<PAGE> 1
================================================================================
FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
(Mark one)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934.
For the quarterly period ended January 28, 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: 000-28369
VA LINUX SYSTEMS, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 77-0399299
-------- ----------
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
1382 BORDEAUX DRIVE, SUNNYVALE, CALIFORNIA 94089
------------------------------------------------
(Address of principal executive offices) (Zip code)
(408) 542-8600
--------------
(Registrant's telephone number, including area code)
NOT APPLICABLE
--------------
(Former name, former address and former fiscal year,
if changed since last report)
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.
Title of Class Outstanding at February 29, 2000
Common Stock, $0.001 par value 41,385,986
================================================================================
<PAGE> 2
VA Linux Systems, Inc.
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PAGE NO.
--------
<S> <C> <C>
PART I. FINANCIAL INFORMATION 3
Item 1. Financial Statements 3
Condensed Balance Sheets at January 28, 2000 and
July 31, 1999 3
Condensed Statements of Operations for the three and
six months ended January 28, 2000 and January 31, 1999 4
Condensed Statements of Cash Flows for the six months
ended January 28, 2000 and January 31, 1999 5
Notes to Condensed Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 8
Item 3. Quantitative and Qualitative Disclosures About
Market Risk 28
PART II. OTHER INFORMATION II-1
Item 2. Changes in Securities and Use of Proceeds II-1
Item 4. Submission of Matters to a Vote of Security Holders II-1
Item 6. Exhibits and Reports on Form 8-K II-2
Signatures II-3
</TABLE>
2
<PAGE> 3
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
VA LINUX SYSTEMS, INC.
CONDENSED BALANCE SHEETS
(In thousands)
<TABLE>
<CAPTION>
JANUARY 28, JULY 31,
2000 1999
----------- --------
(unaudited)
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 148,510 $ 18,653
Accounts receivable, net 11,537 4,033
Inventories -- 1,971
Prepaid expenses and other assets 1,470 381
--------- --------
Total current assets 161,517 25,038
Property and equipment, net 2,931 1,759
Other assets 807 798
--------- --------
$ 165,255 $ 27,595
========= ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Current portion of loans and notes payable $ 563 $ 759
Accounts payable 9,629 6,243
Accrued warranty 607 239
Accrued liabilities and other 3,737 1,567
--------- --------
Total current liabilities 14,536 8,808
--------- --------
Loans and notes payable, net of current portion 575 424
--------- --------
Stockholders' equity:
Convertible preferred stock -- 19
Common stock 41 15
Additional paid-in capital 219,956 45,461
Stockholder note receivable -- (50)
Deferred stock compensation (28,376) (12,121)
Accumulated deficit (41,477) (14,961)
--------- --------
Total stockholders' equity 150,144 18,363
--------- --------
$ 165,255 $ 27,595
========= ========
</TABLE>
The accompanying notes are an integral part of these financial statements.
3
<PAGE> 4
VA LINUX SYSTEMS, INC.
CONDENSED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
(Unaudited)
<TABLE>
<CAPTION>
THREE MONTHS ENDED SIX MONTHS ENDED
--------------------------- --------------------------
JANUARY 28, JANUARY 31, JANUARY 28, JANUARY 31,
2000 1999 2000 1999
----------- ----------- ----------- -----------
<S> <C> <C> <C> <C>
Net revenues $ 20,191 $ 3,170 $ 35,039 $ 5,605
Cost of revenues 17,356 3,324 30,243 5,377
-------- -------- -------- -------
Gross margin 2,835 (154) 4,796 228
Operating expenses:
Sales and marketing 7,111 406 12,175 583
Research and development 2,431 216 5,205 264
General and administrative 1,658 654 3,154 790
Amortization of deferred stock
compensation 4,258 371 7,113 489
-------- -------- -------- -------
Total operating expenses 15,458 1,647 27,647 2,126
-------- -------- -------- -------
Loss from operations (12,623) (1,801) (22,851) (1,898)
Interest and other income (expense), net 1,062 (14) 1,235 (14)
-------- -------- -------- -------
Net loss (11,561) (1,815) (21,616) (1,912)
======== ======== ======== =======
Dividend related to convertible
preferred stock -- -- (4,900) --
-------- -------- -------- -------
Net loss attributable to common
stockholders $(11,561) $ (1,815) $(26,516) $(1,912)
======== ======== ======== =======
Basic and diluted net loss per share $ (0.50) $ (0.57) $ (1.73) $ (0.46)
Pro forma basic net loss per share $ (0.36) $ (0.15) $ (0.90) $ (0.23)
Weighted-average shares
outstanding:
Basic and diluted 23,325 3,203 15,372 4,152
Pro forma basic 32,300 11,827 29,412 8,464
</TABLE>
The accompanying notes are an integral part of these financial statements.
4
<PAGE> 5
VA LINUX SYSTEMS, INC.
CONDENSED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
<TABLE>
<CAPTION>
SIX MONTHS ENDED
---------------------------
JANUARY 28, JANUARY 31,
2000 1999
----------- -----------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $ (21,616) $(1,912)
Adjustments to reconcile net loss to net
cash used in operating activities:
Depreciation and amortization 537 110
Loss on disposal of assets 177 84
Amortization of deferred stock compensation 7,113 489
Non-cash compensation expense 1,434 5
Changes in assets and liabilities:
Accounts receivable (7,504) (610)
Inventories 1,971 7
Prepaid expenses and other assets (1,162) (26)
Accounts payable 3,386 1,207
Accrued liabilities and other 2,172 208
Accrued warranty 368 (72)
--------- -------
Net cash used in operating activities (13,124) (510)
--------- -------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment (1,763) (447)
--------- -------
Net cash used in investing activities (1,763) (447)
--------- -------
CASH FLOWS FROM FINANCING ACTIVITIES:
Payments on loans and notes payable (45) (275)
Proceeds from stockholder note receivable 50 --
Proceeds from issuance of convertible preferred
stock, net 4,834 3,885
Proceeds from issuance of common stock, net 139,930 --
Repurchase of common stock (25) --
--------- -------
Net cash provided by financing activities 144,744 3,610
--------- -------
Net increase in cash and cash equivalents 129,857 2,653
Cash and cash equivalents, beginning of period 18,653 62
--------- -------
Cash and cash equivalents, end of period $ 148,510 $ 2,715
========= =======
</TABLE>
The accompanying notes are an integral part of these financial statements.
5
<PAGE> 6
VA LINUX SYSTEMS, INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS
JANUARY 28, 2000
(UNAUDITED)
NOTE 1 - Basis of Presentation
The condensed financial statements included herein have been prepared by
VA Linux Systems, Inc. ("VA Linux"), without audit, pursuant to the rules and
regulations of the Securities and Exchange Commission. Certain information and
footnote disclosures normally included in financial statements prepared in
accordance with generally accepted accounting principles have been condensed or
omitted pursuant to such rules and regulations. The condensed balance sheet as
of July 31, 1999 has been derived from the audited financial statements as of
that date, but does not include all disclosures required by generally accepted
accounting principles. VA Linux believes the disclosures included in the
unaudited condensed financial statements when read in conjunction with the
financial statements and the notes thereto included in VA Linux's Registration
Statement on Form S-1 declared effective by the Securities Exchange Commission
on December 9, 1999 are adequate to make the information presented not
misleading.
The unaudited condensed financial statements included herein reflect all
adjustments, which are in the opinion of management, necessary for a fair
presentation of financial position, results of operations and cash flows for the
periods presented. These adjustments are of a normal, recurring nature. The
results of operations for the three and six months ended January 28, 2000 and
January 31, 1999 are not necessarily indicative of the results that may be
expected for future quarters or the year ending July 28, 2000.
NOTE 2 - Significant Accounting Policies
Use of Estimates in Preparation of Financial Statements
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and the
disclosure of contingent assets and liabilities at the date of the financial
statements, and the reported amounts of revenue and expenses during the period.
Actual results could differ from those estimates.
Stock Split
Effective October 1998 and March 1999, the Company completed a 2-for-1
and 3-for-2 split, respectively, of its common stock. A 2-for-1 split of the
outstanding shares of common stock and Series B preferred stock and a 3-for-1
split of the outstanding shares of Series A preferred stock was approved by VA
Linux's Board of Directors in October 1999. All share and per share information
included in these financial statements have been retroactively adjusted to
reflect these stock splits.
Inventories
Inventories consisted of (in thousands):
<TABLE>
<CAPTION>
January 28, July 31,
2000 1999
---------- --------
<S> <C> <C>
Raw materials $ -- $1,813
Finished goods -- 158
----- ------
Total $ -- $1,971
</TABLE>
The inventory value as of January 28, 2000 was zero due to the sale, at
cost, of material to the Company's contract manufacturer.
Revenue Recognition
Product revenues from the sale of Linux-based servers and desktop
computers are recognized upon shipment of goods. The Company does not grant to
its customers any rights to return products. The Company provides allowances for
warranty costs at the time of shipment. Revenues from customer support services,
including on-site maintenance and technical support, are recognized pro-rata
over the term of the
6
<PAGE> 7
VA LINUX SYSTEMS, INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS (CONTINUED)
JANUARY 28, 2000
(UNAUDITED)
related service agreement. Revenues from professional service contracts,
including planning, deployment and installation, systems integration,
performance analysis and security consulting of Linux-based solutions, are
recognized as revenue upon project completion, or on the percentage completion
of the project where cost can be reasonably estimated. For the three and six
months ended January 28, 2000 and January 31, 1999, revenues from customer
support services and professional service contracts have not been material.
Net Loss Per Share
Basic and diluted net loss per share is calculated using the
weighted-average number of common shares outstanding during the period.
Pro forma basic net loss per share includes the conversion of the
Company's convertible preferred stock using the if-converted method into an
equivalent number of common shares as if the shares had been converted on the
dates of issuance.
<TABLE>
<CAPTION>
THREE MONTHS ENDED SIX MONTHS ENDED
--------------------------- --------------------------
JANUARY 28, JANUARY 31, JANUARY 28, JANUARY 31,
2000 1999 2000 1999
----------- ----------- ----------- -----------
(In thousands, except per share data)
<S> <C> <C> <C> <C>
Net loss attributable to common
stockholders $(11,561) $ (1,815) $(26,516) $(1,912)
======== ======== ======== =======
Basic and diluted net loss per share $ (0.50) $ (0.57) $ (1.73) $ (0.46)
Pro forma basic net loss per share $ (0.36) $ (0.15) $ (0.90) $ (0.23)
Weighted-average shares outstanding:
Basic and diluted 23,325 3,203 15,372 4,152
Pro forma basic 32,300 11,827 29,412 8,464
</TABLE>
Excluding deferred compensation of $4.3 million and other non-cash
charges of $1.0 million and calculated on a pro forma basis, diluted net loss
per share for the three months ended January 28, 2000 would have been ($0.20)
compared to ($0.15) for the three months ended January 31, 1999. The
non-recurring non-cash charges were associated with stock options issued for
recruiting and marketing services incurred prior to our initial public offering.
Comprehensive Income (Loss)
In June 1997, the Financial Accounting Standards Board issued SFAS No.
130, "Reporting Comprehensive Income," ("SFAS No. 130") which establishes
standards for reporting and presentation of comprehensive income. SFAS No. 130
was adopted by the Company in 1998. This standard defines comprehensive income
as the changes in equity of an enterprise except those resulting from
stockholder transactions. Comprehensive income (loss) for the three and six
months ended January 28, 2000 and January 31, 1999 equaled net income (loss).
Segment Reporting
In June 1997, the Financial Accounting Standards Board issued SFAS No.
131, "Disclosures About Segments of an Enterprise and Related Information"
("SFAS No. 131"). SFAS No. 131 establishes standards for disclosures about
operating segments, products and services, geographic areas and major customers.
The Company is organized and operates as one operating segment, the provision of
Linux-based products and services. The Company markets its products in the
United States through its direct sales force. Revenues for the three and six
months ended January 28, 2000 and January 31, 1999 were primarily generated from
sales to end users in the United States.
Supplier Concentration
7
<PAGE> 8
VA LINUX SYSTEMS, INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS (CONTINUED)
JANUARY 28, 2000
(UNAUDITED)
The Company is dependent on a single contract manufacturer for
substantially all of its manufacturing and supply chain management, including
component procurement and inventory management. The contract manufacturer is
also an investor in the Company. The inability of the manufacturer to fulfill
the production requirements of the Company or make distributions of the
Company's products on a timely basis could negatively impact future results.
Although there are other contract manufacturers that could provide similar
services, a change in the contract manufacturer could cause delays in
manufacturing and distribution of the Company's products and possible loss of
sales.
NOTE 3 - Initial Public Offering
In December 1999, the Company completed an initial public offering of
common stock that resulted in the issuance of 4,400,000 shares of common stock
with an initial public offering price of $30.00 per share. Upon closing of the
initial public offering, all of the outstanding shares of convertible preferred
stock were automatically converted into 19,921,322 shares of common stock. In
conjunction with the initial public offering, the underwriters exercised their
option to purchase an additional 660,000 shares to cover the over-allotments of
shares at the $30.00 per share offering price. The initial public offering
raised approximately $141 million after underwriting fees and $139 million after
all other direct costs.
NOTE 4 - Common Stock
As of January 28, 2000 there were 41,385,986 shares of common stock
issued and outstanding. This share number assumes the conversion of 19,921,322
outstanding shares of preferred stock into equal shares of common stock. The
conversion was effectuated in December 1999 upon the closing of the Company's
initial public offering. VA Linux is authorized to issue 250,000,000 shares of
common stock, $0.001 par value and 10,000,000 shares of preferred stock, $0.001
par value.
NOTE 5 - Subsequent Events
We have entered into an agreement and plan of reorganization with
Andover.Net, Inc. ("Andover.Net") to acquire all of the outstanding shares of
Andover.Net pursuant to a triangular merger with our wholly-owned subsidiary.
This acquisition is subject to various closing conditions. We filed a copy of
the definitive agreement related to this acquisition with the Securities and
Exchange Commission on Form 8-K on February 14, 2000.
8
<PAGE> 9
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Factors That May Affect Future Results
This report contains certain forward-looking statements (as such term is
defined in Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934) and information relating to the Company that
are based on the beliefs of the management of the Company as well as assumptions
made by and information currently available to the management of the Company
including statements related to the growth of the Company's business, the
performance of our contract manufacturer, Synnex. In addition, when used in this
report, the words "likely," "will," "suggests," "target," "may," "would,"
"could," "anticipate," "believe," "estimate," "expect," "intend," "plan,"
"predict" and similar expressions and their variants, as they relate to the
Company or the management of the Company, may identify forward-looking
statements. Such statements reflect the judgment of the Company as of the date
of this quarterly report on Form 10-Q with respect to future events, the outcome
of which is subject to certain risks, including the factors set forth in "Risk
Factors," which may have a significant impact on the Company's business,
operating results or financial condition. Investors are cautioned that these
forward-looking statements are inherently uncertain. Should one or more of these
risks or uncertainties materialize, or should underlying assumptions prove
incorrect, actual results or outcomes may vary materially from those described
herein. Although we believe that the expectations reflected in the
forward-looking statements are reasonable, we cannot guarantee future results,
levels of activity, performance or achievements. Moreover, neither we nor any
other person assumes responsibility for the accuracy and completeness of these
forward-looking statements. VA Linux undertakes no obligation to update forward
looking statements.
The following discussion and analysis should be read in conjunction with
the condensed financial statements and the notes thereto included in Item 1 in
this Quarterly Report and our registration statement on Form S-1 declared
effective by the Securities Exchange Commission on December 9, 1999 with the
SEC.
OVERVIEW
We are a leading provider of complete Linux-based solutions, integrating
systems, software and professional services. Our broad-based technical expertise
in systems and software design, as well as our focus on the Linux operating
system and related open source solutions, enables us to provide high-quality
Linux systems designed for optimal performance, reliability and scalability.
We were founded in January 1995, and grew very modestly until the end of
fiscal 1998. Since July 31, 1998, however, we have experienced significant
growth and have invested in hiring engineers with Linux expertise, growing our
direct sales force to better penetrate the market for Linux products and
marketing our brand. To further implement these strategies, we expanded our
operations, customer support and administrative infrastructure. As a result, our
employee base has grown from 15 at July 31, 1998 to 208 on January 28, 2000, and
our operating expenses grew significantly. This rapid growth has placed
significant demands on our management and operational resources. Since our
inception, we have incurred significant losses. At January 28, 2000, we had an
accumulated deficit of $41.5 million.
Our prospects must be considered in light of the risks, expenses and
difficulties frequently encountered by companies in their early stage of
development, particularly companies in new and rapidly evolving markets. These
risks for VA Linux include the emerging market for Linux products and our
ability to successfully manage our growth. To address these risks, we must:
- develop and increase our customer base;
- implement and successfully execute our business and marketing
strategy;
- continue to develop, introduce, market and sell new products
and services;
- successfully respond to competitive developments; and
- attract, retain and motivate quality personnel.
Net revenue in the second quarter of fiscal 2000 grew sequentially by
36.5% to $20.2 million compared to $14.8 million for the first quarter of fiscal
2000. The net revenue growth was based primarily on increased sales of our
server products. To date, substantially all of our revenues have been derived
from sales of systems and related customer support. Sales of our servers
accounted for approximately 59% of our net revenues in fiscal 1999,
approximately 88% in the quarter ended October 29, 1999 and 91% in the quarter
ended January 28, 2000. While we expect sales of our desktop and storage
products to increase, current and future generations of our server product
families will continue to represent a significant majority of our net revenues
through fiscal 2000.
VA Linux has targeted the Internet market for strategic emphasis. This
segment includes customers in the ISP, ASP, web caching and e-tailing
businesses. In the second quarter of fiscal 2000, sales to customers in this
segment represented
9
<PAGE> 10
61% of our revenue. The scientific market is also an important market for us and
represented 15% of our revenue. We expect that these two market segments will
continue to be the central focus of our sales efforts.
We recognize revenues from product sales upon shipment. We do not grant
any rights to our customers to return products. We also provide allowances for
warranty costs at the time of shipment. Customer support fees are recognized
ratably over the term of the service contract.
We sell Linux expertise. This expertise is based upon our knowledge of
Linux and other open source software and is delivered through sales and support
of our hardware and through the delivery of professional services. Professional
services were 1.5% of our net revenue for the three month period ending January
28, 2000 as compared to 0% of our net revenue for the three month period ending
January 31, 1999.
We believe that the computer industry is generally characterized by
significant demand for professional services. In September 1999, we established
our professional services organization to expand our existing customer service
and support offerings to better address the demand for Linux expertise from our
customers. This organization offers a number of services, including systems
architecture and planning, deployment and installation, system integration, open
source product implementation, performance analysis and security consulting
services.
Professional services revenues are recognized upon project completion,
or by the percentage completion of a project where cost can be reasonably
estimated. Any payments made prior to completion are recorded as deferred
revenue.
Prior to January 1999, we sold our products to customers primarily in
response to telephone inquiries. During the third quarter of fiscal 1999, we
began implementing our direct sales strategy. Our direct sales organization
consists of field sales, telesales and sales support personnel. Although
indirect sales have been insignificant to date, we may pursue selective channel
opportunities to supplement our direct sales efforts. In addition, our
valinux.com web site permits customers to configure and order products online,
allowing us to more efficiently sell products and facilitate order processing.
Substantially all of our sales were processed through this web site. We intend
to continue to enhance our e-commerce solutions to foster closer relationships
with our customers and improve the efficiency of our sales process.
To date, substantially all of our sales have been in North America. We
expect to launch sales and marketing efforts internationally during fiscal 2000,
initially focusing on Europe. However, we expect international revenues to
represent a relatively small percent of our revenues, if any, in fiscal 2000.
We outsource virtually all of our manufacturing and supply chain
management operations, including inventory management and component procurement,
to Synnex, our contract manufacturer. We provide Synnex with five month rolling
forecasts based on anticipated product orders. Synnex uses these forecasts to
purchase components for our products. If we overestimate our component
requirements, Synnex may have excess inventory, which would increase our costs.
If we underestimate our component requirements, Synnex may have inadequate
inventory, which could interrupt their manufacturing of our products and result
in delays in system shipments. Any of these events could harm our business and
results of operations. Our agreement with Synnex may be terminated for any
reason at any time on delivery of 120 days advanced notice. A substantial
majority of our cost of revenues currently consists of payments to Synnex. Cost
of revenues also includes costs associated with our customer support and
professional services. Customer support costs include payments made to
DecisionOne, which provides call-center and onsite service functions to our
customers. We expect revenues from professional services to carry a higher gross
margin than our product revenues. We believe that future gross margin will
primarily be affected by:
- changes in components and manufacturing costs;
- the volume and mix of products and services sold;
- new product introductions both by us and our competitors;
10
<PAGE> 11
- changes in our pricing policies and those of our competitors;
- the size of customer orders; and
- the mix of domestic and international sales.
Prior to October 1998, we operated as a small closely-held company. As
such, we did not have the types of operational and financial controls normally
implemented by growing enterprises. During the second half of fiscal 1999, we
implemented or updated our operational and financial systems, procedures and
controls, including the implementation of an enterprise resource planning system
and an Internet-based ordering system. Our systems will continue to require
additional modifications and improvements, and possibly new systems, to respond
to future changes in our business. Implementation of these modifications and
improvements or new systems could be disruptive to our business.
In connection with the grant of stock options to employees during fiscal
1999 and the first six months of fiscal 2000, we recorded deferred stock
compensation of $14.4 million and $23.4 million, respectively, representing the
difference between the deemed fair market value of the common stock for
accounting purposes and the exercise price of these options as of the date of
grant. Deferred compensation is presented as a reduction of stockholders' equity
and is amortized on an accelerated basis over the vesting period of the
applicable options, generally four years. We expensed $4.3 million and $7.1
million of deferred compensation during the three and six months ended January
28, 2000. Based on option grant activity through January 28, 2000, we expect to
amortize deferred stock compensation of $9.2 million during the remaining six
months of fiscal 2000.
11
<PAGE> 12
RESULTS OF OPERATIONS
The following table sets forth financial data for the periods indicated
as a percentage of net revenue.
<TABLE>
<CAPTION>
PERCENTAGE OF NET REVENUE
-----------------------------------------------------
THREE MONTHS ENDED SIX MONTHS ENDED
------------------------- -------------------------
JANUARY 28, JANUARY 31, JANUARY 28, JANUARY 31,
2000 1999 2000 1999
----------- ----------- ----------- -----------
<S> <C> <C> <C> <C>
Net revenues 100.0% 100.0% 100.0% 100.0%
Cost of revenues 86.0 104.9 86.3 95.9
----- ----- ----- -----
Gross margin 14.0 (4.9) 13.7 4.1
Operating expenses:
Sales and marketing 35.2 12.8 34.7 10.4
Research and development 12.0 6.8 14.9 4.7
General and administrative 8.2 20.6 9.0 14.1
Amortization of deferred stock
compensation 21.1 11.7 20.3 8.7
----- ----- ----- -----
Total operating expenses 76.5 51.9 78.9 37.9
----- ----- ----- -----
Loss from operations (62.5) (56.8) (65.2) (33.8)
Interest and other income (expense),
net 5.3 (0.4) 3.5 (0.2)
----- ----- ----- -----
Net loss (57.2) (57.2) (61.7) (34.0)
===== ===== ===== =====
Dividend related to convertible
preferred stock -- -- (14.0) --
----- ----- ----- -----
Net loss attributable to common
stockholders (57.2%) (57.2%) (75.7%) (34.0%)
===== ===== ===== =====
</TABLE>
THREE AND SIX MONTHS ENDED JANUARY 28, 2000 AND JANUARY 31, 1999
NET REVENUES
Net revenues for the three months ended January 28, 2000 grew to $20.2
million from $3.2 million for the three months ended January 31, 1999, which
represents an increase of 537%. Net revenues increased by 525% to $35.0 million
for the first six months in fiscal 2000 compared to $5.6 million for the first
six months of fiscal 1999. Sales growth was primarily attributable to the
strength of our server products designed for the Internet market and an increase
in our customer base. Virtually all of our sales are to customers in the United
States and Canada.
For the first six months in fiscal 2000, our top ten customers accounted
for approximately 38.5% of net revenues. For the same period in fiscal 1999, our
top ten customers accounted for 21.3% of net revenues. Akamai Technologies,
which represented 12.1% of net revenues, was the only customer to account for
more than 10% of net revenues in the first six months of fiscal 2000. No other
customer accounted for more than 10% of net revenues during any of the periods
presented.
In the three months ended January 28, 2000, professional services
revenue contributed $0.3 million, representing 1.5% of total revenue, as
compared to zero revenue for the three months ended January 31, 1999. For the
six months ended January 28, 2000, revenue from professional services was $0.3
million, compared to zero revenue for the six months ended January 31, 1999.
COST OF REVENUES
12
<PAGE> 13
Cost of revenues increased to $17.4 million for the three months ended
January 28, 2000, as compared to $3.3 million during the same period ended
January 31, 1999. Cost of revenues for the first six months of fiscal 2000
increased to $30.2 million from $5.4 million for the same period of fiscal 1999.
The gross margin percentage was 14.0% and 13.7% for the three months and six
months, respectively, ended January 28, 2000, as compared to (4.9%) and 4.1% for
the three months and six months, respectively, ended January 31, 1999. The
improved margins were due to lower component costs as we benefited from our
relationship with a different contract manufacturer, Synnex, and continued
leverage of our manufacturing and customer support infrastructure as unit
volumes increased. There was no significant contribution from professional
services to gross margins during this fiscal quarter. We expect continued
sequential improvement in our gross margins going forward due to increased
revenues from our professional services, increased unit volumes which allow us
to gain certain cost advantages, and the introduction of new products.
SALES AND MARKETING EXPENSES
In absolute dollars, sales and marketing expenses increased to $7.1
million for the three months ended January 28, 2000 and $12.2 million for the
first six months of fiscal 2000 from $0.4 million and $0.6 million,
respectively, for the three months and six months ended January 31, 1999. For
the second quarter and the first six months of fiscal 2000 the increase reflects
expenses associated with sales growth, increased marketing infrastructure and
branding activities, and non-recurring non-cash charges associated with stock
options issued for recruiting and marketing services incurred prior to our
initial public offering. Sales and marketing expenses were 35.2% of net revenues
for the second quarter of fiscal 2000 and 34.7% of net revenues for the first
six months of fiscal 2000, an increase of 22.4 percentage points and 24.3
percentage points, respectively, when compared to the same periods of fiscal
1999. The increase as a percentage of net revenues was due to the planned
investment in infrastructure to support expected future growth. Excluding the
one-time non-cash charges, sales and marketing expense would have been 30.3% of
net revenues for the second quarter of fiscal 2000. We expect that sales and
marketing expense will increase in absolute dollars in the future but is
expected to decline as a percentage of net revenues.
RESEARCH AND DEVELOPMENT EXPENSES
Research and development expenses consist of payroll and related
expenses for software and hardware engineers and cost of materials for
prototyping and testing units. We expense all of our research and development
costs as they are incurred. Research and development, as a percentage of net
revenues, was 12.0% and 14.9%, respectively for the three month and six month
periods ended January 28, 2000 and were 6.8% and 4.7% for the three month and
six month periods ended January 31, 1999. In absolute dollars, R&D expenses
increased to $2.4 million for the three months ended January 28, 2000 and $5.2
million for the first six months of fiscal 2000 from $0.2 million and $0.3
million for the three and six months ended January 31, 1999. The increase in
both absolute dollars and as a percentage of net revenues was due to an increase
in engineering personnel and spending for prototyping material for new product
development. We believe that a significant level of investment in system design,
open source software and other research and development initiatives is required
to remain competitive. Accordingly, we expect research and development expenses
to continue to increase in absolute dollars and as a percentage of net revenues
in the future.
GENERAL AND ADMINISTRATIVE EXPENSES
General and administrative expenses consist of salaries and related
expenses for finance and administrative personnel, professional fees and costs
associated with implementing and expanding our information systems. General and
administrative expenses, as a percentage of net revenues, were 8.2% and 9.0% in
the second quarter and first six months of fiscal 2000, a decrease of 12.4
percentage points and 5.1 percentage points when compared to the second quarter
and first six months of the prior fiscal year. In absolute dollars, general and
administrative expenses increased to $1.7 million for the three months ended
January 28, 2000 and $3.2 million for the first six months of fiscal 2000 from
$0.7 million and $0.8 million, respectively,
13
<PAGE> 14
for the three and six months ended January 31, 1999. The increase in absolute
dollars was due to an increase in administrative personnel and the associated
costs to support our increased operations. We intend to add personnel to expand
our information infrastructure and to support our operation as a public company.
As a result, we expect general and administrative expenses to increase in
absolute dollars, but decrease as a percentage of net revenues in the future.
AMORTIZATION OF DEFERRED STOCK COMPENSATION
In connection with the grant of stock options to employees during fiscal
1999 and prior to our initial public offering in fiscal 2000, we expensed
deferred stock compensation of $4.3 million for the second quarter and $7.1
million for the first six months of fiscal 2000. We expensed $0.5 million of
deferred stock compensation in the first six months of fiscal 1999. We expect to
expense $4.6 million of deferred stock compensation in each of the next two
quarters of fiscal 2000.
INTEREST AND OTHER INCOME (EXPENSE), NET
Interest and other income (expense) net includes income from our cash
investments net of other expenses. Net interest and other income (expense) of
$1.1 million in the second quarter and $1.2 million in the first six months of
fiscal 2000 increased from virtually zero when compared to the same periods in
the prior year. The increase was due to an increase in interest income earned on
proceeds from the issuance of common stock as a result of our initial public
offering.
INCOME TAXES
As of January 28, 2000, we had federal and state net operating loss
carryforwards for tax reporting purposes available to offset future taxable
income. The federal net operating loss carryforwards expire at various dates
through 2019 to the extent that they are not utilized. We have not recognized
any benefit from these net operating loss carryforwards because of uncertainty
surrounding their realization. The amount of net operating losses that we can
utilize is limited under tax regulations because we have experienced a
cumulative stock ownership change of more than 50% over the last three years.
LIQUIDITY AND CAPITAL RESOURCES
Since inception, our operations have been financed through private sales
of convertible preferred stock and the sale of common stock in our initial
public offering, and from cash flows from operations.
At January 28, 2000, cash and cash equivalents were $148.5 million, as
compared to $18.7 million at January 31, 1999. During the same period working
capital increased to $147.0 million from $16.2 million. The increase in cash was
partially due to proceeds from the sale of common stock in our initial public
offering, partially offset by investments in working capital and capital
expenditures to support operations growth.
Cash used in operations of $13.1 million for the first six months of
fiscal 2000 represented the net loss of $21.6 million, an increase in accounts
receivable of $7.5 million, the add back of the amortization of deferred stock
compensation expense of $7.1 million, an increase in accounts payable of $3.4
million, while partially offset by a decrease in inventory of $2.0 million. The
increase in accounts receivable and accounts payable for the first six months of
fiscal 2000 was principally due to the increase in sales, and the decrease in
inventory was due to the sale of inventory to our contract manufacturer.
Cash used in investing activities consisted of the purchase of $1.8
million in computer and facilities related assets.
Cash from financing activities of $144.7 million for the first six
months of fiscal 2000 was primarily from the sale of our common stock from our
initial public offering in December 1999 and from the proceeds from the issuance
of convertible preferred stock.
14
<PAGE> 15
Our future liquidity and capital requirements will depend upon numerous
factors, including the costs associated with the expansion of our sales and
marketing activities and product development efforts, continued establishment of
our professional services group, the level and timing of product and service
revenues, the amount of working capital required, possible future acquisitions,
the level of fixed asset investment required, and available borrowings under our
line of credit arrangements. We believe that the net proceeds from our initial
public offering, together with our current cash and investment balances and any
cash generated from current or future debt financing, will be sufficient to meet
our operating and capital requirements for at least the next 12 months. However,
it is possible that we may require additional financing within this period,
particularly if we elect to acquire complementary businesses or technologies.
The factors described in this paragraph and other factors which may arise
subsequently, will affect our future capital requirements and the adequacy of
our available funds. As a result, we may be required to raise additional funds
through public financings, strategic relationships or other arrangements. We
cannot assure you that additional funding, if needed, will be available on
reasonable terms, or at all. Furthermore, any additional equity financing may be
dilutive to stockholders, and debt financing, if available, may involve
restrictive covenants. Our inability to raise capital when needed could
seriously harm our business.
RECENT ACCOUNTING PRONOUNCEMENTS
In March 1998, the American Institute of Certified Public Accountants
issued SOP No. 98-1, "Accounting for the Costs of Computer Software Developed or
Obtained for Internal Use," ("SOP No. 98-1"). SOP No. 98-1 requires entities to
capitalize certain costs related to internal-use software once certain criteria
have been met. SOP No. 98-1 was adopted by VA Linux in fiscal 1999. The adoption
of SOP No. 98-1 did not have a material impact on the Company's financial
position or results of operations.
In June 1998, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 133, "Accounting for Derivative
Instruments and Hedging Activities" ("SFAS No. 133"). SFAS No. 133 establishes
accounting and reporting standards requiring that every derivative instrument be
recorded in the balance sheet as either an asset or liability measured at its
fair value. SFAS No. 133, as recently amended, is effective for fiscal years
beginning after June 15, 2000. Management believes the adoption of SFAS No. 133
will not have a material effect on the Company's financial position or results
of operations.
In December 1998, the American Institute of Certified Public Accountants
issued SOP No. 98-9, "Modification of SOP No. 97-2, Software Revenue
Recognition, With Respect to Certain Transactions," ("SOP No. 98-9"). SOP No.
98-9 amends SOP No. 97-2 and SOP No. 98-4 by extending the deferral of the
application of certain provisions of SOP No. 97-2 amended by SOP No. 98-4
through fiscal years beginning on or before March 15, 1999. All other provisions
of SOP No. 98-9 are effective for transactions entered into in fiscal years
beginning after March 15, 1999. VA Linux has not had significant software sales
to date and management does not expect the adoption of SOP No. 98-9 to have a
significant effect on the financial position or results of operations.
In December 1999, the Securities and Exchange Commission issued Staff
Accounting Bulletin No. 101, "Revenue Recognition" ("SAB 101"). SAB 101
summarizes certain areas of the Staff's views in applying generally accepted
accounting principles to revenue recognition in financial statements. VA Linux
believes that its current revenue recognition policies comply with SAB 101.
YEAR 2000 COMPLIANCE
Many existing computer programs use only two digits to identify a year.
These programs were designed and developed without addressing the impact of the
change in the century. If not corrected, many computer software applications
could fail or create erroneous results by, at or beyond the year 2000. As a
result, the networks which incorporate our products and our own internal
networks could fail leading to disruptions in operations and our business
activities.
To date, we have not experienced any year 2000 issues with any of our
internal systems or our products, and we do not expect to experience any in the
future. To date, we have not experienced any year 2000 issues related to any of
our key third
15
<PAGE> 16
party suppliers, vendors, customers or service providers nor do we expect to
experience any in the future. Costs associated with remediating our internal
systems have not been material to date.
RISK FACTORS
RISKS RELATED TO OUR FINANCIAL RESULTS
OUR LIMITED OPERATING HISTORY AND THE FACT THAT WE OPERATE IN A NEW INDUSTRY
MAKES EVALUATING OUR BUSINESS PROSPECTS AND RESULTS OF OPERATIONS DIFFICULT.
Our company was founded in January 1995. Since the second quarter of
fiscal 1999, we have expanded our operations significantly. For example, we grew
from 15 employees at July 31, 1998 to 208 employees at January 28, 2000, and
only two members of our current management team were employed by us at the end
of fiscal 1998. Furthermore, we participate in the Linux industry, which has
only recently exhibited significant growth. You should consider the risks and
difficulties we may encounter as an early stage company in the new and rapidly
evolving Linux products and services market. Some of the factors that may affect
us include:
- the evolving and unpredictable nature of our business given that we
depend on open source software;
- the uncertain rate of growth in usage and acceptance of the Linux
operating system and related open source software;
- acquiring businesses and technologies;
- the uncertain demand for our products;
- the need to expand our sales, professional services and customer
support organizations;
- the need to expand our Internet operations;
- increased competition in the Linux industry, particularly from
larger, more established companies that are entering into the Linux
market, as well as the competition we face from the manufacturers of
computer systems that run proprietary operating systems like
Microsoft Windows; and
- our ability to attract and retain qualified management and
professional services personnel.
If we fail to address any of these risks or difficulties adequately, our
business strategy may not be successful and our revenues may not grow and may
decline.
WE HAVE A HISTORY OF LOSSES AND EXPECT TO CONTINUE TO INCUR NET LOSSES FOR THE
FORESEEABLE FUTURE.
We incurred losses of $26.5 million for the first six months of fiscal
2000 primarily due to expansion of our operations, and we had an accumulated
deficit of $41.5 million as of January 28, 2000. We expect to continue to incur
significant product development, sales and marketing and administrative
expenses, particularly as a result of expanding our direct sales force. In
addition, we are investing considerable resources in our professional services
organization and our Internet operations. We do not expect to generate
sufficient revenues to achieve profitability and, therefore, we expect to
continue to incur net losses for at least the foreseeable future. If we do
achieve profitability, we may not be able to sustain it.
AS OUR BUSINESS MATURES, WE DO NOT EXPECT OUR NET REVENUES TO CONTINUE TO GROW
AT THE SAME RATE AS THEY HAVE IN THE PAST.
Although our net revenues have grown substantially in recent quarters,
we do not expect our net revenues to grow at such a rapid rate in the future and
they could decline. This growth rate reflects increases in customers and average
order
16
<PAGE> 17
size, as well as the introduction of a new server model in the third quarter of
fiscal 1999 and increased focus on professional services in the second quarter
of fiscal 2000. As our business matures, it is unlikely that our net revenues
will continue to grow at the same rate. We believe that our future growth rates
will depend on the success of our sales and marketing efforts, which will
require significant expenditures that we may not have sufficient resources to
undertake, as well as the success of our professional services organization. In
addition, increased competition and slower than anticipated growth in our market
could also affect our revenue growth. If our net revenues do not increase at or
above the rate analysts expect, the trading price for our common stock may
decline.
BECAUSE WE HAVE A LIMITED OPERATING HISTORY AND BECAUSE THE MARKET FOR
LINUX-BASED SYSTEMS IS RAPIDLY EVOLVING, WE MAY NOT ACCURATELY FORECAST OUR
SALES AND REVENUES, WHICH WILL CAUSE QUARTERLY FLUCTUATIONS IN OUR NET REVENUES
AND RESULTS OF OPERATIONS AND MAY RESULT IN VOLATILITY IN OUR STOCK PRICE.
You should not rely on the results of any past periods as an indication
of our future net revenues or results of operations because our ability to
accurately forecast our quarterly sales and revenues is made difficult by our
limited operating history and the new and rapidly evolving market for
Linux-based systems in general, and our products in particular. In addition,
during fiscal 1999 and the first two quarters of fiscal 2000, we greatly
increased our operating expenses. We do not know whether our business will grow
rapidly enough to absorb these costs. As a result, we expect our quarterly
operating results to fluctuate and they may be below expectations of public
market analysts or investors. If this occurs, the price of our common stock may
drop.
Our quarterly net revenues and results of operations may vary
significantly in the future due to a number of additional factors, many of which
are outside of our control. For more information about additional factors and
our quarterly results of operations, see "Management's Discussion and Analysis
of Financial Condition and Results of Operations -- Quarterly Results of
Operations."
OUR FUTURE NET REVENUES DEPEND ON CONTINUED SALES OF OUR SERVERS, AND OUR
BUSINESS WILL SUFFER IF DEMAND FOR, OR REVENUES FROM, OUR SERVERS DECLINES.
Historically, we have derived a large percentage of our net revenues
from sales of our servers. Sales of our servers represented approximately 59% of
our net revenues in fiscal 1999 and approximately 91% of our net revenues in the
quarter ended January 28, 2000. We expect sales of these servers to continue to
account for a substantial majority of our net revenues for the foreseeable
future. Any factors adversely affecting the pricing of, or demand for, these
servers, including increased competition or decreased market acceptance of Linux
systems, could cause our net revenues to decline and our business to suffer.
OUR SUCCESS DEPENDS ON DEVELOPING NEW SYSTEMS THAT ACHIEVE MARKET ACCEPTANCE AND
ON THE SUCCESS OF OUR PROFESSIONAL SERVICES ORGANIZATION.
We develop systems that are optimized to run the Linux operating system,
particularly for use in Internet-related applications. Developing new products
that meet the needs of emerging market segments requires us to incur significant
research and development expenses and commit substantial engineering resources.
If we fail to introduce new products that address the needs of emerging market
segments, or if our new systems do not achieve market acceptance, our future
growth and profitability could suffer. Our success also depends on customers
choosing our professional consulting services and support over those of our
competitors, and our ability to attract and retain qualified personnel in the
area of professional services. If customers do not select our services, or if we
are unable to meet customer demand for such services, our revenues may not grow
and may decline, and our business will be harmed.
FAILURE TO MAINTAIN OR INCREASE OUR GROSS MARGIN WILL HARM OUR RESULTS OF
OPERATIONS.
Our gross margin may be affected by decreases in the average selling
prices of our systems or increased manufacturing costs. We have experienced
fluctuations in the average selling prices of our products to date. We
anticipate that as the market
17
<PAGE> 18
for Linux systems grows, the average unit price of our products will continue to
fluctuate and may decrease. The average unit price of our products may also
decrease in response to changes in product mix, competitive pricing pressures,
new product introductions by us or our competitors or other factors. If we are
unable to offset a decrease in the average selling prices of our existing
products by developing and introducing products and services with higher margins
or by reducing our product and manufacturing costs, our gross margins will
suffer.
To maintain or increase our gross margin, we also must continue to
reduce the manufacturing cost of our products. Our products incorporate a
significant number of commodity components and our gross margin will fluctuate
as a result of changes in the cost of these components. Increases in our
manufacturing costs, whether due to increased component costs or other factors,
could seriously harm our business. For more information related to our costs
associated with manufacturing, see "Management's Discussion and Analysis of
Financial Conditions and Results of Operations -- Results of Operations."
RISKS RELATED TO LINUX AND OPEN SOURCE SOFTWARE
IF THE LINUX OPERATING SYSTEM DOES NOT CONTINUE TO GAIN MARKET ACCEPTANCE, WE
WOULD NOT BE ABLE TO SUSTAIN OUR REVENUE GROWTH AND OUR BUSINESS COULD FAIL.
For the foreseeable future, we expect that substantially all of our
revenues will be derived from sales of systems that run the Linux operating
system and the provision of services and support for these systems. The Linux
operating system has only recently gained broad market acceptance. This
acceptance has been mostly limited to Internet infrastructure applications and
scientific research environments. Our success depends on the continued and
increased rate of adoption of Linux in these and other markets. If this does not
occur, our business will suffer.
Even if Linux is widely accepted, the Linux operating system is an open
source software product, which users are licensed to freely copy, use, modify
and distribute. Accordingly, anyone may download the Linux operating system and
numerous related software applications from the Internet, or otherwise copy it,
without cost, and run it on an existing Linux compatible product. Our success
depends on customers purchasing new systems which integrate and are optimized to
run the Linux operating system.
OUR ABILITY TO INTRODUCE NEW PRODUCTS OR PRODUCT ENHANCEMENTS WOULD BE IMPAIRED
IF LINUX DEVELOPERS DO NOT CONTINUE TO ENHANCE THE CORE SOURCE CODE OF THE LINUX
OPERATING SYSTEM AND DEVELOP LINUX-BASED APPLICATIONS.
We may not be able to introduce new products or product enhancements on
a timely basis unless efforts by Linux developers to expand the functionality of
the Linux operating system continue and are successful. We cannot guarantee that
these efforts will continue or be successful because the core of the Linux
operating system, or 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. Mr. Torvalds is not our employee. If Mr. Torvalds
and other third-party developers fail to further develop the Linux kernel or if
the development community does not continue to improve the functionality of the
operating system or introduce new open source software or software enhancements,
our ability to market our existing and future Linux products would suffer. In
this event, we may also be forced to rely to a greater extent on our own
development efforts or the development efforts of third-party consultants, which
would significantly increase our costs. Any failure on the part of the Linux
kernel developers to further develop and enhance the Linux kernel could stifle
the development of additional Linux-based applications for use with our
products, which would harm our product sales.
IF ADDITIONAL SOFTWARE APPLICATIONS COMPATIBLE WITH LINUX ARE NOT DEVELOPED, THE
MARKET FOR OUR PRODUCTS WILL NOT GROW, AND OUR PRODUCT SALES WILL BE HARMED.
Our products are currently purchased primarily for Internet-related
applications and by research facilities. For Linux, in general, and our
products, in particular, to gain acceptance in mainstream business and consumer
markets, more third-party software applications designed to operate on
Linux-based operating
18
<PAGE> 19
systems must be introduced and achieve market acceptance. Many widely used
applications, such as Microsoft Office, Intuit Quicken, Adobe PhotoShop and
others, cannot run natively on Linux operating systems. Many available Linux
applications, such as word processors, databases, accounting packages,
spreadsheets, e-mail programs, Internet browsers, presentation and graphics
software and personal productivity applications, have not achieved mainstream
market acceptance. If third parties do not introduce more software applications
designed to operate on the Linux operating system and achieve market acceptance,
our products will not gain mainstream business and consumer acceptance, and we
may not be able to maintain our product sales growth.
IF MULTIPLE AND INCOMPATIBLE DISTRIBUTIONS OF LINUX ACHIEVE SUFFICIENT MARKET
ACCEPTANCE, OUR OPERATING EXPENSES COULD INCREASE AND DEMAND FOR OUR PRODUCTS
COULD DECLINE.
If multiple, incompatible versions of Linux are developed, customers may
become less likely to purchase Linux products, and our sales would suffer. In
addition, we may be required to offer and support more distributions of Linux,
which would increase our operating expenses.
IF THE LINUX DEVELOPER COMMUNITY FAILS TO SUPPORT US OR REACTS NEGATIVELY TO OUR
BUSINESS STRATEGY, OUR BUSINESS WILL BE HARMED.
A majority of the software we include with our server products is
developed and maintained by third parties in the open source software community.
The third parties in the Linux developer community, upon whom we rely to develop
and maintain a majority of our software, may not continue to support us, our
product promotions or our corporate or operating decisions. If these third
parties fail to support us for any reason, we would be forced to rely to a
significantly greater extent on our own development efforts, which would require
us to hire additional developers and increase our development expenses and could
adversely impact product release schedules. In addition, negative reactions of
third parties in the Linux developer community could harm our reputation,
diminish our brand and result in lower net revenues.
RISKS RELATED TO OUR PRODUCT MANUFACTURING
WE RELY ON SYNNEX AS OUR SINGLE SOURCE CONTRACT MANUFACTURER. IF SYNNEX IS
UNABLE TO MEET OUR MANUFACTURING NEEDS OR OUR RELATIONSHIP TERMINATES, WE MAY
LOSE REVENUES AND DAMAGE OUR CUSTOMER RELATIONSHIPS.
We rely on Synnex Information Technologies, Inc. to produce
substantially all of our products at its Fremont, California facility on a
purchase order basis, and Synnex is our sole manufacturer. We currently do not
have a long-term supply contract with Synnex.
Qualifying a new contract manufacturer and commencing volume production
is expensive and time consuming. If we are required or choose to change contract
manufacturers, we may lose revenue and damage our customer relationships.
IF WE FAIL TO ACCURATELY PREDICT OUR MANUFACTURING REQUIREMENTS, WE COULD INCUR
ADDITIONAL COSTS OR EXPERIENCE MANUFACTURING DELAYS.
Because we currently do not have a long-term supply contract with
Synnex, it is not obligated to supply products to us for any specific period, in
any specific quantity or at any certain price, except as may be provided in a
particular purchase order. We provide forecasts of our demand to Synnex up to
five months prior to scheduled delivery of products to our customers. If we
overestimate our requirements, Synnex may have excess inventory, which would
increase our costs. If we underestimate our requirements, Synnex may have an
inadequate inventory, which could interrupt manufacturing of our products and
result in delays in shipments and revenues. In addition, lead times for
materials and components we order vary significantly and depend on factors such
as the specific supplier, contract terms and demand for each component at a
given time. We also may experience shortages of certain components from time to
time, which also could delay the manufacturing of our products.
19
<PAGE> 20
SYNNEX DEPENDS ON SINGLE AND LIMITED SOURCE SUPPLIERS FOR KEY COMPONENTS, WHICH
MAKES US SUSCEPTIBLE TO SUPPLY SHORTAGES OR PRICE FLUCTUATIONS THAT COULD
ADVERSELY AFFECT OUR OPERATING RESULTS.
Synnex, our contract manufacturer, depends on single source suppliers
for a number of key components for our products, such as industry standard
processors, power supplies, custom printed circuit boards, chassis and sheet
metal parts. It also depends on a limited number of sources to supply several
other industry standard components. For fiscal 2000, Micro Energy is our single
source for power supplies used in our FullOn model of server product. It would
be difficult for us to identify another source of supply if this supplier were
unable to meet our requirements for any reason. In addition, we do not have a
long-term binding agreement with Micro Energy. For fiscal 2000, Network Engines,
Inc. is our single source for our 1U product. We do not have an alternate source
of supply if this supplier were unable to meet our requirements for any reason.
In the past, Synnex has experienced, and may in the future experience, shortages
of, or difficulties in, acquiring these components. If Synnex is unable to buy
these components in adequate quantities at the times required, we may not be
able to manufacture our products on a timely basis, which would harm our
operating results. In addition, if Synnex is required to pay higher prices for
these single or limited source components and we are required to pay higher
prices for products, our gross margin would be harmed. Furthermore, overall
market conditions affecting supply and pricing for key commodity components are
known to fluctuate significantly at times, and increases in the costs of key
components could harm our business.
IF WE EXPAND OUR MANUFACTURING OPERATIONS INTERNATIONALLY, WE WILL FACE
ADDITIONAL RISKS, WHICH COULD HARM OUR FINANCIAL CONDITION AND RESULTS OF
OPERATIONS.
To date, substantially all of our net revenues have been derived from
sales of our products in North America. However, we intend to begin selling our
products overseas during fiscal 2000, initially in Europe. We anticipate that as
we expand our international sales, we will fulfill orders through international
facilities operated by Synnex. We could experience difficulties and disruptions
in the manufacture of our products while we transition some manufacturing
operations to these new facilities. Our inability to scale manufacturing of our
products in foreign facilities, and any manufacturing delays or disruptions that
occur, could prevent us from increasing international sales and achieving the
timely delivery of products to customers located in foreign jurisdictions. This
could result in lost revenues and slower revenue growth. Additional risks
associated with international manufacturing operations include:
- currency fluctuations;
- the need to comply with regulatory requirements and unexpected
changes in these requirements;
- legal uncertainties regarding liability, tariffs and other trade
barriers;
- greater incidence of shipping delays;
- limited oversight of manufacturing operations; and
- potential political and economic instability.
Any of these factors could significantly impair our ability to source
our contract manufacturing requirements internationally.
RISKS RELATED TO COMPETITION WITHIN OUR INDUSTRY
WE MAY NOT BE ABLE TO COMPETE WITH MORE ESTABLISHED COMPANIES.
In the market for computer systems, we face significant competition from
larger companies who market general-purpose computers and have greater financial
resources, more established direct and indirect sales channels and greater name
recognition than we do. These companies include Compaq Computer Corporation,
Dell Computer Corporation, Fujitsu International Inc., Hewlett-Packard Company,
International Business Machines Corporation and Sun Microsystems, Inc. In most
cases, these companies primarily sell systems that run proprietary operating
systems, such as
20
<PAGE> 21
Microsoft Windows and variants of UNIX, including Solaris. However, some of
them, notably IBM, Compaq, Dell, and HP have announced and are implementing
Linux-based computer businesses. These companies also have larger and more
established service organizations to support these products and operating
systems. These companies may be able to leverage their existing organizations,
including their service organizations, and provide a wider offering of products
and higher levels of support on a more cost-effective basis than we can. In
addition, 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. We also face competition in narrow,
vertical markets from limited purpose computer vendors that offer products that
are carefully tailored for specific applications which better address the needs
of these customers. Furthermore, because Linux 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 market entry are minimal. Accordingly,
it is possible that new competitors or alliances among existing competitors may
emerge and rapidly acquire significant market share. Any pricing pressures or
loss of potential customers resulting from our failure to compete effectively
would reduce our revenues. We also may not be able to compete successfully with
these current or potential competitors.
WE MAY NOT BE ABLE TO EFFECTIVELY COMPETE AGAINST OTHER PROVIDERS OF LINUX-BASED
COMPUTER PRODUCTS OR NEW MARKET ENTRANTS.
Many large, general-purpose computer vendors, such as Compaq, Dell,
Gateway, Hewlett-Packard and IBM, have recently introduced Linux-based systems.
The systems offered by these companies may have greater functionality and lower
prices than those we currently provide, making our systems less attractive to
our customers. Even if the functionality of the standard features of these
products is equivalent to ours, we face a substantial risk that a significant
number of customers will choose not to purchase products from a less well-known
vendor, regardless of the competitiveness of our solutions.
IF WE ARE UNABLE TO PROVIDE HIGH-QUALITY CUSTOMER SUPPORT AND SERVICES, WE WILL
BE UNABLE TO MEET THE NEEDS OF OUR CUSTOMERS. IN ADDITION, OUR PRODUCTS AND
SERVICES ARE DEPENDENT UPON THE EFFORTS OF MEMBERS OF THE OPEN SOURCE COMMUNITY.
For our business to succeed, we must effectively market our integrated
system and service solution. If our service organization does not meet the needs
or expectations of customers, we face an increased risk that customers will
purchase systems from other integrated solution providers or purchase systems
from one vendor and services from a Linux specialist.
The quality of our products and services is dependent on the efforts and
the expertise of members of the open source community. If we do not continue to
work productively with these members, our ability to provide product enhancement
and quality services will be harmed, which would harm our revenues and
compromise our reputation in the open source community and with customers.
IF WE DO NOT INTRODUCE NEW PRODUCTS AND SERVICES IN A TIMELY MANNER, OUR
PRODUCTS AND SERVICES WILL BECOME OBSOLETE, AND OUR OPERATING RESULTS WILL
SUFFER.
The computer systems market is characterized by rapid technological
change, frequent new product enhancements, uncertain product life cycles,
changes in customer demands and evolving industry standards. Our products could
be rendered obsolete if products based on new technologies are introduced or new
industry standards emerge.
Enterprise computing environments are inherently complex. As a result,
we cannot accurately estimate the life cycles of our products. New products and
product enhancements can require long development and testing periods, which
requires us to hire and retain increasingly scarce, technically competent
personnel. Significant delays in new product releases or significant problems in
installing or implementing new products could seriously damage our business. We
have, on occasion, experienced delays in the scheduled introduction of new and
enhanced products and may experience similar delays in the future.
Our future success depends upon our ability to enhance existing
products, develop and introduce new products, satisfy customer requirements and
achieve market
21
<PAGE> 22
acceptance. This process is made more challenging by the fact that much of the
software development for our products is done by the open source community and
we must work with a large number of developers who are not our employees in this
process. We may not successfully identify new product opportunities and develop
and bring new products to market in a timely and cost-effective manner.
IF WE FAIL TO RETAIN AND EXPAND OUR CUSTOMER BASE, OUR REVENUES COULD DECLINE
SUBSTANTIALLY.
We face competition from different sources, and we must compete
effectively against other current and future competitors to retain and expand
our customer base. We believe the principal factors on which we compete include:
- product functionality;
- quality and availability of professional services;
- quality of product and product support;
- total cost of ownership;
- system performance at different price points;
- reusability for multiple applications;
- sales and distribution efficiency; and
- brand name recognition.
To be competitive, we must respond promptly and effectively to the
challenges of technological change, evolving standards and our competitors'
innovations by continuing to enhance our products and grow our sales and
professional services organizations. Any pricing pressures or loss of potential
customers resulting from our failure to compete effectively would reduce our
revenues.
RISKS RELATED TO OUR PRODUCTS' DEPENDENCE ON
INTELLECTUAL PROPERTY AND OUR USE OF OUR BRAND
WE COULD BE PREVENTED FROM SELLING OR DEVELOPING OUR PRODUCTS IF THE GNU GENERAL
PUBLIC LICENSE AND SIMILAR LICENSES UNDER WHICH THE OPERATING SYSTEM
INCORPORATED INTO OUR PRODUCTS IS DEVELOPED AND LICENSED, ARE NOT ENFORCEABLE,
OR ARE NOT EFFECTIVELY ENFORCED.
The Linux kernel and the Linux operating system incorporated into our
products have been developed and licensed under the GNU General Public License,
and similar open source licenses. These licenses require that any software
program licensed under them may be copied, used, modified and distributed
freely, so long as all modifications are also freely made available and licensed
under the same conditions. We know of no instance in which a party has
challenged the validity of these licenses or in which these licenses have been
interpreted in a legal proceeding. To date, all compliance with these licenses
has been voluntary. It is possible that a court would hold one or more of 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
copied, modified, or distributed freely, would have the effect of preventing us
from selling or developing our products, unless we are able to negotiate a
license for the use of the software or replace the affected portions.
It is possible that parties may refuse to comply with the terms of these
licenses. One resulting risk is that entities with the legal right to enforce
these licenses against non-complying parties might not be able to enforce these
licenses effectively, because of a lack of financial resources or otherwise.
Even with vigorous enforcement action, it is possible that a court would hold
one or more of 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 copied, modified, or distributed freely, would have the effect
of preventing us from selling or developing our products, unless we are able to
negotiate a license for the use of the software or replace the affected
portions. In the event that we obtain this license, we would likely be required
to make royalty payments with respect to sale of our products covered by the
license. Any royalty payments would harm our
22
<PAGE> 23
operating results. We may not be able to obtain this license. In the event that
we have to replace portions of the software code ourselves, which could be time
consuming and result in higher development costs, our operating results would be
harmed.
IF WE ARE PROHIBITED FROM USING THE LINUX TRADEMARK, OUR BUSINESS COULD BE
ADVERSELY AFFECTED.
Like many other companies, we market Linux-based products, systems and
services. We do not own the trademark to "Linux." The owner has consented to our
use of the word Linux in our company name and in the title of our web sites. We
believe that the continued efficacy and use of the "Linux" trademark is
important to our business. If the "Linux" trademark is invalidated through a
legal action, or we are no longer permitted to use it, our business could
suffer. In addition, we cannot control the use of this trademark, and use by
others may lead to confusion about the source, quality, reputation and
dependability of Linux, which may harm our business.
OUR BUSINESS WILL BE HARMED IF WE ARE UNABLE TO PROTECT OUR INTELLECTUAL
PROPERTY RIGHTS FROM MISUSE BY THIRD PARTIES.
Our collection of trademarks is important to our business. The
protective steps we take or have taken may be inadequate to deter
misappropriation of our trademark rights. We have filed applications for
registration of some of our trademarks in the United States. Effective trademark
protection may not be available in every country in which we offer or intend to
offer our products and services. Failure to protect our trademark rights
adequately could damage our brand identity 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 ARE VULNERABLE TO CLAIMS THAT OUR PRODUCTS INFRINGE THIRD-PARTY INTELLECTUAL
PROPERTY RIGHTS, ESPECIALLY BECAUSE OUR SYSTEMS INCORPORATE MANY DISTINCT
SOFTWARE COMPONENTS DEVELOPED BY THOUSANDS OF INDEPENDENT THIRD PARTIES. ANY
RESULTING CLAIMS AGAINST US COULD BE COSTLY TO DEFEND OR SUBJECT US TO
SIGNIFICANT DAMAGES.
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 software code in our products is developed by
independent parties over whom we exercise no supervision or control and who,
themselves, might not have the same financial resources as us to pay damages to
a successful litigant. For example, developers may incorporate code into the
Linux operating system under the GPL without proper third party consents. In
addition, these developers are unlikely to perform patent searches and may
therefore unwittingly infringe third party patent rights. Although most of the
software incorporated into our systems is open source, nothing in open source
licenses can prevent current or future patent holders or other owners of
intellectual property from suing us and others in seeking monetary damages or an
injunction against shipment of our systems. A patent holder may deny us a
license or force us to pay royalties. In either event, our operating results
could be seriously harmed. In addition, employees hired from competitors might
utilize proprietary and trade secret information from their former employers
without our knowledge, even though our employment agreements and policies
clearly prohibit such practices. Any litigation, with or without merit, could be
time consuming to defend, result in high litigation costs, divert our
management's attention and resources, or cause product shipment delays. We also
could be required to remove or replace infringing technology. We are not aware
that the technology employed in our systems infringes any proprietary rights of
third parties.
WE MAY NOT BE ABLE TO USE INTELLECTUAL PROPERTY TO PROTECT OURSELVES FROM
COMPETITION.
Our systems consist primarily of commodity hardware components in
combination with the Linux operating system. While we have developed some
proprietary techniques and expertise, most of our activities and systems are not
protectable as proprietary intellectual property and may be used by competitors,
harming our market share and product revenues. To protect our intellectual
property, we generally enter into confidentiality or license agreements with our
employees, consultants and corporate
23
<PAGE> 24
partners. We have also recently commenced a patent program and to date have
filed one patent application. In general, however, we have taken only limited
steps to protect our intellectual property. Accordingly, we may be unable to use
intellectual property to prevent other companies from competing with us. In
addition, we may be unable to prevent third parties from developing techniques
that are similar or superior to our technology, or from designing around our
copyrights, patents and trade secrets.
WE MAY BE SUBJECT TO CLAIMS AS A RESULT OF INFORMATION PUBLISHED ON, POSTED ON
OR ACCESSIBLE FROM OUR INTERNET SITES.
We may be subject to claims of defamation, negligence, copyright or
trademark infringement (including contributory infringement) or other claims
relating to the information contained on our Internet sites, whether written by
us or third parties. These types of claims have been brought against online
services in the past and can be costly to defend regardless of the merit of the
lawsuit. Although recent federal legislation protects online services from some
claims when the material is written by third parties, this protection is
limited. Furthermore, the law in this area remains in flux and varies from state
to state. While no claims have been made against us to date, our business could
be seriously harmed if one were asserted.
OTHER RISKS RELATED TO OUR BUSINESS
IF WE FAIL TO ADEQUATELY PROMOTE AND MAINTAIN OUR BRAND NAME OR ARE UNABLE TO
CONTINUE USING "LINUX" AS PART OF OUR BRAND NAME, OUR PRODUCT SALES WOULD
DECLINE, AND WE WOULD INCUR SIGNIFICANT COSTS TO PROMOTE A NEW BRAND NAME.
We believe that we need a strong brand to compete successfully. In order
to promote and maintain our brand identity and to attract and retain customers,
we plan to increase our spending on advertising and promotions and to implement
new marketing campaigns. These strategies may not be successful. If we are
unable to design and implement effective marketing campaigns or otherwise fail
to promote and maintain our brand, our sales could decline. Our business may
also be harmed if we incur significant expenses in an attempt to promote and
maintain our brand without a corresponding increase in revenues. Linus Torvalds
owns the trademark to "Linux." Mr. Torvalds has consented to our use of the word
Linux in our company name and in the title of our web sites. This consent may be
revoked in the future, however, and we may no longer be able to use this
trademark in our brand or in the title of our web sites. In this event, our
product sales would decline, and we would incur significant costs to promote a
new brand name, which takes time and may not be successful.
IF WE DO NOT SUBSTANTIALLY EXPAND OUR DIRECT SALES OPERATIONS AND E-COMMERCE
INITIATIVES, OUR SALES AND MARKET SHARE WILL NOT GROW.
In order to increase market awareness and sales of our products, we will
need to substantially expand our direct sales operations, both domestically and
internationally. To date, we have relied primarily on our direct sales force to
generate demand for our products. Many of our products require a sophisticated
sales effort targeted at our prospective customers' information technology
departments. Competition for qualified sales personnel is intense, and we might
not be able to hire the quality and number of sales people we require. In
addition, we have devoted significant resources to implementing e-commerce
solutions, such as our valinux.com web site, that broaden our market reach and
we intend to deploy more e-commerce solutions. If we fail to effectively expand
our direct sales operations or strengthen our e-commerce initiatives, our growth
will be limited.
OUR MANAGEMENT TEAM IS NEW AND, IF THEY ARE UNABLE TO WORK TOGETHER EFFECTIVELY,
OUR BUSINESS COULD BE SERIOUSLY HARMED.
Our business is highly dependent on the ability of our management team
to work together effectively to meet the demands of our growth. We grew from 15
employees at July 31, 1998 to 208 employees at January 28, 2000. Only two
members of our current management team were employed by us at the end of fiscal
1998. These individuals have not previously worked together as a management team
and have had only limited experience managing a rapidly growing company on
either a public or private basis. Our productivity and the quality of the
products and services we render may be
24
<PAGE> 25
adversely affected if we do not integrate and train our new employees quickly
and effectively.
EXPANDING OUR SERVICES BUSINESS WILL BE COSTLY AND MAY NOT RESULT IN ANY BENEFIT
TO US.
We believe that the expansion of both our business and the acceptance of
Linux are dependent upon the availability of high quality professional services
to assist customers in designing and implementing Linux-based systems. If we are
unable to successfully provide these services, our revenues will not grow and we
may lose customers seeking quality professional services. We have recently
expanded our strategic focus to place additional emphasis on providing
professional services, from which we have historically derived an insignificant
amount of revenue. Our customers may not engage our professional services
organization to render services such as architecture and planning, system
integration, open source product implementation and security consulting
services. We may not generate sufficient services revenues to offset the
expenses of this organization. We may not attract or retain a sufficient number
of the highly qualified service personnel we need to support the expansion of
our professional services organization. This expansion has required, and will
continue to require, significant additional expenses and resources. In addition,
this expansion will place further strain on our management and operational
resources.
IF WE ARE UNABLE TO HIRE AND RETAIN ADDITIONAL RESEARCH AND DEVELOPMENT,
SUPPORT, SALES AND MARKETING STAFF WE WILL NOT HAVE SUFFICIENT RESOURCES TO
COMPETE AND GROW OUR REVENUES.
We intend to hire a significant number of additional research and
development, support, sales and marketing and other personnel during fiscal
2000. Competition for these individuals is intense, and we may not be able to
attract, assimilate or retain highly qualified personnel. Our future success and
ability to sustain our revenue growth also depend upon the continued service of
our executive officers and other key engineering, sales, marketing and support
personnel. Competition for qualified personnel in our industry and in the San
Francisco Bay Area, as well as the other geographic markets in which we recruit,
is extremely intense and characterized by rapidly increasing salaries, which may
increase our operating expenses or hinder our ability to recruit qualified
candidates.
ATTEMPTS TO EXPAND BY MEANS OF BUSINESS COMBINATIONS AND STRATEGIC ALLIANCES MAY
NOT BE SUCCESSFUL AND MAY DISRUPT OUR OPERATIONS OR HARM OUR REVENUES.
We have in the past, and may in the future, make investments in
complementary companies, products or technologies or buy businesses, products or
technologies in the future. In the event of any future purchases, we will face
additional financial and operational risks, including:
- difficulty in assimilating the operations, technology and personnel
of acquired companies;
- disruption in our business because of the allocation of resources to
consummate these transactions and the diversion of management's
attention from our core business;
- difficulty in retaining key technical and managerial personnel from
acquired companies;
- dilution of our stockholders, if we issue equity to fund these
transactions;
- assumption of operating losses, increased expenses and liabilities;
- harm to our reputation, 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
25
<PAGE> 26
- 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 PROPOSED ACQUISITION OF ANDOVER.NET MAY NOT RECEIVE GOVERNMENTAL CLEARANCE
AND WE MAY NOT BE ABLE TO INTEGRATE THE TWO COMPANIES SUCCESSFULLY.
If our acquisition of Andover.Net closes, achieving the anticipated
benefits of our merger with Andover.Net will depend in part on the integration
of the two businesses in an efficient manner, and there can be no assurance that
this will occur. There are several conditions which must be satisfied before the
acquisition can close, including that our registration statement on Form S-4
must be declared effective by the Securities and Exchange Commission and the
acquisition must be cleared by the United States Federal Trade Commission or the
Department of Justice. A successful combination of VA Linux and Andover.Net will
require substantial effort. The difficulty of the integration may be increased
by the geographical separation of the two companies and their employees. For
example, we may not be able to retain key executives and employees of
Andover.Net after the merger. Diversion of our management's attention from
ongoing operations and any difficulties encountered in trying to close the
acquisition and, subsequently, in the transition and integration process could
have a material adverse effect on our revenues, expenses and operating results.
There can be no assurance that we will realize any of the anticipated benefits
of the merger.
IF WE ARE UNABLE TO IMPLEMENT APPROPRIATE SYSTEMS, PROCEDURES AND CONTROLS TO
MANAGE OUR EXPECTED GROWTH, WE MAY NOT BE ABLE TO SUCCESSFULLY OFFER OUR
SERVICES AND GROW OUR BUSINESS.
Our ability to successfully offer our services and grow our business
requires an effective planning and management process. Since we began
operations, we have significantly increased the size of our operations. This
growth has placed, and we expect that any future growth we experience will
continue to place, a significant strain on our management, systems and
resources. Our key personnel have limited experience managing this type of
growth. In order to manage growth effectively, we will need to continue to
implement or update our operational and financial systems, procedures and
controls, including implementing an enterprise resource planning system and a
web-based ordering system.
WE WILL FACE ADDITIONAL OPERATIONAL AND FINANCIAL RISKS AS WE EXPAND OUR
INTERNATIONAL OPERATIONS, ANY ONE OF WHICH COULD HARM OUR INTERNATIONAL MARKET
SHARE AND REVENUES.
We plan to expand our international operations and enter new
international markets. It will be costly to establish international facilities
and operations, promote our brand internationally and develop localized web
sites and other systems. In addition, we may be required to develop foreign
language translations of software incorporated into our systems. Revenue from
international sales may not offset the expense of establishing and maintaining
these foreign operations. We have no previous experience with any of these
matters. 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 encounter greater difficulty in collecting accounts receivable
resulting in longer collection periods;
- we may not be able to repatriate the earnings of our foreign
operations;
- we will have to comply with a wide variety of foreign laws and
regulatory environments with which we are not familiar;
- we may not be able to adequately protect our trademarks and other
intellectual property overseas due to the uncertainty of laws and
enforcement
26
<PAGE> 27
in certain countries relating to the protection of intellectual
property rights;
- some or all of our domain names may already be in use in countries
we expect to sell and/or establish operations;
- we could face difficulty in building close relationships with
international open source developers;
- 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.
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. 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.
WE DEPEND ON THE CONTINUED SERVICES OF OUR FOUNDERS AND OTHER KEY ENGINEERING
PERSONNEL, WHOSE KNOWLEDGE OF OUR BUSINESS AND TECHNICAL EXPERTISE WOULD BE
DIFFICULT TO REPLACE.
Our products and technologies are complex, and we are substantially
dependent upon the continued services of our existing engineering personnel and
executive management, especially Larry M. Augustin, our President and Chief
Executive Officer. We do not have employment contracts with any of our key
engineering personnel, so that the employment of any key engineer may be
terminated "at will" by such individual. The loss of any, or a group of, our key
engineering personnel, particularly to a competitor, could adversely affect our
business, reduce our market share, slow our product development processes and
diminish our brand identity. Additionally, members of the open source community
are not our employees and have no obligation to perform services on our behalf.
OUR PRODUCTS MAY CONTAIN DEFECTS THAT COULD BE COSTLY TO CORRECT, DELAY MARKET
ACCEPTANCE OF OUR PRODUCTS AND EXPOSE US TO LITIGATION.
Despite testing by us and our customers, errors may be found in our
products after commencement of commercial shipments. We buy almost all of our
component hardware parts from third parties. These parts may fail, cause
unexpected electrical or mechanical problems or otherwise not function properly.
We have not achieved local regulatory compliance in all countries into which we
expect to sell and/or establish operations. In addition, most of the software
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
correct them in a timely manner, if 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 products incorporating Linux-based operating systems and other open
source products.
27
<PAGE> 28
Failures in our products could also cause system failures, including in
critical business systems, for our customers who may assert warranty and other
claims for substantial damages against us. Although our warranties 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 provide
sufficient coverage to adequately limit our exposure to this type of claim.
These claims, even if unsuccessful, could be costly and time consuming to
defend.
OUR PRODUCT SALES AND REVENUE GROWTH DEPEND ON THE CONTINUED POPULARITY AND
ACCEPTANCE OF THE INTERNET, WHICH MAY DECLINE IF NEW LAWS AND GOVERNMENT
REGULATIONS SURROUNDING THE INTERNET ARE APPLIED.
If the popularity and acceptance of the Internet as an effective medium
of commerce does not continue to grow or declines, our product sales and revenue
growth will be harmed. We are significantly dependent on the Internet to process
the sale of our products. We also plan to deploy enhanced e-commerce
applications to facilitate Internet-based ordering and tracking, and sales
processing. New laws and government regulations surrounding the Internet, such
as Internet taxation and consumer privacy laws, could result in a decline in the
use or popularity of the Internet as a medium for commerce, which would harm our
sales and revenue growth.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The primary objective of our investment activities is to preserve
principal while at the same time maximizing the income we receive from our
investments without significantly increasing risk. Some of the securities that
we may invest in may be subject to market risk. This means that a change in
prevailing interest rates may cause the principal amount of the investment to
fluctuate. For example, if we hold a security that was issued with a fixed
interest rate at the then-prevailing rate and the prevailing interest rate later
rises, the principal amount of our investment will probably decline. To minimize
this risk in the future, we intend to maintain our portfolio of cash equivalents
and short-term investments in a variety of securities, including commercial
paper, money market funds and government and non-government debt securities. In
general, money market funds are not subject to market risk because the interest
paid on such funds fluctuates with the prevailing interest rate. As of January
28, 2000, all of our cash and cash equivalents were in money market and checking
funds.
We have operated primarily in the United States, and virtually all sales
have been made in U.S. dollars. Accordingly, we have not had any material
exposure to foreign currency rate fluctuations.
28
<PAGE> 29
PART II. OTHER INFORMATION
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
Item 2(d): On December 14, 1999, we completed the sale of an aggregate of
5,060,000 shares of our common stock, par value $0.001 per share, at a price of
$30.00 per share in a firm commitment underwritten public offering. The offering
was effected pursuant to a Registration Statement on Form S-1 (Registration No.
333-88687), which the United States Securities and Exchange Commission declared
effective on December 9, 1999. Credit Suisse First Boston Corporation, Deutsche
Bank Securities, Inc., Hambrecht & Quist LLC and Lehman Brothers, Inc. were the
lead underwriters for the offering.
Of the $151.8 million in aggregate proceeds we raised in the offering,
(i) $10.6 million was paid to underwriters in connection with the underwriting
discount, and (ii) approximately $2.3 million was paid in connection with
offering expenses, printing fees, filing fees, and legal fees. The legal fees
included approximately $0.5 million paid to Wilson Sonsini, Goodrich & Rosati,
Professional Corporation ("WSGR"), counsel to VA Linux. Judith M. O'Brien, a
member of WSGR, is Secretary of VA Linux. There were no other direct or indirect
payments to directors or officers of the Company or any other person or entity.
In addition to funding operating losses since the completion of the
offering, we expect to use the proceeds of the offering principally for general
corporate purposes, including working capital and the funding of expected
operating losses. We also expect to use a portion of the proceeds to pursue
possible acquisitions of complementary businesses, technologies or products,
including our proposed acquisition of Andover.Net. Pending such uses, the
Company is investing the proceeds in short-term, interest-bearing,
investment-grade securities.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
During the three months ended January 28, 2000, the following matters
were submitted to the shareholders of VA Linux Systems, Inc., a California
corporation ("VA California"). VA California merged into the Company on December
7, 1999 for the purpose of changing its state of incorporation to Delaware:
1. On November 29, 1999, prior to the Company's initial public offering,
the shareholders of VA California acting by written consent, approved (i) an
amendment and restatement of the Company's 1998 Stock Plan to among other things
(a) increase the number of shares reserved for issuance thereunder by 4,000,000
shares, (b) provide for an automatic increase in the number of shares of Common
Stock reserved for issuance thereunder in the amount of the lesser of 4,000,000
shares, 4.9% of the Company's outstanding capital stock or such lesser number of
shares as the Company's Board of Directors may determine; (ii) the Company's
1999 Employee Stock Purchase Plan and the reservation of 1,000,000 shares of
Common Stock thereunder, with an automatic annual increase in number of shares
of Common Stock reserved for issuance thereunder; (iii) the Company's 1999
Director Stock Option Plan and the reservation of 500,000 shares of Common Stock
thereunder, with an automatic annual increase in number of shares of Common
Stock reserved for issuance thereunder; and (iv) the reincorporation merger of
VA California with and into its wholly-owned subsidiary VA Linux Systems, Inc.,
a Delaware corporation, with VA Linux Systems, Inc., a Delaware corporation the
surviving corporation. Stockholders holding 99% of the shares (on an as if
converted into Common Stock basis) outstanding at that time, consented to the
foregoing.
2. On November 22, 1999, prior to the Company's initial public offering,
VA California, the Company's then sole stockholder, acting by written consent,
approved (i) the amendment and restatement of the Company's Certificate of
Incorporation and
II-1
<PAGE> 30
(ii) the reincorporation merger of VA California with and into the Company with
the Company as the surviving corporation.
ITEM 6. Exhibits and Reports on Form 8-K
(a) Exhibits
10.18 Consent by Linus Torvalds.
27.1 Financial Data Schedule.
(b) No reports on Form 8-K were filed with the Securities and Exchange
Commission during the three months ended January 28, 2000.
II-2
<PAGE> 31
VA Linux Systems, Inc.
January 28, 2000
SIGNATURES
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.
VA LINUX SYSTEMS, INC.
DATE: March 13, 2000 BY: /s/ Larry M. Augustin
------------------- --------------------------------------
Larry M. Augustin
President and Chief Executive Officer
DATE: March 13, 2000 BY: /s/ Todd B. Schull
------------------- --------------------------------------
Todd B. Schull
Vice President and Chief Financial Officer
III-3
<PAGE> 32
EXHIBIT INDEX
Exhibit Description
------- -----------
10.18 Consent by Linus Torvalds
27.1 Financial Data Schedule
<PAGE> 1
EXHIBIT 10.18
Dear Linus,
I write to confirm your consent, as owner of the LINUX mark, to our
perpetual use, worldwide, of LINUX in product names and company names that we
shall own. We understand that this consent is based upon the facts that our
products are based upon or related to the genuine LINUX Kernel, and that the
company's activities are substantially related to implementation and development
of products that are based upon or related to the genuine LINUX Kernel. Although
in a consent agreement there is no formal requirement of quality control, we
agree that the relationship of our products to the genuine LINUX Kernel assures
the public of the quality it expects in products and activities that are
associated in any way with the LINUX mark.
Based on this consent, we plan to incorporate the word "Linux" in our
company name; in our product names; and in names, phrases, and logos that will
be used for marketing and advertising purposes. You understand that we will be
relying upon this consent in our commercial activities, including the
development of valuable brands that we shall own independently - although, of
course, we would not claim ownership to the LINUX brand itself. We further
understand that this consent will extend to any successor business of our
company.
At your request, we enclose a check payable to Linux International in the
amount of $1000.00 in return for your consent. We ask that you signal your
formal agreement by signing a copy of this letter below and returning it to us.
If you have any questions, please do not hesitate to contact me.
Yours very truly,
VA LINUX SYSTEMS, INC.
/s/ LARRY M. AUGUSTIN
------------------------------------
Larry M. Augustin, President and CEO
I agree to the foregoing and consent to the use of LINUX as described
above.
/s/ LINUS TORVALDS
- ------------------------------
Linus Torvalds
WARNING: THE EDGAR SYSTEM ENCOUNTERED ERROR(S) WHILE PROCESSING THIS SCHEDULE.
<TABLE> <S> <C>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> JUL-28-2000
<PERIOD-START> AUG-01-1999
<PERIOD-END> JAN-28-2000
<CASH> 148,510
<SECURITIES> 0
<RECEIVABLES> 11,537
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 1,470
<PP&E> 3,719
<DEPRECIATION> 788
<TOTAL-ASSETS> 165,255
<CURRENT-LIABILITIES> 14,536
<BONDS> 0
0
0
<COMMON> 41
<OTHER-SE> 150,103
<TOTAL-LIABILITY-AND-EQUITY> 165,255
<SALES> 35,039
<TOTAL-REVENUES> 35,039
<CGS> 30,243
<TOTAL-COSTS> 30,243
<OTHER-EXPENSES> 24,493
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 28
<INCOME-PRETAX> (21,616)
<INCOME-TAX> 0
<INCOME-CONTINUING> (21,616)
<DISCONTINUED> 0
<EXTRAORDINARY> (4,900)
<CHANGES> 0
<NET-PRIMARY> (26,516)
<EPS-BASIC> (1.73)
<EPS-DILUTED> (1.73)
</TABLE>
