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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
| /x/ |
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the quarterly period ended March 31, 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 000-28329
PREVIEW SYSTEMS, INC.
(Exact name of registrant as specified in its charter)
| Delaware (State or other jurisdiction of incorporation or organization) |
770485517 (I.R.S. Employer Identification No.) |
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| 1195 West Fremont Boulevard |
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| Sunnyvale, California (Address of principal executive offices) |
94087 (Zip Code) |
Registrant's telephone number, including area code: 408-720-3500
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes /x/ No / /
Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.
| Common stock $.0002 par value (Class) |
16,924,436 (Outstanding at May 2, 2000) |
PREVIEW SYSTEMS, INC.
FORM 10-Q
INDEX
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Page |
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| PART I—FINANCIAL INFORMATION | ||||
| Item 1. |
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Financial Statements |
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Consolidated Balance Sheets—March 31, 2000 and December 31, 1999 |
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2 |
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Consolidated Statements of Operations—Three Months Ended March 31, 2000 and 1999 |
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3 |
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Consolidated Statements of Cash Flows—Three Months Ended March 31, 2000 and 1999 |
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4 |
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Notes to Consolidated Financial Statements |
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5 |
| Item 2. |
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Management's Discussion and Analysis of Financial Condition and Results of Operations |
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6 |
| Item 3. |
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Quantitative and Qualitative Disclosures About Market Risk |
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19 |
| PART II—OTHER INFORMATION |
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| Item 1. |
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Legal Proceedings |
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20 |
| Item 2. |
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Changes in Securities and Use of Proceeds |
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20 |
| Item 6. |
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Exhibits and Reports on Form 8-K |
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20 |
| Signatures |
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21 |
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1
Item 1. Financial Information
PREVIEW SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands, except per share amounts)
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March 31, 2000 |
December 31, 1999 |
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|---|---|---|---|---|---|---|---|
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(Unaudited) |
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| ASSETS | |||||||
| Current assets: | |||||||
| Cash and cash equivalents | $ | 61,678 | $ | 71,801 | |||
| Short-term investments | 28,431 | 17,914 | |||||
| Accounts receivable, net of allowance for uncollectible accounts of $100, and $75, respectively | 3,023 | 2,229 | |||||
| Prepaid expenses | 945 | 687 | |||||
| Other current assets | 1,008 | 407 | |||||
| Total current assets | 95,085 | 93,038 | |||||
| Property and equipment, net of accumulated depreciation of $1,341 and $1,168 | 2,071 | 1,521 | |||||
| Intangibles, net of accumulated amortization of $3,775 and $3,218 | 2,935 | 3,492 | |||||
| Long-term investments | 5,478 | — | |||||
| Long-term receivables | 808 | — | |||||
| Other assets | 509 | 174 | |||||
| Total assets | $ | 106,886 | $ | 98,225 | |||
| LIABILITIES AND STOCKHOLDERS' EQUITY |
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| Current liabilities: | |||||||
| Current portion of long-term debt | $ | 157 | $ | 157 | |||
| Current portion of capital lease obligations | 151 | 166 | |||||
| Accounts payable | 759 | 1,092 | |||||
| Accrued liabilities | 1,726 | 1,170 | |||||
| Deferred revenue | 2,805 | 1,916 | |||||
| Total current liabilities | 5,598 | 4,501 | |||||
| Long-term debt, less current portion | 105 | 145 | |||||
| Capital lease obligations, less current portion | 112 | 144 | |||||
| Deferred revenue, less current portion | 1,237 | 627 | |||||
| Other liabilities | 240 | 267 | |||||
| Total liabilities | 7,292 | 5,684 | |||||
| Commitments and contingencies | |||||||
| Stockholders' equity: | |||||||
| Preferred stock, $0.0002 per share par value: | |||||||
| Authorized—5,000 shares; none issued and outstanding | — | — | |||||
| Common stock, $0.0002 per share par value: | |||||||
| Authorized—75,000 shares; issued and outstanding 16,811 and 16,207 shares | 3 | 3 | |||||
| Additional paid-in capital | 139,583 | 125,493 | |||||
| Stockholder notes receivable | (1,912 | ) | (1,912 | ) | |||
| Deferred compensation | (91 | ) | (101 | ) | |||
| Accumulated deficit | (37,989 | ) | (30,942 | ) | |||
| Total stockholders' equity | 99,594 | 92,541 | |||||
| Total liabilities and stockholders' equity | $ | 106,886 | $ | 98,225 | |||
The accompanying notes are an integral part of these consolidated balance sheets.
2
PREVIEW SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
(Unaudited)
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Three Months Ended March 31, |
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|---|---|---|---|---|---|---|---|
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2000 |
1999 |
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| Revenues | |||||||
| Network transaction fees | $ | 1,235 | $ | 295 | |||
| Services | 434 | 168 | |||||
| Total revenues | 1,669 | 463 | |||||
| Operating expenses: |
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| Research and development | 2,819 | 1,624 | |||||
| Sales and marketing | 2,973 | 1,069 | |||||
| General and administrative | 1,015 | 749 | |||||
| Stock based compensation | 2,814 | 108 | |||||
| Acquisition related costs | 519 | 519 | |||||
| Total operating expenses | 10,140 | 4,069 | |||||
| Loss from operations |
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(8,471 |
) |
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(3,606 |
) |
| Other income (expense): |
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| Interest expense | (14 | ) | (23 | ) | |||
| Interest income | 1,465 | 51 | |||||
| Other, net | (27 | ) | — | ||||
| Total other income (expense) | 1,424 | 28 | |||||
| Net loss | $ | (7,047 | ) | $ | (3,578 | ) | |
| Basic and diluted net loss per share |
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$ |
(0.42 |
) |
$ |
(1.33 |
) |
| Shares used in per share calculations |
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16,795 |
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2,693 |
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The accompanying notes are in integral part of these consolidated financial statements.
3
PREVIEW SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
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Three Months Ended March 31, |
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|---|---|---|---|---|---|---|---|
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2000 |
1999 |
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| Cash flows from operating activities: | |||||||
| Net loss | $ | (7,047 | ) | $ | (3,578 | ) | |
| Adjustments to reconcile net loss to net cash used in operating activities: | |||||||
| Depreciation and amortization | 739 | 669 | |||||
| Other non-cash expenses | 2,814 | 108 | |||||
| Loss on sale of fixed assets | 11 | — | |||||
| Changes in operating assets and liabilities: | |||||||
| Accounts receivable | (794 | ) | (158 | ) | |||
| Prepaid expenses and other current assets | (859 | ) | (35 | ) | |||
| Long-term receivables and other assets | (1,143 | ) | (7 | ) | |||
| Accounts payable | (333 | ) | 413 | ||||
| Accrued liabilities | 556 | (296 | ) | ||||
| Deferred revenue | 1,499 | (106 | ) | ||||
| Other liabilities | (27 | ) | 36 | ||||
| Net cash used in operating activities | (4,584 | ) | (2,954 | ) | |||
| Cash flows from investing activities: |
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| Purchase of investments | (15,995 | ) | — | ||||
| Purchases of property and equipment | (756 | ) | (126 | ) | |||
| Proceeds from sale of equipment | 13 | — | |||||
| Net cash used in investing activities | (16,738 | ) | (126 | ) | |||
| Cash flows from financing activities: |
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| Borrowings under line of credit, notes payable and long-term debt | — | 700 | |||||
| Repayments under line of credit, notes payable and long-term debt | (40 | ) | (39 | ) | |||
| Proceeds from obligations under capital leases | — | 178 | |||||
| Payment of obligations under capital leases | (47 | ) | (42 | ) | |||
| Issuance of common stock in public offering, net of issuance costs | 11,118 | — | |||||
| Issuance of common stock pursuant to the exercise of options and warrants | 168 | 13 | |||||
| Net cash provided by financing activities | 11,199 | 810 | |||||
| Net decrease in cash and cash equivalents |
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(10,123 |
) |
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(2,270 |
) |
| Cash and cash equivalents: |
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| Beginning of period | 71,801 | 4,886 | |||||
| End of period | $ | 61,678 | $ | 2,616 | |||
The accompanying notes are an integral part of these consolidated financial statements.
4
PREVIEW SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(In thousands)
(Unaudited)
Note 1. Basis of Presentation
The financial information included herein for the three-month periods ended March 31, 2000 and 1999 is unaudited; however, such information reflects all adjustments consisting only of normal recurring adjustments, which are, in the opinion of management, necessary for a fair presentation of the financial position, results of operations and cash flows for the interim periods. The financial information as of December 31, 1999 is derived from Preview Systems, Inc.'s ("Preview" or the "Company") 1999 Annual Report on Form 10-K. The interim consolidated financial statements should be read in conjunction with the consolidated financial statements and the notes thereto included in Preview's 1999 Annual Report on Form 10-K. The results of operations for the interim periods presented are not necessarily indicative of the results to be expected for the full year.
Note 2. Supplemental Cash Flow Information
Supplemental disclosure of cash flow information is as follows:
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Three Months Ended March 31, |
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|---|---|---|---|---|---|---|
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2000 |
1999 |
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| Cash paid during the period for interest | $ | 14 | $ | 23 | ||
Note 3. Net Loss Per Share
Basic and diluted net loss per share are the same for all periods presented since Preview was in a loss position in all periods. Potentially dilutive securities that are not included in the diluted net loss per share calculation because they would be antidilutive are as follows:
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March 31, |
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|---|---|---|---|---|
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2000 |
1999 |
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| Stock options and warrants | 3,680 | 2,312 | ||
| Convertible preferred stock | — | 4,476 | ||
| Total | 3,680 | 6,788 | ||
Note 4. Issuance of Common Stock
In January 2000, Preview issued 570 shares of its common stock pursuant to the underwriters' over-allotment option for net proceeds to the Company of $11,118.
Note 5. Stock Option Plans
Pursuant to the terms of the plans, on January 1, 2000 the number of shares of the Company's Common Stock authorized for issuance under the 1998 Stock Option Plan, the 1999 Directors Stock Option Plan and the 1999 Employee Stock Purchase Plan were increased by 486, 150 and 324 shares, respectively.
Note 6. Reclassifications
Certain amounts in the prior period financial statements have been reclassified to conform to current presentation.
5
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (In Thousands)
Forward Looking Statements
This Form 10-Q contains forward-looking statements that involve risks and uncertainties. We use words like "anticipate," "believe," "plan," "expect," "future," "intend," and similar expressions to identify forward-looking statements. This Form 10-Q also contains forward-looking statements attributed to third parties relating to their estimates regarding the growth of Internet use and electronic distribution and licensing of digital goods. You should not place undue reliance on these forward-looking statements, which apply only as of the date of this Form 10-Q. Our actual results could differ materially from those anticipated in these forward-looking statements for many reasons, including the risks faced by us and described in our Registration Statement on Form S-1 and in our Form 10-K for the year ended December 31, 1999, as filed with the Securities and Exchange Commission. Moreover, neither we nor any other person assumes responsibility for the accuracy and completeness of the forward-looking statements. We are under no duty to update any of the forward-looking statements after the date of this Form 10-Q to conform these statements to actual results or to changes in our expectations.
Company Overview
Preview Systems is a provider of an Internet-based infrastructure solution that enables networks for distribution and licensing of digital goods. Through our infrastructure solution and strategic relationships, we link software publishers and music labels to their channel partners and end-users worldwide, creating an end-to-end electronic distribution chain that manages the e-commerce of digital goods and associated licensing rights.
We generally provide rights to use our solution and ongoing customer support through licensing agreements. These agreements typically require the payment of network transaction fees based on a percentage of the sales fulfilled using our solution. Our customers typically commit to minimum network transaction fees that entitle them to fulfill an agreed amount of sales during the term of the agreement. Some or all of the minimum network transaction fees are prepaid upon signing the agreement. We record deferred revenue related to these fees and recognize them on a straight-line basis over the license period. To the extent sales fulfilled using our solution exceed the agreed amount of sales, we recognize incremental network transaction fees. We recognize these incremental network transaction fees when the amounts due are known, which will generally be in the month subsequent to our customers' sales.
Service revenues generally consist of consulting, training and integration fees. We typically bill these services and recognize them as the related services are performed or when contract milestones are achieved.
Results of Operations
Revenue
Total revenues were $1,669 for the quarter ended March 31, 2000 compared to $463 for the quarter ended March 31, 1999.
Network transaction fees were $1,235 in the first quarter of 2000 compared to $295 in the first quarter of 1999. The increase in network transaction fees resulted from growth in our customer base and growing market acceptance of electronic distribution of digital content. This growth, in turn, resulted from increased sales and marketing efforts. Future network transaction fee revenue growth will be dependent on continuing to expand our customer base and existing customers generating transaction volume using our solution.
Service revenues were $434 in the first quarter of 2000 compared to $168 in the first quarter of 1999. The increase resulted from training and consulting services to an expanding customer base.
6
Three customers, Ingram Micro, Sony Marketing of Japan and ReleaseNow.com, accounted for 11.8%, 11.4% and 10.9%, respectively, of total revenues in the first quarter of 2000. One customer accounted for 50.4% of total revenues in the first quarter of 1999.
Operating Expenses
Research and development expenses consist principally of salaries and related personnel expenses, consultant fees and the cost of software used in product development. Research and development expenses increased to $2,819 in the first quarter of 2000 from $1,624 in the first quarter of 1999 primarily as a result of a $638 increase in salaries and related costs and a $382 increase in facilities costs due to growth of the Company, as well as an increase in royalties of $91 related to the licensing of certain technology from Intel for the distribution of music.
Sales and marketing expenses consist of salaries and related expenses for personnel engaged in direct sales, partner development, marketing and field service support, consultant fees, advertising, promotional materials, trade show exhibits, and other marketing program expenses. Sales and marketing expenses increased to $2,973 in the first quarter of 2000 from $1,069 in the first quarter of 1999 primarily as a result of a $790 increase in salaries and related costs, $168 for recruiting and related costs and a $272 increase in facilities costs. In addition, advertising and other marketing program costs increased approximately $237 during the first quarter of 2000 compared to the first quarter of 1999.
General and administrative expenses consist primarily of salaries and related expenses for executive, legal, accounting and administrative personnel, professional services and general corporate expenses. General and administrative expenses increased to $1,015 in the first quarter of 2000 compared to $749 in the first quarter of 1999 primarily as a result of a $387 increase in salaries and related costs and a $70 increase in facilities costs, partially offset by a decrease in legal costs of $256. Legal costs were higher in the first quarter of 1999 as a result of litigation related expenses for defense of the 20/20 case.
Stock based compensation relates to the issuance of common stock warrants and options to non-employees or to employees at below the fair market value of the Company's common stock. The $2,814 of stock based compensation in the first quarter of 2000 primarily relates to the vesting of a portion of the warrant issued to Virgin Holdings, Inc. during the quarter based on achievement of pre-determined performance criteria related to market development activities. Another 133 shares of this warrant become exercisable upon achievement of a final milestone in the fourth quarter of 2000, and may have a material impact on our results of operations upon vesting.
Acquisition related costs consist of the amortization of patents and other intangibles and totaled $519 in the first quarter of both 2000 and 1999.
Income Taxes
We have incurred net losses since inception for federal and state tax purposes and have not recognized any tax provision or benefit.
We are in a net deferred tax asset position, which has been fully reserved. We will continue to provide a valuation allowance for our net deferred tax assets until it becomes more likely than not, in our assessment, that our net deferred tax assets will be realized.
Interest Income
Interest income increased to $1,465 in the first quarter of 2000 from $51 in the first quarter of 1999 as a result of increased cash and investment balances resulting from the issuance of our Series G Preferred Stock and our initial public offering of common stock.
7
Liquidity and Capital Resources
Historically, we funded our operations through the sale of preferred stock and, to a much lesser degree, our bank credit facility. Through March 31, 2000, we raised cash proceeds of $39,699 through these privately placed preferred stock financings and had outstanding borrowings at March 31, 2000, including capital lease commitments, of $525. In December 1999, we completed our initial public offering of 3,800 shares of common stock for net proceeds of $71,245. In January 2000, the underwriters of our initial public offering exercised their over-allotment option, resulting in the sale of an additional 570 shares of common stock for net proceeds of $11,118.
At March 31, 2000, we had working capital of $89,487, including $61,678 of cash and cash equivalents and $28,431 of short-term investments. We used $4,584 for operations during the quarter ended March 31, 2000 compared to $2,954 in the quarter ended March 31, 1999. We also used $5,478 for the purchase of long-term investments during the quarter ended March 31, 2000. These investments have maturities beyond 12 months, but less than 24 months from March 31, 2000.
We have a loan agreement with a bank, which provides for borrowings under a term loan. Amounts borrowed under term loan bear interest at the bank's prime rate plus 1% (10% at March 31, 2000). The loan is payable in 36 equal installments of $13 of principal, plus interest. Borrowings are collateralized by all of our tangible and intangible assets. At March 31, 2000, amounts outstanding under the term loan were $262. Under this agreement, we are required to maintain compliance with financial covenants regarding minimum tangible net worth, liquidity coverage and ratio of quick assets to current liabilities minus deferred revenue. We were in compliance with these financial covenants at March 31, 2000. The term loan matures on November 2, 2001.
Accounts receivable were $3,023 at March 31, 2000 compared to $2,229 at December 31, 1999. The increase was primarily attributable to the execution of new licensing agreements with customers. Days sales outstanding at March 31, 2000 were 165 compared to 167 at December 31, 1999. Our contract terms allow for installment payments, a majority of which, according to our revenue recognition policy, are recorded as deferred revenue.
Deferred revenue increased to $4,042 at March 31, 2000 from $2,543 at December 31, 1999 as a result of growth in our customer base. $2,805 of the deferred revenue at March 31, 2000 was current.
Risk Factors
You should carefully consider the risks described below in evaluating our company. In addition, you should keep in mind that the risks described below are not the only risks that we face. The risks described below are the risks that we currently believe are material risks. However, additional risks not presently known to us, or risks that we currently believe are not material, may also impair our business operations. Moreover, you should refer to the other information contained in this Form 10-Q and in our Form 10-K for the year ended December 31, 1999 as filed with the Securities and Exchange Commission for a better understanding of our business. All dollar references are in thousands.
Our business, financial condition, or results of operations could be adversely affected by any of the following risks. If we are adversely affected by these risks, then the trading price of our common stock could decline, and you could lose all or part of your investment.
Risks Related to Our Business
Because our business model is new and unproven, we may not succeed in generating sufficient
revenues to sustain or increase our business.
Our success depends upon our ability to generate network transaction fees based on a percentage of the sales fulfilled by our customers using our solution. This business model is unproven, our customers have only recently begun to use our solution to distribute their products and we have not received
8
significant network transaction fees under this transaction fee model. If we are unable to generate significant revenues from network transaction fees, our current revenues, consisting of annual minimum network transaction fees payable upon execution and renewal of customer agreements, will be insufficient to sustain our business. If customers wish to use different business models, such as the payment of a one-time license fee instead of ongoing network transaction fees, our revenues will suffer and we may not be able to grow our business. Our existing customers may not elect to renew their agreements or they, as well as future customers, may seek more favorable terms.
Our limited operating history makes it difficult for you to evaluate our business and your investment.
We were formed in April 1998 to acquire all of the outstanding equity interests of Preview Software and Portland Software. These acquisitions closed in August 1998. Prior to August 1998, Portland Software and Preview Software had achieved only limited distribution of their respective products. For example, in 1998, 1997, and 1996, total revenues generated by both businesses combined were $809, $763, and $335, respectively. For the year ended December 31, 1999, our total revenues were $3,483. A majority of our significant customers entered into their agreements with us since September 1998. Accordingly, we have a limited operating history and you have little historical basis upon which to evaluate our business, products, markets and general prospects of your investment.
If our relationship with Ingram Micro does not succeed, our revenues will suffer and we may be unable to sustain or increase our business.
Our relationship with Ingram Micro, the leading wholesale distributor of computer-based technology products and services worldwide, is significant to us financially and is key to our strategy of building networks of participants using our solution. Ingram Micro only commenced commercial deployment of an electronic software distribution program using our solution in November 1999. Moreover, Ingram Micro is not obligated to use our solution under our non-exclusive agreement. If Ingram Micro fails to successfully deploy an electronic software distribution program using our solution or fails to generate significant software sales using our solution, our business will be seriously harmed. Our agreement with Ingram Micro, which we entered into on June 30, 1999, has an initial one-year term. Any failure to renew, or termination of, this agreement could result in revenue shortfalls, preventing us from growing or sustaining our business.
We expect operating expenses to increase significantly, we have incurred significant net losses and we expect our losses will continue in the future.
As of March 31, 2000, we had an accumulated deficit of $37,989. We experienced a net loss of $7,047 for the quarter ended March 31, 2000 and net losses of $17,054, $11,276 and $2,380 in 1999, 1998 and 1997, respectively. We have not achieved profitability and we expect significant operating losses and negative cash flow to continue for at least the next two years, and possibly longer. Our losses will continue to increase because we expect to incur additional costs and expenses related to research and development as well as expanding our organization, especially in general and administrative functions, sales, marketing and consulting.
In addition, we are in the early stages of expanding our solution to address electronic distribution of digital music. We anticipate that this effort will entail additional significant increases in research and development costs as well as in sales and marketing. We do not expect to recognize meaningful revenues from the music business for at least the next 12 months, if ever. Because we will spend these amounts before we receive any incremental revenues from these efforts, our losses will be greater than the losses we would incur if we developed our business more slowly. In addition, we may find that these efforts are more expensive than we currently anticipate, which would further increase our losses.
9
The loss of any of our current major customers would cause our revenues to decline.
Three customers combined, Sony Marketing of Japan, Ingram Micro and ReleaseNow.com, accounted for 34% of our total revenues in the first quarter of 2000. Sony Marketing and Ingram Micro combined accounted for approximately 38% of our revenues in 1999. Sony Marketing accounted for approximately 45% of our revenues in 1998. We expect that a small number of customers will account for a significant percentage of our future revenues, although we can give you no assurance in that regard. We expect that a small percentage of our customers will continue to account for a substantial portion of our revenues for at least the next 12 months. Contracts with these customers are generally short term in nature, varying in length from one to three years, and can be terminated by the customer on short notice without significant penalties. If any one of these contracts is not renewed or otherwise ends, we would lose a large portion of our revenues.
If a significant number of distribution channel participants do not agree to sell digital goods through our solution, we may not be successful.
The distribution channel for digital goods is complex and multi-tiered, consisting of publishers, which sell to distributors, resellers and end customers; distributors, which sell to resellers; original equipment manufacturers, which sell to resellers and end customers; and resellers, which sell to end customers. Unless a significant number of these channel participants adopts our solution in a timely manner, we will not achieve the critical mass of participants we believe necessary for our success. Our success depends on the adoption of our solution not only by our customers but by the distribution channel partners of our customers as well. For example, in order for a distributor to sell digital goods using our solution, the publisher of the goods must consent to distribute its goods electronically and the reseller of the goods must also agree to use our solution. We do not know whether our customers' distribution channel partners will agree to use our solution. We depend on our customers to obtain publisher consents and to facilitate the adoption of our solution by their distribution channel partners. Unless a significant number of our customers' distribution channel partners agree to sell digital goods through our solution, we may not be able to earn enough revenues from our network transaction fees to become profitable or execute our business model.
If Microsoft does not consent to the electronic distribution of its products through distributors using our solution or adopt our solution for direct sales, we may be unable to increase our revenues or become profitable.
Sales of Microsoft products accounted for approximately 13% of worldwide software sales in 1998 based on Microsoft's public reports and industry analyst data. If Microsoft does not consent to the electronic distribution of its products through distributors using our solution or adopt our solution for direct sales, we will lose a significant revenue opportunity. Additionally, Microsoft may initiate its own standard for the electronic distribution of its software over the Internet. Microsoft has initiated programs for the secure electronic distribution of music. If distribution channel participants favor Microsoft's existing or future solution for electronic distribution of digital goods, we may be unable to increase our revenues or become profitable.
Our sales cycle is lengthy and unpredictable which could cause us to fail to achieve projected results.
Our sales cycle is a long and complex process. If network transaction fees are delayed or reduced as a result of this process, our future revenue and operating results could be impaired. Our sales process requires a significant level of education regarding the use and benefits of our solution. The purchase and deployment of our solution involves a significant commitment of capital and other resources. As a result, our customers typically spend substantial time performing internal reviews and obtaining corporate approvals before making a purchasing decision. Accordingly, the period between our initial sales call and the signing of a contract with significant sales potential typically ranges from four to six months and can be
10
significantly longer. Therefore, the timing of sales to new customers is difficult to predict. Delays in receiving signed contracts with major customers could cause us to fail to achieve our projected results, as well as those of industry analysts, which would have a severe adverse effect on the price of our stock.
Our solution has not been used under high-volume transaction conditions and it may not meet the demands of our high-volume customers.
Our solution has not yet been subjected to the volume of business and the complexity we anticipate will be required to fully support the future transactions of our largest customers. If our solution is not capable of processing the necessary volume of transactions, our business will be seriously harmed because the number of revenue generating transactions using our solution will be limited, customers may elect to use another solution and we may be exposed to adverse publicity. In addition, it is likely that production software tools, diagnostic tools and maintenance upgrades, as well as significant financial and other resources, will be required to achieve reliability and resolve technical issues related to large-scale transactions.
If our maintenance and upgrades to our solution disrupt our customers' operations, we may suffer lost revenues and harm to our reputation.
We will need to upgrade and improve our solution periodically. Upgrading or deploying a new version of our solution requires the cooperation of our existing customers and their network participants. These network participants may be reluctant to upgrade our solution since this process can be complicated and time-consuming and poses the risk of network failures. If our periodic upgrades and maintenance cause disruptions, we will lose revenue generating transactions, our customers may elect to use other solutions and we may also be the subject of negative publicity that may further adversely affect our business and reputation.
Delays caused by integrating our solution with channel participants' existing systems may cause
revenue shortfalls in a particular quarter.
Our customers and their distribution channel partners must integrate our solution into their existing systems or a new system. Our business model is based on receiving network transaction fees. Thus, our success depends upon the timely and successful deployment of our solution by customers and their distribution channel partners for the distribution and licensing of digital goods.
The timing and success of commercial deployment depends upon the:
We have, in the past, experienced, and continue to experience, delays in the period between entering into a licensing arrangement and the time a customer commercially deploys our solution. We expect that this period will continue to vary widely from customer to customer.
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Variations in the volume of sales of digital goods and services over the Internet will cause fluctuations in our quarterly operating results, which could cause our stock price to decline.
The amount of network transaction fees we receive in any given quarter will depend on the sales of digital goods that occur using our solution. Because sales of digital goods using our solution are outside of our control, it will be difficult for us to make accurate quarterly revenue projections, even if our solution is deployed commercially by our licensees. In addition, our revenues will depend on the number of new deployments of our solution that occur in a particular quarter. However, in the short term, our operating expenses are relatively fixed and based in part on our revenue projections. As a result, if our revenue projections are not accurate for a particular quarter, our operating results for that quarter could fall below the expectations of analysts and investors. Our failure to meet these expectations would likely cause the market price of our common stock to decline significantly and rapidly.
Security breaches to our encryption technology may harm our reputation and business and may cause us to expend significant additional resources to protect against future breaches.
Individuals, referred to as crackers, have in the past gained unlicensed access to secured digital goods distributed through our solution. While we expend significant efforts to make unauthorized access increasingly difficult, we expect that determined crackers will continue their attempts to crack our solution and may prove successful. We may have to expend significant resources to alleviate problems caused by these attempts to crack our solution.
Any breach of our security systems could harm our reputation, which could materially harm our business. A party who is able to circumvent our security measures could misappropriate digital goods without paying the required license fees, gain unauthorized access to proprietary information, erase or modify electronic audit trails, or disrupt our customers' operations. Security breaches could also harm our reputation and expose us to litigation and liability. We cannot assure you that our security measures will prevent security breaches or that a failure to prevent such security breaches will not seriously harm our business.
We do not expect to recognize any significant revenues from the use of our solution by our customers to sell digital music for at least the next 12 months, and we may not ever recognize meaningful revenues from these sales.
We have only recently begun to market our solution for electronic distribution of music and few customers are currently using our solution to distribute music. As a result, we do not believe that we will recognize any significant revenue from the use of our solution to sell music or any type of digital goods other than software for at least the next 12 months, if at all. We expect to incur significant expenses to develop and promote the use of our solution for the electronic distribution of music. If electronic distribution of music fails to develop or we are unable to penetrate this market, we will have expended a great deal of time, effort and financial resources that could have been directed to more beneficial activities. In addition, our business may be adversely impacted if our efforts are not successful.
Several factors create risk in our ability to be successful in the this market, including:
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provide a viable solution for electronic distribution of music. Even if we successfully incorporate the content protection agent system into our solution, it may not provide adequate security.
Our intellectual property rights are difficult and costly to protect because our industry is characterized by the existence of a large number of patents and frequent litigation. This may place a significant burden on our management team and may make it difficult for us to operate our business successfully.
The digital encryption and distribution industry is characterized by the existence of a large number of patents and frequent litigation based on allegations of patent infringement and the violation of other intellectual property rights. We regard our patents, copyrights, trademarks, trade dress, trade secrets, and similar intellectual property as critical to our success. We have 9 patents issued or allowed and an additional 15 applications pending with the United States Patent and Trademark Office. Our proprietary technologies will be protected from unauthorized use by third parties only to the extent that they are covered by valid and enforceable patents or copyrights or are effectively maintained as trade secrets. These legal protections afford only limited protection and may be time consuming and expensive. In addition, litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets or to determine the validity and scope of the proprietary rights of others. Litigation could result in substantial costs and diversion of management and technical resources away from our business operations. Despite our efforts, we may be unable to prevent third parties from infringing upon or misappropriating our intellectual property. If we are not able to protect our intellectual property rights, our business may not succeed.
Factors outside our control may limit our expansion in international markets and may prevent us from developing international revenues.
Although we sell our solution to customers outside the United States, we might not succeed in expanding our international presence. As a result of our agreement with Sony Marketing of Japan, which provides them the exclusive right to distribute our products in Japan, our success in this market depends on their efforts and ability to sell our solution. This grant of an exclusive right to Sony Marketing may prevent widespread adoption of our solution by the Japanese market, which may prevent us from becoming a widely-used solution in Japan.
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Conducting our business outside the United States subjects us to unfavorable international regulations and conditions affecting businesses that operate in our industry and could cause our international business to fail.
Conducting our business outside of the United States is subject to additional risks related to our business which are largely outside our control, including:
One or more of these factors may materially and adversely affect our future international operations, and consequently, our business.
If our key employees do not continue to work for us, our business will be harmed because competition for replacements is intense.
We are substantially dependent on the continued services of our officers and key personnel who are all at-will employees. These individuals have acquired specialized knowledge and skills with respect to our business. As a result, if any of these individuals were to leave, we could face substantial difficulty in hiring qualified successors and could experience a loss in productivity while the new employee obtains the necessary training and experience. We expect that we will need to hire additional personnel in all areas. The competition for qualified personnel in our industry is intense, particularly in the San Francisco Bay Area, where our corporate headquarters are located. At times, we have experienced difficulties in hiring personnel with the right training or experience, particularly in technical areas. New employees require extensive training and typically require four to six months of training to achieve full productivity. Our success depends on attracting and retaining personnel.
We may need to raise additional funds in the future, which could result in dilution.
We require substantial working capital to fund our business. We expect our existing capital resources to be sufficient to meet our working capital and capital expenditure needs for at least the next 12 months. After that, we may need to raise additional funds, and additional financing may not be available on favorable terms, if at all. This could seriously harm our business and operating results. Furthermore, if we issue additional equity securities, stockholders may experience dilution, and the new equity securities could have rights senior to those of existing holders of our common stock. If we raise additional funds through the issuance of debt securities, holders of these securities could have rights, preferences, and privileges senior to holders of common stock, and the terms of this debt could impose restrictions on our operations. If we need to raise funds and cannot do so on acceptable terms, we may not be able to develop or enhance our solution, take advantage of future opportunities, or respond to competitive pressures or unanticipated requirements.
Our executive officers and directors will continue to have substantial ownership control over us, which could delay or prevent a merger or other change in control.
As of May 2, 2000, our executive officers, directors and entities affiliated with them, in the aggregate, beneficially owned approximately 34.2% of our outstanding common stock. These stockholders, if acting
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together, would be able to influence significantly the election of directors and all other matters requiring approval by our stockholders. This concentration of voting control could have the effect of delaying or preventing a merger or other change in control, even if it would benefit our other stockholders.
Some provisions of our charter documents may have anti-takeover effects that could discourage a change in control, even if an acquisition would be beneficial to our stockholders.
Our certificate of incorporation, our bylaws and Delaware law contain provisions that could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders. These provisions include:
Substantial sales of our common stock could depress our stock price.
Substantial sales of our common stock could depress our stock price. If our stockholders sell substantial amounts of our common stock in the public market, the market price of our common stock could fall. Based on 16,924,436 shares outstanding as of May 2, 2000, we had 4,435,407 shares of common stock eligible for sale in the public market. The remaining shares of common stock outstanding are subject to lock-up agreements that prohibit the sale of shares for 180 days from the date of our initial public offering (December 8, 1999). Immediately after the 180 day lock-up period, the remaining outstanding shares of our common stock will become available for sale in the public market, except in the case of 4,797,199 shares which are subject to the expiration of one-year holding periods and/or the lapse of our repurchase options.
We expect to make future acquisitions where advisable and acquisitions involve numerous risks. Our business is highly competitive, and as such, our growth is dependent upon market growth and our ability to enhance our existing solution and introduce new products and services on a timely basis.
One of the ways we anticipate addressing the need to enhance our solution and develop new products is through acquisitions of other companies or technologies where advisable.
Acquisitions involve numerous risks, including the following:
Mergers and acquisitions of high technology companies are inherently risky, and no assurance can be given that any acquisition will be successful and will not materially adversely affect our business, operating results or financial condition. We must also maintain our ability to manage any such growth effectively. Failure to manage growth effectively and successfully integrate acquisitions made by us would materially harm our business and operating results.
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Risks Related to Our Industry
The success of our business will largely depend on the widespread acceptance of commerce in digital goods over the Internet.
The use of the Internet for distribution and licensing of digital goods may not be commercially accepted for a number of reasons, including:
In addition, our business will be seriously harmed if publishers, distributors or resellers of digital goods are unwilling to sell their digital goods over the Internet. These factors are outside of our control. If commerce in digital goods does not achieve widespread market acceptance or grow significantly, we may be unable to generate sufficient revenue to sustain our business.
Our market is subject to rapid technological changes; we may not be able to introduce new products and enhancements on a timely basis, impairing our ability to generate future revenue.
The market for electronic distribution and licensing of digital goods is fragmented and marked by rapid technological change, frequent new product introductions and enhancements, uncertain product life cycles, and changes in customer demands. There is currently no standard for electronic distribution and licensing of digital goods. New products based on new technologies or new industry standards can quickly render existing products obsolete and unmarketable. In the past we have experienced delays in new product releases and we may experience similar delays in the future. Any delays in our ability to develop and release enhanced or new systems could seriously impair our ability to generate future revenue.
We are in a highly competitive industry, and we expect to face increased competition in the future; increased competition may reduce our revenues and market opportunity.
The market for electronic distribution and licensing of digital goods is new, rapidly evolving and intensely competitive. We expect competition to intensify in the future. We currently compete directly with other providers of electronic commerce solutions for digital goods such as Cybersource, Digital River and InterTrust Technologies. More broadly, we compete with other providers of technology to secure digital content such as AT&T, IBM, Liquid Audio, Microsoft, Real Networks, and Xerox, as well as solutions developed in-house. In the future, operating system manufacturers may include digital rights management solutions in their operating systems.
We believe that the principal competitive factors in our markets include:
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Many of our current and potential competitors have longer operating histories, larger customer bases, greater brand recognition and much greater financial, marketing and other resources than we do. In addition, larger, well-established and well-financed entities may acquire, invest in or form joint ventures with competitors as the use of the Internet and other online services increases. Increased competition may result in reduced prices, and loss of market share may negatively impact our ability to obtain network transaction fees. In addition, adoption by publishers, distributors and resellers of competing systems may significantly limit the size of the potential market for our solution. We may not be able to compete successfully against current and future competitors, and any inability to do so would materially adversely affect our business.
We may be sued for violating the intellectual property rights of others.
The digital encryption and distribution industry is characterized by the existence of a large number of patents and frequent litigation based on allegations of patent infringement and the violation of other intellectual property rights. We have not completed an in-depth and exhaustive analysis of such patents or applications. Some of our competitors have extensive patent portfolios with broad claims. As the number of competitors in the market grows and the functionality of our solution increases, the possibility of an intellectual property claim against us increases. In addition, because patent applications can take many years to issue, there may be a patent application now pending, of which we are unaware, which will cause us to be infringing when it is issued in the future. Moreover, we expect to receive more patent infringement claims as companies increasingly seek to patent their software, especially in light of recent developments in the law that extend the ability to patent software. To address these patent infringement or other intellectual property claims, we may have to redesign our solution to avoid infringement or enter into royalty or licensing agreements on disadvantageous commercial terms. We may be unable to successfully redesign our solution or obtain a necessary license. A successful claim against us or our licensees, or our failure to design around the infringed technology or license it or similar technology, would harm our business. In addition, any infringement or other intellectual property claims, with or without merit, which are brought against us could be time consuming and expensive to litigate or settle and could divert management's attention from our business.
In April 1998, our predecessor and subsidiary, Portland Software, received a letter from representatives of TAU Systems Corporation informing us of two patents held by TAU Systems. In the letter, the representatives stated their opinion that Portland Software's ZipLock System software contained various elements recited in the two patents and requested that Portland Software discuss licensing the technology of these patents. Portland Software responded to the letter stating that although it had not undertaken a detailed review of the patents, it was unaware of any of its products having one of the elements required by the patent claims. In March 1999, we received correspondence from TAU Systems, essentially reiterating the above claims. In August 1999, after further investigation of the TAU Systems patents, we notified TAU Systems that we do not believe our software falls within the scope of coverage of TAU Systems' patents and, therefore, we were not interested in licensing arrangements. We have not received further correspondence from TAU Systems. On March 30, 1999, the United States District Court for the District of Connecticut dismissed a lawsuit filed by E-Data against several defendants, including Portland Software, alleging that they infringed E-Data's U.S. Patent No. 4,528,643 ("System for Reproducing Information in Material Objects at a Point of Sale Location") issued July 9, 1985. Although the suit was dismissed, it may be reinstated depending upon the outcome of E-Data's appeal before the Federal Circuit of a New York district court's dismissal of a prior patent infringement suit on the same patent that was filed by E-Data
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against different defendants. In the future, we, or our licensees, could be found to infringe upon the patent rights of TAU Systems, E-Data or other companies.
We have been, and may in the future be, subject to litigation that may adversely affect us.
From time to time we have been, and may in the future be, subject to legal proceedings and claims in the ordinary course of our business, including claims of alleged infringement of third-party intellectual property rights by us and our licensees. We were subject to litigation initiated by 20/20 Software, Inc. in the United States Court for the District of Northern California. The 20/20 complaint alleged copyright infringement, unfair competition, interference with prospective economic advantage and misappropriation of trade secrets and confidential information of 20/20. On October 21, 1999, we entered a settlement agreement with 20/20 regarding these claims for an amount which was not material and with no admission of liability. On December 21, 1999, 20/20's counsel sent us a letter indicating that 20/20 continued to believe that we had misappropriated 20/20's technology and 20/20 therefore intended to assert additional claims. Our counsel responded that any such claims would be covered by the prior settlement agreement. As of now, it remains unclear whether 20/20 will in fact assert any future claims or, if so, on what basis such claims might be asserted. Claims like these, whether or not meritorious, could result in the expenditure of significant financial and managerial resources and could materially and adversely affect our business.
Legal uncertainties and potential government regulation could increase our costs and be a barrier to doing business.
To date, communications and commerce on the Internet have not been highly regulated. State and federal governments may decide to enact new laws or regulations at any time and it may take years to determine the extent to which existing laws relating to issues including property ownership, defamation, and personal privacy apply to the Internet. Any new laws or regulations or implementations of existing laws and regulations relating to the Internet could harm our business.
The European Union has adopted a privacy directive that regulates the collection and use of information that identifies an individual person. These regulations may inhibit or prohibit the collection and sharing of personal information in ways that could harm our partners or us. The globalization of Internet commerce may be harmed by these and similar regulations since the European Union privacy directive prohibits transmission of personal information outside the European Union unless the receiving country has enacted individual privacy protection laws at least as strong as those enacted by the European Union privacy directive. The United States and the European Union have not yet resolved this matter, and they may not ever do so, in a manner favorable to our customers or us.
Imposition of sales and other taxes on electronic commerce transactions may hinder electronic commerce.
The taxation of commerce activities in connection with the Internet has not been established, may change in the future and may vary from jurisdiction to jurisdiction. One or more states or other countries may seek to impose sales or other taxes on companies that engage in or facilitate electronic commerce. A number of proposals have been made at the local, state and international level that would impose additional taxes on the sale of products and services through the Internet. These proposals, if adopted, could substantially impair the growth of electronic commerce and could significantly harm our business. Moreover, if any state or other country were to assert successfully that we should collect sales or other taxes on the exchange of products and services through the Internet, our business may be harmed.
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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.
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 as a result of numerous factors such as:
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 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. These broad market and industry factors may materially, adversely affect the market price of the 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 could materially adversely affect our business, financial condition and operating results.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
We develop products in the United States and make agreements with customers in North America, Europe, and Asia. As a result, our financial results could be adversely affected by various factors, including foreign currency exchange rates or weak economic conditions in foreign markets. Network transaction fees from our European and Asian partners will be primarily denominated in foreign currencies and generally translated on a monthly basis to U.S. dollars to determine the amount of fees we are due. As a result, we could be affected adversely by fluctuations in foreign currency exchange rates.
Our exposure to market risk for changes in interest rates is limited to the exposure related to our debt instruments and credit facilities, which are tied to market rates. We do not plan to use derivative financial instruments in our investment portfolio. We plan to ensure the safety and preservation of our invested principal funds by limiting default risk market risk, and reinvestment risk. We plan to mitigate default risk by investing in high credit quality securities.
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Item 1. Legal Proceedings
See "Risk Factors—We may be sued for violating the intellectual property rights of others" and "We have been, and may in the future be, subject to litigation that may adversely affect us."
Item 2. Changes in Securities and Use of Proceeds
The Company filed a registration statement on Form S-1, File No. 333-87181, for an initial public offering of Common Stock, which was declared effective by the Securities and Exchange Commission on December 8, 1999. In that offering, the Company sold an aggregate of 4,370,000 shares of its Common Stock with net offering proceeds of $82.4 million. As of March 31, 2000, the Company had used approximately $5.4 million of those proceeds as follows:
| Cash loss from operations | $ | 3.5 million | |
| Working capital | $ | 1.1 million | |
| Purchases of property and equipment | $ | 0.8 million |
No payments were made to directors or officers of the Company or their associates, holders of 10% or more of any class of equity securities of the Company or to affiliates of the Company.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
The exhibits filed as a part of this report are listed below and this list is intended to constitute the exhibit index.
| Exhibit No. |
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|---|---|---|
| 27 | Financial Data Schedule |
(b) Reports on Form 8-K
There were no reports on Form 8-K filed during the quarter ended March 31, 2000.
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Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| Date: May 8, 2000 | PREVIEW SYSTEMS, INC. | |||
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By: |
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/s/ G. BRADFORD SOLSO |
| G. Bradford Solso Chief Operating Officer and Chief Financial Officer (Principal Financial and Accounting Officer) |
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