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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[x] Quarterly report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
FOR THE QUARTERLY PERIOD ENDED DECEMBER 31, 1996
or
[_] Transition report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from _____ to _____
COMMISSION FILE NUMBER 0-12167
RATIONAL SOFTWARE CORPORATION
(Exact name of Registrant as specified in its charter)
DELAWARE 54-1217099
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
2800 SAN TOMAS EXPRESSWAY, SANTA CLARA, CA 95051-0951
(Address of principal executive office) (Zip Code)
408-496-3600
(Registrant's telephone number including area code)
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes [x] No [_]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock as of the latest practicable date.
COMMON STOCK, PAR VALUE 40,254,005
$.01 PER SHARE
(Class) (Shares outstanding on January 31,
1997)
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CONTENTS PAGE
<S> <C>
PART I -- FINANCIAL INFORMATION
Item 1 -- Consolidated Financial Statements:
Condensed Consolidated Balance Sheets................................. 3
Condensed Consolidated Statements of Operations....................... 5
Condensed Consolidated Statements of Cash Flows....................... 6
Notes to Condensed Consolidated Financial Statements.................. 7
Item 2 -- Management's Discussion and Analysis of Financial Condition
and Results of Operations ............................................ 9
PART II -- OTHER INFORMATION
Item 1 -- Legal Proceedings..................................................... 19
Item 5 -- Other Information..................................................... 19
Item 6 -- Exhibits and Reports on Form 8-K...................................... 19
SIGNATURE........................................................................ 20
</TABLE>
2
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RATIONAL SOFTWARE CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
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<CAPTION>
ASSETS
- ------
December 31, March 31,
1996 1996
---------------- -------------
<S> <C> <C>
(Unaudited)
Cash and cash equivalents $221,998 $ 43,934
Short-term investments 7,751 8,711
Accounts receivable, net 25,387 23,408
Prepaid expenses and other assets 1,971 2,074
---------------- -------------
Total current assets 257,107 78,127
Property and equipment, at cost:
Computer, office and manufacturing equipment 23,977 22,779
Office furniture 1,981 2,109
Leasehold improvements 1,264 1,209
---------------- -------------
27,222 26,097
Accumulated depreciation and amortization (20,737) (20,715)
---------------- -------------
Property and equipment, net 6,485 5,382
Other assets, net 6,974 2,165
---------------- -------------
Total assets $270,566 $ 85,674
================ =============
</TABLE>
3
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RATIONAL SOFTWARE CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT PAR VALUE)
LIABILITIES AND STOCKHOLDERS' EQUITY
- ------------------------------------
<TABLE>
<CAPTION>
December 31, March 31,
1996 1996
-------------- --------------
(Unaudited)
<S> <C> <C>
Accounts payable $3,348 $2,983
Accrued employee benefits 8,602 8,476
Other accrued expenses 6,288 4,285
Accrued merger and restructuring expenses, current portion 720 575
Deferred revenue 11,177 15,606
Current portion of long-term debt and lease obligations 3 654
-------------- --------------
Total current liabilities 30,138 32,579
Accrued rent 590 880
Accrued merger and restructuring expenses, long-term 980 1,309
-------------- --------------
Total liabilities 31,708 34,768
-------------- --------------
Stockholders' equity:
Common stock, $.01 par value, 75,000
shares authorized 405 336
Additional paid-in capital 306,089 113,771
Treasury stock (1,340) (1,340)
Accumulated deficit (66,162) (61,995)
Cumulative translation adjustment (134) 134
-------------- --------------
Total stockholders' equity 238,858 50,906
-------------- --------------
Total liabilities and stockholders' equity $270,566 $85,674
============== ==============
</TABLE>
See accompanying notes
4
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RATIONAL SOFTWARE CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS, UNAUDITED)
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
December 31, December 31,
----------------------------- -----------------------------
1996 1995 1996 1995
----------------------------- -----------------------------
<S> <C> <C> <C> <C>
Net product revenue $ 20,826 $ 14,905 $55,997 $40,174
Consulting and support revenue 11,429 9,099 32,335 25,229
------------ ------------ ------------ ------------
Total revenue 32,255 24,004 88,332 65,403
Cost of product revenue 2,329 1,952 6,235 5,081
Cost of consulting and support revenue 6,106 4,860 17,038 13,788
------------ ------------ ------------ ------------
Total cost of revenue 8,435 6,812 23,273 18,869
------------ ------------ ------------ ------------
Gross margin 23,820 17,192 65,059 46,534
Research and development expenses 4,852 5,374 13,807 11,830
Sales and marketing expenses 10,812 10,906 28,694 26,989
General and administrative expenses 5,252 3,446 10,289 7,223
Charges for acquired in-process research and development 17,658 8,700 17,658 8,700
------------ ------------ ------------ ------------
Total operating expenses 38,574 28,426 70,448 54,742
------------ ------------ ------------ ------------
Operating loss (14,754) (11,234) (5,389) (8,208)
Other income, net 2,391 291 3,610 917
------------ ------------ ------------ ------------
Loss before income taxes (12,363) (10,943) (1,779) (7,291)
Provision for income taxes 800 220 2,388 512
------------ ------------ ------------ ------------
Net loss $(13,163) $(11,163) $(4,167) $(7,803)
============ ============ ============ ============
Net loss per common share $(0.34) $(0.34) $(0.12) $(0.26)
Shares used in computing per share amounts 38,833 32,466 35,668 29,968
</TABLE>
See accompanying notes
5
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RATIONAL SOFTWARE CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS, UNAUDITED)
<TABLE>
<CAPTION>
Nine Months Ended
December 31,
------------------------------
1996 1995
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<S> <C> <C>
Cash flows from operating activities:
Net loss $(4,167) $(7,803)
Adjustments to reconcile net loss to net
cash provided by operating activities:
Charges for acquired in-process research and development 17,658 8,700
Depreciation and amortization 3,307 3,665
Amortization of deferred compensation 109 0
(Increase) decrease in assets:
Accounts receivable (1,979) 340
Prepaids and other, net (122) (3,211)
Increase (decrease) in liabilities:
Accounts payable 365 1,120
Accrued employee benefits 126 1,755
Deferred revenue (4,429) (1,261)
Accrued expenses 1,445 (50)
Accrued merger and restructuring expenses (184) 1,131
-------------- -------------
Net cash provided by operating activities 12,129 4,386
Cash flows used in investing activities:
Purchase of investments (8,173) (2,479)
Sale of investments 9,133 3,459
Capital expenditures (3,652) (2,256)
Purchase of Visual Test product (23,000) 0
-------------- -------------
Net cash used in investing activities (25,692) (1,276)
Cash flows from financing activities:
Principal payments under debt and lease obligations (651) (1,842)
Proceeds from issuance of common stock 192,278 32,166
-------------- -------------
Net cash provided by financing activities 191,627 30,324
-------------- -------------
Net increase in cash and cash equivalents 178,064 33,434
Cash and cash equivalents at beginning of period 43,934 9,440
-------------- -------------
Cash and cash equivalents at end of period $221,998 $42,874
============== =============
</TABLE>
6 See accompanying notes.
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RATIONAL SOFTWARE CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION -- The consolidated financial information included
herein has been prepared without audit in accordance with the Company's
accounting policies, as described in its latest annual report filed with
the Securities and Exchange Commission on Form 10-K. In the opinion of
management, all adjustments, which consist only of normal recurring
adjustments necessary for a fair presentation of the Company's financial
position, statements of income, and cash flows for the interim periods
presented have been made. As permitted by Form 10-Q, certain information
and footnote disclosures normally included in financial statements prepared
in accordance with generally accepted accounting principles have been
condensed or omitted where such disclosure would substantially duplicate
previous disclosures. Operating results for the period ended December 31,
1996 are not necessarily indicative of the results that may be expected for
the year ending March 31, 1997.
2. ACCOUNTS RECEIVABLE -- Accounts receivable were reduced by an allowance for
doubtful accounts of $1,046,000 at December 31, 1996 and $1,042,000 at
March 31, 1996, respectively.
3. NET LOSS PER COMMON SHARE -- Net loss per share has been computed by
dividing the net loss by the weighted average number of common shares
outstanding during the period.
4. CONTINGENCY -- On December 1, 1995, Interactive Development Environments
("IDE") filed an action against the Company in the San Francisco County
Superior Court seeking monetary damages in excess of $3 million and other
relief for the Company's alleged breach of an alleged contract,
misrepresentation and related claims based on Rational's preliminary, non-
binding merger discussions in 1995 with IDE. In March 1996, the court
sustained the Company's demurrer to IDE's claim for specific performance of
the alleged contract between the parties. In October 1996, IDE amended its
complaint to add a claim for "Fraud--Non-Disclosure," in which it alleges
that the Company was obligated to tell IDE of its acquisition discussions
regarding Objectory AB, and to lower the amount of damages claimed to $2
million. Trial on IDE's remaining claims is set for April 1997. In February
1997, IDE dropped its breach of contract claim and a related claim. The
Company believes IDE's complaints are without merit and intends to defend
the case vigorously, although the Company makes no assurance that it will
be successful in defending the action. There are no other material pending
legal proceedings to which the Company is a party or to which any of the
Company's property is subject.
5. MAJOR CUSTOMERS -- Sales to one customer, Lockheed Martin Corporation,
accounted for 10.9% of revenue for the three-months ended December 31,
1996. No single customer accounted for 10% or more of revenues for the
nine-month period ending December 31, 1996, or during the comparable
periods in fiscal 1996.
6. STOCKHOLDERS' EQUITY -- On July 23, 1996, the Company's Board of Directors
approved a two-for-one stock split payable in the form of a stock dividend
to stockholders of record as of August 27, 1996. All shares and per share
information have been adjusted to reflect this change. On August 27, 1996
the stockholders approved an increase in the authorized number of shares of
common stock from 25,000,000 to 75,000,000. On September 10, 1996, the
stock dividend was distributed to stockholders.
During October 1996, the Company sold 5,188,094 shares of common stock in a
public offering. Net proceeds from the sales were approximately
$186,000,000 after deducting underwriting discounts, commissions and other
related expenses. The Company was contractually obligated to
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reimburse certain of its stockholders who participated in the offering as
selling shareholders for the underwriting discount applicable to the shares
of common stock sold by them, as well as certain fees and expenses of such
stockholders' legal counsel incurred in connection with the public
offering. The reimbursement resulted in a reduction in earnings of
approximately $1,200,000 for the quarter ended December 31, 1996.
7. MERGERS AND PRODUCT ACQUSITIONS -- On October 2, 1996, the Company
purchased the Visual Test product from Microsoft Corporation. The purchase
price consisted of a single $23,000,000 cash payment, of which $17,658,000
was allocated to acquired in-process research and development. In-process
research and development represents the present value of the estimated
discounted cash flow expected to be generated by Visual Test related
technology, which at the acquisition date had not yet reached the point of
technological feasibility and does not have an alternative future use. The
acquired in-process research and development was written off and charged to
operations during the quarter ended December 31, 1996. The balance of the
purchase price was allocated to other intangible assets having an estimated
useful life of approximately 5 years.
On November 12, 1996, the Company and SQA, Inc., (SQA) a provider of
automated software quality testing tools, jointly announced a definitive
merger agreement whereby all outstanding shares of SQA common stock will be
exchanged for shares of the Company on the basis of 0.86 shares of the
Company for each share of SQA. The transaction is expected to be accounted
for as a pooling of interests and to qualify as a tax-free reorganization.
Completion of the transaction is subject to customary conditions, including
approval by the stockholders of the Company and SQA at a special meeting of
the stockholders scheduled for February 26, 1997. The merger is expected to
close in the fourth quarter of fiscal 1997. Upon completion of the merger,
the Company expects to recognize a one-time charge related to certain
merger costs and related expenses in the fourth quarter of its fiscal 1997.
The Company and SQA estimate that they will incur aggregate direct
transaction costs of approximately $3 million associated with the merger,
which will be charged to operations upon consummation of the merger. The
Company expects to incur additional charge to operations of between $5
million and $7 million primarily in the quarter ended March 31, 1997 to
reflect costs associated with integrating the two companies.
8. SUBSEQUENT EVENT -- During February, 1997, the Company purchased Requisite,
Inc. a Colorado based provider of software requirements-management tools
and training, for $8.5 million cash. The acquisition is being treated as a
purchase transaction. The Company expects to allocate a substantial portion
of the acquisition cost to acquired in-process research and development,
which will be expensed in the March quarter. As a result of this charge and
charges associated with the previously announced acquisition of SQA, Inc.,
which is expected to be completed in February 1997, the Company will incur
a loss in the March quarter and for the fiscal year.
8
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ITEM 2 -- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
OVERVIEW
The statements contained in Management's Discussion and Analysis of Financial
Condition and Results of Operations include "forward looking" information within
the meaning of Sections 27A of the Securities Act of 1933 and 21E of the
Securities and Exchange Act of 1934, as amended, and are subject to the safe
harbor created by those sections. The actual future results of the Company could
differ materially from those projected in the forward looking information. For a
discussion of certain factors that could cause actual results to differ
materially from those projected by the forward looking information, see "Factors
That May Affect Future Results". The Company assumes no obligation to update the
forward-looking information or such factors.
The Company's revenue is derived from product license fees and charges for
services, including technical consulting, training, and customer support. In
accordance with generally accepted accounting principles, the Company recognizes
software license revenue upon shipment and recognizes customer-support revenue
over the term of the maintenance agreement. Revenue from consulting and training
is recognized when earned. The Company's license agreements generally do not
provide a right of return, and reserves are maintained for potential credit
losses, of which historically there have been only immaterial amounts.
COMPARATIVE ANALYSIS OF OPERATING RESULTS FOR THE THREE AND NINE MONTHS
ENDED DECEMBER 31, 1996
Total revenue increased 34% and 35%, respectively, for the three- and nine-month
periods ended December 31, 1996 from the comparable prior year periods. The
Company's revenue is derived from product license fees and charges for services
including training, consulting, and customer support.
Net product revenue increased by 40% and by 39%, respectively, for the three-and
nine-month periods ended December 31, 1996 from the comparable prior year
periods. The increase in net product revenue for the three-month period was due
to continued strong customer acceptance of the Company's object modeling tools
(the Rational Rose family), while year-to-date product revenue was also
positively impacted by the introduction of new versions of the Company's
Rational Apex product for C/C++ application construction.
Consulting and support revenue increased 26% and 28% , respectively, in the
fiscal 1997 three- and nine-month periods versus the same fiscal 1996 periods.
These increases reflected higher demand for the Company's consulting expertise
in object modeling and advanced software development practices, and, to a
lesser extent, increased training and customer support revenues.
International revenues from product sales and related consulting and customer
support accounted for 29% and 32%, respectively, of total revenues for the
three-and nine-month periods ended December 31, 1996, as compared to 34% and
35%, respectively, for the same fiscal 1996 periods. The Company's international
sales are principally priced in foreign currencies and are generally exported
out of the U.S. Rational has attempted to limit its exposure to fluctuations in
foreign currencies from time to time by utilizing a hedging strategy for
existing receivables denominated in various primarily European foreign
currencies. At December 31, 1996, the Company had unhedged net monetary assets
denominated in foreign currencies of less than 5% of working capital. The impact
of using actual exchange rates throughout the three- and nine-month periods as
compared to the exchange rates in effect for the comparable periods of the prior
fiscal year was immaterial to the Company's results of operations.
9
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Cost of product revenue consists principally of materials, packaging and
freight, and royalties. Cost of product revenue increased 19% and 23% for the
three- and nine-month periods of fiscal 1997 compared to the corresponding
periods of fiscal 1996. These costs represented 11% of total product revenue for
the three- and nine-month periods of fiscal 1997 compared to 13% for the
corresponding periods of fiscal 1996. The decrease in product cost as a
percentage of product revenue was due mainly to lower royalty expenses to
third parties.
Cost of consulting and support revenue consists principally of personnel costs
for training, consulting and customer support. Cost of consulting and support
increased 26% and 24% for the three- and nine-month periods of fiscal 1997
compared to the corresponding periods of fiscal 1996. These costs represented
53% of total consulting and support revenue for the three- and nine-month
periods of fiscal 1997 compared to 53% and 55% for the corresponding periods of
fiscal 1996. The nine-month decrease in cost as a percentage is primarily due to
more efficient management of the Company's consulting resources, combined with
the impact of an underlying relatively fixed support cost base being spread over
increased revenues.
Total expenditures for research and development decreased 10% for the three-
month period of fiscal 1997 compared to the corresponding period of fiscal 1996;
however, total expenditures increased 17% for the nine-month period of fiscal
1997 compared to the corresponding period of fiscal 1996. Research and
development costs represented 15% and 16% of total revenue for the three- and
nine-month periods of fiscal 1997 compared to 22% and 18% for the corresponding
periods of fiscal 1996. The comparative decrease in research and development
expense as a percent of revenues is by reason of the fiscal 1996 periods
including nonrecurring operating and merger-related expenses associated with the
acquisition of Objectory AB in October 1995.
Sales and marketing expenses decreased 1% for the three-month period of fiscal
1997 compared to the corresponding period of fiscal 1996 and increased 6% for
the nine-month period of fiscal 1997 compared to the corresponding period of
fiscal 1996. These expenses represented 33% and 32% of total revenue for the
three- and nine-month periods of fiscal 1997 compared to 45% and 41% for the
corresponding periods of fiscal 1996. The fiscal 1997 results include increased
marketing expenditures related to the promotion of the Visual Test product. The
comparative decrease in sales and marketing expenses as a percent of revenues is
because of the fiscal 1996 periods including nonrecurring operating and merger-
related expenses associated with the acquisition of Objectory AB in October
1995.
General and administrative expense consists of personnel costs for
administration, finance, information systems, human resources and general
management, as well as legal and accounting expenses. General and administrative
expense increased 52% and 42% for the three- and nine-month periods of fiscal
1997 compared to the corresponding periods of fiscal 1996. General and
administrative expenses represented 16% and 12% of total revenue for the three-
and nine-month periods of fiscal 1997 compared to 14% and 11% for the
corresponding periods of fiscal 1996. The increased expense for the fiscal 1997
periods resulted from increased employee-related expenses associated with
staffing requirements needed to support the Company's expanding business, and
the reimbursement of approximately $1,200,000 in expenses of certain of its
stockholders for the underwriting discount applicable to the shares of common
stock sold by them, as well as certain fees and expenses of such stockholders'
legal counsel incurred in connection with the Company's October 1996 public
stock offering. In addition, amortization of goodwill increased to $436,000 and
$704,000 for the three- and nine-month periods ended December 31, 1996,
respectively, from $134,000 and $260,000, respectively, for the corresponding
periods of fiscal 1996 as a result of the Objectory AB and Visual Test
acquisitions.
On October 2, 1996, Rational and Microsoft announced the formation of a business
alliance that will consist of Rational's acquisition of Microsoft's Visual Test
product, technology cross-licensing arrangements and certain joint development
projects and marketing programs. The purchase price of the Visual Test product
consisted of a single $23 million cash payment, which is being accounted for
using the purchase method. The Company's operating results for
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acquired in-process research and development of $17,658,000. The charge to
operations for acquired in-process research and development represents the
present value of the estimated cash flow expected to be generated by Visual Test
related technology, which at the acquisition date had not yet reached the point
of technological feasibility and does not have an alternative future use.
Rational intends to continue devoting effort to developing commercially viable
products from the acquired in-process research and development. Amounts
attributed to other purchased intangible assets will be amortized to operations
over their estimated useful lives, which in most cases are two to four years.
Other income, net consists of interest income, interest expense, gains and
losses on foreign currency transactions and miscellaneous items of income and
expense. Other income has fluctuated as a result of the amount of cash available
for investment in interest-bearing accounts and from foreign currency
transactions. Other income, net increased $2,100,000 and $2,693,000 and for the
three- and nine-month periods of fiscal 1997 compared to the corresponding
periods of fiscal 1996. The increases are primarily the result of investment
earnings on the additional cash generated by the Company's public offering in
October 1996.
The provision for income taxes for the three- and nine-month periods
ending December 31, 1996 are based on the estimated annual effective tax rate
applied to the profit before income taxes (excluding one-time charges for
acquired in-process research and development) and includes current federal,
state and foreign income taxes. The provision for income taxes for the three-
and nine-month periods ending December 31, 1995 consists primarily of foreign
income taxes as well as federal and state minimum taxes. The effective tax
rates for fiscal 1997 and 1996 differ from the federal statutory rate,
primarily as a result of the utilization of net operating loss carryforwards,
offset by certain foreign and state taxes.
The Company estimates that it will incur an aggregate of approximately $3
million in direct transaction costs in connection with the merger with SQA,
which will be charged to operations upon consummation of the merger,
expected to occur in February 1997. The Company expects to incur an additional
charge to operations of between $5 million and $7 million primarily in the
quarter ending March 31, 1997 to reflect costs associated with integrating the
two companies. Integration costs of merging the companies are expected to
include severance costs associated with any employee terminations, costs
associated with conforming employee benefits plans, charges associated with the
closure of duplicate facilities and asset writedowns related to duplicate
business systems. The final amounts associated with each of these items has not
yet been determined. Total costs associated with the merger are anticipated to
result in an operating loss and a net loss for the Company's quarter ending
March 31, 1997, and are expected to contribute to an operating loss and a net
loss for the Company's 1997 fiscal year.
During February, 1997, the Company purchased Requisite, Inc. a Colorado based
provider of software requirements-management tools and training, for $8.5
million cash. The acquisition is being treated as a purchase transaction. The
Company expects to allocate a substantial portion of the acquisition cost to
acquired in-process research and development, which will be expensed in the
March quarter. As a result of this charge and charges associated with the
previously announced acquisition of SQA, Inc., which is expected to be completed
in February 1997, the Company will incur a loss in the March quarter, and for
the fiscal year.
LIQUIDITY AND CAPITAL RESOURCES AT DECEMBER 31, 1996
During October 1996, the Company sold 5,188,094 shares of common stock in a
public offering. Net proceeds from the sales were approximately $186,000,000
after deducting underwriting discounts, commissions and other related expenses.
The proceeds to the Company from the offering will be used for working capital
and general corporate purposes.
In October 1996, the Company purchased the Visual Test product from Microsoft
Corporation. The purchase price consisted of a single $23,000,000 cash payment,
which will be allocated to the fair value of the assets acquired, including
acquired in-process research and development estimated at $15,000,000 to
$19,000,000. In February 1997, the Company acquired Requisite, Inc. The purchase
price consisted of a single $8,500,000 cash payment and the assumption of
certain stock options, the aggregate of which will be allocated to the fair
value of the assets acquired, including a substantial portion that will be
allocated to acquired in-process research and development.
As of December 31, 1996, the Company had cash, cash equivalents and short-term
investments of $229,749,000 and working capital of $226,969,000. Net cash used
in operating activities for the period ended December 31, 1996 was composed
primarily of a net loss offset by a decrease in deferred revenue and non-cash
adjustments consisting of the charge for acquired in-process research and
development and depreciation.
The Company believes that expected cash flow from operations combined with
existing cash and cash equivalents and short-term investments will be sufficient
to meet its cash requirements for the foreseeable future.
11
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FACTORS THAT MAY AFFECT FUTURE RESULTS
DEPENDENCE UPON MARKET GROWTH AND DEVELOPMENT OF INDUSTRY STANDARDS.
The Company's product lines are designed for use in visual modeling of business
processes, in the development of software systems and in the day-to-day
development of software by teams of developers. The Company's future growth and
financial performance will depend in part upon continued growth in the market
for tools supporting component-based development. There can be no assurance that
the market will continue to grow or that the Company will be able to respond
effectively to the evolving requirements of the market. In addition, the
Company's future growth and financial performance may depend upon the
development of industry standards that facilitate the adoption of component-
based development, as well as the Company's ability to play a leading role in
the establishment of those standards. The Company believes that the Unified
Modeling Language developed at Rational has become the de facto standard
language for visual modeling and intends to submit an application to the Object
Management Group ("OMG"), an industry consortium, for inclusion of the UML in
their Object Analysis and Design Facility specification. Competing standards,
including some that support the UML as well as other notations, also are
expected to be submitted to the OMG. The official sanction of a competing
standard by the OMG could have a material adverse effect on Rational's marketing
and sales efforts and, in turn, on revenues and operating results
The number of software developers using component-based development technology
is relatively small compared to the number of developers using more traditional
software development technology. The adoption of component-based development
technology by software programmers who have traditionally used other technology
requires re-orientation to significantly different programming methods, and
there can be no assurance that the acceptance of component-based development
technology will expand beyond sophisticated programmers who are early adopters
of the technology. Furthermore, there can be no assurance that potential
customers will be willing to make the investment required to retrain programmers
to build software using component-based development technology rather than
traditional programming techniques. Many of the Company's customers have
purchased only small quantities of the Company's tools, and there can be no
assurance that these or new customers will broadly implement component-based
development technology or purchase additional tools
EXPANSION OF PRODUCT LINES.
The Company believes that its continued success will depend in part upon its
ability to provide a tightly integrated line of software application development
tools that support software development for a number of implementation
languages. This will require the Company to enhance its current products and to
continue to develop and introduce new products. The Company also believes its
continued success will become increasingly dependent on its ability to support
the Microsoft platform, including Windows 95 and Windows NT. The Company
believes that it will be particularly important to successfully develop and
market a broader line of products for C++, Visual Basic, Java and other
implementation languages in order to be successful in its efforts to reach
broader markets and to further increase its market share within its existing
market segments. There can be no assurance that the Company will be able to
successfully develop and market such a broad line of products or that the
Company will not encounter unexpected difficulties and delays in integrating new
products with existing product lines
FLUCTUATIONS IN OPERATING RESULTS.
The Company's revenue is difficult to forecast due to the fact that the
Company's sales cycle, from initial evaluation to purchase, varies substantially
from customer to customer. The Company typically has operated with little
backlog because software products are generally shipped as orders are
12
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received. As a result, revenue in any quarter is substantially dependent on
orders booked and shipped in that quarter. Because the Company's staffing and
operating expenses are based on anticipated revenue levels, and a high
percentage of the Company's costs are fixed, small variations in the timing of
the recognition of specific revenues could cause significant variations in
operating results from quarter to quarter. Historically, the Company has earned
a substantial portion of its revenues in the last weeks of the quarter. To the
extent this trend continues, the failure to achieve such revenues in the last
weeks of any given quarter will have a material adverse effect on the Company's
financial results for that quarter. Although the Company has experienced
increasing revenues in each of the past nine quarters, the Company's sales
compensation structure has historically resulted in revenues for the first
quarter of a fiscal year being lower than revenues for the fourth quarter of the
prior fiscal year. There can be no assurance that similar fluctuations will not
occur again in the future
The Company's earnings will be reduced by charges and operating expenses
associated with the merger with SQA for the quarter ended March 31, 1997, the
quarter in which the merger is expected to be consummated. Direct transaction
costs are estimated at approximately $3 million, and costs of integrating the
two companies are estimated at an additional $5 million to $7 million. There
can be no assurance that actual costs will not substantially exceed such
estimates, that unanticipated expenses associated with the integration of the
two companies will not arise, or that the Company will not incur additional
material charges in subsequent quarters to reflect additional costs associated
with the integration of the two companies. Total costs associated with the
merger are anticipated to result in an operating loss and a net loss for the
Company's quarter ending March 31, 1997, and are expected to contribute to an
operating loss and a net loss for the Company's 1997 fiscal year, and could
negatively impact financial results in future periods for the reasons discussed
above.
The Company's earnings will be reduced by charges and operating expenses
associated with the purchase of Requisite, Inc. during the quarter ended March
31, 1997. The Company expects to allocate a substantial portion of the $8.5
million purchase price to acquired in-process research and development. There
can be no assurance that actual costs will not substantially exceed such
estimates, that unanticipated expenses associated with the integration of the
two companies will not arise, or that the Company will not incur additional
material charges in subsequent quarters to reflect additional costs associated
with the integration of the two companies.
The growth in revenues and operating income (exclusive of nonrecurring
operating, restructuring and merger-related expenses) experienced by the Company
in recent quarters is not necessarily indicative of future results and period-
to-period comparisons of its financial results should not be relied upon as an
indication of future performance. Fluctuations in operating results may also
result in volatility in the price of the Company's Common Stock. See "--
Possible Volatility of Stock Price."
DEPENDENCE UPON REVENUES FROM NEW PRODUCTS.
The Company plans to introduce new products during fiscal 1997. Delay in the
start of shipment of the Company's new products would have an adverse effect on
the Company's revenues, gross profit and operating income. As a result of the
Company's business alliance with Microsoft, certain of the Company's new product
releases are expected to be tightly integrated with new releases of certain
Microsoft products. To the extent that scheduled Microsoft product releases are
delayed, there could be a material adverse effect on the Company's revenues from
new products. The Company attempts to make adequate allowances in its new
product release schedules for both internal and beta-site testing of product
performance. Because of the complexity of the Company's products, however, the
release of new products may be postponed should test results indicate the need
for redesign and retesting, or should the Company elect to add product
enhancements in response to beta customer feedback. The Company's sales remain
sensitive to its existing and prospective customers' budgeting practices and to
potential cutbacks in defense spending.
BUSINESS ALLIANCE WITH MICROSOFT.
On October 2, 1996, Rational and Microsoft announced the formation of a business
alliance which will consist of Rational's acquisition of Microsoft's Visual Test
product, technology cross-licensing, joint development projects and joint
marketing programs. While the Company believes that Microsoft's current strategy
in relation to the enterprise information systems market is based on component-
based development, there can be no assurance that this strategy will continue or
that, if it does continue, Microsoft's emphasis or priorities will not change in
the future, resulting in less attention and fewer resources being devoted to
Microsoft's relationship with Rational. Although certain aspects of the business
alliance are contractual in nature, many important aspects of the relationship
depend on the continued cooperation of the two companies, and there can be no
assurance that the Company and Microsoft will be able to work together
successfully over an extended period of time. In addition, there
13
<PAGE>
can be no assurance that Microsoft will not use the information it gains in its
relationship with Rational to develop or market competing products.
ACQUISITION OF THE VISUAL TEST PRODUCT.
The Company acquired the Visual Test product from Microsoft on October 2, 1996.
There can be no assurance that Rational will be able to successfully incorporate
Visual Test into its integrated family of products, or that it will be able to
achieve significant sales of the Visual Test product. Many potential customers
for Visual Test differ from the Company's historical customer base in terms of
component-based software development expertise, purchasing processes, financial
resources and expectations regarding software-engineering tools. There can be no
assurance that the Company will not encounter unanticipated concerns of Visual
Test customers that are different from the concerns of the Company's traditional
customers, or that the Company will have the infrastructure and experience
necessary to adequately respond to the volume and type of such concerns.
Rational has granted Microsoft a non-exclusive, perpetual license to the Visual
Test product source code for the purpose of creating derivative works and for
the purpose of distributing portions of the Visual Test product and derivative
works as part of Microsoft products that do not directly compete with the Visual
Test product in the market for software testing tools. There can be no assurance
that Microsoft will not use such rights to create and distribute products that
compete with other Rational products, including without limitation testing tools
that the Company expects to acquire pursuant to the proposed merger with SQA.
Rational has also granted Microsoft a five-year option to obtain a license to
incorporate certain elements of Visual Test technology into Microsoft
development tool products, including Visual Basic, Visual C++ and Visual J++.
Should Microsoft exercise such right, sales of the Visual Test product by
Rational could be materially and adversely impacted. See "-- Fluctuations in
Operating Results."
LICENSING OF ROSE TECHNOLOGY TO MICROSOFT.
Microsoft and Rational have entered into a two-year agreement providing for the
inclusion of a subset of the Rational Rose visual modeling technology in future
versions of Microsoft's enterprise-oriented visual tools. The Company's
objective in entering into this arrangement is to expose the Company's
technology to a broader market than Rational's historical customer base, and is
not to generate direct product revenue from Microsoft. The Company expects that
changes in the Company's pricing models and combinations of features within
product lines will be required to appeal to this market, and there can be no
assurance that such changes will achieve market acceptance. Rational does not
expect the licensing of its Rose technology to Microsoft to directly result in a
material increase in product revenue. In addition, there can be no assurance
that developers introduced to the Rose technology incorporated into Microsoft
products will become purchasers of Rational products in the future. Rational has
granted Microsoft the option to obtain a perpetual, non-exclusive right to
source code for certain aspects of Rational's Rose technology after the
expiration of the agreement. While Rational believes that Microsoft's and
Rational's strategies currently are complementary, there can be no assurance
that Microsoft will not use this right to develop and market competing products
in the future.
ADVERSE IMPACT OF PROMOTIONAL PRODUCT VERSIONS ON ACTUAL PRODUCT SALES.
The Company's marketing strategy relies in part on making elements of its
technology available for no charge or at a very low price, either directly or by
incorporating such elements into products offered by the Company's partners,
such as Microsoft. This strategy is designed to expose the Company's products to
a broader market than its historical customer base, and to encourage potential
customers in that market to purchase an upgrade or other higher-priced product
from the Company. There can be no assurance that the Company will be able to
introduce enhancements to its full-price products or versions of its products
with intermediate functionality at a rate necessary to adequately differentiate
14
<PAGE>
them from the promotional versions, particularly in cases where the Company's
partners are distributing versions of the Company's products with other
desirable features.
MANAGEMENT OF GROWTH.
The Company is experiencing a period of rapid growth and aggressive product
introductions that have placed, and may continue to place, a significant strain
on its financial, operational, management, marketing and sales systems and
resources, including its personnel. Projects such as the expansion of
enhancements to the Company's product lines, efforts to address broader markets
and to expand distribution channels, acquisitions of companies or technologies
such as the anticipated merger with SQA and the recent acquisitions of
Requisite, Inc., Objectory AB and the Visual Test product, and business
alliances such as the recent arrangement with Microsoft, when added to the day-
to-day activities of the Company, will place a further strain on the Company's
resources and personnel. If Company management is unable to effectively manage
growth, the Company's business, competitive position, results of operations and
financial condition will be materially and adversely affected. See also,
"Dependence on Key Personnel."
RISKS ASSOCIATED WITH RECENT AND FUTURE ACQUISITIONS.
During the past three years the Company has made a number of strategic
acquisitions, including without limitation the acquisition of Objectory AB,
Requisite, Inc. and the Visual Test product. Considering acquisitions may
result in the diversion of management's attention from day-to-day operations
and, in the event such consideration leads to consummation of acquisitions, may
include numerous other risks, including difficulties in the integration of
operations, products and personnel. To the extent that efforts to pursue
acquisition opportunities have in the past resulted, or may in the future
result, in a diversion of resources or that efforts to integrate recent and
future acquisitions fail, there could be a material adverse effect on the
Company's business, results of operations and financial condition. Acquisitions
by the Company have the potential to result in dilutive issuances of equity
securities, the incurrence of additional debt, and amortization expenses related
to goodwill and other intangible assets. While there are currently no
commitments with respect to any particular material future acquisitions other
than the merger with SQA, Company management frequently evaluates the strategic
opportunities available to it and may in the near-term or long-term future
pursue acquisitions of complementary products, technologies or businesses.
On November 12, 1996, the Company entered into an agreement to merge with SQA,
with the expectation that the proposed merger will result in long-term strategic
benefits. These anticipated benefits will depend in part on whether the
companies' operations can be integrated in an efficient and effective manner.
There can be no assurance that this will occur. The successful integration of
SQA with Rational will require, among other things, integration of the
companies' respective product offerings and coordination of the companies' sales
and marketing and research and development efforts, and will involve substantial
transaction costs and costs of integration. The difficulties of such integration
may be increased by the necessity of coordinating geographically separated
organizations. There can be no assurance that integration will be accomplished
smoothly or successfully. Additional risks related to the merger include
without limitation the risk that negative reaction to the merger on the part of
the Company's and/or SQA's resellers or customers could result in disruption to
revenues and earnings, which could in turn have a negative impact on the price
of the Company's Common Stock, risks associated with potential conflicts of
interests to which certain officers and directors of SQA and a director of
Rational are subject, the risk that dilution of ownership interests of current
Rational stockholders will result from the Merger, and the risk that future
sales of shares of the Company's Common Stock may adversely affect the market
price of such stock. The integration of the two companies will require
substantial attention from management. The diversion of the attention of
management from day-to-day operations and any difficulties encountered in the
transition process could have an adverse impact on the Company's business,
results of operations and financial condition following the Merger, and the
process of combining the operations of the two organizations could cause the
interruption of, or a loss of momentum in, the activities of either or both of
the companies' businesses, which could have an adverse effect on their combined
operations. After the Merger, the Company's future business, results of
operations and financial condition will be subject to certain additional risks
related to SQA's business, including without limitation risks related to the
dependence of SQA on the client/server environment and the potential that SQA
may not successfully respond to evolving requirements of customers in the
client/server environment, the risk that any adverse affect on the demand for or
use of Microsoft's Windows operating system could have a material adverse effect
on SQA's business, results of operations, and financial condition, the risk that
SQA's products will not achieve broad customer acceptance, the risks inherent in
SQA's reliance on a limited number of products, and the potential inability of
SQA to successfully achieve widespread distribution of its products through
indirect channels.
DEPENDENCE ON STRATEGIC RELATIONSHIPS.
The Company's development, marketing and distribution strategies rely
increasingly on the Company's ability to form long-term strategic relationships
with major software and hardware vendors, many of whom are substantially larger
than the Company. There can be no assurance that the merger with SQA will not
disrupt these relationships or activities. Divergence in strategy between the
Company and any given partner, a change in focus by a given partner, or
competitive product offerings introduced by any partner may interfere with the
Company's ability to develop, market, sell or support its products, which in
turn would have a material adverse effect on the Company's business, results of
operations and financial condition. See "Business Alliance with Microsoft."
RAPID TECHNOLOGICAL CHANGE.
The market for software development tools is characterized by rapid
technological advances, changes in customer requirements and frequent new
product introductions and enhancements. The introduction of products embodying
new technologies and the emergence of new industry standards and practices can
render existing products obsolete and unmarketable. The Company must respond
rapidly to developments related to Internet and intranet applications, hardware
platforms, operating systems and applicable programming languages. Such
developments will require the Company to make substantial product development
investments. Any failure by the Company to anticipate or respond adequately to
technology developments and customer requirements, or any significant delays in
product development or introduction, could result in a loss of competitiveness
or revenue. In addition, there can be no assurance that new products or product
enhancements intended to respond to technological change or evolving customer
requirements will achieve market acceptance.
In addition, rapid growth of interest in and use of Internet and intranet
environments is a recent and emerging phenomenon. The Company's success may
depend, in part, on the compatibility of its products with Internet and intranet
applications. There can be no assurance that the Company will be able to
effectively adapt its products for use in Internet or intranet environments or
to successfully compete in the market for Internet and intranet products.
RISK OF SOFTWARE DEFECTS.
Software products as complex as those sold by the Company often contain
undetected errors, or "bugs," or
15
<PAGE>
performance problems. Such defects are most frequently found during the period
immediately following introduction of new products or enhancements to existing
products. Despite extensive product testing prior to introduction, the Company's
products have in the past contained software errors that were discovered after
commercial introduction. There can be no assurance that errors or performance
problems will not be discovered in the future. Any future software defects
discovered after shipment of the Company's products could result in loss of
revenues or delays in market acceptance, which could have a material adverse
effect on the Company's business, operating results or financial condition.
Further, because the Company relies on its own products in connection with the
development of its software, any such errors could make it more difficult to
sell such products in the future.
COMPETITION.
The software engineering tools market is extremely competitive and rapidly
changing. The Company believes that the increased level of competition it
observed in fiscal 1996 and the first three quarters of fiscal 1997 will
continue to increase. The Company competes primarily on the bases of corporate
and product reputation, breadth of its integrated product line, product
architecture, functionality and features, product quality, performance, ease-of-
use, quality of support, availability of technical consulting services and
price. The Company faces intense competition for each product within its product
line. Because individual product sales are often the first step in a broader
customer relationship, the Company's success depends in part upon its ability to
successfully compete with numerous competitors at each point within its product
line. Certain of the Company's competitors are more experienced than the Company
in the development of software-engineering tools, databases or software-
development products. Some of the Company's competitors have, and new
competitors may have larger technical staffs, more established distribution
channels and greater financial resources than the Company. The Company also
encounters substantial competition from in-house developers of solutions for
large organizations. There can be no assurance that either existing or new
competitors will not develop products that are superior to the Company's
products or that achieve greater market acceptance. The Company's future success
will depend in large part upon its ability to increase its share of its target
markets and to license additional products and product enhancements to existing
customers. There can be no assurance that future competition will not result in
price reductions, reduced margins or loss of sales, which in turn would have a
material adverse effect on the Company's business, results of operations and
financial condition.
DEPENDENCE ON SALES FORCE AND OTHER CHANNELS OF DISTRIBUTION.
The Company currently distributes its products primarily through field sales
personnel teamed with highly trained technical support personnel. The Company
believes that a high level of technical consulting, training and customer
support is essential to maintaining its competitive position, and has found that
the ability to deliver a high level of technical consulting, training and
customer support is an important selling point with respect to its products.
While complementary to the Company's products, the services provided by these
personnel have historically yielded lower margins for the Company than its
product business. To the extent that these services constitute a higher
proportion of total revenues in the future, the Company's margins will be
adversely affected. The Company has also developed other direct and indirect
sales channels, including telesales, the World Wide Web, and partnering with
external service providers and VARs. There can be no assurance that such
channels will be successful in increasing sales of the Company's products or in
reducing the Company's sales costs on a percentage basis.
DEPENDENCE ON KEY PERSONNEL.
The Company believes that the hiring and retaining of qualified individuals at
all levels in the Company will be essential to the Company's ability to manage
growth successfully, and there can be no assurance that the Company will be
successful in attracting and retaining the necessary personnel. The Company will
be particularly dependent upon the efforts and abilities of its senior
management personnel. The departure of any of the executive officers of the
Company could have a material adverse effect on the Company's business,
financial condition, or results of operations depending upon the timing of the
departure, changes in the Company's business prior to such time, the
availability of qualified personnel to replace them, and whether such personnel
depart singly, contemporaneously, or as a group, among other factors. None of
the Company's executive officers is subject to any agreement not to compete or
severance agreement with the Company.
The rate at which the Company can attract and retain the highly trained
technical personnel that are integral to its direct sales teams may limit the
rate at which the Company can increase sales. Competition for qualified
personnel in the software industry is intense, and there can be no assurance
that the Company will be successful in
16
<PAGE>
attracting and retaining such personnel.
RISKS ASSOCIATED WITH INTERNATIONAL OPERATIONS.
International sales accounted for approximately 31%, 34%, 36% and 32% of the
Company's revenues in fiscal 1994, 1995, 1996 and the nine months ended December
31, 1996, respectively, and the Company expects that international sales will
continue to account for a significant portion of the Company's revenues in
future periods. In addition, the Company expects that the majority of Visual
Test product sales will come from outside the United States. International sales
are subject to inherent risks, including unexpected changes in regulatory
requirements and tariffs, difficulties in staffing and managing foreign
operations, longer payment cycles, greater difficulty in accounts receivable
collection, potentially adverse tax consequences, price controls or other
restrictions on foreign currency and difficulties in obtaining export and import
licenses. Any material adverse effect on the Company's international business
would be likely to materially and adversely affect the Company's business,
operating results and financial condition as a whole. The Company's
international sales are generally denominated in foreign currencies and the
Company does not currently engage in any hedging activities. Gains and losses on
the conversion of foreign payments into U.S. dollars may contribute to
fluctuations in the Company's results of operations. Although the Company has
not experienced any material adverse impact to date from fluctuations in foreign
currencies, there can be no assurance that the Company will not experience a
material adverse impact on its financial condition and results of operations
from fluctuations in foreign currencies in the future. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations."
LIMITED PROTECTION OF INTELLECTUAL PROPERTY AND PROPRIETARY RIGHTS.
The Company regards its software as proprietary and attempts to protect it with
a combination of copyright, trademark and trade secret laws, employee and third-
party nondisclosure agreements and other methods of protection. Despite these
precautions, it may be possible for unauthorized third parties to copy certain
portions of the Company's products or reverse engineer or obtain and use
information the Company regards as proprietary. The Company's software products
are generally licensed to end-users on a "right to use" basis pursuant to a
perpetual license. The Company licenses its products primarily under "shrink-
wrap" licenses (i.e., licenses included as part of the product packaging).
Shrink-wrap licenses are not negotiated with or signed by individual licensees,
and purport to take effect upon the opening of the product package. Certain
license provisions protecting against unauthorized use, copying, transfer and
disclosure of the licensed program may be unenforceable under the laws of
certain jurisdictions and foreign countries. In addition, the laws of some
foreign countries do not protect proprietary rights to the same extent as do the
laws of the United States. There can be no assurance that these protections will
be adequate. To the extent that the Company increases its international
activities, it expects that its exposure to unauthorized copying and use of its
products and proprietary information will increase.
The status of United States patent protection in the software industry is not
well defined and will evolve as the United States Patent and Trademark Office
grants additional patents. Because patent applications in the United States are
not publicly disclosed until the patent is issued, applications may have been
filed which would relate to the Company's products. The Company expects that
software product developers will be increasingly subject to infringement claims
as the number of products and competitors grows and the functionality of
products in different industry segments overlaps. There can be no assurance that
third parties will not assert infringement claims against the Company in the
future or that such claims will not be successful. The Company could incur
substantial costs in defending itself and its customers against any such claims.
Parties making such claims may be able to obtain injunctive or other equitable
relief that could effectively block the Company's ability to sell its products
in the United States and abroad, and could result in an award of substantial
damages. In the event of a claim of infringement, the Company and its customers
may be required to obtain one or more licenses from third parties. There can be
no assurance that the Company or its customers could obtain necessary licenses
from third parties at a reasonable cost or at all. Defense of any lawsuit or
failure to obtain any such required license would have a material adverse effect
on the Company's results of operations.
17
<PAGE>
The Company also relies on certain software that it licenses from third parties,
including software that is integrated with internally developed software and
used in its products to perform key functions. There can be no assurance that
these third-party software licenses will continue to be available to the Company
on commercially reasonable terms, or that the software will be appropriately
supported, maintained or enhanced by the licensors. The loss of licenses to, or
inability to support, maintain and enhance, any of such software could result in
increased costs, or in delays or reductions in product shipments until
equivalent software could be developed, identified, licensed and integrated,
which would materially adversely affect the Company's business, operating
results and financial condition.
POSSIBLE VOLATILITY OF STOCK PRICE.
The market price of the Company's Common Stock has been, and is likely to
continue to be, volatile. Factors such as new product announcements or changes
in product pricing policies by the Company or its competitors, quarterly
fluctuations in the Company's operating results, announcements of technical
innovations, announcements relating to strategic relationships or acquisitions,
changes in earnings estimates by analysts and general conditions in the
component-based software development market, among other factors, may have a
significant impact on the market price of the Company's Common Stock. Should the
Company fail to introduce products on the schedule expected, the Company's stock
price could be adversely affected. Due to analysts' expectation of continued
growth and the recent high price/earnings ratio at which the Company's Common
Stock has traded, any shortfall in anticipated operating results could have an
immediate and significant adverse effect on the market price of the Company's
Common Stock. In addition, in recent years the stock market in general, and the
shares of technology companies in particular, have experienced extreme price
fluctuations. This volatility has had a substantial effect on the market prices
of securities issued by many companies, including Rational, for reasons
unrelated to the operating performance of the specific companies. These broad
market fluctuations may adversely affect the market price of the Company's
Common Stock. See "Fluctuations in Operating Results" and "Dependence Upon
Revenues From New Products."
DEFERRED TAX ASSETS.
Based upon the weight of available evidence, which includes the Company's
historical operating performance, the reported cumulative net loss for the prior
three years, the anticipated net loss to be reported for the nine months ended
December 31, 1996, and the uncertainties regarding future results of operations
of the Company, the Company has provided a full valuation allowance against its
net deferred tax assets as it is more likely than not that the deferred tax
assets will not be realized.
18
<PAGE>
PART II -- OTHER INFORMATION
ITEM 1 - LEGAL PROCEEDINGS
- --------------------------------------------------------------------------------
On December 1, 1995, Interactive Development Environments ("IDE") filed an
action against the Company in the San Francisco County Superior Court seeking
monetary damages in excess of $3 million and other relief for the Company's
alleged breach of an alleged contract, misrepresentation and related claims
based on Rational's preliminary, non-binding merger discussions in 1995 with
IDE. In March 1996, the court sustained the Company's demurrer to IDE's claim
for specific performance of the alleged contract between the parties. In October
1996, IDE amended its complaint to add a claim for "Fraud -- Non-Disclosure," in
which it alleges that the Company was obligated to tell IDE of its acquisition
discussions regarding Objectory AB, and to lower the amount of damages claimed
to $2 million. In February 1997, IDE dropped its claim for breach of contract
and a related claim. Trial on IDE's remaining claims is set for April 1997. The
Company believes IDE's complaints are without merit and intends to defend the
case vigorously, although the Company makes no assurance that it will be
successful in defending the action. There are no other material pending legal
proceedings to which the Company is a party or to which any of the Company's
property is subject.
Item 5 - OTHER INFORMATION
- --------------------------------------------------------------------------------
On February 4, 1997, the Company acquired all of the outstanding shares of
capital stock of Requisite, Inc., a Colorado corporation ("Requisite"), for $8.5
million in cash (the "Requisite Acquisition") pursuant to an Agreement and Plan
of Share Exchange by and between the Company and Requisite. In connection with
the Requisite Acquisition, the Company assumed certain stock options held by
Requisite employees which, when and if they become fully vested, will be
exercisable for an aggregate of 6,450 shares of the Company's Common Stock. The
Requisite Acquisition was effected via a statutory share exchange under the
Colorado Business Corporation Act and is being accounted for using the purchase
method. Upon the consummation of the Requisite Acquisition, Requisite became a
wholly-owned subsidiary of the Company. A copy of the press release issued by
the Company regarding the Requisite Acquisition is filed herewith as Exhibit
99.1 and incorporated by reference herein. See also Note 8 of the Notes to
Condensed Consolidated Financial Statements in Part I hereof.
ITEM 6 -- EXHIBITS AND REPORTS ON FORM 8-K
- --------------------------------------------------------------------------------
(a) Exhibit 11.1: Statement of Computation of Net Income per Common Share
Exhibit 27: Financial Data Schedule
Exhibit 99.1: Press Release dated February 7, 1997 relating to the
acquisition of Requisite, Inc.
(b) Reports on Form 8-K:
On October 2, 1996, the Company filed Form 8-K regarding the outcome of the
Company's annual meeting of stockholders held on August 27, 1996.
On October 3, 1996, the Company filed Form 8-K regarding two agreements entered
into between the Company and Microsoft Corporation, an Agreement for Purchase
and Sale of Assets and a Development and License Agreement.
On October 16, 1996, the Company filed Form 8-K/A, which was amendment number 1
to the Company's Form 8-K Current Report filed October 2, 1996 regarding two
agreements entered into between the Company and Microsoft Corporation.
On December 6, 1996, the Company filed Form 8-K regarding the Agreement and Plan
of Reorganization dated November 12, 1996 by and among the Company, Sunshine
Acquisition Corp., a wholly owned subsidiary of the Company, and SQA, Inc., a
Delaware corporation.
19
<PAGE>
SIGNATURE
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.
RATIONAL SOFTWARE CORPORATION
by: /s/ Robert T. Bond
------------------------------------------
Robert T.Bond
Senior Vice President
Chief Operating Officer,
Chief Financial Officer and Secretary
February 14, 1997
20
<PAGE>
Exhibit 11.1
Statement of Computation of Net Income Per Common Share
<TABLE>
<CAPTION>
(In thousands, except per share amounts) Three Months Ended Six Months Ended
December 31, December 31,
-------------------------------- ----------------------------------
1996 1995 1996 1995
-------------- ------------- ---------------- ---------------
<S> <C> <C> <C> <C>
Primary:
Weighted average
shares outstanding 38,833 32,466 35,668 29,968
Dilutive stock options - - - -
-------------- ------------- ---------------- ---------------
Total 38,833 32,466 35,668 29,968
============== ============= ================ ===============
Fully diluted:
Weighted average
shares outstanding 38,833 32,466 35,668 29,968
Dilutive stock options - - - -
-------------- -------------- -------------- -------------
Total 38,833 32,466 35,668 29,968
============== ============== ============== ==============
Net loss $(13,163) $(11,163) $(4,167) $(7,803)
Income per common share
Primary: $(0.34) $(0.34) $(0.12) $(0.26)
Fully diluted: $(0.34) $(0.34) $(0.12) $(0.26)
</TABLE>
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> MAR-31-1997
<PERIOD-START> APR-01-1996
<PERIOD-END> DEC-31-1996
<CASH> 221,998
<SECURITIES> 7,751
<RECEIVABLES> 25,387
<ALLOWANCES> 1,046
<INVENTORY> 0
<CURRENT-ASSETS> 257,107
<PP&E> 27,222
<DEPRECIATION> 20,737
<TOTAL-ASSETS> 270,566
<CURRENT-LIABILITIES> 30,138
<BONDS> 3
0
0
<COMMON> 305,154
<OTHER-SE> (66,296)
<TOTAL-LIABILITY-AND-EQUITY> 270,566
<SALES> 55,997
<TOTAL-REVENUES> 88,332
<CGS> 6,235
<TOTAL-COSTS> 23,273
<OTHER-EXPENSES> 70,448
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> (3,610)
<INCOME-PRETAX> (1,779)
<INCOME-TAX> 2,388
<INCOME-CONTINUING> (4,167)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (4,167)
<EPS-PRIMARY> (.34)
<EPS-DILUTED> (.34)
</TABLE>
<PAGE>
EXHIBIT 99.1
FOR IMMEDIATE RELEASE
Investor contact: Bob Bond, Rational Software Corporation
(408) 496-3694
E-mail [email protected]
Press contact: Kara Myers, Rational Software Corporation
(408) 496-3891
E-mail [email protected]
RATIONAL ACQUIRES REQUISITE, INC., LEADING PROVIDER OF REQUIREMENTS-MANAGEMENT
SOFTWARE AND TRAINING
Acquisition Adds Key Software-Management Capabilities to Rational's Lifecycle
Solution for Component-Based Development
Santa Clara, CA (February 7, 1997)--Rational Software Corporation announced
today that it has acquired Requisite, Inc., a leading provider of requirements-
management tools and training. Requisite's tools enable development teams to
capture application requirements directly in Microsoft Word documents. These
tools automatically create and maintain a projectwide requirements database that
supports impact analysis, change management, and traceability to design models,
software components, and test cases.
Setting a new standard in ease-of-use, these best-of-breed tools automate
activities that are critical to timely application delivery. Requisite's rapidly
growing installed base includes teams developing enterprise information systems,
telecommunications equipment, medical instruments, process control systems,
aerospace applications, and packaged software.
The Requisite tools--Requisite Baseline and RequisitePro--will provide an
early-lifecycle entry point into Rational's product line through integration
with Rational Rose, Rational's industry-leading visual modeling tool. Rational
also plans to integrate RequisitePro with its Rational Apex development
environment and its Rational Summit project-management tools.
"By connecting requirements with use cases, Rational can bridge the
communications gap separating an application's prospective users from its
developers," said Mike Devlin, president at Rational. "Linking requirements to
test cases closes another long-standing gap in the software-development
process."
RequisitePro is already integrated with SQA Suite, the industry-leading
client/server automated software-quality product from SQA, Inc. Rational's
previously announced acquisition of SQA, Inc., scheduled for completion this
month, subject to stockholder approval, is designed to add powerful automated
testing capabilities to the Rational product line. Integration of the three
products will be demonstrated at the Rational International User Conference,
which is being held February 10-12, 1997, in San Francisco.
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"The integration of RequisitePro, Rational Rose, and SQA Suite gives developers
the highest level of support available for the specification, modeling,
implementation, and testing of software systems," said Paul Levy, chief
executive officer and chairman of the board at Rational. "The Rational solution
lets developers focus on defining, designing, implementing, and testing software
components, raising the levels of productivity and quality beyond what is
possible with a traditional focus on individual lines of code."
Requisite Baseline and RequisitePro run on Windows NT, Windows 95, and Windows
3.1, and they can be used for Windows-based development efforts and for
UNIX-based projects with Windows clients. Requirements can be captured directly
in Microsoft Word documents, or they can be automatically extracted from a wide
variety of sources using a flexible import mechanism.
The $8.5 million cash acquisition of Requisite is being accounted for as a
purchase transaction. The company expects to allocate a substantial portion of
the acquisition cost to acquired in-process research and development, which will
be expensed in the March quarter. As a result of these charges and charges
associated with the previously announced acquisition of SQA, Inc., which is
expected to be completed this month, the company will incur a loss in the March
quarter.
Requisite will operate as a business unit of Rational run by the Requisite
management team, continuing to develop, market, and support the Requisite
product line, which includes Requisite Baseline, RequisitePro, IEEE Standards,
and Requirements College.
Rational Software Corporation (NASDAQ: RATL) develops, markets, and supports a
comprehensive solution for the component-based development of software systems,
based on visual modeling and object technology. Rational's solution includes an
integrated family of products that automate development throughout the software
lifecycle, a software process that can be configured to the specific needs of
customers, and a range of consulting and support services. For more information
on Rational's products and services, visit Rational's Web Site at
www.rational.com.
# # # # #
The word "Rational" and Rational's products are trademarks of Rational Software
Corporation. References to other companies and their products use trademarks
owned by the respective companies and are for reference purposes only.
For more information contact:
Rational Software Corporation
2800 San Tomas Expressway
Santa Clara, CA 95051-0951
Tel. (408) 496-3600 or (800) RAT-1212
Fax (408) 496-3636
Fax-on-demand (408) 496-3966
E-mail [email protected]
Web www.rational.com
