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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-KSB
[ X ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE
ACT OF 1934 [Fee Required]
For the fiscal year ended December 31, 1997
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE
SECURITIES EXCHANGE ACT OF 1934 [No Fee Required]
For the transition period from to
Commission File Number: 0-14793
TEKNOWLEDGE CORPORATION
(Name of small business issuer as specified in its charter)
Delaware 94-2760916
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
1810 Embarcadero Road, Palo Alto, California 94303
(Address of principal executive offices) (Zip Code)
Issuer's telephone number: (650)424-0500
Securities registered pursuant to Section 12 (b) of the Act: None
Securities registered pursuant to Section 12 (g) of the Act:
Common Stock, $.01 par value per share
Check whether the issuer (1) filed all reports required to be filed by Section
13 or 15(d) of the Exchange Act during the past 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[ ]
Check if there is no disclosure of delinquent filers in response to Item 405 of
Regulation S-B contained in this form, and no disclosure will be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-KSB or any
amendment to this Form 10-KSB. [X]
State issuer's revenues for its most recent fiscal year. $11,094,930
The aggregate market value of Common Stock, $.01 par value per share, held by
non-affiliates of the registrant was $18,018,715 on March 23, 1998 (based on the
average bid and ask price per share of Common Stock on that date as reported
over-the-counter by the National Quotation Bureau). Shares of Common Stock held
by each officer and director and by each person who owns 5% or more of the
outstanding common stock have been excluded in that such persons may be deemed
to be affiliates. This determination of affiliate status is not necessarily
a conclusive determination for other purposes.
On March 23, 1998, there were 24,082,714 shares of Common Stock, $.01 par value
per share, of the registrant outstanding.
Documents Incorporated by Reference
Proxy Statement for the 1998 Annual Meeting of Stockholders Part III
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PART I
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Item 1. Description of Business
Teknowledge Corporation (the "Company") is in the distributed knowledge
management business. Teknowledge is leveraging its core competencies in
knowledge based systems and large scale, distributed object-oriented software
with the expanding opportunities presented by the Internet and the World Wide
Web. The Company provides software products and consulting services for
government and commercial applications. The Company's key business lines are:
Distributed Systems Engineering, Situation Assessment and Data Fusion, Education
& Training Technologies, C4I & Information Security Systems, and Electronic
Commerce ("E-Commerce") Systems. The Company was incorporated on July 8, 1981
under the laws of the State of Delaware. The Company's principal executive
offices are located at 1810 Embarcadero Road, Palo Alto, California 94303.
Teknowledge is the surviving corporation of the merger (the "Merger") of
American Cimflex Corporation and Teknowledge, Inc., that was consummated in
1989. Since the Merger, the Company has discontinued or divested some of its
business units, and grown new lines of business. Ongoing operations of the
Company consist of a Corporate headquarters located in Palo Alto, California and
four distributed engineering offices located in San Diego, California (1996),
Arlington, Virginia (1996), Fairfax, Virginia (1997), and Orlando, Florida
(1997).
Teknowledge is increasing its focus on commercial software products and
services, particularly in the E-Commerce market; however, this transition takes
time. The current customer base for the Company's products and services consists
primarily of government related projects. For the year ended December 31, 1997,
the Company's direct revenue mix from continuing operations was approximately
99% government and 1% commercial products and services. The Company's business
is concentrated in the United States.
Overview
The information economy places a huge competitive premium on an
organization's ability to manage its knowledge effectively. Knowledge has become
the key competitive weapon in the marketplace and the battlespace. However,
knowledge acquired by people often does not get reused because it is not
organized or distributed effectively. Knowledge management systems are software
programs that enable combinations of people and computers to capture, refine,
distribute, and apply knowledge to solve business application problems.
Teknowledge develops software architectures and programs which integrate
conventional software and knowledge management systems in distributed,
heterogeneous network applications. These architectures are embodied in products
and services that support integration, processing, and systematic utilization of
an organization's knowledge assets.
Teknowledge has five business units. Specifically, Teknowledge's
Distributed Systems Engineering program provides the foundation for distributing
webs of objects that contain information about an application's technical
content and its relationships to other applications. The Data Fusion and
Situation Assessment program develops software algorithms that refine
information from multiple sources into a coherent body of knowledge that can be
acted upon. The Education and Training Technologies program encapsulates
knowledge into reusable media, develops intelligent tutoring systems to
communicate that knowledge, and distributes the tutoring systems over the World
Wide Web. The C4I and Information Security Systems program focuses on
architectures and software that protect the information stored in computer
networks, and utilize the knowledge to make timely decisions, and execute plans
effectively. Finally, Teknowledge's E-Commerce Systems business unit provides
commercial software products and services that enable corporations to manage
their sales knowledge, and sell products effectively over the Internet.
Each of Teknowledge's business units provides essential components of an
integrated knowledge management solution.
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Computer software applications provide maximum value when integrated into
networked operations, both within and among enterprises. Integration of these
various functions is facilitated if object-oriented software is designed with an
"open architecture." This allows the same applications software and user
interfaces to be distributed via network protocols across many different types
of computers. The Company's products and services are designed to maximize the
value of integrating, distributing and activating application knowledge.
Since the U.S. Department of Defense and many commercial businesses are
now conducting large-scale operations over international computer networks such
as the Internet, much of the Company's current and future business focus is on
providing software to make it possible to delegate knowledge-intensive tasks to
network-enabled computer software associate systems. These associate systems may
accomplish routine tasks as well as accelerate knowledge gathering, refinement,
dissemination, and utilization over computer networks. Teknowledge's strategic
plans include commercializing associate systems software that amplifies human
productivity and the ability to manage knowledge effectively. Teknowledge has
built six associate systems and commercialized one. These systems include: the
Briefing Associate, the Parent's Associate, the Student's Associate, the Project
Center Associate, the Desktop Associate, and the commercial Sales Associate(TM).
Operations
Teknowledge has distributed operations, with its headquarters located in
Palo Alto, California and offices in San Diego, California, Orlando,Florida, and
Arlington and Fairfax, Virginia. The Company continues to expand its technical
staff in accord with the mix of skills needed in each office. The Company has
five business areas that represent interrelated, but distinct lines of business,
as discussed below.
Distributed Systems Engineering
Operations that are widely distributed require extensive object-oriented
systems infrastructure. Currently, the World Wide Web provides little of this
systems infrastructure, but instead relies on the distribution of multimedia
documents. In the future, complex webs of objects and knowledge will have to be
distributed systematically and dynamically updated. This requires the ability to
provide reliable quality of service, security of operations, maintainability,
and distribution by intelligent "push" and "pull" techniques. In addition, the
types and quantity of knowledge distributed will require new designs and new
software, specialized for specific knowledge processing tasks. Teknowledge's
Distributed Systems Engineering program focuses on providing next generation
systems infrastructure.
Situation Assessment and Data Fusion
Complex problem solving in emergencies and international conflicts
requires the ability to quickly and effectively access and combine data from
multiple sources in order to develop a dynamic assessment of an evolving
situation. Teknowledge's Situation Assessment and Data Fusion program focuses on
providing distributed tools and systems infrastructure to fuse data from
multiple sources and combine those data into a cogent and often shared
perception of a situation. An example includes the Defense Advanced Research
Projects Agency ("DARPA") sponsored HIBURST project that focuses on the design
and implementation of high performance information bases using real-time
scaleable technology in time critical applications. This program is developing a
situation server, which combines data from multiple sources, and detects
patterns or conditions of interest to a customer. These conditions may in turn
trigger alerts or actions to respond to a situation quickly and effectively.
Education and Training Technologies
The Internet and the World Wide Web have created a new opportunity for
formerly isolated desktop systems that provided computer-aided instruction. Not
only have the techniques of computer aided instruction improved dramatically in
recent years, but the means to distribute them have undergone a veritable
revolution. Now it is possible to provide distance learning via an interactive
course delivered through a standard World Wide Web browser or associated
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application system. There are opportunities to deliver in-house corporate
training over intranets, K-12 education over the Internet, and just-in-time
adult training on the job or in the home. Teknowledge has been involved in
education and training since 1981, and in 1997 it created a program devoted
entirely to this growing opportunity. Teknowledge served for the past two years
as the Cluster Leader for the US's largest multi-institution project on
Intelligent Tutors and Associates. The DARPA Computer Assisted Education and
Training Initiative sponsored Teknowledge's work on Parents Associate to enable
parents to get advice on parenting and access to Internet-based educational
resources, and a Center Associate to provide a computer-based coach or peer to
help guide users in getting the most from education resources available to them.
Teknowledge is now leading the Business and Marketing Group of the new
Government sponsored Advanced Distance Learning Initiative, which is actively
developing distance learning technology to provide cost effective industrial
strength courseware over the Internet.
C4I and Information Security Systems
Teknowledge's Command, Control, Communications, Computer, and Intelligence
("C4I") program has focused on the use of computers and communications in
command and control applications. These applications may be used in times of
natural disasters such as floods or hurricanes, humanitarian interventions into
war torn areas such as Bosnia, or external conflicts, such as the Gulf War. C4I
systems uses all of the available information provided by web servers, situation
servers, and other specialized servers. The resulting digital planning
application is used to assess alternative courses of action, to select action
plans, and to monitor and control the results of those plans. Teknowledge has
contracts to provide architectures and systems implementations for several
command and control applications. The Briefing Associate developed in this
program supports briefers in constructing Internet accessible command and
control briefings and customizing them for specific audiences.
The new focus of this program is in information security systems which
protect information stored in computers or distributed over networks. This is a
critical, high priority application area that requires the technical resources
Teknowledge possesses. The need for information security solutions has created
tremendous demand in both government and industry, including E-Commerce
applications.
E-Commerce Systems
Electronic Commerce is the conduct of business operations over computer
networks. It is an obvious commercial target for knowledge management technology
and product development. Teknowledge began focusing a business unit on
commercial sales knowledge management in 1997. The E-Commerce Systems business
unit provides assessments of corporate E-Commerce strategy and technology,
services to support leading E-Commerce products, and installations of
Teknowledge's own Sales Associate(TM) software.
The Sales Associate(TM) is a commercial software product which provides
unassisted sales over the Internet. It incorporates rules of selling and
utilizes specific product knowledge to emulate the best practices of the most
productive sales person in a firm. The product goes beyond the typical browsing
interaction on the World Wide Web by engaging the customer in an interactive
dialog about products. The Sales Associate(TM) creates a unique profile of every
customer and specializes the sales presentation to each prospect. It learns and
remembers a customer's profile and preferences, and applies all available
information towards the next sale. The system can cater its visual form to match
the user's profile, selecting among web text, audio, or 3D graphics. The Sales
Associate(TM) incorporates both generic and domain-specific "rules of selling"
to guide the sales process. It matches a customer profile with the products in a
product knowledge base. The Sales Associate delivers up-to-the-minute
information on product features and availability, as well as news of special
discounts and other promotions. Sales are processed immediately on-line through
third-party electronic credit or digital cash. Customer fulfillment comes via
third-party express mail service or local delivery.
The Sales Associate(TM) is a new product in a relatively new market. There
are uncertainties and risks associated with the introduction of any new software
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product; (see Part II Item 6. Management's Discussion & Analysis or Plan of
Operation - Certain Factors That May Affect Future Results of Operations and/or
Stock Price) however, Teknowledge has continued to evolve Sales Associate(TM)
capabilities, and is committed to making the product a commercial success.
Teknowledge has also developed custom application software systems for
several customers to design and check hardware configurations. This
configuration software is in daily use at Applied Materials and Motorola
Corporation. The Company has been building configuration systems for over a
decade, and has codified some of that experience in reusable configuration
software.
M.4 is a commercial software tool developed by Teknowledge and sold to
customers who want to build their own knowledge-based problem-solving systems.
M.4 and its predecessors have been sold and supported by Teknowledge as
shrink-wrapped software since 1985. M.4 is used primarily as a tool that allows
users to embed expertise within other software systems. M.4 is sold principally
on PC platforms, and it includes interfaces to Visual BasicTM1, Visual C++TM1,
and ToolbookTM2. The market for expert systems tools is limited, but M.4
provides a useful infrastructure for developing knowledge based application
systems.
Sales and Marketing
Teknowledge's services and software are marketed primarily by the
Company's employees, including the Chief Executive Officer, the President, and
five experienced business unit managers supported by senior technical engineers.
Each business unit offers consulting services to help prospective customers
define their problems and projects. Government proposal work conducted in
response to a Broad Area Announcement or Request for Proposal is typically not
funded. However, consulting assignments are funded to evaluate current corporate
E-Commerce capabilities, and to recommend next steps, including application
work.
The Company has increased its commercial sales and marketing efforts to
lay the foundation for increased commercial business. In 1998, the Company has
begun implementation of a new strategy to win potential customers. This strategy
includes earning Value Added Reseller (VAR) and premier certified solution
provider status from market leaders such as IBM, Microsoft, and Oracle. The
Company is targeting value-added services squarely in the center of the
commercial marketplace to broaden the appeal and reduce the risk to potential
customers. Teknowledge is positioning its products to integrate with and add
value to the large number of services and products third-parties develop for the
Internet market.
Teknowledge has launched a public relations program to ensure greater
awareness of the Company in a broader base of customers, industry analysts,
market makers, stock brokers, and the general public.
Backlog
At December 31, 1997, the expected order backlog was approximately $25
million, which consisted of (i) new orders for which work has not yet begun, and
(ii) revenue remaining to be recognized on work in progress. 100% of the
December 31, 1997 backlog is from government customers. Approximately 84% of the
backlog consists of government-sponsored programs that are awarded but not yet
authorized for funding. The government normally funds a contract in incremental
amounts for the tasks that are currently in production. Backlog is an estimate
and is subject to a number of risks (see Part II Item 6. Management's Discussion
& Analysis or Plan of Operation - Certain Factors That May Affect Future Results
of Operations and/or Stock Price). The portion of the overall backlog that is
reasonably expected to be fulfilled in the current fiscal year is approximately
48%.
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1 Visual Basic(TM) and Visual C++(TM) are trademarks of Microsoft Corporation.
2 Toolbook(TM) is a trademark of Asymetrix Corporation.
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Research and Development
Almost all of the Company's operations except for the E-Commerce business
unit were related to advanced government development projects. As a result, the
Company's R&D activities were mostly funded externally by the Federal
Government. Generally, the Company retains the exclusive right to market the
government sponsored R&D commercially. From time to time the Company funds its
own R&D, mostly in the form of commercializing the technology developed under
its government contracts. As the Company continues to grow the commercial
products and services business, more internally-funded R&D is expected. The
Company expensed $206,603 and $0 of its own funds on R&D for the years ended
December 31, 1997 and 1996, respectively.
In accordance with SFAS 86, "Accounting for the Costs of Computer Software
to be Sold, Leased or Otherwise Marketed," the Company incurred software
development costs which were capitalized. These capitalized software development
costs were $10,712 and $59,485 for the periods ended December 31, 1997 and 1996,
respectively.
Competition
A number of companies provide consulting services and software that
compete with aspects of the Company's business. Many of these companies are
substantially larger and have greater financial resources than the Company.
Sales and configuration systems are provided by Trilogy Development Group,
Calico, Concentra, Selectica, Brightware, Baan, SAP, Oracle and others.
Knowledge management systems are provided by Carnegie Group, Inference Corp.,
Neuron Data Corp., Intellicorp, Inc., and Trinzic Corp. Distributed systems
engineering, data fusion, and C4I & Information Security services are provided
by GTE, Trusted Information Systems, Lockheed-Martin, Boeing, Perceptronics,
ISX, and SAIC, among others. Internet-based distance education and training
technologies are mostly in the R&D stage, with competitors still emerging in the
commercial marketplace.
The major part of the Company's business consists of performing
cost-plus-fixed-fee contracts. The Company also offers licenses for the use of
its software products with installation, maintenance and support services
offered separately. The sales process is traditionally characterized by long
lead times from first contact to sale, substantial up-front sales costs, and
significant competition. Contract awards are generally made on the basis of the
concept and quality of the technical proposal, the track record of the bidder,
the quality and experience of project management and technical personnel, and
price.
Proprietary Rights
Teknowledge maintains an active intellectual property program, and
currently holds eight U.S. software patents. The application software developed
by Teknowledge includes the Sales Associate(TM) for configuring automated sales
on the Internet, knowledge-based expert systems, pattern detection and data
fusion tools, and systems to manage and protect webs of networked information.
Sales Associate(TM) is a trademark of the Company. The COPERNICUS(TM) trademark
is registered in the US and many foreign jurisdictions. As use of any
product name becomes consistent and established, the Company intends to apply
for formal registration of the product name as a trademark in the United States
and any applicable foreign jurisdictions.
The Company has relied on a combination of patent, copyright, trade secret
and trademark laws, as well as contractual provisions, to protect its
proprietary technology. The Company has required employees, customers, vendors,
and others who have access to proprietary technology to sign nondisclosure
agreements. The Company retains a proprietary right to market commercially most
of the development that was sponsored by government agencies. The government may
not distribute proprietary information that was developed by the Company to any
third party for commercial purposes without first receiving permission from the
Company.
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The Company provides its software products to end users under
non-exclusive, non-transferable licenses which typically have a perpetual term
unless terminated for breach. The Company protects the source code of its
software products as trade secrets and unpublished copyrighted works.
Additionally, the Company holds patents for the knowledge processing and systems
engineering technologies that form the basis for many of the products and
configuration services that the Company markets.
There can be no assurance that the Company's protective measures will be
adequate to protect its proprietary rights, that others have not or will not
independently develop or acquire equivalent or superior technology, or that the
Company will not be required to obtain royalty-bearing licenses to use other
intellectual property in order to utilize the inventions embodied in its
patents. There also can be no assurance that any patents will be issued pursuant
to the Company's current or future patent applications or that patents issued
pursuant to such applications or any patents the Company currently owns will not
be invalidated, circumvented or challenged. From time to time, the Company may
be notified that it may be infringing patents or proprietary rights owned by
third parties. There can be no assurance that the Company would be able to enter
into an acceptable license under such third party patent or proprietary rights
or redesign or modify its products and processes to avoid infringement of such
patent or proprietary rights, or that the Company could otherwise avoid
infringement of such patent or proprietary rights. In the event the Company is
unable to take such action, its business, financial condition and results of
operations could be materially and adversely affected. Additionally, litigation
may be necessary to protect the Company's proprietary rights.
Government Contracts
In 1997, approximately 99% of the Company's revenues were from cost-type
government contracts, and 100% of its December 31, 1997 backlog was from
government contracts. The Company's business has been dependent upon successful
bidding for government contracts. The Company applies for contracts in the form
of a proposal by responding to Requests for Proposals and Broad Agency
Announcements issued by the United States Federal Government or by prime
contractors under contract to the Federal Government. Proposals include
discussion of the technical approach to be taken to satisfy the government's or
the prime contractor's requirements and a detailed presentation of costs
expected to be incurred. The proposal is reviewed and evaluated by technical and
administrative personnel employed by the government or the prime contractor. If
the procurement method is "competitive bid," the contract is awarded to the
company which would best satisfy the government's or the prime contractor's
requirements. If the procurement method is a "negotiated award," the government
or the prime contractor would enter into negotiations to determine a price for
the contract; upon successful conclusion of negotiations, a contract is awarded.
Government contracts contain termination clauses which permit contract
termination upon the Company's default or at the government's discretion.
Currently, agencies of the U.S. Government sponsor most of the Company's
technical work. The portion of the Company's revenues attributed to government
business has risen from 98% in 1996 to 99% in 1997. Government contracts are
potentially more risky than commercial contracts because they are subject to
agency funding limitations, congressional appropriation, and the political
agenda of the current administration in Washington, D.C. However, the particular
government customers that have sponsored Teknowledge contract work have been
relatively stable in recent years. While there is no guarantee that this will
continue to be the case, it is an indication of the priority that the government
has historically placed on this type of contract R&D work.
The typical cost-type government contract performed by the Company has a
regulated fixed fee limit which inhibits the Company from improving profit
margins beyond what is permitted in the government regulations. In addition,
Federal Acquisition Regulations exclude from reimbursement some "unallowable"
expenses which the Company considers a regular part of the business.
Furthermore, almost all the Company's contracts contain termination clauses
which permit contract termination upon the Company's default or at the
contracting party's discretion. The Company has not experienced any material
cancellations to date; however there can be no assurance that such cancellations
will not occur in the future.
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The indirect costs and expenses accumulated in the performance of
government contracts are allocated to the customer in the form of overhead
(indirect) rates. These rates, which are periodically reviewed by government
auditors, fluctuate based on the relationship between the overhead costs and
direct costs incurred in the performance of the contracts during the year.
Excluded from these rates, and not subject to reimbursement, are certain costs
(approximately 3% of total costs in 1997) which are proscribed as unallowable by
the government, such as entertainment and advertising, and a considerable
portion of patent litigation costs. In addition, the government has established
compensation limits for employees which expressly reduces the amount of
compensation and related expenses, such as bonuses and stock options, that can
be passed on to the government through the overhead rates. In recent years, the
Company has experienced a decline in the fees on new government contracts due to
government cost saving efforts. Some new contracts may not suffer this fee
erosion; however, the overall limitation on potential government contract fees
coupled with a potential increase in the expenses not eligible for
reimbursement, combine to restrict the Company's ability to improve profit
margins on government contracts in the future. The Company's
government-sponsored R&D is most valuable as a technology incubator, development
laboratory, and testbed. The best software from this work becomes a candidate
for software product commercialization. This helps the government amortize the
considerable cost of maintenance, and it provides Teknowledge with the
opportunity to compete in a growing commercial marketplace.
Employees
Including contract engineers and temporaries, the Company had a total of
71 full time employees at December 31, 1997. All the employees were employed in
the continental United States. The majority of employees, including top
management, are technical. They perform direct billable work on contracts or
develop and support software products. A core group of administrative staff
performs general and administrative functions. A large percentage of the
employees hold advanced degrees in technical disciplines. The future success of
the Company will depend, in part, on the Company's ability to continue to
retain, attract, and motivate highly qualified technical, marketing, and
management personnel. This has become a particular challenge as increasing
demand for top quality software professionals has exceeded supply. The Company
has never had a work stoppage, and it is not a party to any collective
bargaining agreement with any of its employees.
Item 2. Description of Property
The Company's executive offices are located at 1810 Embarcadero Road, Palo
Alto, California, under a lease for a period of three years commencing April 5,
1996, with an option to extend the lease for an additional three years when the
lease expires. The Company has also signed renewable leases for office space in
Arlington and Fairfax, Virginia, San Diego, California and Orlando, Florida.
Although there is sufficient space to accommodate new employees in the near
term, the Company will contemplate acquiring additional office space in the
future as it approaches full capacity.
In January 1994, the Company entered into a settlement agreement with the
landlord for its former Franklin, Massachusetts location. Under the terms of
this agreement, the lease scheduled to expire in May 1999 was terminated for a
total consideration, including accrued interest, of $131,760 which is to be paid
in escalating payments over a five-year period. Payments are due January 31 of
each year. As of December 31, 1997, a total of $77,328 in payments have been
made and the remaining liability was included in "Current liabilities - Other"
(see Part II Item 7. Financial Statements).
In September 1993, the Company entered into a settlement agreement with
the landlord at the former Bridgeville, Pennsylvania location. Under the terms
of the agreement, the Company will avoid an annual settlement amount of $18,306
unless there exists a differential in rent between what the new tenant pays and
what the Company was expected to pay during the term of the original lease. The
settlement agreement provides for a maximum payment of $18,305 by the Company
per annum until 1998. There has been no such rent assessment to date. As of
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December 31, 1997, a future possible assessment of $18,305 was included in
"Current liabilities - Other" (see Part II Item 7. Financial Statements).
Item 3. Legal Proceedings
On May 15, 1997, the Company and Trilogy Development Group, Inc.
("Trilogy") agreed to a settlement of all outstanding lawsuits and debts between
the companies. Pursuant to the Settlement Agreement, License Agreement, and
Mutual Release, the Company immediately granted to Trilogy a non-exclusive,
royalty-free license to the Company's United States Patent 4,591,983 in exchange
for 2,338,969 shares of Company stock owned by Trilogy, which the Company valued
at $1,006,000, and $400,000 in cash. The Agreement also provided for the
transfer of certain proxy rights to the Company and other consideration,
including the orderly disposal of Trilogy's remaining stock ownership of
approximately 900,000 shares in open market transactions through May 14, 1998.
On or about August 2, 1994, Daniel R. Robusto, a former executive of the
Company, filed a suit in the Court of Common Pleas of Allegheny County,
Pennsylvania, pursuant to Pennsylvania Wage Payment and Collection Law, alleging
breach by the Company of an employment settlement agreement and the nonpayment
of severance wages of $107,307 plus liquidated damages of $26,827, attorney
fees, interest, and other court costs. The Company has responded to the initial
complaint and asserted certain counterclaims against Mr. Robusto based upon his
actions while in office. The litigation process is continuing. Management
believes the ultimate resolution of the above matter will not have an adverse
material impact on the Company's financial position and results of operations.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of security holders during the fourth
quarter of 1997.
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PART II
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Item 5. Market for Common Equity and Related Stockholder Matters
The Common Stock of Teknowledge is traded under the symbol TEKC on the
"Bulletin Board," an over-the-counter ("OTC") listing service provided by the
National Quotation Bureau. The price of the stock is updated periodically when a
trade is made. On March 23, 1998 the listed closing "bid" price of the stock was
$.84 a share.
The following table sets forth the range of high and low bid information
for the Common Stock on the OTC Bulletin Board for the quarterly periods
indicated. The bid information reflects inter-dealer prices, without retail
mark-up, mark-down or commission and may not represent actual transactions. The
Company has never paid dividends on its capital stock.
1997 High Low
First quarter, ended March 31, 1997 $ .59 $ .38
Second quarter, ended June 30, 1997 .68 .38
Third quarter, ended September 30, 1997 .51 .43
Fourth quarter, ended December 31, 1997 .65 .43
1996 High Low
First quarter, ended March 31, 1996 $ .55 $ .25
Second quarter, ended June 30, 1996 .86 .46
Third quarter, ended September 30, 1996 .86 .56
Fourth quarter, ended December 31, 1996 .72 .40
As of December 31,1997 there were 1,900 holders of record of Common Stock
of the Company.
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Item 6. Management's Discussion and Analysis or Plan of Operation
Overview of Significant Matters
Forward looking statements made in this section relate to recruiting of
additional employees, expected growth and revenues, realizability of backlog,
competition for expected new government contracts, development and announcement
of commercial products, and deferred tax assets. All forward looking statements
involve risks and uncertainties, and actual results could differ materially from
those set forth in the forward looking statements contained herein as a result
of competition, agency funding limitations, other factors relating to government
contracting, ability to attract and retain technical and management personnel,
and other factors described in "Certain Factors That May Affect Future Results
of Operations and/or Stock Price."
Year Ended December 31, 1997
Quarterly Results Summary
(in thousands except for per share data)
First Second Third Fourth Total
Revenues $1,805 $2,482 $3,367 $3,441 $11,095
Costs and Expenses 1,690 2,457 3,045 3,249 10,441
Other and Tax Benefit/Provision 10 1,130 50 916 2,106
Net Income 125 1,155 372 1,108 2,760
Net Income per share .00 .04 .01 .04 .10
Teknowledge's revenues for the year ended December 31, 1997 increased to
$11,094,930, a 55% improvement over 1996. 99% and 98% of the revenue in 1997 and
1996, respectively, were from agencies of the Federal government. Revenue growth
was fueled by new contract awards totaling $17.5M, which increased total backlog
from $18.5M at December 31, 1996, to approximately $25M at December 31, 1997. To
meet the demands of the new contracts, the Company grew its total workforce by
45% to over 70 employees, despite competition for technical personnel in the
Silicon Valley labor market. The growth of the workforce in 1998 is likely to be
modest compared to 1997 as the Company approaches targeted staffing levels on
existing projects. This situation could change, however, if the Company wins new
contracts currently under consideration by the government. There can be no
assurance that the Company will be able to attract and retain the key technical
personnel needed to perform the contracts.
During the second quarter of 1997, the Company reached an amicable
settlement with Trilogy in Federal court. As a result, approximately $1,146,000
of income was recorded during the second quarter of 1997 (see Part 1 Item 3.
Legal Proceedings). This additional income contributed $.04 diluted earnings per
share in 1997.
The Company recorded a deferred tax asset of $900,000 in the fourth
quarter of 1997, after evaluating the Company's profitable results over the last
three years and the prospects for improvements in the future. Recognition of the
deferred tax asset contributed $.03 diluted earnings per share in 1997. The
Company's net operating loss carryforwards, subject to certain annual
expirations, can be utilized until the year 2009. The amount recorded in 1997
represents only a fraction of the potential tax savings which may be realized in
subsequent years (see Note 6. Tax Loss Carryforwards). Additional amounts may be
recorded for estimated reductions in tax liabilities pertaining to future
periods if the Company continues to maintain its profitability and positive
outlook. Likewise, an unfavorable future event may require an adjustment in the
amount of the tax asset, with a negative effect on income.
Net income for the year improved 310% over the previous year to
$2,759,654, or $.10 diluted earnings per share. Net income before the Trilogy
settlement and recognition of the deferred tax asset was $713,825, or $.02
diluted earnings per share. 88% of this income is from government sources. The
government has approved an increase in the allowable compensation limit used in
the computation of government overhead rates in 1998. This change is expected to
have a positive effect on income in 1998.
<PAGE>
12
Generally, product sales were below expectations in 1997. Breaking through
Internet fire walls proved harder than expected and potential customers were
reluctant to invest in a new product offered by an emerging company. As a
result, the Company has fortified and restructured its product sales team and
adopted a new marketing strategy as discussed in Part I Item 1. Sales and
Marketing.
Certain Factors that May Affect Future Results of Operations and/or Stock Price:
The Company recognizes that the continued success of the business is
dependent on key management and technical personnel, the loss of one or more of
whom could adversely affect aspects of the Company's business. To mitigate this
risk, five senior program managers have been hired in recent years. The Company
relies on its executives and program managers for the acquisition and
negotiation of government awards, preparation of proposals, and the general
direction and management of the Company. The Company believes that its future
success depends on attracting and retaining highly skilled technical personnel
and other employees.
Management believes that the market for Internet software is a significant
new opportunity for the Company, and that it is in an excellent position to
convert software developed under government R&D contracts into new commercial
products. The market for Internet software, however, is at an early stage of
development, rapidly evolving, and characterized by an increasing number of
market entrants who have introduced or are developing competing software
products and services. As is typical for a new and rapidly evolving industry,
demand and market acceptance for recently introduced products and services are
subject to a high level of uncertainty. Further, aspects of the Internet
(including security, reliability, cost, ease of use and quality of services) are
undergoing rapid evolution that may affect growth of the use of the Internet in
general and of Internet software in particular. The demand for Internet software
will require broad acceptance of new methods of conducting business and
exchanging information over the Internet. It is not known how soon, if ever, the
demand for Internet software will become sufficient to sustain a viable market
for the products developed by the Company. Even if a market develops, there can
be no assurance that the Company will be able to develop and bring to market
products which will gain market acceptance or generate significant revenue or
profits. The Company's products may be subject to price erosion and marketing
risks due to free client software distributed by on-line service providers,
Internet access providers, and others. If the Internet E-Commerce develops more
slowly than expected, becomes saturated with competitors, or if the Company's
products for the Internet market do not achieve market acceptance, the Company's
business, financial condition, and results of operation may be materially and
adversely affected.
The Company's operating results are affected by a wide variety of factors,
including successful commercialization of the Company's products, competition
from larger companies, ability to staff and recruit employees, general economic
conditions, and government intervention.
Year 2000
The Company is aware of the issues associated with the programming code in
existing computer systems as the millennium ("year 2000") approaches. The key
issue is whether computer systems will properly recognize date-sensitive
information when the year changes to 2000. All of the hardware and software
currently in use at the Company are relatively new and year 2000 compliant. No
significant reprogramming efforts and year 2000 compliance expenses inside the
Company are expected to be necessary.
<PAGE>
13
Results of Operations
1997 compared to 1996
Revenues rose $3,936,167, or 55%, to $11,094,930 in 1997, from $7,158,763
in 1996. During 1997, the Company was successful in winning a number of new
contracts from the government. In order to meet the new project requirements,
the Company accelerated its recruiting efforts and grew its workforce by 45%.
There was also a corresponding increase in subcontractor and consultant
engagements, as the Company often teamed with subcontractors on larger and more
complex projects. For the year ended December 31, 1997, subcontractor and
consultant costs were $2,417,308, as compared to $747,399 in 1996. The increase
in labor and subcontractor costs incurred by the Company in the performance of
the contracts are reimbursed by the government and the results are reflected in
revenues.
Cost of revenues increased 67% from $4,541,823 in 1996 to $7,575,634 in
1997. The increase was mostly attributable to the aforementioned growth in labor
and use of subcontractors and consultants, the costs of which accounted for
nearly 70% of total cost of revenues in 1997. As a percentage of revenues, cost
of revenues rose from 63% in 1996 to 68% in 1997. As the company continued to
grow its technical staff on a relatively stable general and administrative base,
cost of revenues accounted for an increasingly larger portion of total revenues
from its cost-plus-fixed fee contracts.
General and administrative costs were $2,122,499 and $2,054,698 in 1997
and 1996, respectively. Although the Company incurred increased expenses related
to recruiting and bonuses as it grew, there was an offsetting decrease in
executive stock compensation costs and legal expenses as a result of the
settlement of the Trilogy litigation. Overall, general and administrative costs
were relatively stable between years, reflecting the Company's conscientious
effort to control administrative costs as it grew. General and administrative
costs decreased from 29% in 1996 to 19% in 1997 as a percentage of revenues.
Sales and marketing costs increased almost five times from $95,961 in 1996
to $535,746 in 1997, as the Company built a team and dedicated increasingly
substantial resources to market and sell commercial Internet products and
services. The Company's sales and marketing efforts include applications
engineering and technical support, as well as trade shows, demonstrations,
advertising and other traditional marketing activities. The Company has not
recognized any marked revenues from these efforts to date and there can be no
assurance these revenues will develop.
The Company expended $206,603 of its internally funded research and
development ("R&D") costs in 1997 and did not report measurable amounts in 1996.
Most of the Company sponsored R&D was concentrated in the development of
commercial products for the Internet. The development of commercial products for
the Internet has not achieved significant revenues to date. The majority of the
Company's R&D efforts were funded externally through government projects (and
recorded as cost of revenues), which are expected to provide the basis for
future commercial development opportunities.
Interest income was $83,229 in 1997 versus $57,612 in 1996. The increase
was primarily due to increased cash balances during the year. Other income
increased from $173,131 to $1,145,108 in 1997, largely as a result of the
settlement of a lawsuit with Trilogy earlier in the year. Income from the sale
of a product line was completed in 1996 and there was no income from this sale
in 1997.
Net income in 1997 was $2,759,654 versus $672,374 in 1996. Income per
share on a diluted basis was $.10 for 1997 and $.02 in 1996.
<PAGE>
14
Inflation
During the year, the Company did not experience any significant effect
from inflation.
Liquidity and Capital Resources
As of December 31, 1997, unused sources of liquidity of the Company were
$2,172,235 in cash and cash equivalents, an increase of $374,343 over the
previous year. The Company generated cash reserves of $863,887 from its
operating activities and used $500,426 for computer equipment and other
improvements.
The Company believes that the present level of cash and cash equivalents
is adequate to service the liquidity needs of the Company in 1998. The Company
relies principally on the collection of receivables to generate internal cash
reserves.
The Company has an unsecured line of credit from a financial institution
in the amount of $1,500,000. The Company may borrow up to the lower of 60% of
the receivable base or $1,500,000 at a rate of one percent over Prime. The line
is subject to certain covenants and maintenance requirements which have been
fulfilled. The line expires in June 1998 and is expected to be renewed. The
Company did not utilize the credit line in 1997.
Item 7. Financial Statements
The response to this item is incorporated by reference in a separate
section of this report. See Exhibits, Financial Statement Schedules and
Reports on Form 8-K, Item 13(a)(1) and (2).
Item 8. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure
Not applicable.
PART III
- --------------------------------------------------------------------------------
Item 9. Directors, Executive Officers, Promoters and Control Persons; Compliance
With Section 15(a) of the Exchange Act
The information required by Item 9 regarding directors and executive
officers of the Company is incorporated herein by reference to the sections
entitled "Election of Directors" and "Executive Compensation - Employment
Arrangements" included in the definitive proxy statement for the Company's 1998
Annual Meeting of Stockholders (the "1998 Annual Meeting Proxy Statement").
Item 10. Executive Compensation
The information required by Item 10 is incorporated herein by reference
to the section entitled "Executive Compensation and Other Matters" and "Proposal
1: Election of Directors - Directors Compensation" included in the 1998 Annual
Meeting Proxy Statement.
Item 11. Security Ownership of Certain Beneficial Owners and Management
The information required by Item 11 is incorporated herein by reference
to the section entitled "Security Ownership" included in the 1998 Annual Meeting
Proxy Statement.
<PAGE>
15
Item 12. Certain Relationships and Related Transactions
The information required by Item 12 is incorporated herein by reference
to the section entitled "Certain Relationships and Other Transactions" included
in the 1998 Annual Meeting Proxy Statement.
Item 13. Exhibits and Reports on Form 8-K
(a)(1) and (2): Financial Statements and Financial Statement Schedules
Reference is made to the Index to Financial Statements preceding the
consolidated financial statements included in response to Part II, Item 7 of
this annual report for a list of all financial statements filed.
(a)(3): Exhibits
Set forth below is a list of all exhibits filed herewith or incorporated
by reference as part of this Annual Report on Form 10-KSB.
Exhibit No. Description
- ----------- -----------
3.1 Amended and Restated Certificate of Incorporation of Teknowledge
Corporation (5)
3.2 Amended and Restated Bylaws of Teknowledge Corporation (9)
3.3 Certificate of Designation, Preferences and Rights of the Terms of
the Series A Preferred Stock (8)
4.1 Rights Agreement dated January 29, 1996 between the Company and
Registrar and Transfer Company as Rights Agent (8)
10.1 Teknowledge Corporation 1989 Stock Option Plan (7)
10.2 Amendment to Stock Option Agreement, dated November 30, 1988,
between American Cimflex Corporation and Romesh T. Wadhwani (1)
10.3 Amended Employment Agreement, dated as of January 21, 1992, between
Cimflex Teknowledge Corporation and Daniel R. Robusto (2)
10.4 Settlement Agreement, General Release, and Waiver of Claims, dated
November 21, 1992, between Daniel R. Robusto and Cimflex
Teknowledge Corporation (3)
10.5 Settlement Agreement, dated May 21, 1993, between Cimflex
Teknowledge Corporation and Third Copley-Franklin Trust (4)
10.6 Settlement Agreement, dated September 1, 1993, between Cimflex
Teknowledge Corporation and Pittsburgh Great Southern Company (4)
10.7 Change of Control Agreement, dated November 21, 1994, between
Teknowledge Corporation and Frederick Hayes-Roth and Neil
Jacobstein (6)
23.1 Consent of Arthur Andersen LLP, independent public accountants
27 Financial Data Schedule
<PAGE>
16
References
(1) Filed as an Exhibit to the Company's Annual Report on Form 10-K for
the fiscal year ended December 31, 1989.
(2) Filed as an Exhibit to the Company's Annual Report on Form 10-K for the
fiscal year ended December 31, 1991.
(3) Filed as an Exhibit to the Company's Annual Report on Form 10-K for the
fiscal year ended December 31, 1992.
(4) Filed as an Exhibit to the Company's Annual Report on Form 10-KSB, as
amended, for the fiscal year ended December 31, 1993.
(5) Filed as an Exhibit to the Company's Quarterly Report on Form 10-QSB for
the quarter ended June 30, 1994.
(6) Filed as an Exhibit to the Company's Annual Report on Form 10-KSB, for
the fiscal year ended December 31, 1994.
(7) Filed as an Exhibit to the Company's Annual Report on Form 10-KSB, for
the fiscal year ended December 31, 1995.
(8) Filed as an Exhibit to the Company's Current Report on Form 8-K dated
February 12, 1996, related to the adoption of a 12(g) Shareholder Rights
Agreement dated January 29, 1996.
(9) Filed as an Exhibit to the Company's Quarterly Report on Form 10-QSB for
the quarter ended March 31, 1996.
(b) Reports on Form 8-K
None.
(c) Exhibits
Reference is made to the response to Item 13(a)(3) above for a list of all
exhibits filed herewith or incorporated by reference as part of this Annual
Report on Form 10-KSB. Reference is also made to the Exhibit Index forming part
of this Annual Report on Form 10-KSB.
(d) Financial Statement Schedules
Reference is made to the response to Item 13(a)(1) and (2) above with
regard to the financial statement schedules filed as part of this Annual Report
on Form 10-KSB.
<PAGE>
17
SIGNATURES
In accordance with the requirements of Section 13 or 15(d) of the
Securities Exchange Act of 1934, the Registrant has duly caused this report to
be signed on its behalf by the undersigned, thereunto duly authorized.
Teknowledge Corporation
Date: March 30, 1998 By: /s/ Frederick Hayes-Roth
------------------------
Frederick Hayes-Roth
Chairman of the Board of
Directors
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
Name Capacity Date
---- -------- ----
/s/ Frederick Hayes-Roth Chairman of the Board March 30, 1998
- --------------------------- of Directors and
Frederick Hayes-Roth Chief Executive Officer
(Principal Executive
Officer)
/s/ Neil A. Jacobstein President, Chief Operating March 30, 1998
- --------------------------- Officer and Director
Neil A. Jacobstein
/s/ Dennis A. Bugbee Director of Finance, March 30, 1998
- --------------------------- Treasurer and Secretary
Dennis A. Bugbee (Principal Financial and
Accounting Officer)
/s/ Lawrence Druffel Director March 30, 1998
- ---------------------------
Lawrence Druffel
/s/ General Robert T. Marsh Director March 30, 1998
- ---------------------------
General Robert T. Marsh
/s/ William G. Roth Director March 30, 1998
- ---------------------------
William G. Roth
/s/ James C. Workman Director March 30, 1998
- ---------------------------
James C. Workman
<PAGE>
18
ANNUAL REPORT ON FORM 10-KSB
ITEM 7, ITEM 13(a)(1) and (2), (c) and (d)
LIST OF FINANCIAL STATEMENTS
CERTAIN EXHIBITS
FINANCIAL STATEMENTS
AS OF DECEMBER 31, 1997 AND FOR THE TWO YEARS ENDED DECEMBER 31, 1997
TEKNOWLEDGE CORPORATION
PALO ALTO, CALIFORNIA
<PAGE>
19
TEKNOWLEDGE CORPORATION
FORM 10-KSB - ITEM 13(a)(1) and (2)
LIST OF CONSOLIDATED FINANCIAL STATEMENTS
The following consolidated financial statements of Teknowledge Corporation are
included in Item 7:
Page
Report of Independent Public Accountants 20
Consolidated Balance Sheet - December 31, 1997 21
Consolidated Statements of Operations - Years ended
December 31, 1997 and 1996 22
Consolidated Statements of Stockholders' Equity - Years ended
December 31, 1997 and 1996 23
Consolidated Statements of Cash Flows - Years ended
December 31, 1997 and 1996 24
Notes to Consolidated Financial Statements 25 - 34
<PAGE>
20
Report Of Independent Public Accountants
To Teknowledge Corporation:
We have audited the accompanying consolidated balance sheet of Teknowledge
Corporation (a Delaware Corporation) and subsidiary as of December 31, 1997, and
the related consolidated statements of operations, stockholders' equity and cash
flows for the years ended December 31, 1997 and 1996. These financial statements
are the responsibility of the Company's management. Our responsibility is to
express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Teknowledge Corporation and
subsidiary as of December 31, 1997, and the results of their operations and
their cash flows for the years ended December 31, 1997 and 1996 in conformity
with generally accepted accounting principles.
/s/ Arthur Andersen LLP
San Jose, California
February 11, 1998
<PAGE>
21
TEKNOWLEDGE CORPORATION
CONSOLIDATED BALANCE SHEET
As of December 31, 1997
ASSETS
Current assets:
Cash and cash equivalents $ 2,172,235
-----------
Receivables:
Customer - billed, net of allowance of $10,000 1,949,476
Customer - unbilled 339,277
-----------
Total receivables 2,288,753
-----------
Deferred tax asset, short-term 400,000
Deposits and prepaid expenses 97,905
-----------
Total current assets 4,958,893
-----------
Capitalized software development costs, net of accumulated
amortization of $623,215 27,398
-----------
Fixed assets, at cost:
Computer and other equipment 2,758,384
Furniture and fixtures 103,909
Leasehold improvements 829,904
-----------
3,692,197
Less accumulated depreciation and amortization (3,093,603)
-----------
Net fixed assets 598,594
-----------
Deferred tax asset, long-term 500,000
-----------
Total assets $ 6,084,885
===========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 702,898
Payroll and related liabilities 744,934
Other accrued liabilities 477,012
-----------
Total current liabilities 1,924,844
-----------
Commitments and contingencies (Notes 4 and 11)
Stockholders' equity:
Preferred stock, $.01 par value, authorized 2,500,000
shares, Series A, Convertible, none issued -
Common stock, $.01 par value, authorized 50,000,000
shares, issued and outstanding 23,982,714 shares 239,823
Additional paid-in capital 1,217,055
Retained earnings since January 1, 1993
(following quasi-reorganization) 2,703,163
-----------
Total stockholders' equity 4,160,041
-----------
Total liabilities and stockholders' equity $ 6,084,885
===========
The accompanying notes are an integral part of these consolidated financial
statements.
<PAGE>
22
TEKNOWLEDGE CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
Years Ended December 31,
------------------------
1997 1996
---- ----
Revenues $ 11,094,930 $ 7,158,763
------------- -------------
Costs and expenses:
Cost of revenues 7,575,634 4,541,823
General and administrative 2,122,499 2,054,698
Sales and marketing 535,746 95,961
Research and development 206,603 -
------------- -------------
Total costs and expenses 10,440,482 6,692,482
------------- -------------
Operating income 654,448 466,281
Interest income 83,229 57,612
Other income and expense, net (Note 10) 1,145,108 173,131
------------- -------------
Income before tax 1,882,785 697,024
Provision (Benefit) for income tax (876,869) 24,650
------------- -------------
Net income $ 2,759,654 $ 672,374
============= =============
Net income per share:
- Basic $ 0.11 $ 0.03
============= =============
- Diluted $ 0.10 $ 0.02
============= =============
Shares used in computing net income per share:
- Basic 24,714,501 26,010,743
============= =============
- Diluted 28,878,933 30,275,473
============= =============
The accompanying notes are an integral part of these consolidated financial
statements.
<PAGE>
23
<TABLE>
TEKNOWLEDGE CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
<CAPTION>
Common Stock Retained
---------------------- Additional Earnings
Shares Par Paid-in Deferred (Accumulated Treasury
Issued Value Capital Compensation Deficit) Stock Total
-----------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
Balance, January 1, 1996 25,923,674 $ 259,232 $ 1,968,719 $ (120,173)$ (728,865) $ (3,000)$ 1,375,913
Exercise of stock options 173,096 1,731 5,773 - - - 7,504
Net income - - - - 672,374 - 672,374
Stock compensation expense - - - 120,173 - - 120,173
Reversal of portions of
provisions made prior to
quasi-reorganization for
restructuring reserve - - 18,306 - - - 18,306
------------- ---------- ------------ ------------- ------------- ------------ ------------
Balance, December 31, 1996 26,096,770 260,963 1,992,798 - (56,491) (3,000) 2,194,270
Exercise of stock options 248,913 2,490 16,078 - - - 18,568
Net income - - - - 2,759,654 - 2,759,654
Reversal of portions of
provisions made prior to
quasi-reorganization for
restructuring reserve - - 193,306 - - - 193,306
Company stock from
Trilogy settlement - - - - - (1,005,757) (1,005,757)
Retirement of treasury stock (2,362,969) (23,630) (985,127) - - 1,008,757 -
------------- ---------- ------------ ------------- ------------- ------------ ------------
Balance, December 31, 1997 23,982,714 $ 239,823 $ 1,217,055 $ - $ 2,703,163 $ - $ 4,160,041
============= ========== ============ ============= ============= ============ ============
The accompanying notes are an integral part of these consolidated financial statements.
</TABLE>
<PAGE>
24
TEKNOWLEDGE CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31,
------------------------
1997 1996
---- ----
Cash flows from operating activities:
Net income $ 2,759,654 $ 672,374
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 326,805 296,590
Noncash portion of other income from Trilogy
settlement (1,005,757) -
Stock compensation expense - 120,173
(Gain) Loss on sales of equipment 729 (100)
Changes in assets and liabilities:
Receivables (999,350) 65,975
Deposits and prepaid expenses (36,453) (4,748)
Deferred tax asset (900,000) -
Accounts payable 493,136 28,255
Accrued liabilities 225,123 (29,543)
------------- ------------
Net cash provided by operating activities 863,887 1,148,976
------------- ------------
Cash flows from investing activities:
Capitalization of software development costs (10,712) (59,485)
Purchase of fixed assets (500,426) (258,328)
Proceeds from sale of equipment 3,026 100
------------- ------------
Net cash used for investing activities (508,112) (317,713)
------------- ------------
Cash flows from financing activities:
Proceeds from issuance of common stock 18,568 7,504
Payments of capital lease obligations - (3,599)
------------- ------------
Net cash provided by financing activities 18,568 3,905
------------- ------------
Net increase in cash and cash equivalents 374,343 835,168
Cash and cash equivalents at beginning of year 1,797,892 962,724
------------- ------------
Cash and cash equivalents at end of year $ 2,172,235 $ 1,797,892
============= ============
The accompanying notes are an integral part of these consolidated financial
statements.
<PAGE>
25
TEKNOWLEDGE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1997
1. History and Business
Teknowledge Corporation (the "Company") is the surviving corporation
of the merger of American Cimflex Corporation ("Cimflex") and Teknowledge
Inc., which was consummated in 1989. Prior to 1993, Cimflex restructured
and divested a significant part of its operations. Reserves for
discontinued operations and restructuring obligations were established for
those events. In December 1992, the Board of Directors approved a
quasi-reorganization, which had the effect of eliminating the accumulated
deficit at December 31, 1992 of approximately $58 million by reducing
paid-in-capital. Adjustments to previously established reserves and
realization of tax benefits subsequent to the quasi-reorganization will be
recorded as adjustments to additional paid-in-capital in the future. As of
December 31, 1997, there remained approximately $73,000 of accrued
liabilities for discontinued operations and restructuring obligations,
which are scheduled to be paid in 1998.
The Company is in the distributed knowledge management business.
Teknowledge is leveraging its core competencies in knowledge based systems
and large scale, distributed object-oriented software with the expanding
opportunities presented by the Internet and the World Wide Web. The
Company provides software products and consulting services for primarily
government and commercial applications. The Company's key business lines
are: Distributed Systems Engineering, Situation Assessment and Data
Fusion, Education & Training Technologies, C4I and Information Security
Systems, and E-Commerce. The Company was incorporated on July 8, 1981
under the laws of the State of Delaware.
The Company recognizes that the continued success of the business is
dependent on key management and technical personnel, the loss of one or
more of whom could adversely affect the Company's business. The Company is
also subject to risks inherent to companies at a similar stage of
development, including the successful commercialization of the Company's
products, competition from larger companies with financial resources
greater than the Company, the ability to retain and attract employees, and
capital and financing needs.
2. Summary of Significant Accounting Policies
Use of Estimates in the 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
disclosure of contingent assets and liabilities at the date of the
financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from these
estimates.
Consolidated Financial Statements
The consolidated financial statements include the accounts of
Teknowledge Corporation and its wholly owned subsidiary, Teknowledge
Federal Systems, Inc. All significant intercompany transactions and
balances have been eliminated.
<PAGE>
26
2. Summary of Significant Accounting Policies (cont'd)
For certain income statement amounts, prior year balances have been
reclassified to conform to the current year presentation.
Cash and Cash Equivalents
The Company considers all highly liquid investments, with original
maturity dates of less than 90 days, as cash equivalents. As of December
31, 1997, the Company's funds were invested almost entirely in money
market instruments at various institutions.
Unbilled Receivables
Unbilled receivables represent differences between billings and
revenues recognized on cost-type contracts. The unbilled amounts primarily
represent (i) amounts which are recognized as revenue but not billed
pending receipt of the next funding authorization, (ii) timing differences
between incurred costs and billed costs, or (iii) a portion of the earned
fee held back as retention until the contract is completed and the final
indirect overhead rates have been determined. A substantial portion of the
retained fee may be billed to the government after the final indirect
rates are submitted to the government; however, they are subject to future
review and approval by the Defense Contract Audit Agency. The Company has
received final overhead rate approval for costs incurred through December
31, 1993.
Concentration of Credit Risk
The Company performs periodic credit evaluations of the financial
condition of commercial customers and generally does not require
collateral. Historically, the Company has experienced only minimal
write-offs from commercial receivables. The Company has not experienced a
credit loss from a government customer nor does it anticipate such losses.
Capitalized Software Development Costs
Teknowledge capitalizes software development costs starting from the
point technological feasibility is determined and continuing until the
general availability of the product. During 1997 and 1996, software
development costs of $10,712 and $59,485 were capitalized, respectively.
Amortization costs were $83,408 in 1997 and $114,458 in 1996.
The Company's policy is to amortize capitalized software development
costs by the greater of (a) the ratio that current gross revenues for a
product bear to the total of current and anticipated future gross revenues
for that product, or (b) the straight-line method over the remaining
estimated economic life of the product including the period being
reported on.
<PAGE>
27
2. Summary of Significant Accounting Policies (cont'd)
Fixed Assets
Equipment and improvements, which include assets under capital
leases, are depreciated using the straight-line method over their
estimated useful lives ranging from three to five years. Maintenance and
repairs are charged to expense as incurred. Leasehold improvements are
amortized over the shorter of the useful life or the remaining lease term.
Revenue Recognition
(a) Government Contracts
The Company's revenues are primarily generated from U.S. Government
contracts under which the Company may be either the prime contractor or a
subcontractor. The Company principally uses the percentage-of-completion
method of accounting for contract revenues. The percentage-of-completion
method is based on total costs incurred to date compared with estimated
total costs upon completion of contracts. The Company charges all losses
on contracts to operations in the period when the loss is known.
In 1997, approximately 99% of the Company's revenues were recorded
in connection with U.S. Government contracts, principally of the
cost-plus-fixed-fee type. These contracts are predominantly funded by the
Defense Advanced Research Projects Agency and administered by various
government agencies. In 1996 cost-type government contracts represented
approximately 98% of the revenues.
For the year ended December 31, 1997, the Naval Command, Control and
Ocean Surveillance Center ("NCCOSC") was the sponsor of the Company's two
largest government contracts, accounting for approximately 23% of total
revenues. This percentage represents a reduction from 1996, when NCCOSC
sponsored the Company's three largest government contracts, which accounted
for approximately 85% of the Company's revenues in that year. For 1997, the
third largest government contract, which contributed 9% of total
revenues, was sponsored by Rome Laboratories.
(b) Commercial Contracts
Revenues earned under software license agreements with end users are
generally recognized when the software has been shipped and there are no
significant obligations remaining. Revenue from post-contract customer
support is recognized ratably over the period the customer support
services are provided, and software services revenue is recognized as
services are performed.
Revenues from professional services provided principally under
technology contracts are recognized when costs for time and materials are
incurred.
<PAGE>
28
2. Summary of Significant Accounting Policies (cont'd)
Net Income Per Share
Net income per share is calculated in accordance with the provisions
of Statement of Financial Accounting Standards (SFAS) No. 128 "Earnings
per Share", adopted by the Company in the fourth quarter of 1997. SFAS No.
128 requires companies to compute earnings per share under two different
methods (basic and diluted). Basic earnings per share is calculated by
dividing net income (loss) by the weighted average shares of common stock
outstanding during the period. Diluted earnings per share is calculated by
dividing net income (loss) by the weighted average shares of outstanding
common stock and common stock equivalents during the period. Common stock
equivalents included in the diluted calculation consist of dilutive shares
issuable upon the exercise of outstanding common stock options. As a
result, the 1996 earnings per share amount has been restated. The effect
of this accounting change on previously reported earnings per share data
was as follows:
1996
----
Earnings per share as previously reported $0.02
Effect of SFAS No. 128 0.01
-----
Basic earnings per share $0.03
=====
A summary of the earnings per share calculation for each of the two
years ended December 31, 1997 and 1996 is as follows (in thousands, except
per share amounts):
1997 1996
---- ----
Basic earnings per share:
Net income $2,760 $ 672
Weighted average common shares 24,715 26,011
------ ------
Basic earnings per share $ 0.11 $ 0.03
====== ======
Diluted earnings per share:
Net income $2,760 $ 672
------ ------
Weighted average common shares 24,715 26,011
Weighted average common shares equivalent:
Options 4,164 4,264
------ ------
Diluted weighted average common shares 28,879 30,275
------ ------
Diluted earnings per share $ 0.10 $ 0.02
====== ======
SFAS 123 Accounting for Stock-Based Compensation
Effective January 1, 1997, the Company adopted the disclosure
provisions of SFAS No. 123, "Accounting for Stock-Based Compensation." The
adoption did not have a significant effect on the Company's results of
operations as the Company continues to apply the principles of APB Opinion
No. 25 and related interpretations in accounting for the Company's stock
plans. Note 9 to the Consolidated Financial Statements contains a summary
of the pro forma effects on reported net income and earnings per share for
1997 and 1996 based on the fair value of the options at the grant date as
prescribed by SFAS 123.
<PAGE>
29
2. Summary of Significant Accounting Policies (cont'd)
New Accounting Standards
During 1997, the Financial Accounting Standards Board ("FASB")
issued SFAS No. 130 "Reporting Comprehensive Income" and SFAS No. 131
"Disclosures About Segments of an Enterprise and Related Information." The
Company's adoption of these standards in the fourth quarter of 1997 has no
effect on the Company's consolidated financial statements.
3. Other Accrued Liabilities
Other Accrued liabilities as of December 31, 1997 consist of the
following:
Legal reserve $ 184,134
Provision for contract charges 150,000
Restructuring reserve 54,534
Provision for discontinued operations 18,305
Miscellaneous 70,039
---------
$ 477,012
=========
4. Commitments
Teknowledge leases its facilities and certain equipment under
operating leases. As of December 31, 1997, the Company had active leases
in Palo Alto and San Diego, California, Fairfax and Arlington, Virginia,
and Orlando, Florida. The remaining obligations under these leases are as
follows:
Year Ending
December 31,
------------
1998 $382,000
1999 212,000
2000 160,000
2001 126,000
2002 45,000
--------
$925,000
========
Rent expense for the years ended December 31, 1997 and 1996
totaled $421,655 and $326,720, respectively.
5. Line of Credit
The Company has a $1,500,000 unsecured line of credit agreement with a
bank. The line expires on June 10, 1998 and can be extended from year to
year. The Company can borrow up to 60% of the eligible receivables base or
$1,500,000, whichever is lower. The maximum rate that may be charged is one
percent over the bank's prime rate. The agreement includes certain
financial reporting and disclosure requirements that were met during the
year. The line was not utilized in 1997.
<PAGE>
30
6. Tax Loss Carryforwards
The Company accounts for income taxes in accordance with Statement
of Financial Accounting Standards No. 109 ("SFAS 109"), "Accounting for
Income Taxes." SFAS 109 is an asset and liability approach for computing
deferred income taxes based on enacted tax laws and rates applicable to
the period in which the taxes become payable.
The provision for income taxes differs from the statutory U.S.
Federal income tax rate due to the following:
1997 1996
---- ----
Provision at U.S. statutory rate 34.0% 34.0%
State income taxes, net of Federal benefit 6.1 6.1
Permanent differences 0.0 7.0
Change in valuation allowance (86.7) (43.6)
------ -----
Provision (benefit) for income taxes (46.6)% 3.5%
====== =====
The components of the net deferred income tax asset as of December
31, 1997 was as follows:
Net operating loss carryforwards $27,701,153
Cumulative temporary differences 516,593
Tax credit carryforwards 1,756,613
-----------
29,974,359
Valuation allowance (29,074,359)
-----------
Net deferred income tax asset $ 900,000
===========
The valuation allowance consists of net operating losses, cumulative
temporary differences and tax credit carryforwards which may expire before
they can be used. The Company believes sufficient uncertainty exists
regarding the realizability of these items, and accordingly, a valuation
allowance has been established.
At December 31, 1997, the Company had net operating loss carryforwards
of approximately $81 million available to offset future Federal taxable
income. These loss carryforwards expire through the year 2009. The
availability and timing of the amount of prior losses to be used to offset
taxable income in future years may be limited due to various provisions,
including any change in ownership interest of the Company resulting from
significant stock transactions.
Realization of the net deferred tax asset of $900,000 as of December
31, 1997 is dependent on generating sufficient taxable income to offset
future deduction of the related items. Although realization is not assured,
management believes it is more likely than not that the net deferred tax
asset will be realized. The amount of the deferred tax asset considered
realizable, however, could be reduced in the near term if estimates of
future taxable income are reduced.
<PAGE>
31
7. 401(k) Plan
Teknowledge has a 401(k) plan covering all of the Company's regular
employees. Participants in the plan may make a contribution as a percentage
of their gross wages subject to the applicable government limits. Effective
January 1, 1998, the Board of Directors amended the Plan, and increased the
Company matching provision of eligible wages from 3% to 4%. The Company
matching contribution vests at 20% a year over a five-year period. During
1997, the Company contributed $115,599 to the plan.
8. Executive Compensation Plan
The Chief Executive Officer and the President of the Company each
have an employment agreement that provides for annual base salaries and an
incentive compensation plan with target objectives established in the five
strategic areas of cash flow, profitability, bookings, new commercial
lines, and recruiting, that were determined and assessed by the Board of
Directors to a maximum of 100% of base salary. As of December 31, 1997,
$249,137 in incentive compensation was accrued for these executives and
was included in Accrued Payroll & Related Liabilities.
9. Stock-Based Compensation Plans
The Company has two stock option plans. The stock option plan for
employees is called the Teknowledge Corporation 1989 Stock Option Plan
(the "1989 Plan") and the stock option plan for Directors is called the
Teknowledge Plan for Non-Employee Directors. The Company accounts for
these plans under APB Opinion No. 25, under which no compensation cost has
been recognized.
Had compensation cost for this plan been determined consistent with
SFAS 123, the Company's net income and earnings per share would have been
reduced to the following pro forma amounts:
1997 1996
---- ----
Net Income As Reported $2,759,654 $672,374
Pro Forma $2,642,156 $575,043
Diluted EPS As Reported $.10 $.02
Pro Forma $.09 $.02
Because the SFAS 123 method of accounting has not been applied to
options granted prior to January 1, 1995, the resulting pro forma
compensation cost may not be representative of that to be expected in
future years.
The Company may grant options for up to 10,250,000 shares under the
1989 Plan for employees.The Company has granted options for 800,000 shares
($.38 - $.65 per share) and 459,022 shares ($.25 - $.86 per share) in 1997
and 1996, respectively, and has reserved for issuance a total of 6,545,288
shares through December 31, 1997. The Board of Directors has granted
options to employees that are either incentive stock options ("ISO") or
non-statutory stock options ("NSO"). For ISO, the exercise price of the
common stock options granted under the 1989 Plan may not be less than the
fair market price on the date of grant. For NSO, the exercise price of the
<PAGE>
32
9. Stock-Based Compensation Plans (cont'd)
common stock may not be less than 85% of the fair market price of the
common stock on the date of grant. Options that have been granted normally
vest in quarterly increments starting the second year of a three-year
term and expire ten years after the grant date. The 1989 Stock Option
Plan is scheduled to expire at the end of 1998.
The Company also has a stock option plan for non-employee directors.
The aggregate number of shares which may be issued under the Plan may not
exceed 250,000 shares of Common Stock. 60,000 shares were available for
future grant as of December 31, 1997. Under this plan, non-employee
directors are entitled to receive annual option grants to purchase 15,000
shares of Common Stock on their initial election to the Board and
thereafter on the anniversary date of their election to the Board.
Options, which are granted at fair market value, are exercisable one year
after the grant date and expire ten years from the grant date. Options to
purchase a total of 165,000 shares were outstanding as of December 31,
1997 at $.15 to $.86 per share and a weighted average of $.56 per share.
Options for 105,000 shares at $.15 to $.86 per share and a weighted
average of $.55 per share were vested at December 31, 1997. Options for
25,000 shares were exercised at a weighted average price of $.21 during
the year.
A summary of the status of the Company's stock option plans as
of December 31, 1997 and 1996, and changes during the years then ending
is presented below:
1997 1996
------------------ -----------------------
Wtd Avg Wtd Avg
Shares Ex Price Shares Ex Price
------------------ -----------------------
Outstanding at beg.of year 6,046,828 $.32 5,880,902 $.30
Granted 990,000 .48 459,022 .55
Exercised (248,913) .07 (173,096) .04
Forfeited (445,334) .50 (120,000) .17
------------------ -----------------------
Outstanding at end of year 6,342,581 .35 6,046,828 .32
------------------ -----------------------
Exercisable at end of year 5,586,705 .33 5,520,453 .31
Weighted average fair value
of options granted $0.27 $0.39
The following table summarizes information about stock options
outstanding at December 31, 1997:
<PAGE>
33
9. Stock-Based Compensation Plans (cont'd)
Options Outstanding Options Exercisable
------------------------------- ------------------------
Wtd Avg
Range of Number Remaining Number
Ex Prices Outstanding Plan Life Wtd Avg Exercisable Wtd Avg
($'s) 12/31/97 (Years) Ex Price 12/31/97 Ex Price
----------- ------------------------------- ------------------------
.01 - .03 4,051,164 6.5 $ .03 4,044,914 $ .03
.04 - .99 1,498,938 7.9 .44 749,312 .37
1.00 -3.53 792,479 .8 1.80 792,479 1.80
------------- -------------
.01 -3.53 6,342,581 6.1 .35 5,586,705 .33
------------- -------------
The fair value of each option grant is estimated on the date of
grant using the Black-Scholes option pricing model with the following
weighted-average assumptions used for grants in 1997 and 1996,
respectively; risk-free interest rates of 6.3 and 6.1 percent; expected
lives of 5.3 and 3.4 years; expected volatility of 50% and 100%; and
expected dividend yield of 0%.
As of December 31, 1997, the following number of shares of Common
Stock have been reserved for future issuance under both Plans:
Teknowledge Corporation 1989 Stock Option Plan 6,545,288
Stock Option Plan for Non-Employee Directors 225,000
---------
6,770,288
=========
10. Other Income and expense
The composition of other income and expense is as follows:
1997 1996
---- ----
Income from sale of product line $ - $148,998
Settlement of patent litigation, net 1,145,108 -
Other - 24,133
---------- --------
Total $1,145,108 $173,131
========== ========
On May 15, 1997, the Company and Trilogy Development Group, Inc.
("Trilogy") agreed to a settlement of all outstanding lawsuits and debts
between the companies. The Settlement Agreement, License Agreement, and
Mutual Release specifies that the Company immediately grant to Trilogy a
non-exclusive, royalty-free license to the Company's United States Patent
4,591,983 in exchange for 2,338,969 shares of Company stock owned by
Trilogy, with a fair value of $1,006,000, based on the average
trading stock price over six months preceding the settlement, and $400,000
in cash. After the provision for legal fees of $260,000, net proceeds
of $1,145,000 were reported as Other Income.
<PAGE>
34
11. Contingencies
Litigation
The Company is subject to legal proceedings and claims, either
asserted or unasserted, which arise in the ordinary course of business
from time to time. While the outcome of these claims cannot be predicted
with certainty, management does not believe that the outcome of any of the
pending legal matters will have a material adverse effect on the Company's
consolidated results of operations or consolidated financial position.
Change of Control - Severance Benefits
In the event of a change of control, defined as any consolidation or
merger of the Company in which the Company is not the continuing or
surviving corporation, the Chief Executive Officer and the President of
the Company will be entitled to severance benefits to include: (i) full
accrued salaries and vacation pay, (ii) accrued incentive compensation
awarded or determined to be awarded by the Board of Directors, (iii)
insurance coverage, (iv) retirement benefits and (v) a lump sum severance
payment equal to two times their most recent respective annual salaries.
Rights Agreement
On January 29, 1996, the Company's Board of Directors approved a
Rights Agreement (the "Plan"). The adoption of the Plan is intended as a
means to guard against takeover tactics designed to gain control of
Teknowledge without paying all stockholders full and fair value.
Under the Plan, stockholders will receive a Right to purchase one
one-hundredth of a share of a new series of Preferred Stock for each
outstanding share of Teknowledge Common Stock of record held at the close
of business on February 12, 1996.
The Rights, which will initially trade with the Common Stock, become
exercisable to purchase one one-hundredth of a share of the new Preferred
Stock, at $2.00 per Right, when a third party acquires 15 percent or more
of Common Stock or announces a tender offer which could result in such
person owning 15 percent or more of Common Stock. Each one one-hundredth
of a share of the new Preferred Stock has terms designed to make it
substantially the economic equivalent of one share of Common Stock. Prior
to a third party acquiring 15 percent, the Rights can be redeemed for
$.001 each by action of the Board. Under certain circumstances, if a third
party acquires 15 percent or more of Common Stock, the Rights permit the
holders to purchase Teknowledge Common Stock having a market value of
twice the exercise price of the Rights, in lieu of the Preferred Stock. In
addition, in the event of certain business combinations, the Rights permit
purchase of the Common Stock of an acquirer at a 50 percent discount. In
either case, Rights held by the acquirer will become null and void.
<PAGE>
Exhibit 23.1
CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS
As independent public accountants, we hereby consent to the incorporation of our
report included in this Form 10-KSB, into the Company's previously filed
Registration Statements File Nos. 33-27291, 33-77874, 33-78984, 33-82720 and
333-00261 on Form S-8.
/s/ Arthur Andersen LLP
San Jose, California
March 27, 1998
<TABLE> <S> <C>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-START> JAN-01-1997
<PERIOD-END> DEC-31-1997
<CASH> 2,172,235
<SECURITIES> 0
<RECEIVABLES> 1,959,476
<ALLOWANCES> 10,000
<INVENTORY> 0
<CURRENT-ASSETS> 4,958,893
<PP&E> 3,692,197
<DEPRECIATION> 3,093,603
<TOTAL-ASSETS> 6,084,885
<CURRENT-LIABILITIES> 1,924,844
<BONDS> 0
0
0
<COMMON> 239,823
<OTHER-SE> 2,920,218
<TOTAL-LIABILITY-AND-EQUITY> 6,084,885
<SALES> 0
<TOTAL-REVENUES> 11,094,930
<CGS> 0
<TOTAL-COSTS> 7,575,634
<OTHER-EXPENSES> 2,864,848
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> 1,882,785
<INCOME-TAX> (876,869)
<INCOME-CONTINUING> 2,759,654
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 2,759,654
<EPS-PRIMARY> 0.11
<EPS-DILUTED> 0.10
</TABLE>
