made cash payments for interest of $145,479, $103,121 and $22,941
for the years ended February 29, 2000 and February 28, 1999 and 1998,
respectively. The Company made cash payments of $5,637, $164,461 and $3,117 for
income taxes during the years ended February 29, 2000 and February 28, 1999 and
1998, respectively.
The Company acquired property and equipment through the assumption of capital
lease obligations amounting to $309,132, $488,310 and $122,541 for the years
ended February 29, 2000 and February 28, 1999 and 1998, respectively.
Net Loss Per Common Share
The Company computes net loss per common share in accordance with Statement of
Financial Accounting Standards No. 128, "Earnings Per Share," ("SFAS 128") and
SEC Staff Accounting Bulletin No. 98 ("SAB 98"). Under the provisions of SFAS
128 and SAB 98, basic net loss per common share ("Basic EPS") is computed by
dividing net loss available to common stockholders by the weighted average
number of common shares outstanding. Diluted net loss available to common
stockholders per common share ("Diluted EPS") is computed by dividing net loss
by the weighted average number of common shares and dilutive potential common
share equivalents then outstanding. Potential common shares consist of shares
issuable upon the exercise of stock options and warrants and shares issuable
upon conversion of outstanding mandatorily redeemable preferred stock. The
calculation of net loss per share available to common stockholders does not
include 51,098,239, 49,185,957, and 22,169,099 potential shares of common stock
equivalents for the years ended February 29, 2000 and February 28, 1999 and
1998, as their impact would be antidilutive.
58
<PAGE>
RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Segment Reporting
In June 1997, the Financial Accounting Standards Board, ("FASB") issued
Statement of Financial Accounting Standards No. 131, "Disclosures About Segments
of an Enterprise and Related Information" ("SFAS 131"). This statement requires
companies to report information about operating segments in interim and annual
financial statements. It also requires segment disclosures about products and
services, geographic areas and major customers. The Company adopted SFAS 131
effective for its fiscal year ended February 28, 1998. Required segment
disclosures are presented below:
The Company has international sales offices in the United Kingdom, Ireland,
Germany, Switzerland, Australia, and Japan. The following disclosure aggregates
individually immaterial international operations and separately discloses the
significant international operations at and for the years ended February 29,
2000 and February 28, 1999.
<TABLE>
<CAPTION>
North Europe Asia Pacific Total
America ------ and Japan -----
------- ---------
Year Ended February 29, 2000
----------------------------
<S> <C> <C> <C> <C>
Revenues from unaffiliated customers.. $ 31,764,315 $ 4,230,213 $ 6,432,975 $ 42,427,503
Net Loss ............................. $(36,128,251) $(2,203,242) $(1,510,873) $(39,842,366)
Total Assets ......................... $416,315,522 $ 5,642,561 $ 1,576,748 $423,534,235
</TABLE>
<TABLE>
<CAPTION>
Year Ended February 28, 1999
----------------------------
<S> <C> <C> <C> <C>
Revenues from unaffiliated customers.. $19,885,561 $334,579 $12,811,542 $33,031,682
Net Income (Loss)..................... $(6,435,621) $134,523 $ 513,153 $(5,787,945)
Total Assets.......................... $31,769,839 $287,879 $ 673,505 $32,731,223
</TABLE>
Internal Use Software
In March 1998, the Accounting Standards Executive Committee of the American
Institute of Certified Public Accountants issued Statement of Position No. 98-1
"Accounting for the Costs of Computer Software Developed or Obtained for
Internal Use" "SOP 98-1" which provides guidance regarding when software
developed or obtained for internal use should be capitalized. The Company
adopted SOP 98-1 effective March 1, 1999. The adoption of SOP 98-1 did not have
a material impact on the Company's financial position or results of operations.
Comprehensive Income
In June 1997, the FASB issued Statement of Financial Accounting Standards No.
130, "Reporting Comprehensive Income" ("SFAS 130"). SFAS 130 establishes
standards for reporting and display of comprehensive income and its components
in a full set of general-purpose financial statements. SFAS 130 is effective for
financial statements for fiscal years beginning after December 15, 1997. Its
adoption did not impact the Company's financial position, results of operations,
or cash flows as the
59
<PAGE>
RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Company had no items of other comprehensive income during the years ended
February 28, 1999 and 1998. The Company's items of other comprehensive income
(loss) during year ended February 29, 2000 totaled $515,868 and are comprised of
an unrealized loss on investments in marketable securities of $575,647 and a
foreign currency translation adjustment of $59,779.
Recent Accounting Pronouncements
In June 1998, the FASB issued Statement of Financial Accounting Standards No.
133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS
133"). SFAS 133 establishes accounting and reporting standards for derivative
instruments, including certain derivative instruments embedded in other
contracts (collectively referred to as derivatives), and for hedging activities.
SFAS 133, as amended by SFAS 137, is effective for all fiscal quarters of all
fiscal years beginning after June 15, 2000, with earlier application encouraged.
The Company does not currently nor does it intend in the future to use
derivative instruments and therefore does not expect that the adoption of SFAS
133 will have any impact on its financial position or results of operations.
In December 1999, the Securities and Exchange Commission issued Staff Accounting
Bulletin No. 101, "Revenue Recognition in Financial Statements" ("SAB 101")
which addresses certain criteria for revenue recognition. SAB 101 is required
to be adopted for reporting periods beginning after January 15, 2000. The
adoption of SAB 101 is not expected to have a material impact on the
consolidated financial position or results of operation.
NOTE 3-Business Combinations
In January 2000, the Company completed a merger with Cygnus Solutions, Inc.
("Cygnus") by exchanging 10,867,966 shares of its common stock for all of the
outstanding common and preferred stock of Cygnus. In addition, approximately
1,514,168 outstanding Cygnus employee stock options were converted at the same
exchange factor into options to purchase approximately 2,380,722 shares of the
Company's common stock.
The merger constituted a tax-free reorganization and has been accounted for
using the pooling of interests method of accounting under Accounting Principles
Board Opinion No. 16 ("APB 16"). Accordingly, all prior period financial
statements have been restated to include the results of operations, financial
position and cash flows of Cygnus as though it had always been a part of the
Company.
Prior to the merger, Cygnus' fiscal year ended on June 30. In recording the
business combination, Cygnus' prior period financial statements have been
restated to a year ended March 31, to be within a 90-day period of the Company's
fiscal year end. In order to fully conform Cygnus' period end with the fiscal
quarter end of the Company, in preparing the consolidated results of operations
of the Company for the year ended February 29, 2000, the results of operations
of Cygnus for the month of September 1999, have been included twice. Cygnus'
net loss for the month of September 1999 was $981,314. A credit to accumulated
deficit has been recorded to remove the effect of including the net loss of
Cygnus for the month of September 1999, in the results of operations of the
Company more than once.
60
<PAGE>
RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The results of operations for the separate companies and the consolidated
amounts presented in the consolidated financial statements are as follows:
<TABLE>
<CAPTION>
Year ended Year ended Year ended
February 29, 2000 February 28, 1999 February 28, 1998
------------------ ----------------- ------------------
<S> <C> <C> <C>
Total revenue
Red Hat............................................ $ 19,108,661 $10,789,919 $ 5,155,623
Cygnus............................................. 23,318,842 22,241,763 17,487,827
Consolidated....................................... $ 42,427,503 $33,031,682 $22,643,450
Net income (loss) available to common stockholders
Red Hat............................................ $(25,903,056) $ (130,424) $ 7,773
Cygnus............................................. (14,021,783) (5,696,877) (2,973,619)
Consolidated....................................... $(39,924,839) $(5,827,301) $(2,965,846)
</TABLE>
Immaterial adjustments were made to conform the Company and Cygnus' accounting
policies. Certain reclassifications were made to Cygnus' financial statements to
conform to the Company's presentation.
In connection with the merger, the Company recorded a charge of approximately
$9.4 million to operating expenses for costs incurred related to the merger at
the date of the merger was completed. These merger costs consist primarily of
$5.9 million in investment banking and filing fees, $1.1 million in costs of
attorneys and accountants, $0.8 million in severance and other employee related
costs, $0.7 million in infrastructure reconfiguration to improve overall
business efficiency, and $0.2 million in facilities closure costs and other
directly related costs.
In January 2000, the Company completed the acquisition of all of the outstanding
common stock of Hell's Kitchen Systems, Inc. ("HKS") in exchange for the
issuance of 478,004 shares of the Company's common stock valued at $57,671,183.
The acquisition of HKS has been accounted for using the purchase method of
accounting in accordance with APB 16 and, accordingly, the excess of purchase
price over the fair values of the net assets acquired of $57,771,183 has been
recorded as goodwill, which is being amortized on a straight-line basis over
three years. An additional 239,000 shares valued at $28,835,350 may be issued
to certain shareholders contingent upon their continued employment with the
Company for a period of three years after the date of the acquisition. This
amount has been recorded as deferred compensation and is being amortized on a
straight-line basis over three years. In addition to the above, 79,666 shares
may be issued if certain performance objectives are met. The value of these
shares will be determined and recorded as goodwill as the performance objectives
are met.
In January 2000, the Company completed the acquisition of all of the outstanding
common stock of Sistemi Research Laboratories s.r.l., ("Sistemi") for $300,000
in cash and 3,781 shares of the Company's common stock, valued at $468,332. The
acquisition of Sistemi has been accounted for using the purchase method of
accounting in accordance with APB 16 and, accordingly, the excess of purchase
price over the fair values of the net assets acquired of $968,252 has been
recorded as goodwill, which is being amortized on a straight-line basis over
three years. In addition to the above, 1,512 shares may be issued if certain
performance objectives are met. The value of these shares will be determined
and recorded as goodwill as the performance objectives are met.
In February 2000, the Company completed the acquisition of all of the
outstanding common stock of Logiciels Du Soleil SARL, ("LDS") for a cash
purchase price of $300,000. The acquisition of LDS has
61
<PAGE>
RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
been accounted for using the purchase method of accounting in accordance
with APB 16 and, accordingly, the excess of purchase price over the fair
values of the net assets acquired of $337,039 has been recorded as
goodwill, which is being amortized on a straight-line basis over three
years. In addition to the above, 22,472 shares may be issued if certain
performance objectives are met. The value of these shares will be
determined and recorded as goodwill as the performance objectives are met.
NOTE 4-Accounts Receivable
Accounts receivable are presented net of an allowance for doubtful
accounts. The activity in the Company's allowance for doubtful accounts for
the years ended February 29, 2000 and February 28, 1999 and 1998 is
presented in the following table:
Balance at Charged to Deductions (a) Balance at
beginning income or -------------- end of
of period expense period
---------- ---------- ----------
1998.................. $245,151 $ 38,141 $(152,904) $130,388
1999.................. $130,388 $185,092 $ (61,999) $253,481
2000.................. $253,481 $504,246 $(280,969) $476,758
___________
(a) Represents amounts written-off as uncollectible accounts receivable.
NOTE 5-Property and Equipment
The Company's property and equipment consisted of the following:
February 29, February 28,
------------ ------------
2000 1999
---- ----
Computer equipment.................. $ 8,084,468 $ 4,847,833
Software............................ 3,022,509 540,125
Furniture and fixtures.............. 1,684,972 1,388,118
Leasehold improvements.............. 249,499 214,868
13,041,448 6,990,944
Less: accumulated depreciation..... (5,132,345) (3,069,146)
$ 7,909,103 $ 3,921,798
Depreciation expense was $2,847,255, $1,468,430, and $843,779 for the years
ended February 29, 2000 and February 28, 1999 and 1998, respectively.
62
<PAGE>
RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 6-Goodwill and Intangible Assets
Goodwill and intangible assets were comprised of the following:
February 29, February 28,
------------ ------------
2000 1999
---- ----
Goodwill and intangibles - HKS................. $55,054,621 $ -
Goodwill and intangibles - LDS and Sistemi..... 1,305,291 -
Web site domain names.......................... 1,542,891 -
Other.......................................... 364,616 154,249
$58,267,419 $154,249
NOTE 7-Other Assets
Other assets were comprised of the following:
February 29, February 28,
------------ ------------
2000 1999
---- ----
Cost basis investments......................... $3,500,005 $ -
Note receivable................................ 1,000,000 -
Prepaid directors' and officers' insurance..... 251,441 -
Security deposits.............................. 94,099 78,130
Other.......................................... 14,413 -
$4,859,958 $78,130
NOTE 8-Fair Value of Financial Instruments
The carrying value of cash and cash equivalents, accounts receivable, and
accounts payable at February 29, 2000 and February 28, 1999 approximated their
fair value due to the short-term nature of these items.
The fair value of the Company's short-term and long-term investments at February
29, 2000, differed from their historical cost by $575,647. The Company had no
realized gains or losses on investments during the years ended February 29, 2000
and February 28, 1999 and 1998. Following is a summary of the historical cost,
unrealized loss and fair values of the Company's investments at February 29,
2000:
Unrealized
-----------
Cost Loss Fair Value
----- ---- ----------
Short-term................ $ 27,460,222 $ - $27,460,222
Long-term................. 72,929,859 (575,647) 72,354,212
$100,390,081 $(575,647) $99,814,434
63
<PAGE>
RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 9-Accrued Expenses
Accrued expenses were comprised of the following:
February 29, February 28,
----------- -----------
2000 1999
---- ----
Wages and other compensation..... $3,020,738 $1,944,526
Trade............................ 2,996,705 232,304
Taxes............................ 503,074 255,824
Other............................ 1,050,541 776,426
$7,571,058 $3,209,080
64
<PAGE>
RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 10-Income Taxes
The components of the Company's provision for income taxes consisted of the
following:
February 29, February 28, February 28,
----------- ----------- -----------
2000 1999 1998
---- ---- ----
Current:
Foreign....................... $271,826 $503,112 $251,798
Federal....................... - 149,284 (34,500)
State......................... 22,499 69,820 (1,950)
Current tax expense........... 294,325 722,216 215,348
Deferred:
Foreign....................... - - -
Federal....................... - - -
State......................... - - -
Deferred tax expense.......... - - -
Net provision for income taxes.. $294,325 $722,216 $215,348
The provision for income taxes in all periods primarily relates to foreign
withholding taxes on foreign revenues earned by a U.S. Company. These
withholding taxes paid may be creditable against U.S. federal income taxes in
future periods.
Significant components of the Company's deferred tax assets and liabilities at
February 29, 2000 and February 28, 1999, consisted of the following:
<TABLE>
<CAPTION>
February 29, February 28,
------------ ------------
2000 1999
---- ----
<S> <C> <C>
Deferred Tax Assets:
Domestic net operating loss carryforwards...... $ 8,396,328 $ 2,906,601
Foreign net operating loss carryforwards....... 1,104,295 -
Accounts receivable............................ 1,927,857 284,957
Allowance for inventory obsolescence........... 129,930 70,785
Other accruals and liabilities................. 376,908 92,090
Property and equipment......................... - 146,048
Intangibles.................................... 640,068 673,125
Research and development credit................ 1,127,415 809,258
Foreign tax credit............................. 1,053,422 885,730
Compensation-related accruals.................. 1,762,402 98,582
Total deferred tax assets...................... 16,518,626 5,967,176
Valuation allowance for deferred tax assets.... (16,177,284) (5,967,176)
Deferred tax assets............................ 341,342 -
Deferred Tax Liabilities:
Fixed and intangible assets.................... 341,342 -
Total deferred tax liabilities................. 341,342 -
Net deferred taxes............................. $ - $ -
</TABLE>
65
<PAGE>
RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
As of February 29, 2000 and February 28, 1999, the Company provided a full
valuation allowance against its net deferred tax assets since realization of
these benefits cannot be reasonably assured. An increase in the valuation
allowance was recorded during the years ended February 29, 2000 and February 28,
1999 to reserve the increase in total deferred tax assets during such periods
due to uncertainty of realizability.
As of February 29, 2000, the Company had Federal and state net operating loss
carryforwards of approximately $22,800,000 and $13,600,000, respectively. These
net operating loss carryforwards expire in varying amounts beginning in 2011 and
2001 for Federal and state income tax purposes, respectively. The utilization of
the Federal net operating loss carryforwards may be subject to limitation under
the rules regarding a change in stock ownership as determined by the Internal
Revenue Code. If the Company's utilization of its net operating loss
carryforwards is limited and the Company has taxable income which exceeds the
permissible yearly net operating loss utilization, the Company would incur a
Federal income tax liability even though its net operating loss carryforwards
exceed its taxable income.
The Company's foreign net operating loss carryforwards expire in varying amounts
beginning in 2005. The Company's research and development credits begin to
expire in varying amounts beginning in 2009.
Taxes computed at the statutory federal income tax rate of 34% are reconciled to
the provision for income taxes for the years ended February 29, 2000 and
February 28, 1999 and 1998 as follows:
<TABLE>
<CAPTION>
Year Ended Year Ended Year Ended
---------- ---------- ----------
February 29, February 28, February 28,
------------ ------------ ------------
2000 1999 1998
---- ---- ----
<S> <C> <C> <C>
Effective rate.................................................. (0.7)% (14.3)% (7.9)%
United States Federal tax benefit at statutory rate............. $(13,446,334) $(1,722,348) (935,169)
State tax benefit (net of Federal tax).......................... (1,016,862) (440,355) (81,845)
Foreign taxes................................................... 325,805 422,680 250,798
Charge in valuation reserves.................................... 10,210,080 3,257,231 1,812,861
Research and development tax credit............................. (318,157) (256,104) (553,154)
Foreign tax credit.............................................. (167,692) (563,000) (322,730)
Acquisition related expenses.................................... 4,113,793 - -
Nondeductible items............................................. 593,693 24,112 44,587
Provision for income taxes...................................... $ 294,325 $ 722,216 $ 215,348
</TABLE>
NOTE 11-Mandatorily Redeemable Preferred Stock
At February 28,1999, the Company had authorized 6,801,400, 8,116,550 and
2,054,776 shares of Series A, Series B and Series C mandatorily redeemable
preferred stock, respectively. The shares of Series A, Series B and Series C
mandatorily redeemable preferred stock had a par value of $0.0001 per share.
On August 15, 1997, the Company entered into a purchase agreement with an
investor (the "Series A Investor"). In connection with this agreement, the
Company issued 6,801,400 shares of Series A preferred stock to the Series A
Investor for $2,000,000 or $0.2941 per share, less related issuance costs of
$16,791. The Series A preferred stock became mandatorily redeemable with the
issuance of the Series B mandatorily preferred stock in September 1998.
On September 29, 1998, the Company entered into a purchase agreement with
several investors (the "Series B Investors"). In connection with this agreement,
the Company issued 8,116,550 shares of
66
<PAGE>
RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Series B mandatorily redeemable preferred stock to the Series B Investors for
$6,955,884, or $0.857 per share, less related issuance costs of $66,621.
On February 25, 1999, the Company entered into a purchase agreement with several
investors (the "Series C Investors"). In connection with this agreement, the
Company issued 1,027,388 shares of Series C mandatorily redeemable preferred
stock to the Series C Investors for $3,227,026, or $3.141 per share.
In March and April 1999, the Company had additional closings of the Series C
mandatorily redeemable preferred stock financing in which the Series C Investors
purchased 1,027,388 shares of Series C mandatorily redeemable preferred stock
for $3,227,026, or $3.141 per share. Total issuance costs related to sales of
Series C mandatorily redeemable preferred stock were $62,870.
Conversion
All outstanding shares of Series A, Series B and Series C mandatorily redeemable
preferred stock automatically converted into 67,890,904 shares of common stock,
at the then effective conversion rate, upon the closing of the Company's initial
public offering of common stock in August 1999.
Redemption
Holders of the Series A, Series B and Series C mandatorily redeemable preferred
stock could have required the Company to redeem the stock upon receipt of
written request from Holders of shares representing at least 66 2/3% of
the aggregate number of shares of common stock issuable upon conversion. The
redemption price was equal to $0.343 per share in the case of Series A, $0.996
per share in the case of Series B, and $3.893 per share in the case of Series C,
after adjustment for certain events. Until the date of conversion, as noted
above, the carrying value of the Company's mandatorily redeemable preferred
stock was being accreted to its redemption price over the redemption period
using the effective interest rate method. In conjunction with the sale of the
Series B mandatorily redeemable preferred stock in September 1998, the Series A
mandatorily redeemable preferred stock became mandatorily redeemable.
Carrying Value
The Series A, Series B and Series C mandatorily redeemable preferred stock were
initially recorded at the total net proceeds received by the Company upon
issuance. The difference between the total net proceeds at issuance of
$12,068,063 and the total redemption price of $14,416,585 was being charged to
accumulated deficit over the period from issuance until redemption first becomes
available. The amount of accretion recognized during each period is determined
by using the effective interest rate method. The Company recognized $82,473 and
$39,356 in accretion for the years ended February 29, 2000 and February 28,
1999, respectively. The Company had no outstanding mandatorily redeemable
preferred stock prior to the year ended February 28, 1999.
Cygnus Series B Mandatorily Redeemable Preferred Stock
Cygnus had authorized 1,042,000 shares of Series B mandatorily redeemable
preferred stock at February 28, 1999. On January 27, 1997, Cygnus entered into a
purchase agreement with several investors (the "Cygnus Series B Investors"). In
connection with this agreement, the Company issued 1,042,000 shares of Series B
preferred stock for $6,252,000 or $6.00 per share.
The holders of the Cygnus Series B preferred stock could require Cygnus to
redeem, at any time after January 1, 2004, in two equal annual installments, the
holders' outstanding Series B preferred stock at a redemption price of $6 per
share or a total of $6,252,000.
The Cygnus Series B preferred stock was convertible at the option of the holder
into the number of shares of common stock of Cygnus as is determined by dividing
$6 by the conversion price in effect at the date of
67
<PAGE>
RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
conversion. On January 7, 2000, simultaneous with the closing of the merger
between the Company and Cygnus, the Cygnus Series B preferred stock converted
into 1,638,520 shares of the Company's common stock.
NOTE 12-Common and Preferred Stock
Common Stock
The Company has authorized 225,000,000 shares of common stock with a par value
of $0.0001 per share. Holders of these shares have one vote per share. Upon the
dissolution, liquidation or winding up of the Company, holders of common stock
will be entitled to receive the assets of the Company after satisfaction of the
preferential rights of the outstanding preferred stock or any other outstanding
stock ranking on liquidation senior to or on parity with the common stock.
On each of August 11, 1999 and January 7, 2000, the Company effected two-for-one
stock splits of its common stock. All common share and per common share
information in the accompanying consolidated financial statements and related
notes have been restated to reflect these stock splits.
On September 29, 1998, in connection with the above mentioned sale of Series B
mandatorily redeemable preferred stock, certain stockholders, primarily
comprised of officers of the Company, entered into a common stock purchase
agreement with the Series B Investors. In connection with this agreement, those
stockholders sold 5,251,000 shares of common stock to the Series B Investors for
$1,125,000 or $0.215 per share.
On February 25, 1999, in connection with the above mentioned sale of Series C
mandatorily redeemable preferred stock, certain stockholders, primarily
comprised of officers of the Company, entered into a common stock purchase
agreement with the Series C Investors. In connection with this agreement, those
stockholders sold 984,368 shares of common stock to the Series C Investors for
$772,975 or $0.786 per share. Upon additional closings of the Series C
mandatorily redeemable preferred stock financing in March and April of 1999, an
additional 984,368 shares of common stock were sold by certain stockholders,
primarily comprised of officers of the Company, to the additional Series C
Investors for $772,975 or $0.786 per share.
On August 16, 1999, the Company closed its initial public offering of 13,800,000
shares of its common stock at a price of $7.00 per share. The Company received
proceeds from this offering of $88,466,929, net of $8,133,071 in offering costs.
On February 9, 2000, the Company closed a secondary public offering of 2,750,000
shares of its common stock at a price of $95.00 per share. The Company received
proceeds from this offering of $248,586,054, net of $12,663,946 in offering
costs.
Preferred Stock
At February 29, 2000, the Company has authorized 5,000,000 shares of preferred
stock with a par value of $0.0001 per share. The Company has no outstanding
shares of preferred stock at February 29, 2000.
Cygnus Preferred Stock
Cygnus had authorized 7,798,180 shares of Series A preferred stock at February
28, 1999 and February 28, 1998. On January 15, 1997, Cygnus converted 5,882,633
outstanding shares of common stock to Series A preferred stock. In addition,
914,493 Series A preferred shares were issued from exercise of options by
employees to purchase Cygnus Series A preferred stock.
68
<PAGE>
RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The Cygnus Series A preferred stock was convertible, at the option of the
holder, into the number of common shares of Cygnus common stock determined by
dividing $3.11 by the conversion price in effect at the date of conversion. All
outstanding Cygnus Series A preferred stock was converted into 6,318,219 shares
of the Company's common stock on January 7, 2000, the closing date of the merger
between Red Hat and Cygnus.
Cygnus had authorized 0 and 1,572,476 shares of Series C preferred stock at
February 29, 2000 and February 28, 1999, respectively. In March and June 1999,
Cygnus entered into purchase agreements with several investors, whereby,
1,233,715 shares of Cygnus Series C preferred stock were sold for $9.50 per
share, or net proceeds of $11,734,476.
The Cygnus Series C preferred stock was convertible into Cygnus common stock, at
the option of the holder, into the number of common shares determined by
dividing $9.50 by the conversion price in effect at the date of conversion. All
outstanding Cygnus Series C preferred stock was converted into 1,233,715 shares
of the Company's common stock on the closing date of the merger between the
Company and Cygnus.
NOTE 13-Stock Options and Warrants
Stock Options
The Company has two stock options plans that provide for the granting of either
incentive stock options or non-qualified stock options (1998 and 1999 plans). As
of February 29, 2000, 14,929,600 shares of common stock were reserved for
issuance upon exercise of options granted to any employee, officer or director
or consultant of the Company at terms and prices to be determined by the Board
of Directors. The plans provide that the purchase price per share for each non-
qualified option should be set by the Board of Directors on the date of grant.
The purchase price per share for each Incentive Stock Option (ISO) shall not be
less than the fair market value of the common stock on the date of grant. The
maximum term for an option granted is ten years from the date of grant. Options
granted under the plans generally vest 25% upon completion of one full year of
service and 6.25% on the first day of each subsequent three-month period. Under
the 1998 plan, all options are immediately exercisable upon grant into
restricted shares of the Company's common stock with the same vesting provisions
as the original option. The Company, at its option, may repurchase these
restricted shares at the original purchase price under certain circumstances. No
additional options may be granted under the 1998 plan.
Cygnus Stock Option Plans
In March 1997, Cygnus's Board of Directors adopted the 1997 Cygnus Stock Plan.
At the time of adoption, all of the remaining shares available under the 1995
Cygnus Stock Plan were rolled into the 1997 Cygnus Stock Plan and 959,210 shares
of common stock were reserved for issuance under the 1997 Cygnus Stock Plan. The
provisions of the 1997 Cygnus Stock Plan provided for incentive stock options to
be issued to employees and nonstatutory stock options and stock purchase rights
to be issued to employees and consultants.
The exercise price of incentive stock options and nonstatutory stock options
granted under the 1997 Cygnus Stock Plan was required to be at least 100% and
85%, respectively, of the fair market value of the shares on the date of grant.
Options issued under the Cygnus 1997 Stock Plan generally expired ten years from
the date of the grant or such shorter term as may be provided in the option
agreement. Options granted under the 1997 Cygnus Stock Plan typically vest over
a four year period at a rate of 25% after the first year and ratably each month
thereafter.
Stock Purchase Rights provide for issuance of common stock at not less than 85%
of the fair market value of the stock. The 1997 Cygnus Stock Plan provides that
the Administrator of the 1997 Cygnus Stock Plan shall advise the offeree in
writing of the terms, conditions and restrictions related to the offer.
Restricted
69
<PAGE>
RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
stock purchases generally vest 25% after the first year and 1/48th each month
thereafter. Unvested shares are subject to repurchase upon termination of
employment.
In May 1998, Cygnus's Board of Directors adopted the 1998 Cygnus Executive Stock
Plan (the "1998 Plan") and 959,025 shares of common stock were reserved for
issuance under the 1998 plan. In January 1999, Cygnus authorized an additional
613,451 shares for issuance under this plan, for a total of 1,572,476 shares.
All of Cygnus outstanding stock options were converted into 2,380,772 options to
purchase the Company's common stock on the closing date of the merger between
the Company and Cygnus.
The activity for the stock option plans for the years ended February 29, 2000
and February 28, 1999 is presented in the following table and includes common
stock options of the Company and both common and preferred stock options of
Cygnus.
<TABLE>
<CAPTION>
Weighted
Shares Average
Underlying Exercise Price
Options Per Share
------- ---------
<S> <C> <C>
Outstanding at February 28, 1998.............. 2,156,560 $ 0.95
Granted....................................... 11,442,215 0.84
Exercised..................................... (1,365,019) 2.41
Forfeited..................................... (702,267) 2.06
---------- -------
Outstanding at February 28, 1999.............. 11,531,488 0.60
Granted....................................... 11,568,218 11.81
Exercised..................................... (7,402,098) 0.50
Forfeited..................................... (1,539,580) 3.03
---------- -------
Outstanding at February 29, 2000.............. 14,158,028 $ 9.54
---------- -------
</TABLE>
The Company recorded deferred compensation of $8,928,009 during the year ended
February 29, 2000 to reflect the difference between the aggregate fair value and
exercise price during this period of all stock options granted with an exercise
price below the fair value of the Company's common stock at the date of the
grant. Amortization of deferred compensation totaled $2,345,452 and $737,840
during the years ended February 29, 2000 and February 28, 1999, respectively.
70
<PAGE>
RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The following summarizes information about the Company's stock options at
February 29, 2000:
<TABLE>
<CAPTION>
Exercise Number Weighted Weighted Number Weighted
Prices Outstanding Average Average Exercisable Average
------- ----------- Contractual Exercise ----------- Exercise
Life Price Price
---- ----- -----
Options Outstanding Options Exercisable
------------------- -------------------
<S> <C> <C> <C> <C> <C>
$0.09-$0.79 7,612,458 8.85 $ 0.45 2,181,907 $ 0.40
1.09-5.00 4,211,273 8.98 $ 3.09 1,100,111 $ 2.61
5.40-7.00 700,626 9.43 $ 5.58 99,795 $ 5.58
36.75-42.94 861,096 9.61 $ 40.69 82,535 $ 40.09
74.13-92.50 299,600 9.98 $ 76.22 1,813 $ 79.59
108.5-133.97 472,975 9.81 $120.07 21,391 $120.90
</TABLE>
Stock Warrants
On October 10, 1995, the Company issued warrants (which are equivalent to
nonqualified stock options) to purchase 7,480,800 shares of common stock to
three of its employees with an exercise price of $0.0001 per share. The warrants
vested 25% annually on each May 1, beginning May 1, 1996 and ending May 1, 1999.
The warrants terminate upon death, permanent disability, termination of
employment or May 1, 2006. The Company and certain founding shareholders have a
right of first refusal to purchase the warrant shares on the same terms as a
proposed purchaser and a right to purchase the shares upon the death,
disability, or termination of employment of the employee. Upon the death,
disability, or termination without cause of the employee, the purchase price
shall be 80% of the fair market value of the Company's common stock as
determined by the board of directors. If the employee is terminated for cause,
the purchase price shall be 80% of the lesser of the book value or the fair
market value of the Company's common stock.
The activity for the stock warrants is presented in the following table:
<TABLE>
<CAPTION>
Shares Weighted Shares Weighted Shares Weighted
Underlying Average Underlying Average Underlying Average
Warrants Exercise Warrants Exercise Warrants Exercise
---------- Price ---------- Price ---------- Price
Per Share Per Share Per Share
--------- --------- ---------
Year Ended February 29, Year Ended February 28, Year Ended February 28,
------------------------ ----------------------- ------------------------
2000 1999 1998
---- ---- ----
<S> <C> <C> <C> <C> <C> <C>
Outstanding at beginning of year 6,774,900 $.0001 7,480,800 $.0001 7,480,800 $.0001
Exercised........................... (3,160,000) (705,900) $.0001
Outstanding at end of year.......... 3,614,900 $.0001 6,774,900 $.0001 7,480,800 $.0001
Exercisable at end of year.......... 3,614,900 $.0001 4,908,700 $.0001 3,740,400 $.0001
</TABLE>
SFAS 123 requires the Company to disclose pro forma information regarding
stock option grants and warrants issued to its employees. SFAS 123
specifies certain valuation techniques that produce estimated compensation
charges that are included in the pro forma results below. These amounts
have not been reflected in the Company's statement of operations, because
APB 25 specifies that no compensation charge arises when the exercise price
of employees' stock options and warrants equal the market value of the
underlying stock at the grant date, as in the case of options and warrants
granted to
71
<PAGE>
RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
the Company's employees. The fair value of options and warrants was estimated
using the following assumptions for the years ended February 29, 2000 and
February 28, 1999:
<TABLE>
<CAPTION>
Year Ended Year Ended
February 29, 2000 February 28, 1999
----------------- -----------------
<S> <C> <C>
Expected dividend yield................................ 0.00% 0.00%
Risk-free interest rate................................ 5.85% 4.98%
Expected volatility.................................... 129.96% 0.00%
Expected life (in years)............................... 5 6
</TABLE>
Had the Company accounted for its stock option plan and stock warrants by
recording compensation expense based on the fair value at the grant date on a
straight-line basis over the vesting period, stock-based compensation costs
would have increased net loss available to common stockholders by $10,162,258
and $738,563 for the years ended February 29, 2000 and February 28, 1999,
respectively. The pro forma effect on basic and diluted earnings per common
share would have been a reduction of $0.1010 and $0.0155 for the years ended
February 29, 2000 and February 28, 1999, respectively.
The weighted average estimated fair value of employee stock options granted was
$32.03 per share during the year ended February 29, 2000 and $0.41 per share
during the year ended February 28, 1999. The weighted average estimated fair
value of the warrants at the time of grant was $0.0001 per share.
NOTE 14-Related-Party Transactions
At February 29, 2000, the Company holds a $1,000,000 interest bearing promissory
note receivable with an officer of the Company. The principal amount of the
loan is due on the earlier of February 28, 2003 or certain other events
described in the promissory note. The loan may be forgiven upon the occurrence
of certain events as described in the promissory note.
72
<PAGE>
RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 15-Commitments and Contingencies
As of February 29, 2000, the Company leased office space and certain equipment
under various non-cancelable operating and capital leases. Future minimum lease
payments required under the operating and capital leases at February 29, 2000
are as follows:
<TABLE>
<CAPTION>
Operating Capital
Leases Leases
------ ------
<S> <C> <C>
2001..................................................................... $1,957,945 $ 329,713
2002..................................................................... 1,803,395 155,922
2003..................................................................... 1,344,030 118,447
2004..................................................................... 1,117,098 101,422
2005..................................................................... 113,733 145
Total minimum lease payments............................................ $6,336,201 705,649
Less amount representing interest (at rates ranging from 8.2% to 9.6%)... (109,071)
Present value of net minimum lease payments.............................. 596,578
Less current portion..................................................... (366,062)
Long-term portion.................................................... $ 230,516
</TABLE>
Rent expense under operating leases was $1,897,644, $1,205,973 and $1,018,191
for the years ended February 29, 2000 and February 28, 1999 and 1998,
respectively.
The Company has entered into an agreement with a bank to provide a letter of
credit pertaining to its building lease. The Company is required by the bank to
maintain a compensating balance of $65,000 which is equal to the amount of the
letter of credit. This amount is included in cash and cash equivalents.
The Company has executed licensing contracts to publish, bundle and distribute
software products developed by other companies in return for royalty payments
based on a percentage of the revenues generated by the Company from the sale of
these products. Prepaid royalty payments are included in current assets and
royalty payments due are included in royalties payable.
The Company is involved in certain legal proceedings as a part of its normal
course of business. Management does not believe that the ultimate resolution of
these matters will have a material impact on the Company's results of operations
or financial position in any quarterly or annual period.
NOTE 16-Employee Benefit Plans
401(k) Plan
The Company provides a retirement plan qualified under Section 401(k) of the
Internal Revenue Code ("IRC") of 1986, as amended. Participants may elect to
contribute a portion of their annual compensation to the plan, after complying
with certain limitations set by the IRC. Employees are eligible to participate
in the plan who are over 21 years of age and have completed three months of
service with Red Hat. If, however, an employee was employed by the Company prior
to February 1999, the 401(k) Plan covers such employee regardless of age or
length of service. The Company has the option to make contributions to the plan
but did not make any contributions to the plan for the years ended February 29,
2000 and February 28, 1999 and 1998.
73
<PAGE>
RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Employee Stock Purchase Plan
In 1999, the Company's stockholders approved the 1999 Employee Stock Purchase
Plan (the "Plan"), under which 1,500,000 shares of the Company's common stock
could be sold to employees. All full-time U.S. and certain non-U.S. employees
are eligible to participate in the Plan. The Plan provides that participants
may authorize the Company to withhold up to 10% of their earnings, on a semi-
annual basis, to purchase shares of stock at a price equal to the lesser of 85%
of the fair value of the stock as of the first business day of the period or the
last business day of the period. The Plan will terminate at the earlier of the
date that all 1,500,000 shares have been sold or at June 2, 2009. No shares of
the Company's common stock were sold under the Plan during the year ended
February 29, 2000.
NOTE 17-Subsequent Event (Unaudited)
On April 17, 2000, the Company executed a definitive agreement to acquire all of
the outstanding common and preferred stock and assume all of the outstanding
options of Bluecurve, Inc., ("Bluecurve") for up to 1,257,862 shares of the
Company's common stock. Bluecurve provides performance management solutions
which allow customers to simulate and measure the transactions and user activity
that place demands on Internet infrastructure and applications. The acquisition
will be accounted for using the purchase method of accounting. Accordingly, a
portion of the purchase price will be allocated to net tangible and intangible
assets acquired based on their estimated fair market values. The balance of the
purchase price will be recorded as goodwill.
NOTE 18-Unaudited Quarterly Results
<TABLE>
<CAPTION>
Year Ended February 29, 2000
----------------------------
(in thousands, except per share data)
-------------------------------------
4/th/ 3/rd/ 2/nd/ 1/st/
----- ----- ----- -----
Quarter Quarter Quarter Quarter
------- ------- ------- -------
<S> <C> <C> <C> <C>
Total revenue................................ $ 13,108 $ 10,549 $ 10,536 $ 8,234
Gross profit................................. 6,213 4,336 4,782 4,259
Loss from operations......................... (26,853) (7,685) (5,119) (4,256)
Net loss..................................... (24,609) (6,299) (4,845) (4,090)
Net loss per common share (a) (b):
Basic...................................... (0.1689) (0.0453) (0.0711) (0.0828)
Diluted.................................... (0.1689) (0.0453) (0.0711) (0.0828)
Number of weighted average shares
outstanding (b):
Basic...................................... 145,694 139,082 68,648 49,926
Diluted.................................... 145,694 139,082 68,648 49,926
</TABLE>
74
<PAGE>
RED HAT, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
Year Ended February 28, 1999
----------------------------
(in thousands, except per share data)
-------------------------------------
4/th/ 3/rd/ 2/nd/ 1/st/
----- ----- ----- -----
Quarter Quarter Quarter Quarter
------- ------- ------- -------
<S> <C> <C> <C> <C>
Total revenue................................. $ 9,442 $ 8,940 $ 7,292 $ 7,358
Gross profit.................................. 5,698 5,866 4,560 4,192
Loss from operations.......................... (1,095) (1,411) (826) (1,774)
Net loss...................................... (1,224) (1,476) (1,020) (2,067)
Net loss per common share (a) (b):
Basic...................................... (0.0259) (0.0319) (0.0215) (0.0439)
Diluted.................................... (0.0259) (0.0319) (0.0215) (0.0439)
Number of weighted average shares
outstanding (b):
Basic...................................... 48,210 47,834 47,387 47,097
Diluted.................................... 48,210 47,834 47,387 47,097
</TABLE>
_____________
(a) Earnings per common share are computed independently for each of the
quarters presented. Therefore, the sum of the quarterly per common share
information may not equal the annual earnings per common share.
(b) All share and per share information has been retroactively restated to
reflect the two-for-one splits of common stock. See NOTE 12-Common and
Preferred Stock.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None
75
<PAGE>
PART III
Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information under the Sections "Election of Directors," "Occupations of
Directors and Executive Officers" and "Section 16(a) Beneficial Ownership
Reporting Compliance" from the registrant's definitive proxy statement for the
annual meeting of stockholders to be held on August 3, 2000 (the "Proxy
Statement"), which is to be filed with the Securities and Exchange Commission
not later than 120 days after the close of the registrant's fiscal year ended
February 29, 2000, is hereby incorporated by reference.
Item 11. EXECUTIVE COMPENSATION
The information under the Sections "Compensation and Other Information
Concerning Directors and Officers" and "Stock Performance Graph" from the Proxy
Statement is hereby incorporated by reference.
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information under the Section "Securities Ownership of Certain Beneficial
Owners and Management" from the Proxy Statement is hereby incorporated by
reference.
Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information under the Sections "Compensation and Other Information
Concerning Directors and Officers" and "Certain Relationships and Related
Transactions" from the Proxy Statement is hereby incorporated by reference.
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-
Financial statements and supplementary data":
<TABLE>
<S> <C>
1. Financial Statements:
Report of Independent Accountants 49
Consolidated Balance Sheets at February 29, 2000 and February 28, 1999 50
Consolidated Statements of Operations for the years ended February 29, 2000
and February 28, 1999 and 1998 51
Consolidated Statements of Stockholders' Equity (Deficit) for the years ended
February 29, 2000 and February 28, 1999 and 1998 52
Consolidated Statements of Cash Flows for the years ended February 29, 2000
and February 28, 1999 and 1998 53
Notes to Consolidated Financial Statements 54
</TABLE>
2. Financial Statement Schedules:
76
<PAGE>
All other schedules for which provision is made in the applicable
accounting regulations of the Securities and Exchange Commission are not
required under the related instructions or are inapplicable and
therefore have been omitted.
3. List of Exhibits:
<TABLE>
<CAPTION>
Exhibit No. Description of Exhibit
- ----------- ----------------------
<S> <C>
2.1 Agreement and Plan of Reorganization dated November 5, 1999 by and among the registrant, Cygnus Solutions, Miami
Acquisition Corp. and Michael Tiemann, as Securityholder Agent (incorporated by reference from Exhibit 2.1 to the
registrant's Quarterly Report on Form 10-Q for the fiscal quarter ended November 30, 1999)
2.2 Agreement and Plan of Merger by and among the registrant, HKS Acquisition Corp., Hell's Kitchen Systems, Inc. and
certain shareholders of Hell's Kitchen Systems, Inc., dated as of January 4, 2000 (incorporated by reference from
Exhibit 2.2 to the registrant's Registration Statement on Form S-1 (File no. 333-94775))
3.1 Third Amended and Restated Certificate of Incorporation, as amended, of the registrant (incorporated by reference
from Exhibit 3.1 to the registrant's Registration Statement on Form S-1 (File no. 333-94775))
3.2 Amended and Restated By-laws, as amended, of the registrant (incorporated by reference from Exhibit 3.2 to the
registrant's Registration Statement on Form S-1 (File no. 333-94775))
4.1 Specimen certificate representing the common stock (incorporated by reference from Exhibit 4.1 to the registrant's
Registration Statement on Form S-1 (File no. 333-80051))
10.1* Red Hat, Inc. 1998 Stock Option Plan, as amended (incorporated by reference from Exhibit 10.1 to the registrant's
Registration Statement on Form S-1 (File no. 333-80051))
10.2* Red Hat, Inc. 1999 Stock Option and Incentive Plan (incorporated by reference from Exhibit 10.2 to the registrant's
Registration Statement on Form S-1 (File no. 333-80051))
10.3* Red Hat, Inc. 1999 Employee Stock Purchase Plan (incorporated by reference from Exhibit 10.3 to the registrant's
Registration Statement on Form S-1 (File no. 333-80051))
10.4* Cygnus Solutions. 1995 Stock Plan (incorporated by reference from Exhibit 10.4 to the registrant's Registration
Statement on Form S-1 (File no. 333-94775))
10.5* Cygnus Solutions 1997 Stock Plan (incorporated by reference from Exhibit 10.5 to the registrant's Registration
Statement on Form S-1 (File no. 333-94775))
10.6* Cygnus Solutions 1998 Executive Stock Plan (incorporated by reference from Exhibit 10.6 to the registrant's
Registration Statement on Form S-1 (File no. 333-94775))
10.7 Amended and Restated Warrant Agreement by and among the registrant, Robert F. Young, Nancy R. Young, Marc Ewing and
Erik Troan, dated as of October 21, 1999 (incorporated by reference from Exhibit 10.7 to the registrant's Registration
Statement on Form S-1 (File no. 333-94775))
10.8 Amended and Restated Warrant Agreement, by and among the registrant, Robert F. Young, Nancy R. Young, Marc Ewing and
Donald Barnes, dated as of October 21, 1999 (incorporated by reference from Exhibit 10.8 to the
</TABLE>
77
<PAGE>
<TABLE>
<S> <C>
registrant's Registration Statement on Form S-1 (File no. 333-94775))
10.9 Amended and Restated Warrant Agreement by and among the registrant, Robert F. Young, Nancy Young, Marc Ewing and Lisa
Sullivan, dated as of October 21, 1999 (incorporated by reference from Exhibit 10.9 to the registrant's Registration
Statement on Form S-1 (File no. 333-94775))
10.10 First Amended and Restated Investor Rights Agreement by and among the registrant and the Investors and Founders listed
therein, dated as of February 25, 1999, as amended (incorporated by reference from Exhibit 10.7 to the registrant's
Registration Statement on Form S-1 (File no. 333-80051))
10.11 Registration Rights Agreement by and among the registrant and Open Source, Inc., dated as of December 14, 1999
(incorporated by reference from Exhibit 10.11 to the registrant's Registration Statement on Form S-1 (File no.
333-94775))
10.12 Asset Purchase Agreement by and among the registrant and Open Source, Inc., dated as of December 14, 1999
(incorporated by reference from Exhibit 10.12 to the registrant's Registration Statement on Form S-1 (File no.
333-94775))
10.13 Escrow Agreement by and among the registrant, Miami Acquisition Corp., Cygnus Solutions, Inc., Michael Tiemann, as
Securityholder Agent, and First Union National Bank, as Escrow Agent, dated as of January 7, 2000 (incorporated by
reference from Exhibit 10.1 to the registrant's Quarterly Report on Form 10Q for the fiscal quarter ended November 30,
1999)
10.14 Office Lease by and between the registrant and CMD Properties, Inc., dated November 13, 1998 (incorporated by
reference from Exhibit 10.8 to the registrant's Registration Statement on Form S-1 (File no. 333-80051))
10.15* Non-Qualified Stock Option Agreement by and between the registrant and Matthew Szulik (incorporated by reference from
Exhibit 10.9 to the registrant's Registration Statement on Form S-1 (File no. 333-80051))
10.16* Incentive Stock Option Agreement by and between the registrant and Matthew Szulik (incorporated by reference from
Exhibit 10.10 to the registrant's Registration Statement on Form S-1 (File no. 333-80051))
10.17* Non-Qualified Stock Option Agreement by and between the registrant and Timothy Buckley (incorporated by reference from
Exhibit 10.11 to the registrant's Registration Statement on Form S-1 (File no. 333-80051))
10.18* Incentive Stock Option Agreement by and between the registrant and Timothy Buckley (incorporated by reference from
Exhibit 10.12 to the registrant's Registration Statement on Form S-1 (File no. 333-80051))
10.19 GNU General Public License (incorporated by reference from Exhibit 10.13 to the registrant's Registration Statement on
Form S-1 (File no. 333-80051))
10.20** Distribution Agreement by and between the registrant and Ingram Micro Inc. dated as of October 15, 1998, as amended
(incorporated by reference from Exhibit 10.14 to the registrant's Registration Statement on Form S-1 (File no.
333-80051))
10.21** Red Hat Product Distribution Agreement by and between the registrant and Frank Kasper Associates, Inc., dated as of
April 30, 1999 (incorporated by reference from Exhibit 10.15 to the registrant's Registration Statement on Form S-1
(File no. 333-80051))
10.22** Software Distribution Agreement between Tech Data Product Management, Inc. and the registrant, dated as of April 29,
1999 (incorporated by reference from Exhibit 10.16 to the registrant's Registration Statement on Form S-1 (File no.
333-80051))
</TABLE>
78
<PAGE>
<TABLE>
<S> <C>
10.23** Independent Contractor Agreement by and between the registrant and Ingo Molnar, dated as of August 18, 1998
(incorporated by reference from Exhibit 10.18 to the registrant's Registration Statement on Form S-1 (File no.
333-80051))
10.24** Escrow Agreement by and among the registrant and Lawrence Weidman, as Shareholder Representative, dated January 6,
2000 (incorporated by reference from Exhibit 99.3 to the registrant's Current Report on Form 8-K dated January 6, 2000)
10.25* Promissory Note dated February 28, 2000 issued by Harold L. Covert to Red Hat, Inc. in the principal amount of
$1,000,000.00
21.1 Subsidiaries of Red Hat, Inc.
23.2 Consent of PricewaterhouseCoopers LLP
24.1 Power of Attorney (included on signature page of Annual Report)
27.1 Financial Data Schedule
</TABLE>
* Indicates a management contract or compensatory plan, contract or
arrangement.
** Confidential materials omitted and filed separately with the Securities
and Exchange Commission
(b) Reports on Form 8-K:
The registrant filed a Current Report on Form 8-K with the Securities and
Exchange Commission on January 21, 2000 to disclose the acquisition by the
registrant on January 6, 2000 of all of the capital stock of Hell's Kitchen
Systems, Inc., a Pennsylvania corporation ("HKS"), by means of a merger
(the "HKS Merger") of HKS Acquisition Corp., a Pennsylvania corporation and
wholly owned subsidiary of Red Hat ("HKS Merger Sub"), with and into HKS,
pursuant to the Agreement and Plan of Merger dated as of January 4, 2000
(the "HKS Merger Agreement") by and among Red Hat, HKS Merger Sub, HKS and
the majority shareholders of HKS. As a result of the HKS Merger, HKS became
a wholly owned subsidiary of Red Hat and will continue to operate as a
wholly-owned subsidiary of Red Hat. The following historical financial
statements of HKS, together with the report thereon signed by
PricewaterhouseCoopers LLP, were included as Exhibit 99.4 to the Form 8-K:
the Balance Sheets at December 31, 1998, March 9, 1999 and September 30,
1999, the Statements of Operations for the year ended December 31, 1998,
the period from January 1, 1999 to March 9, 1999 and for the period from
March 10, 1999 to September 30, 1999,and the Statements of Stockholders
Equity (Deficit) for the year ended December 31, 1998, the period from
January 1, 1999 to March 9, 1999 and for the period from March 10, 1999 to
September 30, 1999.
79
<PAGE>
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.
RED HAT, INC.
By: /s/ MATTHEW J. SZULIK
Matthew J. Szulik
President and Chief Executive
Officer
Date: May 23, 2000
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report
has been signed below by the following persons on behalf of the Registrant and
in the capacities and on the dates indicated.
<TABLE>
<CAPTION>
Signature Title Date
--------- ----- ----
<S> <C> <C>
/s/ MATTHEW J. SZULIK Chief Executive Officer, President and Director (principal May 23, 2000
- ------------------------------------- executive officer)
Matthew J. Szulik
/s/ HAROLD L. COVERT Chief Financial Officer May 23, 2000
- ------------------------------------- (principal financial and accounting officer)
Harold L. Covert
/s/ ROBERT F. YOUNG Director May 23, 2000
- -------------------------------------
Robert F. Young
/s/ MARC EWING Director May 23, 2000
- -------------------------------------
Marc Ewing
/s/ WILLIAM S. KAISER Director May 23, 2000
- -------------------------------------
William S. Kaiser
/s/ KEVIN HARVEY Director May 23, 2000
- -------------------------------------
Kevin Harvey
/s/ ERIC HAHN Director May 23, 2000
- -------------------------------------
Eric Hahn
</TABLE>
80
<PAGE>
Exhibit 10.25
PROMISSORY NOTE - FEBRUARY 28, 2000
For Value Received, the undersigned, Harold L. Covert ("Employee" or
"Borrower"), promises to pay to Red Hat, Inc., a Delaware corporation (the
"Company" or the "Lender"), with its principal place of business at 2600
Meridian Parkway, Durham, NC 27713 (or at such other place as Lender may from
time to time designate by written notice to Borrower), in lawful money of the
United States of America, without abatement, demand, deduction, set-off or
counterclaim, the principal sum of One Million Dollars ($1,000,000) together
with interest at the rate of six percent per annum, compounded annually, from
the date first set forth above until all outstanding principal and accrued
interest under this Promissory Note are paid in full.
1. Principal Payment. On the Maturity Date (as defined below), the entire
principal amount of One Million Dollars ($1,000,000) and any unpaid and accrued
interest shall be immediately due and payable by the Borrower to the Company in
lawful money of the United States. This shall be a full recourse loan. Each
payment in connection with this Note shall be paid by the Borrower to the Lender
at the Lender's principal office or to such bank account as shall be notified by
the Lender to the Borrower in writing, such payments shall be made in
immediately available funds not later than 12:00 noon (Eastern Standard Time) on
the Maturity Date (as defined below).
2. Interest Payment. The outstanding principal amount of the Note shall bear
interest, for each day from the date of the Note's origination until its
principal amount is paid in full, at a rate per annum equal to 6.00%. The
Borrower shall make quarterly interest payments to the Company, which payments
are due to the Company on the last business day of March, June, September and
December for each year that the Note is outstanding.
3. Maturity Event. The entire principal amount of the Loan and any interest
due shall become immediately due and payable without further demand or notice to
the Borrower on the earlier of February 28, 2003 or the date which a Maturity
Event occurs (the "Maturity Date"). To the extent permitted by law, the first to
occur of any of the following events shall be a "Maturity Date" under this
note:
a. The Employee does not begin his employment relationship, by being present
or available to commence his duties as Chief Financial Officer for the Lender,
on or before March 16, 2000.
b. The date that a Change in Control of the Company occurs. For these
purposes a "Change in Control" shall be deemed to occur if the Company mergers
or consolidates with another company and at any time Harold L. Covert does not
hold the position of Chief Financial Officer of the surviving entity resulting
from the merger or consolidation; or the Company sells all or substantially all
of its assets to another company for cash and/or public securities.
c. The date of termination or cessation of Employee's employment with the
Company (i) if the Employee terminates his employment for any reason, or (ii) if
the Company terminates the Employee's employment for Cause. For these purposes,
"Cause" shall mean that the Employee was terminated for one of the following
reasons: (1.) for willfully refusing or failing to carry out specific directions
of the Board of Directors or the Chief Executive Officer of the Company; (2.)
for acting fraudulently or dishonestly in his relations with the Company; (3.)
for committing larceny, embezzlement, conversion or any act involving the
misappropriation of funds from the Company in the course of his employment; (4.)
for having been convicted of a felony involving an act of moral turpitude, fraud
or misrepresentation; (5.) for willfully engaging in misconduct which materially
injured the reputation, business or business relationship of the Company.
d. The date that Borrower (i) admits in writing his inability to pay debts,
(ii) makes an assignment for the benefit of creditors, (iii) files a voluntary
petition in bankruptcy, effects a plan or other arrangements with creditors,
liquidates his assets under arrangement with creditors, or liquidates his assets
under court
<PAGE>
supervision, (iv), has an involuntary petition in bankruptcy filed against him
that is not discharged within sixty (60) days after such petition is filed, or
(v) applies for or permits the appointment of a receiver or trustee or custodian
for any of his propriety or assets which shall not have been discharged within
(60) days after the date of appointment.
4. Loan Extension. On February 28, 2003 the loan shall automatically be
extended for a one-year period if the Total Spread (as hereafter defined) with
respect to the Borrower's vested stock options from initial date of employment
is not greater than $1 million for ninety (90) or more trading days during the
period ending February 28, 2003. "Total Spread" shall be equal to (a) the total
number of units or shares of equity securities underlying the Option(s) (without
regard to whether the Option(s) has been exercised in whole or in part),
multiplied by (b) the closing sales price of the equity securities of the
Lender, less the exercise price of the Option(s) (as such exercise price may be
adjusted from time to time).
5. Loan Forgiveness.
a. The loan shall be forgiven, to the extent described in 5.b. below, upon the
occurrence of one of the following events: (i) the Company terminates the
Employee's employment with the Company for reasons other than for Cause; or (ii)
the Total Spread does not exceed the principal balance of the loan for ninety
(90) or more trading days during the period ending February 28, 2004; (iii) the
Employee dies; or (iv) the Employee's employment with the Company is terminated
due to Employee's physical or mental disability. For these purposes, a medical
doctor mutually agreed upon by the Company and Employee or his designee shall
make the determination as to whether the Employee has become disabled.
b. Upon the date of occurrence of one of the events listed in 5.a. above, in
the event that the principal balance of the loan minus the Total Spread is
greater than zero, then the loan shall be forgiven to the extent of that
difference, but in no event in an amount greater than $1,000,000 (one million
dollars).
c. In the event that there is a Change of Control and the consideration given
for the Total Spread, or its equivalent computation, is less than the principal
balance of the loan, the loan shall be forgiven to the extent of such difference
between the Total Spread and the principal balance of the loan. In such an
event, the Employee shall be obligated to pay to the Company the amount of his
Total Spread or equivalent computation.
6. Tax Liability. Lender understands and agrees that any and all income tax
liability to Borrower resulting from the forgiveness of loan principal, due to
Employee's employment being terminated by the Company, for other than Cause,
prior to February 28, 2004, shall be reimbursed, and appropriately grossed-up,
by the Lender. The gross-up shall ensure that the Employee is not adversely
impacted from a tax standpoint by forgiving loan principal due to Employee's
employment termination by the Company, for other than Cause, prior to February
28, 2004.
7. Attorneys' Fees. In the event any legal action or proceeding is required
to enforce or interpret any provision of this Promissory Note, including,
without limitation, any forgiveness of principal and interest hereunder, each
party shall be responsible for its own attorneys fees and costs.
8. Miscellaneous. If any provision of this Promissory Note shall be
unenforceable for any reasons, the same shall be ineffective, but the remainder
of this Promissory Note shall not be affected thereby and shall remain in full
force and effect. North Carolina law shall govern the provisions of this
Promissory Note.
9. Prepayment. Borrower may prepay all or any portion of this Note any time
prior to the stated maturity date, with no premium penalty.
In witness whereof, Borrower has executed this Promissory Note as of the date
first set forth above.
Borrower:
Harold L. Covert
<PAGE>
Exhibit 21.1
North America
- -------------
Red Hat, Inc. Delaware
Hell's Kitchen Systems, Inc. Pennsylvania
Cygnus Solutions California
Cygnus Solutions Canada Limited Ontario, Canada
Nihon Cygnus Solutions California
Europe
- ------
Red Hat UK Limited United Kingdom
Red Hat GmbH Germany
Red Hat Ireland Limited Ireland
Red Hat France SARL France
Red Hat Italy s.r.l. Italy
Cygnus Solutions Limited United Kingdom
Cygnus Solutions GmbH Germany
Asia-Pacific/Japan
- ------------------
Red Hat Asia-Pacific Pty. Ltd. Australia
Red Hat KK Japan
<PAGE>
Exhibit 23.2
CONSENT OF INDEPENDENT ACCOUNTANTS
We hereby consent to the incorporation by reference in the Registration
Statement on Form S-8 (No. 333-96163 and 333-88159) of Red Hat, Inc. of our
report dated March 24, 2000 relating to the financial statements of Red Hat,
Inc. which appears in this Form 10-K.
PRICEWATERHOUSECOOPERS LLP
Raleigh, North Carolina
May 22, 2000
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM RED HAT
INC. FINANCIAL STATEMENTS AS OF AND FOR THE FISCAL YEAR ENDED FEBRUARY 29, 2000
AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> FEB-29-2000
<PERIOD-START> MAR-01-1999
<PERIOD-END> FEB-29-2000
<CASH> 242,426
<SECURITIES> 99,814
<RECEIVABLES> 8,371
<ALLOWANCES> 477
<INVENTORY> 489
<CURRENT-ASSETS> 280,144
<PP&E> 13,041
<DEPRECIATION> 5,132
<TOTAL-ASSETS> 423,535
<CURRENT-LIABILITIES> 29,857
<BONDS> 597
0
0
<COMMON> 15
<OTHER-SE> 393,432
<TOTAL-LIABILITY-AND-EQUITY> 423,535
<SALES> 23,960
<TOTAL-REVENUES> 42,428
<CGS> 13,070
<TOTAL-COSTS> 45,421
<OTHER-EXPENSES> 40,919
<LOSS-PROVISION> 504
<INTEREST-EXPENSE> 558
<INCOME-PRETAX> (39,548)
<INCOME-TAX> 294
<INCOME-CONTINUING> (39,842)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (39,842)
<EPS-BASIC> (0.397)
<EPS-DILUTED> (0.397)
</TABLE>
