<PAGE>
AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON JANUARY 13, 1997
REGISTRATION NO.
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
----------------
FORM S-4
REGISTRATION STATEMENT
UNDER
THE SECURITIES ACT OF 1933
----------------
RATIONAL SOFTWARE CORPORATION
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 7372 54-1217099
(STATE OR OTHER (PRIMARY STANDARD INDUSTRIAL (I.R.S. EMPLOYER
JURISDICTION OF CLASSIFICATION CODE NUMBER) IDENTIFICATION NUMBER)
INCORPORATION OR
ORGANIZATION)
2800 SAN TOMAS EXPRESSWAY, SANTA CLARA, CALIFORNIA 95051-0951
(408) 496-3600
(ADDRESS, INCLUDING ZIP CODE, AND TELEPHONE NUMBER, INCLUDING AREA CODE, OF
REGISTRANT'S PRINCIPAL EXECUTIVE OFFICES)
PAUL D. LEVY
CHIEF EXECUTIVE OFFICER
RATIONAL SOFTWARE CORPORATION
2800 SAN TOMAS EXPRESSWAY
SANTA CLARA, CALIFORNIA 95051-0951
(408) 496-3600
(NAME, ADDRESS, INCLUDING ZIP CODE, AND TELEPHONE NUMBER, INCLUDING AREA CODE,
OF AGENT FOR SERVICE)
----------------
COPIES TO:
FRANCIS S. CURRIE, ESQ. WILLIAM J. SCHNOOR JR., ESQ.
GAIL C. HUSICK, ESQ. MINNIE P. JOUNG, ESQ.
MARTIN A. WELLINGTON, ESQ. JAMES D. DOHERTY, ESQ.
WILSON SONSINI GOODRICH & ROSATI EDWARD D. FREEDMAN, ESQ.
PROFESSIONAL CORPORATION TESTA, HURWITZ & THIBEAULT, LLP
650 PAGE MILL ROAD HIGH STREET TOWER
PALO ALTO, CALIFORNIA 94304 125 HIGH STREET
(415) 493-9300 BOSTON, MASSACHUSETTS 02110
(617) 248-7000
----------------
APPROXIMATE DATE OF COMMENCEMENT OF PROPOSED SALE TO THE PUBLIC: Upon
consummation of the Merger described herein.
----------------
If the securities being registered on this Form are being offered in
connection with the formation of a holding company and there is compliance
with General Instruction G, check the following box. [_]
----------------
CALCULATION OF REGISTRATION FEE
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- -------------------------------------------------------------------------------
<TABLE>
<CAPTION>
PROPOSED PROPOSED
TITLE OF EACH CLASS OF AMOUNT MAXIMUM MAXIMUM
SECURITIES TO BE TO BE OFFERING PRICE AGGREGATE AMOUNT OF
REGISTERED REGISTERED(1) PER UNIT(2) OFFERING PRICE(2) REGISTRATION FEE(3)
- ----------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Common Stock, Par Value
$0.01 per share....... 7,273,000 shares $37.57 $273,266,058 $84,000
</TABLE>
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- -------------------------------------------------------------------------------
(1) Represents the number of shares of the Common Stock of the Registrant
which may be issued to stockholders of SQA, Inc. ("SQA") pursuant to the
Merger described herein.
(2) Each share of SQA Common Stock will be converted into 0.86 shares of
Common Stock of the Registrant pursuant to the Merger described herein.
Pursuant to Rule 457(f) under the Securities Act of 1933, as amended, the
registration fee has been calculated as of January 9, 1997. The number
shown is rounded from $37.572674.
(3) The amount of the registration fee includes $51,000 previously paid
pursuant to Section 14(g) of the Securities Exchange Act of 1934, as
amended, in connection with the filing by the Registrant and SQA of a
preliminary Prospectus/Joint Proxy Statement related to the proposed
Merger.
----------------
THE REGISTRANT HEREBY AMENDS THIS REGISTRATION STATEMENT ON SUCH DATE OR
DATES AS MAY BE NECESSARY TO DELAY ITS EFFECTIVE DATE UNTIL THE REGISTRANT
SHALL FILE A FURTHER AMENDMENT WHICH SPECIFICALLY STATES THAT THIS
REGISTRATION STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH
SECTION 8(A) OF THE SECURITIES ACT OF 1933, AS AMENDED, OR UNTIL THE
REGISTRATION STATEMENT SHALL BECOME EFFECTIVE ON SUCH DATE AS THE COMMISSION,
ACTING PURSUANT TO SAID SECTION 8(A), MAY DETERMINE.
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
<PAGE>
[RATIONAL LOGO]
January , 1997
Dear Stockholder:
As most of you are aware, Rational Software Corporation ("Rational") has
entered into an agreement providing for the merger of SQA, Inc. ("SQA") with
Rational in a strategic business combination (the "Merger"). At our Special
Meeting on February 26, 1997, you will be asked to consider and vote upon the
issuance of shares of the Common Stock, par value $0.01 per share, of Rational
(the "Rational Common Stock," and the "Combined Company Common Stock"
immediately following the Merger) to the stockholders of SQA pursuant to an
Agreement and Plan of Reorganization, dated November 12, 1996 (the
"Agreement"), among Rational, SQA and Sunshine Acquisition Corp., a wholly
owned subsidiary of Rational ("Merger Sub").
In the Merger, Merger Sub will be merged with and into SQA, which will be
the surviving corporation and will become a wholly owned subsidiary of
Rational. Pursuant to the Merger, each outstanding share of Common Stock, par
value $0.01 per share, of SQA (the "SQA Common Stock") will be converted into
the right to receive 0.86 (the "Exchange Ratio") shares of Rational Common
Stock, and each outstanding option or right to purchase SQA Common Stock under
the SQA stock option plans, the SQA stock purchase plan or outstanding
warrants will be assumed by Rational and will become an option or right to
purchase Combined Company Common Stock, with appropriate adjustments to be
made to the number of shares issuable thereunder and the exercise price
thereof based on the Exchange Ratio. The shares of Rational Common Stock held
by Rational stockholders immediately prior to the Merger will remain unchanged
by the Merger. It is expected that SQA stockholders will receive approximately
7.0 million shares of Rational Common Stock in the Merger, and another
approximately 2.0 million shares of Combined Company Common Stock will be
reserved for issuance pursuant to options, warrants and rights to purchase SQA
Common Stock outstanding immediately prior to the Merger. Upon the
consummation of the Merger, Ronald H. Nordin, currently the President and
Chief Executive Officer of SQA, will be employed by Rational and will join the
existing Rational Board of Directors. The proposal relating to the Merger is
described more fully in the accompanying Notice of Special Meeting of
Stockholders and Prospectus/Joint Proxy Statement.
After careful consideration, Rational's Board of Directors has approved the
Agreement and the transactions contemplated thereby by the unanimous vote of
all non-interested directors, and recommends that you vote FOR the proposal
relating to the Merger.
Rational has retained the investment banking firm of Hambrecht & Quist LLC
("Hambrecht & Quist") to advise it with respect to the consideration to be
paid by Rational in the Merger. Hambrecht & Quist has advised the Rational
Board that, in its opinion, the consideration to be paid is fair, from a
financial point of view, to Rational. A copy of the Hambrecht & Quist opinion
is attached to the Prospectus/Joint Proxy Statement as Annex C.
The Board of Directors of Rational believes the Merger offers Rational and
its stockholders a number of important benefits, including the strategic fit
between the two companies' product lines, technologies, development teams and
sales and marketing resources, as well as long-term administrative and
operational economies of scale.
All stockholders are invited to attend the meeting in person. The issuance
of the shares of Rational Common Stock in connection with the Merger requires
the affirmative vote of the majority of the total votes cast regarding such
proposal.
Stockholders are urged to review carefully the information contained in the
accompanying Prospectus/Joint Proxy Statement, including in particular the
information under the captions "Risk Factors," "Rational Software Corporation
Special Meeting--Recommendation of Rational Board of Directors," "Approval of
the Merger and Related Transactions--Joint Reasons for the Merger" and "--
Rational's Reasons for the Merger" prior to making any voting decision.
In addition to the proposal relating to the Merger, Rational's Board of
Directors has deemed it to be in the best interest of Rational that Rational
adopt a 1997 Stock Option Plan (the "Plan") which conforms to recent changes
in federal securities laws. Upon stockholder approval, there will be reserved
for issuance under the Plan 1,000,000 shares of Rational Common Stock, plus
all shares of Rational Common Stock available for issuance under existing
Rational option plans (exclusive of the Stock Option Plan for Directors) for
which there are no options to purchase outstanding at the time of the
approval. Once the Plan is approved by stockholders, no new options will be
issued under pre-existing option plans. After careful consideration,
Rational's Board of Directors unanimously approved the Plan, and recommends
that you vote FOR the proposal related to the Plan.
Whether or not you expect to attend the Special Meeting in person, please
complete, sign and promptly return the enclosed proxy card in the enclosed
postage-prepaid envelope to assure representation of your shares. You may
revoke your proxy at any time before it has been voted, and if you attend the
meeting you may vote in person even if you have previously returned your proxy
card. Your prompt cooperation will be greatly appreciated.
Sincerely,
/s/ Paul D. Levy
-------------------------------------
Paul D. Levy
Chief Executive Officer
Santa Clara, California
YOUR PROXY IS IMPORTANT--PLEASE VOTE PROMPTLY
<PAGE>
RATIONAL SOFTWARE CORPORATION
2800 SAN TOMAS EXPRESSWAY
SANTA CLARA, CALIFORNIA 95051
NOTICE OF SPECIAL MEETING OF STOCKHOLDERS
TO BE HELD ON FEBRUARY 26, 1997
TO THE STOCKHOLDERS OF RATIONAL SOFTWARE CORPORATION:
NOTICE IS HEREBY GIVEN that a Special Meeting of Stockholders (the "Rational
Meeting") of Rational Software Corporation, a Delaware corporation
("Rational"), will be held on February 26, 1997 at 9:00 a.m., local time, at
2800 San Tomas Expressway, Santa Clara, California.
At the Rational Meeting you will be asked to consider and vote upon the
following matters:
(1) The reservation and issuance of shares of the Common Stock, par value
$0.01 per share, of Rational (the "Rational Common Stock" and the "Combined
Company Common Stock" following the Merger (as defined below)) to the
stockholders of SQA, Inc. ("SQA") pursuant to an Agreement and Plan of
Reorganization, dated November 12, 1996 (the "Agreement"), among Rational,
SQA and Sunshine Acquisition Corp., a wholly owned subsidiary of Rational
("Merger Sub"), providing, among other things, (i) for the merger of Merger
Sub with and into SQA, resulting in SQA becoming a wholly owned subsidiary
of Rational (the "Merger"), (ii) for the conversion of outstanding shares
of Common Stock, par value $0.01 per share, of SQA ("SQA Common Stock")
into the right to receive 0.86 (the "Exchange Ratio") shares of Rational
Common Stock, and (iii) that each outstanding option or right to purchase
SQA Common Stock under the SQA stock option plans, the SQA stock purchase
plan and outstanding warrants will be assumed by Rational and will become
an option or right to purchase Combined Company Common Stock, with
appropriate adjustments to be made to the number of shares issuable
thereunder and the exercise price thereof based on the Exchange Ratio.
(2) The adoption of the Rational 1997 Stock Option Plan, including the
reservation thereunder of 1,000,000 shares of Rational Common Stock plus
all shares of Rational Common Stock available for issuance under pre-
existing Rational option plans (exclusive of the Stock Option Plan for
Directors) for which there are no options to purchase outstanding at the
time of the approval.
(3) Such other matters as may properly come before the Rational Meeting
or any postponements or adjournments thereof.
The proposal relating to the Merger is described more fully in the
accompanying Prospectus/Joint Proxy Statement.
Stockholders of record at the close of business on January 10, 1997 are
entitled to notice of, and to vote at, the Rational Meeting and any
adjournments or postponements thereof. All stockholders are cordially invited
to attend the Rational Meeting in person.
By Order of the Board of Directors
Paul D. Levy
Chief Executive Officer
Santa Clara, California
January , 1997
WHETHER OR NOT YOU EXPECT TO ATTEND THE MEETING, PLEASE COMPLETE, DATE AND
SIGN THE ENCLOSED PROXY CARD AND MAIL IT PROMPTLY IN THE ENCLOSED ENVELOPE IN
ORDER TO ASSURE REPRESENTATION OF YOUR SHARES. NO POSTAGE NEED BE AFFIXED IF
THE PROXY CARD IS MAILED IN THE UNITED STATES.
<PAGE>
[SQA, INC. LOGO]
January , 1997
Dear Stockholder:
As most of you are aware, SQA, Inc. ("SQA") has entered into a definitive
merger agreement to combine with Rational Software Corporation ("Rational") in
a strategic business combination (the "Merger"). At our Special Meeting
onFebruary 26, 1997, you will be asked to consider and approve the Agreement
and Plan of Reorganization between Rational, its wholly owned subsidiary,
Sunshine Acquisition Corp., and SQA (the "Agreement") relating to the Merger.
In the Merger, Sunshine Acquisition Corp., a wholly-owned subsidiary of
Rational ("Merger Sub"), will be merged with and into SQA, which will be the
surviving corporation and will become a wholly owned subsidiary of Rational.
Pursuant to the Merger, each outstanding share of Common Stock, par value
$0.01 per share, of SQA (the "SQA Common Stock") will be converted into the
right to receive 0.86 (the "Exchange Ratio") shares of Common Stock, par value
$0.01 per share, of Rational (the "Rational Common Stock," and the "Combined
Company Common Stock" immediately following the Merger), and each outstanding
option or right to purchase SQA Common Stock under the SQA stock option plans,
the SQA stock purchase plan or outstanding warrants will be assumed by
Rational and will become an option or right to purchase Combined Company
Common Stock, with appropriate adjustments to be made to the number of shares
issuable thereunder and the exercise price thereof based on the Exchange
Ratio. The shares of Rational Common Stock held by Rational stockholders
immediately prior to the Merger will remain unchanged by the Merger. It is
expected that SQA stockholders will receive approximately 7.0 million shares
of Rational Common Stock in the Merger, and another approximately 2.0 million
shares of Combined Company Common Stock will be reserved for issuance pursuant
to options, warrants and rights to purchase SQA Common Stock outstanding
immediately prior to the Merger. Upon the consummation of the Merger, Ronald
H. Nordin, currently the President and Chief Executive Officer of SQA, will be
employed by Rational and will join the existing Rational Board of Directors.
The accompanying Prospectus/Joint Proxy Statement describes more fully the
proposal relating to the Merger.
After careful consideration, SQA's Board of Directors has approved the
Agreement by the unanimous vote of all non- interested directors, and
recommends that you vote FOR the approval and adoption of the Agreement.
SQA has retained the investment banking firm of Robertson Stephens & Company
LLC ("RS & Co.") to advise it with respect to the Purchase Price Value, as
defined in RS & Co.'s written opinion, to be paid by Rational in the Merger.
RS & Co. has advised the SQA Board that, in its opinion, the Purchase Price
Value to be paid is fair, from a financial point of view, to SQA. A copy of
the RS & Co. opinion is attached to the Prospectus/Joint Proxy Statement as
Annex D.
The Board of Directors of SQA believes the Merger offers SQA and its
stockholders a number of important benefits, including the strategic fit
between the two Companies' product lines, technologies, development teams and
sales and marketing resources, as well as long-term administrative and
operational economies of scale.
All stockholders are invited to attend the meeting in person. The
affirmative vote of holders of a majority of the shares of SQA Common Stock
outstanding as of the record date will be necessary for approval and adoption
of the Agreement and the transactions contemplated thereby.
Stockholders are urged to review carefully the information contained in the
accompanying Prospectus/Joint Proxy Statement, including in particular the
information under the captions "Risk Factors," "SQA, Inc. Special Meeting--
Recommendation of SQA, Inc. Board of Directors," "Approval of the Merger and
Related Transactions--Joint Reasons for the Merger" and "--SQA's Reasons for
the Merger" prior to making any voting decision in connection with their SQA
Common Stock.
Whether or not you expect to attend the Special Meeting in person, please
complete, sign and promptly return the enclosed proxy card in the enclosed
postage-prepaid envelope to assure representation of your shares. You may
revoke your proxy at any time before it has been voted, and if you attend the
meeting you may vote in person even if you have previously returned your proxy
card. Your prompt cooperation will be greatly appreciated.
Sincerely,
/s/ Ronald H. Nordin
-------------------------------------
Ronald H. Nordin
President and Chief Executive
Officer
Burlington, Massachusetts
YOUR PROXY IS IMPORTANT-PLEASE VOTE PROMPTLY
SQA STOCKHOLDERS SHOULD NOT SURRENDER OR OTHERWISE ATTEMPT TO EXCHANGE THEIR
SQA STOCK CERTIFICATES FOR RATIONAL STOCK CERTIFICATES UNLESS AND UNTIL THEY
HAVE RECEIVED APPROPRIATE NOTICE AND INSTRUCTIONS FOR EXCHANGE.
<PAGE>
SQA, INC.
ONE BURLINGTON WOODS DRIVE
BURLINGTON, MASSACHUSETTS 01803
NOTICE OF SPECIAL MEETING OF STOCKHOLDERS
TO BE HELD ON FEBRUARY 26, 1997
TO THE STOCKHOLDERS OF SQA, INC.
NOTICE IS HEREBY GIVEN that a Special Meeting of Stockholders (the "SQA
Meeting") of SQA, Inc., a Delaware corporation ("SQA"), will be held at the
offices of Testa, Hurwitz & Thibeault, LLP, located at High Street Tower, 125
High Street, Boston, Massachusetts 02110 on February 26, 1997, at 12:00 p.m.,
local time, to consider and vote upon the following matters:
1. Approval and adoption of the Agreement and Plan of Reorganization (the
"Agreement") dated November 12, 1996, among Rational Software Corporation,
a Delaware corporation ("Rational"), Sunshine Acquisition Corp., a Delaware
corporation and wholly owned subsidiary of Rational ("Merger Sub"), and
SQA, pursuant to which, among other matters (i) Merger Sub will be merged
with and into SQA (the "Merger"), (ii) each share of Common Stock, $0.01
per share of SQA ("SQA Common Stock"), will be converted into the right to
receive, and become exchangeable for, 0.86 (the "Exchange Ratio") shares of
Common Stock, $0.01 per share, of Rational ("Combined Company Common Stock"
immediately following the Merger) and (iii) each outstanding option or
right to purchase SQA Common Stock under the SQA stock options plans, the
SQA stock purchase plan or outstanding warrants will be assumed by Rational
and will become an option or right to purchase Combined Company Common
Stock, with appropriate adjustments to be made to the number of shares
issuable thereunder and the exercise price thereof based on the Exchange
Ratio.
2. Such other matters as may properly come before the SQA Meeting or any
postponements or adjournments of the SQA Meeting.
The proposal relating to the Merger is described more fully in the
accompanying Prospectus/Joint Proxy Statement. Stockholders of record as of
the close of business on January , 1997 will be entitled to notice of, and to
vote at, the SQA Meeting and any adjournments or postponements thereof.
All stockholders are cordially invited to attend the meeting in person.
By Order of the Board of Directors
William J. Schnoor, Jr.
Secretary
Burlington, Massachusetts
January , 1997
WHETHER OR NOT YOU EXPECT TO ATTEND THE MEETING, PLEASE COMPLETE, DATE AND
SIGN THE ENCLOSED PROXY CARD AND MAIL IT PROMPTLY IN THE ENCLOSED ENVELOPE IN
ORDER TO ASSURE REPRESENTATION OF YOUR SHARES. NO POSTAGE NEED BE AFFIXED IF
THE PROXY CARD IS MAILED IN THE UNITED STATES.
<PAGE>
PROSPECTUS/JOINT PROXY STATEMENT
7,273,000 SHARES
[LOGO]
RATIONAL SOFTWARE CORPORATION
COMMON STOCK
This Prospectus/Joint Proxy Statement constitutes the Prospectus of Rational
Software Corporation, a Delaware corporation ("Rational"), with respect to up
to 7,273,000 shares of its Common Stock, par value $0.01 per share ("Rational
Common Stock"), to be issued in connection with the proposed merger (the
"Merger") of Sunshine Acquisition Corp., a Delaware corporation and a wholly
owned subsidiary of Rational ("Merger Sub"), with and into SQA, Inc., a
Delaware corporation ("SQA"), pursuant to the terms set forth in the Agreement
and Plan of Reorganization, dated November 12, 1996 (the "Agreement"), among
Rational, Merger Sub and SQA. As used herein, the term "Combined Company"
means Rational and SQA and their respective subsidiaries as a consolidated
entity following the Merger and references to the products, business, results
of operations or financial condition of the Combined Company should be
considered to refer to Rational and SQA, unless the context otherwise
requires. The shares of Rational Common Stock after the Merger are referred to
herein as "Combined Company Common Stock" and the Common Stock, par value
$0.01 per share, of SQA is referred to herein as "SQA Common Stock." As a
result of the Merger, each outstanding share of SQA Common Stock will be
converted into the right to receive 0.86 shares of Rational Common Stock (the
"Exchange Ratio"), and each outstanding option or right to purchase SQA Common
Stock under the SQA 1990 Incentive and Nonqualified Stock Option Plan, the SQA
1995 Stock Plan and the SQA 1995 Non-Employee Director Stock Option Plan
(collectively, the "SQA Stock Option Plans"), the SQA 1995 Employee Stock
Purchase Plan (the "SQA Stock Purchase Plan") or outstanding warrants will be
assumed by Rational and will become an option or right to purchase Combined
Company Common Stock, with appropriate adjustments to the number of shares
issuable thereunder and the exercise price thereof based on the Exchange
Ratio.
This Prospectus/Joint Proxy Statement also constitutes the Proxy Statements
of Rational and SQA with respect to the Special Meeting of Stockholders of
Rational scheduled to be held on February 26, 1997 (the "Rational Meeting")
and the Special Meeting of Stockholders of SQA scheduled to be held on
February 26, 1997 (the "SQA Meeting").
This Prospectus/Joint Proxy Statement and the accompanying form of proxy are
first being mailed to the stockholders of Rational and SQA on or about January
, 1997.
----------------
SEE "RISK FACTORS" BEGINNING AT PAGE 22 FOR CERTAIN INFORMATION THAT SHOULD
BE CONSIDERED BY THE RATIONAL STOCKHOLDERS IN EVALUATING THE PROPOSALS TO BE
VOTED ON AT THE RATIONAL MEETING AND BY THE SQA STOCKHOLDERS IN EVALUATING THE
PROPOSALS TO BE VOTED ON AT THE SQA MEETING AND THE ACQUISITION OF THE
SECURITIES OFFERED HEREBY.
----------------
NEITHER THIS TRANSACTION NOR THE SECURITIES OF RATIONAL OFFERED HEREBY HAVE
BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND EXCHANGE COMMISSION OR
ANY STATE SECURITIES COMMISSION NOR HAS THE SECURITIES AND EXCHANGE
COMMISSION OR ANY STATE SECURITIES COMMISSION PASSED UPON THE ACCURACY
OR ADEQUACY OF THIS PROSPECTUS/JOINT PROXY STATEMENT. ANY
REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE.
----------------
The date of this Prospectus/Joint Proxy Statement is January , 1997.
<PAGE>
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PAGE
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<S> <C>
AVAILABLE INFORMATION...................................................... 1
INCORPORATION OF CERTAIN DOCUMENTS BY REFERENCE............................ 1
TRADEMARKS................................................................. 2
FORWARD-LOOKING STATEMENTS................................................. 2
SUMMARY.................................................................... 3
INTRODUCTION............................................................... 18
RATIONAL SPECIAL MEETING................................................... 18
Date, Time and Place of Rational Meeting................................. 18
Purpose.................................................................. 18
Record Date and Outstanding Shares....................................... 18
Vote Required............................................................ 18
Proxies.................................................................. 19
Solicitation of Proxies; Expense......................................... 19
Recommendation of Rational Board of Directors............................ 19
SQA SPECIAL MEETING........................................................ 20
Date, Time and Place of SQA Meeting...................................... 20
Purpose.................................................................. 20
Record Date and Outstanding Shares....................................... 20
Vote Required............................................................ 20
Proxies.................................................................. 20
Solicitation of Proxies; Expense......................................... 21
Recommendation of SQA Board of Directors................................. 21
PROPOSAL NO. 1: THE MERGER
RISK FACTORS............................................................... 22
Risks Related to the Merger.............................................. 22
Risks Related to Rational and SQA........................................ 24
Risks Related to Rational................................................ 30
Risks Related to SQA..................................................... 32
APPROVAL OF THE MERGER AND RELATED TRANSACTIONS............................ 34
Joint Reasons for the Merger............................................. 34
Rational's Reasons for the Merger........................................ 35
SQA's Reasons for the Merger............................................. 37
Material Contacts and Board Deliberations................................ 38
Opinion of Rational's Financial Advisor.................................. 44
Opinion of SQA's Financial Advisor....................................... 47
Certain Federal Income Tax Considerations................................ 50
Governmental and Regulatory Approvals.................................... 52
Accounting Treatment..................................................... 52
TERMS OF THE MERGER........................................................ 53
Effective Time........................................................... 53
Manner and Basis of Converting Shares.................................... 53
Stock Ownership Following the Merger..................................... 54
Conduct of Combined Company Following the Merger......................... 54
Conduct of Rational's and SQA's Businesses Prior to the Merger........... 55
No Solicitation.......................................................... 56
Termination of the Agreement............................................. 57
Break Up Fees; Expenses.................................................. 58
Stock Option Agreement................................................... 59
</TABLE>
i
<PAGE>
<TABLE>
<CAPTION>
PAGE
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<S> <C>
Conditions to the Merger................................................ 59
Participation Agreement................................................. 61
Affiliate Agreements.................................................... 61
Interests of Certain Persons............................................ 61
UNAUDITED PRO FORMA CONDENSED COMBINED FINANCIAL INFORMATION.............. 63
RATIONAL BUSINESS......................................................... 67
RATIONAL MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.................................................... 81
RATIONAL MANAGEMENT....................................................... 88
RATIONAL STOCK INFORMATION................................................ 91
SQA BUSINESS.............................................................. 94
SQA MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.................................................... 102
SQA MANAGEMENT............................................................ 109
SQA STOCK INFORMATION..................................................... 111
COMPARISON OF CAPITAL STOCK............................................... 114
PROPOSAL No. 2 FOR RATIONAL STOCKHOLDERS: APPROVAL OF THE 1997 STOCK
OPTION PLAN.............................................................. 117
Federal Income Tax Consequences......................................... 119
Required Vote........................................................... 120
EXPERTS................................................................... 121
LEGAL MATTERS............................................................. 121
FUTURE STOCKHOLDER PROPOSALS.............................................. 121
ACCOUNTANTS' REPRESENTATIVES.............................................. 121
FINANCIAL STATEMENTS
Index to Consolidated Financial Statements.............................. F-1
Report of Ernst & Young LLP (Rational).................................. F-2
Report of Arthur Andersen LLP (SQA)..................................... F-19
ANNEX A--Agreement and Plan of Reorganization, dated November 12, 1996, by
and among Rational Software Corporation, Sunshine Acquisition
Corp. and SQA , Inc., and form of Certificate of Merger Merging
Sunshine Acquisition Corp. with and into SQA, Inc................ A-1
ANNEX B--Stock Option Agreement dated November 12, 1996, by and between
Rational Software Corporation and SQA, Inc. ..................... B-1
ANNEX C--Opinion of Hambrecht & Quist LLC................................. C-1
ANNEX D--Opinion of Robertson, Stephens & Company LLC..................... D-1
</TABLE>
ii
<PAGE>
AVAILABLE INFORMATION
Rational and SQA are subject to the information reporting requirements of
the Securities Exchange Act of 1934, as amended (the "Exchange Act"), and in
accordance therewith file reports, proxy statements and other information with
the Securities and Exchange Commission (the "SEC"). Such reports, proxy
statements and other information may be inspected and copied at the public
reference facilities maintained by the SEC at Room 1024, Judiciary Plaza, 450
Fifth Street, N.W., Washington, D.C. 20549, and at the SEC's regional offices
located at Seven World Trade Center, Suite 1300, New York, New York 10048, and
at Citicorp Center, 500 West Madison Street, Suite 1400, Chicago, Illinois
60601-2511. Copies of such material may be obtained by mail from the Public
Reference Section of the SEC at Judiciary Plaza, 450 Fifth Street, N.W.,
Washington, D.C. 20549, at prescribed rates. The SEC also maintains a Web site
that contains reports, proxy and information statements and other information
regarding registrants that file electronically with the SEC at the address
"http://www.sec.gov". Rational Common Stock and SQA Common Stock are quoted on
the Nasdaq National Market ("Nasdaq"), and such reports, proxy statements and
other information can also be inspected at the offices of Nasdaq Operations,
1735 K Street, N.W., Washington, D.C. 20006.
Rational has filed with the SEC a registration statement on Form S-4
(herein, together with all amendments and exhibits, referred to as the
"Registration Statement") under the Securities Act of 1933, as amended (the
"Securities Act"). This Prospectus/Joint Proxy Statement does not contain all
of the information set forth in the Registration Statement, certain parts of
which are omitted in accordance with the rules and regulations of the SEC. For
further information, reference is hereby made to the Registration Statement.
Copies of the Registration Statement and the exhibits and schedules thereto
may be inspected, without charge, at the offices of the SEC, or obtained at
prescribed rates from the Public Reference Section of the SEC at Judiciary
Plaza, 450 Fifth Street, N.W., Washington, D.C. 20549.
NO PERSON HAS BEEN AUTHORIZED TO GIVE ANY INFORMATION OR TO MAKE ANY
REPRESENTATION OTHER THAN AS CONTAINED HEREIN IN CONNECTION WITH THESE
MATTERS, AND, IF GIVEN OR MADE, SUCH INFORMATION OR REPRESENTATION MUST NOT BE
RELIED UPON AS HAVING BEEN AUTHORIZED BY RATIONAL OR SQA. NEITHER THE DELIVERY
HEREOF NOR ANY DISTRIBUTION OF SECURITIES MADE HEREUNDER SHALL, UNDER ANY
CIRCUMSTANCES, CREATE AN IMPLICATION THAT THERE HAS BEEN NO CHANGE IN THE
FACTS HEREIN SET FORTH SINCE THE DATE HEREOF. THIS PROSPECTUS/JOINT PROXY
STATEMENT DOES NOT CONSTITUTE AN OFFER TO SELL OR A SOLICITATION OF AN OFFER
TO BUY THE SECURITIES OFFERED BY THIS PROSPECTUS/JOINT PROXY STATEMENT WHERE,
OR TO ANY PERSON TO WHOM, IT IS UNLAWFUL TO MAKE SUCH AN OFFER OR
SOLICITATION.
INCORPORATION OF CERTAIN DOCUMENTS BY REFERENCE
Rational's Annual Report on Form 10-K for the fiscal year ended March 31,
1996, as amended, Rational's Quarterly Report on Form 10-Q for the quarter
ended June 30, 1996, Rational's Quarterly Report on Form 10-Q for the quarter
ended September 30, 1996, Rational's Form 8-K dated October 2, 1996,
Rational's Form 8-K dated October 3, 1996, as amended, Rational's Form 8-A
dated May 25, 1984 and amended on Form 8-A/A dated May 25, 1995, and
Rational's Form 8-K dated December 6, 1996, previously filed by Rational with
the SEC are hereby incorporated by reference in this Prospectus/Joint Proxy
Statement except as superseded or modified herein. SQA's Annual Report on Form
10-K for the fiscal year ended December 31, 1995 and amended on SQA's Form 10-
K/A for the fiscal year ended December 31, 1995 dated October 22, 1996, SQA's
Quarterly Report on Form 10-Q for the quarter ended March 31, 1996, SQA's
Quarterly Report on Form 10-Q for the quarter ended June 30, 1996, SQA's
Quarterly Report on Form 10-Q for the quarter ended September 30, 1996, SQA's
Form 8-A dated October 29, 1995, and SQA's Form 8-K dated December 6, 1996,
previously filed by SQA with the SEC, are hereby incorporated by reference in
this Prospectus/Joint Proxy Statement except as superseded or modified herein.
All documents filed by Rational and SQA with the Commission pursuant to
Section 13(a), 13(c), 14 or 15(d) of the Exchange Act after the date of this
Prospectus/Joint Proxy Statement and prior to the termination of the offering
of the shares offered hereby shall be deemed to be incorporated by reference
into this Prospectus/Joint Proxy Statement and to be a part hereof from the
date of filing of such
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documents. Any statement contained in any document incorporated or deemed to
be incorporated by reference herein shall be deemed to be modified or
superseded for purposes of this Prospectus/Joint Proxy Statement to the extent
that a statement contained herein or in any other subsequently filed document
which also is or is deemed to be incorporated by reference herein modifies or
supersedes such statement. Any such statement so modified or superseded shall
not be deemed, except as modified or superseded, to constitute a part of this
Prospectus/Joint Proxy Statement.
THIS PROSPECTUS/JOINT PROXY STATEMENT INCORPORATES DOCUMENTS BY REFERENCE
WHICH ARE NOT PRESENTED HEREIN OR DELIVERED HEREWITH. RATIONAL AND SQA WILL
PROVIDE WITHOUT CHARGE TO EACH PERSON, INCLUDING ANY BENEFICIAL OWNER, TO WHOM
THIS PROSPECTUS IS DELIVERED, UPON WRITTEN OR ORAL REQUEST OF SUCH PERSON, A
COPY OF ANY AND ALL OF THE DOCUMENTS THAT HAVE BEEN OR MAY BE INCORPORATED BY
REFERENCE HEREIN (OTHER THAN EXHIBITS TO SUCH DOCUMENTS WHICH ARE NOT
SPECIFICALLY INCORPORATED BY REFERENCE INTO SUCH DOCUMENTS). IN THE CASE OF
DOCUMENTS RELATED TO RATIONAL, SUCH REQUESTS SHOULD BE DIRECTED TO THE
SECRETARY AT RATIONAL'S PRINCIPAL EXECUTIVE OFFICES AT 2800 SAN TOMAS
EXPRESSWAY, SANTA CLARA, CALIFORNIA 95051-0951 (TELEPHONE (408) 496-3600). IN
THE CASE OF DOCUMENTS RELATED TO SQA, SUCH REQUESTS SHOULD BE DIRECTED TO
SQA'S PRINCIPAL EXECUTIVE OFFICES AT ONE BURLINGTON WOODS DRIVE, BURLINGTON,
MASSACHUSETTS, 01803, ATTN: INVESTOR RELATIONS (TELEPHONE (617) 229-3500). IN
ORDER TO ENSURE TIMELY DELIVERY OF THE DOCUMENTS, REQUESTS SHOULD BE MADE BY
FEBRUARY 19, 1997.
TRADEMARKS
This Prospectus/Joint Proxy Statement contains trademarks of Rational and
SQA and may contain trademarks of others. Rational(R), Rational Rose(R),
SoDA(R), Verdix(R), Rational Summit, Rational Apex, VADScross, Rational
Approach and Rational Visual Test are trademarks of Rational Software
Corporation. SQA and Software Quality Automation are registered trademarks of
SQA, and SQA Suite, SQA Robot, SQA LoadTest, SQA Manager, SQA Process, Object
Testing and SQA Test Repository are trademarks of SQA for which registration
has been applied. Microsoft, Windows(R)95, Windows(R) NT, Visual Basic(R),
Visual C++, Visual J++, ActiveX, BackOffice and Developer Studio are
trademarks of Microsoft Corporation. Java and all Java-based trademarks are
trademarks or registered trademarks of Sun Microsystems, Inc. in the U.S. and
other countries.
FORWARD-LOOKING STATEMENTS
Except for historic information contained herein, this Prospectus/Joint
Proxy Statement contains forward- looking statements within the meaning of
Section 27A of the Securities Act and Section 21E of the Exchange Act. Actual
results could differ materially from those projected in the forward-looking
statements as a result of certain factors, including those set forth in the
risk factors set forth below. Reference is made to the particular discussions
set forth under "Approval of the Merger and Related Transactions--Joint
Reasons for the Merger," "--Rational's Reasons for the Merger," "--SQA's
Reasons for the Merger," "Rational Management's Discussion and Analysis of
Financial Condition and Results of Operations" and "SQA Management's
Discussion and Analysis of Financial Condition and Results of Operations." In
connection with forward-looking statements which appear in these disclosures,
stockholders should carefully review the factors set forth in this
Prospectus/Joint Proxy Statement under "Risk Factors."
Readers are cautioned not to place undue reliance on these forward-looking
statements, which reflect management's analysis only as of the date hereof.
Neither Rational nor SQA undertakes any obligation to release publicly the
results of any revision to these forward-looking statements which may be made
to reflect events or circumstances after the date hereof or to reflect the
occurrence of unanticipated events.
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SUMMARY
The following contains a summary of certain information contained elsewhere
in this Prospectus/Joint Proxy Statement. This summary does not contain a
complete statement of all material elements of the proposals to be voted on and
is qualified in its entirety by the more detailed information appearing
elsewhere in this Prospectus/Joint Proxy Statement and in the documents annexed
hereto.
"SPECIAL MEETINGS"'
SPECIAL MEETING OF STOCKHOLDERS OF RATIONAL
Date, Time, Place and Purpose
A special meeting of the Rational stockholders will be held at 2800 San Tomas
Expressway, Santa Clara, CA 95051, on February 26, 1997 at 9:00 a.m. local
time. The purpose of the Rational Meeting is to approve the reservation and
issuance of shares of Rational Common Stock to the securityholders of SQA
pursuant to the Agreement and the adoption of the Rational 1997 Stock Option
Plan. See "Rational Special Meeting--Date, Time and Place of Rational Meeting"
and "--Purpose."
Record Date and Vote Required
Only Rational stockholders of record at the close of business on January 10,
1997 (the "Rational Record Date") are entitled to notice of and to vote at the
Rational Meeting. Because the number of shares of Rational Common Stock to be
issued or reserved for issuance in connection with the Merger will exceed 20%
of the number of shares of Rational Common Stock outstanding prior to the
Merger, approval by holders of Rational Common Stock of the reservation and
issuance of Rational Common Stock pursuant to the Agreement is required under
Nasdaq rules. Under Nasdaq rules, the proposal to reserve and issue Rational
Common Stock pursuant to the Agreement must be approved by a majority of the
votes cast at the Rational Meeting. If holders of Rational Common Stock do not
vote to approve such reservation and issuance, the Merger will not be
consummated. Rational is not a constituent corporation to the Merger and,
therefore, specific approval of the Agreement by Rational's stockholders is not
required under the Delaware General Corporation Law (the "DGCL") or the
Rational Certificate of Incorporation or the Rational Bylaws. The proposal to
adopt the Rational 1997 Stock Option Plan must be approved by a majority of the
votes cast at the Rational Meeting.
As a group, all executive officers and directors of Rational and their
affiliates owned shares, or approximately %, of Rational Common Stock
outstanding as of the Rational Record Date. No executive officer or director of
SQA or any affiliate of any such executive officer or director beneficially
owned any shares of Rational Common Stock as of such date.
As of the Rational Record Date, there were shares of Rational Common
Stock outstanding and stockholders of record of Rational Common Stock, each
of which will be entitled to cast one vote per share on the matters to be acted
on at the Rational Meeting. See "Rational Special Meeting--Record Date and
Outstanding Shares" and "--Vote Required."
Recommendation of Rational Board of Directors
Rational's Board of Directors (the "Rational Board") has approved the
Agreement and the transactions contemplated thereby by the unanimous vote of
all non-interested directors, and has determined that the Merger is fair and in
the best interests of Rational and its stockholders. Daniel H. Case III, a
member of the Rational Board and the President and Chief Executive Officer of
Hambrecht & Quist, which is serving as Rational's financial advisor in
connection with the Merger, abstained from the voting on the Agreement and the
transactions contemplated thereby. After careful consideration, the Rational
Board recommends a vote FOR the reservation and issuance of shares of Rational
Common Stock pursuant to the Agreement and a vote FOR the adoption of
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the 1997 Stock Option Plan. See "Proposal No. 1: The Merger," "Rational Special
Meeting--Recommendation of Rational Board of Directors" and "Approval of the
Merger and Related Transactions-- Joint Reasons for the Merger," "--Rational's
Reasons for the Merger," "--Material Contacts and Board Deliberations," and
"Proposal No. 2 for Rational Stockholders: Approval of the 1997 Stock Option
Plan."
SPECIAL MEETING OF STOCKHOLDERS OF SQA
Date, Time, Place and Purpose
A special meeting of the SQA stockholders will be held at Testa, Hurwitz &
Thibeault, LLP, located at High Street Tower, 125 High Street, Boston,
Massachusetts 02110, on February 26, 1997 at 12:00 p.m., local time. The
purpose of the SQA Meeting is to approve and adopt the Agreement, including the
Certificate of Merger attached as Exhibit A thereto (the "Certificate of
Merger"), and the Merger contemplated thereby. See "SQA Special Meeting--Date,
Time and Place of SQA Meeting" and "--Purpose."
Record Date and Vote Required
Only stockholders of record of SQA Common Stock at the close of business on
February , 1997 (the "SQA Record Date") are entitled to notice of, and to
vote at, the SQA Meeting. Pursuant to the DGCL and the SQA Amended and Restated
Certificate of Incorporation and the SQA Bylaws, the affirmative vote of at
least a majority of the outstanding shares of SQA Common Stock entitled to vote
at the SQA Meeting is required to approve and adopt the Agreement and the
transactions contemplated thereby.
As a group, all executive officers and directors of SQA and their affiliates
owned shares, or approximately %, of SQA Common Stock outstanding as of
the SQA Record Date. No executive officer or director of Rational or any
affiliate of any such executive officer or director beneficially owned any
shares of SQA Common Stock as of such date. SQA's directors, certain of its
officers and certain of its stockholders have entered into a Participation
Agreement with Rational, pursuant to each of the foregoing SQA stockholders has
agreed to vote in favor of the Merger and against approval of any proposal made
in opposition to or competition with consummation of the Merger.
As of the SQA Record Date, there were shares of SQA Common Stock
outstanding and stockholders of record of SQA Common Stock, each of which
will be entitled to cast one vote per share on the matters to be acted on at
the SQA Meeting. See "SQA Special Meeting--Record Date and Outstanding Shares,"
"--Vote Required," and "Proposal No. 1: The Merger--Terms of the Merger--
Participation Agreement" and "--Interests of Certain Persons."
Recommendation of SQA Board of Directors
SQA's Board of Directors (the "SQA Board"), by the unanimous vote of all non-
interested directors, has approved the Agreement, including the Certificate of
Merger, and the Merger contemplated thereby and has determined that the Merger
is fair to, and in the best interests of, SQA and its stockholders. Mr. Nordin,
a member of the SQA Board and the President and Chief Executive Officer of SQA,
who will be employed by Rational and will join the Rational Board following the
Merger, abstained from voting on the proposal to approve the Agreement,
including the Certificate of Merger, and transactions contemplated thereby.
After careful consideration, the SQA Board recommends a vote FOR approval and
adoption of the Agreement, including the Certificate of Merger, and the Merger
contemplated thereby. See "SQA Special Meeting--Recommendation of the SQA Board
of Directors," "Proposal No. 1: The Merger--Approval of the Merger and Related
Transactions--Joint Reasons for the Merger," "--SQA's Reasons for the Merger,"
and "--Material Contacts and Board Deliberations."
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PROPOSAL NO. 1: THE MERGER
THE COMPANIES
Rational Software Corporation
Rational develops, markets and supports a comprehensive solution for the
component-based development of software systems. Rational's objective is to
ensure the success of customers in developing and managing software systems
that are strategically important to their businesses. Rational provides an
integrated family of tools that spans the critical phases of the software
development process from initial analysis and design through delivery and
maintenance. In addition, Rational provides technical consulting, training and
support services. By supporting controlled iterative development, visual
modeling and an architecture-driven process, Rational's products and services
enable customers to reduce the risk of project failure, improve the quality of
the software systems they develop, increase developer productivity, reduce
time-to-market and increase software reusability.
Rational was incorporated in Delaware in 1982. Rational's executive offices
are located at 2800 San Tomas Expressway, Santa Clara, California 95051-0951,
and its telephone number is (408) 496-3600.
Sunshine Acquisition Corp.
Merger Sub is a corporation recently organized by Rational for the purpose of
effecting the Merger. It has no material assets and has not engaged in any
activities except in connection with the proposed Merger. Merger Sub's
executive offices are located at 2800 San Tomas Expressway, Santa Clara,
California, 95051, and its telephone number is (408) 496-3600.
SQA, Inc.
SQA develops and markets integrated software products for the automated
testing and quality management of Windows-based client/server applications.
SQA's products are designed to improve software quality, reduce development
costs and shorten time-to-deployment for large organizations building mission-
critical client/server applications. SQA's comprehensive SQA Suite is used by
developers, quality assurance ("QA") engineers and project managers during the
application lifecycle, including development, deployment and maintenance.
SQA's objective is to be the leading supplier of automated testing and
quality management solutions for organizations building enterprise-wide
applications. SQA's strategy is to build on its early position in the market
for the automated testing of Windows-based client/server applications and
extend that position to support enterprises building Internet and intranet
applications. SQA intends to continue focusing on strategic platforms and
technology, offering comprehensive end-to-end testing, integrating its products
with leading development tools and related products, and supporting a broad
range of users.
SQA was incorporated in Delaware on March 8, 1990 under the name "Software
Quality Automation, Inc." On April 6, 1995, SQA was renamed "SQA, Inc." SQA's
principal executive offices are located at One Burlington Woods, Burlington, MA
01803, and its telephone number is (617) 229-3500.
RISK FACTORS
THE FOLLOWING RISK FACTORS SHOULD BE CONSIDERED CAREFULLY BY STOCKHOLDERS IN
EVALUATING THE MATTERS TO BE VOTED ON AT THE RATIONAL MEETING AND THE SQA
MEETING AND THE ACQUISITION OF THE SECURITIES OFFERED HEREBY: (I) THAT THE
EXPECTED LONG-TERM STRATEGIC BENEFITS OF THE MERGER ARE DEPENDENT UPON THE
SUCCESSFUL INTEGRATION OF SQA INTO RATIONAL'S OPERATIONS, AND THERE CAN BE NO
ASSURANCE THAT THIS WILL OCCUR, (II) THAT NEGATIVE REACTION TO THE MERGER ON
THE PART OF RATIONAL'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 RATIONAL COMMON STOCK, SQA COMMON STOCK AND/OR COMBINED COMPANY
COMMON STOCK, (III) THAT THE FLUCTUATION OF RATIONAL'S COMMON STOCK PRICE AND
SQA'S COMMON STOCK PRICE, AND THE FIXED NATURE OF THE EXCHANGE RATIO, MAY CAUSE
THE RELATIVE OR ABSOLUTE VALUE RECEIVED BY SQA STOCKHOLDERS TO INCREASE OR
DECREASE PRIOR TO THE EFFECTIVE TIME, (IV) THE FACT THAT THE MERGER IS EXPECTED
TO RESULT IN SUBSTANTIAL DIRECT TRANSACTION COSTS AND OPERATING CHARGES
RELATING TO THE INTEGRATION OF SQA'S OPERATIONS INTO RATIONAL'S OPERATIONS, AND
THERE IS NO ASSURANCE THAT THE INTEGRATION OF THE TWO COMPANIES WILL NOT
INVOLVE ADDITIONAL UNEXPECTED COSTS, (V) THE FACT THAT THERE ARE RISKS
ASSOCIATED WITH POTENTIAL CONFLICTS OF INTERESTS TO WHICH CERTAIN OFFICERS
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AND DIRECTORS OF SQA AND A DIRECTOR OF RATIONAL ARE SUBJECT, (VI) THAT DILUTION
OF OWNERSHIP INTERESTS OF CURRENT RATIONAL STOCKHOLDERS WILL RESULT FROM THE
MERGER, (VII) THAT FUTURE SALES OF SHARES OF COMBINED COMPANY COMMON STOCK MAY
ADVERSELY AFFECT THE MARKET PRICE OF SUCH STOCK, (VIII) THAT A NUMBER OF
FACTORS THAT MAY RESULT IN FLUCTUATIONS IN QUARTERLY RESULTS OF OPERATIONS OF
RATIONAL, SQA, AND/OR THE COMBINED COMPANY, (IX) THE VOLATILITY OF THE STOCK
PRICES OF BOTH RATIONAL AND SQA, (X) THE DEPENDENCE OF BOTH RATIONAL AND SQA
UPON EMERGING INDUSTRIES, EXPANSION OF PRODUCT LINES, AND NEW PRODUCT
INTRODUCTIONS IN A FIELD CHARACTERIZED BY RAPID TECHNOLOGICAL CHANGE, (XI) THE
FACT THAT BOTH COMPANIES DEPEND UPON THE HIRING AND RETENTION OF KEY PERSONNEL,
AND THERE CAN BE NO ASSURANCE THAT THE COMBINED COMPANY WILL BE SUCCESSFUL IN
ATTRACTING OR RETAINING SUCH PERSONNEL, (XII) THE INHERENT RISKS ASSOCIATED
WITH RECENT AND FUTURE ACQUISITIONS, (XIII) THE RISK THAT DEFECTS IN THE
SOFTWARE PRODUCTS OF RATIONAL, SQA, AND/OR THE COMBINED COMPANY COULD HAVE A
MATERIAL ADVERSE EFFECT ON SUCH COMPANIES' BUSINESS, RESULTS OF OPERATIONS OR
FINANCIAL CONDITION, (XIV) THE RISKS INHERENT IN MANAGING AND MAINTAINING RAPID
GROWTH, (XV) THE DEPENDENCE OF BOTH RATIONAL AND SQA ON THE SUCCESS OF CERTAIN
STRATEGIC RELATIONSHIPS, (XVI) THE HIGHLY COMPETITIVE NATURE OF THE MARKET FOR
SOFTWARE DEVELOPMENT TOOLS, (XVII) THE RISKS INHERENT IN INTERNATIONAL
OPERATIONS, (XVIII) THE DEPENDENCE OF RATIONAL AND SQA ON PROPRIETARY
TECHNOLOGY, WHICH THEY MAY NOT BE ABLE TO PROTECT FULLY, (XIX) THE RISKS
ASSOCIATED RATIONAL'S RELATIONSHIP WITH MICROSOFT, INCLUDING RATIONAL'S
ACQUISITION OF THE VISUAL TEST PRODUCT FROM MICROSOFT (XX) THE POTENTIAL
ADVERSE IMPACT ON RATIONAL'S SALES OF PROMOTIONAL PRODUCT VERSIONS, (XXI) THE
POTENTIAL THAT RATIONAL'S UNIFIED MODELING LANGUAGE (THE "UML") MAY NOT EMERGE
AS AN INDUSTRY STANDARD, (XXII) THE POTENTIAL THAT RATIONAL MAY FAIL TO
MAINTAIN A SUCCESSFUL DIRECT SALES FORCE OR FAIL TO DEVELOP CHANNELS OF
DISTRIBUTION THAT WILL INCREASE SALES WHILE REDUCING SALES COSTS ON A
PERCENTAGE BASIS, (XXIII) THE RISKS ASSOCIATED WITH CERTAIN DEFERRED TAX
ASSETS, (XXIV) 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, (XXV) 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, (XXVI) THE RISK THAT SQA'S PRODUCTS WILL NOT ACHIEVE BROAD
CUSTOMER ACCEPTANCE, (XXVII) THE RISKS INHERENT IN SQA'S RELIANCE ON A LIMITED
NUMBER OF PRODUCTS, AND (XXVIII) THE POTENTIAL INABILITY OF SQA TO SUCCESSFULLY
ACHIEVE WIDESPREAD DISTRIBUTION OF ITS PRODUCTS THROUGH INDIRECT CHANNELS. SEE
"RISK FACTORS."
REASONS FOR THE MERGER
The Rational Board and the SQA Board have authorized the execution and
delivery of the Agreement with the expectation that the proposed Merger will
contribute to the success of the Combined Company by (i) creating a competitive
advantage through combining complementary product lines; (ii) accelerating
tighter integration of product lines by leveraging combined software
development teams and technologies; (iii) accelerating sales force development
by combining Rational's direct, major-account sales organization with SQA's
telesales force; and (iv) sharing administrative and operating expenses. In
addition the Rational Board approved the proposed Merger because it believes
the Merger will: (i) help Rational maintain technology leadership; (ii) allow
Rational to complement the Visual Test acquisition with SQA Suite; (iii) help
Rational expand market penetration by gaining access to the SQA customer base;
(iv) help Rational expand its presence in the Windows client/server market; and
(v) allow Rational to expand and strengthen its strategic relationships.
Further, the SQA Board approved the proposed Merger because it believes the
Merger will: (i) allow expansion of its product offering with a complementary
product; (ii) help expand market penetration of SQA's products; and (iii)
facilitate capitalization on strategic opportunities created by integrating the
two companies' products. See "Risk Factors," "Approval of the Merger and
Related Transactions--Joint Reasons for the Merger," "--Rational's Reasons for
the Merger," and "--SQA's Reasons for the Merger."
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FAIRNESS OPINIONS
Hambrecht & Quist LLC ("Hambrecht & Quist") has delivered to the Rational
Board its written opinion, dated November 12, 1996, to the effect that as of
such date, the consideration to be paid by Rational in the Merger was fair from
a financial point of view to Rational. The full text of the opinion of
Hambrecht & Quist which set forth assumptions made and matters considered, is
attached as Annex C to this Prospectus/Joint Proxy Statement and is
incorporated herein by reference. HOLDERS OF RATIONAL COMMON STOCK ARE URGED
TO, AND SHOULD, READ SUCH OPINION IN ITS ENTIRETY. See "Approval of the Merger
and Related Transactions--Opinion of Rational's Financial Advisor" and Annex C
hereto.
Robertson, Stephens & Company LLC ("RS & Co.") has delivered to the SQA Board
its written opinion, dated November 12, 1996, to the effect that, as of such
date, the Purchase Price Value, as defined in RS & Co.'s written opinion was
fair from a financial point of view to SQA. The full text of the opinion of RS
& Co., which sets forth assumptions made and matters considered, is attached as
Annex D to this Prospectus/Joint Proxy Statement, and is incorporated herein by
reference. HOLDERS OF SQA COMMON STOCK ARE URGED TO, AND SHOULD, READ SUCH
OPINION IN ITS ENTIRETY. See "Approval of the Merger and Related Transactions--
Opinion of SQA's Financial Advisor" and Annex D attached hereto.
INCOME TAX TREATMENT
The Merger is intended to qualify as a "reorganization" under Section 368(a)
of the Internal Revenue Code of 1986, as amended (the "Code"), in which case no
gain or loss should generally be recognized by the holders of shares of SQA
Common Stock on the exchange of their shares of SQA Common Stock solely for the
shares of Rational Common Stock. Rational and SQA have each received an opinion
from their respective tax counsel that, based upon certain assumptions and
qualifications, the Merger will constitute a reorganization under Section
368(a) of the Code. HOWEVER, ALL SQA STOCKHOLDERS ARE URGED TO CONSULT THEIR
OWN TAX ADVISORS. See "Approval of the Merger and Related Transactions--Certain
Federal Income Tax Considerations."
REGULATORY MATTERS
The notification and waiting period imposed upon Rational and SQA under the
Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, expired on
December 29, 1996. Rational and SQA are aware of no other material governmental
or regulatory approvals required for consummation of the Merger, other than
compliance with the federal securities law and applicable securities and "blue
sky" laws of the various states. See "Approval of the Merger and Related
Transactions--Governmental and Regulatory Approvals."
ACCOUNTING TREATMENT
The Merger is intended to qualify as a pooling of interests for financial
reporting purposes in accordance with generally accepted accounting principles.
Consummation of the Merger is conditioned upon (i) receipt by SQA of a letter
from its independent auditors to the effect that SQA qualifies as an entity
that may be a party to a business combination for which the pooling-of-
interests method of accounting would be available and (ii) receipt by Rational
of a letter from its independent auditors regarding concurrence with Rational
management's conclusion as to the appropriateness of pooling-of-interests
accounting treatment for the Merger under APB No. 16, if consummated in
accordance with the Agreement.
THE MERGER
Terms of the Merger
At the Effective Time of the Merger, Merger Sub will merge with and into SQA
and Rational will own all of the capital stock of SQA. As a result of the
Merger, each outstanding share of SQA Common Stock, except
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for shares of Common Stock held in the treasury of SQA or owned by Merger Sub,
Rational or any wholly owned subsidiary of Rational or SQA, will be converted
into the right to receive 0.86 shares of Rational Common Stock, and each
outstanding option or right to purchase SQA Common Stock under the SQA Stock
Option Plans, SQA Stock Purchase Plan or outstanding warrants will be assumed
by the Combined Company and will become an option or right to purchase Combined
Company Common Stock, with appropriate adjustments to be made to the number of
shares issuable thereunder and the exercise price thereof based on the Exchange
Ratio.
No fractional shares will be issued by virtue of the Merger, but in lieu
thereof each holder of shares of SQA Common Stock who would otherwise be
entitled to a fraction of a share (after aggregating all fractional shares to
be received by such holder) will receive from the Combined Company an amount of
cash (rounded to the nearest whole cent) equal to the product of (i) such
fraction, multiplied by (ii) the average closing price of a share of Rational
Common Stock for the ten most recent days that Rational Common Stock has traded
ending on the trading day immediately prior to the Effective Time, as reported
on the Nasdaq National Market. See "Terms of the Merger--Manner and Basis of
Converting Shares."
Effective Time of the Merger
The Merger will become effective upon the filing of the Certificate of Merger
(the "Certificate of Merger") with the Secretary of State of the State of
Delaware or at such later time as may be agreed in writing by Rational, SQA and
Merger Sub and specified in the Certificate of Merger (the "Effective Time").
Assuming all conditions to the Merger are met or waived prior thereto, it is
anticipated that the closing date of the Merger (the "Closing Date") and
Effective Time will be on or about February 26, 1997. See "Terms of the
Merger--Effective Time."
Exchange of SQA Stock Certificates; Assumption of Options and Rights under the
SQA Stock Options Plans and the SQA Stock Purchase Plan
Promptly after the Effective Time, the Combined Company, acting through
ChaseMellon Shareholder Services as its exchange agent (the "Exchange Agent"),
will deliver to each SQA stockholder of record a letter of transmittal with
instructions to be used by such stockholder in surrendering certificates which,
prior to the Merger, represented shares of SQA Common Stock. CERTIFICATES
SHOULD NOT BE SURRENDERED BY THE HOLDERS OF SQA COMMON STOCK UNTIL SUCH HOLDERS
RECEIVE THE LETTER OF TRANSMITTAL FROM THE EXCHANGE AGENT. At the Effective
Time, each then outstanding option or right to purchase SQA Common Stock,
whether vested or unvested, will be assumed by Rational without any action on
the part of the holder thereof and the number of shares issuable thereunder and
the exercise price thereof shall be appropriately adjusted according to the
Exchange Ratio. OPTION AGREEMENTS AND WARRANTS NEED NOT BE SURRENDERED. See
"Terms of the Merger--Manner and Basis of Converting Shares."
Form S-8 Registration Statement
No later than five business days after the Closing Date, the Combined Company
will file a registration statement on Form S-8 under the Securities Act
covering the shares of Combined Company Common Stock issuable upon exercise of
options and rights to purchase SQA Common Stock granted under the SQA Stock
Option Plans and the SQA Stock Purchase Plan to be assumed by Rational at the
Effective Time. See "Terms of the Merger--Manner and Basis of Converting
Shares."
Stock Ownership Following the Merger
Based upon the capitalization of SQA as of the close of business on November
11, 1996 (including the number of shares of SQA Common Stock outstanding and
the number of shares issuable upon exercise of outstanding options, warrants
and rights to purchase SQA Common Stock) an aggregate of approximately 7.0
8
<PAGE>
million shares of Rational Common Stock will be issued to SQA stockholders in
the Merger and Rational will assume options, warrants and rights to purchase
SQA Common Stock for up to approximately 2.0 million additional shares of
Combined Company Common Stock. Based upon the number of shares of Rational
Common Stock issued and outstanding as of November 11, 1996, and after giving
effect to the issuance of Rational Common Stock as described in the previous
sentence, the former holders of SQA Common Stock would hold, and have voting
power with respect to, approximately 15% of the Combined Company's total issued
and outstanding shares, and holders of former SQA options would hold options
exercisable for approximately 5% of the Combined Company's total issued and
outstanding shares (assuming the exercise of only such options). The foregoing
numbers of shares and percentages are subject to change in the event that the
capitalization of either Rational or SQA changes subsequent to November 11,
1996 and prior to the Effective Time, and there can be no assurance as to the
actual capitalization of Rational or SQA at the Effective Time or of the
Combined Company at any time following the Effective Time. See "Terms of the
Merger--Stock Ownership Following the Merger."
Officers and Directors of Combined Company Following the Merger
Immediately after the Effective Time, the Combined Company's Board of
Directors will consist of the seven existing directors of Rational (two of whom
will be Paul Levy and Mike Devlin and five of whom will be non-employee
directors and are expected to be James Campbell, Daniel Case III, Leslie
Denend, John Montague and Allison Schleicher), and Ronald H. Nordin, a director
of SQA, who, pursuant to the Agreement, will be appointed to the Board of
Directors of Rational contingent upon consummation of the Merger. Immediately
after the Effective Time the Audit and Compensation Committees of the Combined
Company shall be the Audit and Compensation Committees of Rational immediately
prior to the Effective Time.
At the Effective Time, Paul Levy will be the Chairman of the Board and Chief
Executive Officer of the Combined Company, Michael Devlin will be the President
of the Combined Company, and Robert Bond will be the Senior Vice President,
Chief Financial Officer, Chief Operating Officer and Secretary of the Combined
Company. See "Terms of the Merger--Conduct of the Combined Company Following
the Merger."
No Solicitation
SQA has agreed not to, directly or indirectly, solicit, initiate discussions,
encourage or engage in negotiations with, or disclose any nonpublic information
relating to SQA or any of its subsidiaries to, any person relating to a
possible acquisition of SQA, except that, if the SQA Board of Directors
receives an unsolicited proposal, or written expression of interest that SQA
expects to lead to a proposal, that the SQA Board of Directors believes would,
if consummated, result in a transaction more favorable to its stockholders from
a financial point of view than the Merger, and the SQA Board of Directors
determines in good faith, after consultation with outside legal counsel, that
such actions are necessary for the SQA Board of Directors to comply with its
fiduciary duties under applicable law, then the SQA Board of Directors will not
be prevented from taking such other actions as are consistent with the
fiduciary obligations of the SQA Board of Directors. See "Terms of the Merger--
No Solicitation."
Termination; Fees; Expenses; Stock Option Agreement
The Agreement may be terminated under certain circumstances, including,
without limitation: by mutual written consent of Rational and SQA authorized by
their respective Boards of Directors; by either Rational or SQA if the other
party commits certain breaches of any representation, warranty or covenant
contained in the Agreement; if consummation of the Merger is permanently
enjoined or prevented by order of a court or other competent authority which
shall have become final and nonappealable; if the Merger is not consummated on
or before April 15, 1997 (except that the Agreement cannot be terminated
pursuant to this provision by a party whose action or failure to act has been a
principal cause of the failure of the Merger to occur on or before such
9
<PAGE>
date where such action or failure to act constitutes a breach of the
Agreement); or if a material adverse effect with respect to the other party has
occurred since the date of the Agreement. See "Terms of the Merger--Termination
of Agreement."
Generally, each party will bear its own expenses in connection with the
Agreement in the event it is terminated without consummation of the Merger.
However, after certain events, if the Agreement is terminated under certain
circumstances, SQA must pay Rational a $6 million break-up fee and/or reimburse
Rational up to $1 million in expenses incurred in connection with the Agreement
and transactions contemplated thereby. Similarly, if, after certain events, the
Agreement is terminated under certain other circumstances, Rational must pay
SQA a break-up fee of $20 million and/or reimburse SQA up to $1 million in
expenses incurred in connection with the Agreement and the transactions
contemplated thereby. See "Terms of the Merger--Break-Up Fees; Expenses."
As an inducement to Rational to enter into the Agreement, Rational and SQA
entered into a Stock Option Agreement dated November 12, 1996 ("Stock Option
Agreement") pursuant to which SQA granted Rational the right (the "Option"),
under certain conditions, to purchase up to 1,213,296 shares of SQA Common
Stock at a price of $35.26 per share. See "Terms of the Merger--Stock Option
Agreement."
Conditions to the Merger
In addition to the requirement that the requisite approval of stockholders of
Rational and SQA be received, consummation of the Merger is subject to a number
of other conditions that, if not satisfied or waived, may cause the Merger not
to be consummated and the Agreement to be terminated. Each party's obligation
to consummate the Merger is conditioned on, among other things, the accuracy of
the other party's representations, the other party's performance of its
covenants and the absence of legal action preventing consummation of the
Merger. Either party may waive compliance with any of the agreements or
satisfaction of any of the conditions in the Agreement. See "Terms of the
Merger--Conditions to the Merger."
Participation Agreement
Each of the members of the SQA Board (including Ronald H. Nordin, Edward T.
Anderson, Thomas Csathy, Ted R. Dintersmith, Jerald G. Fishman and Paul A.
Maeder); Thomas F. Bogan, SQA's Senior Vice President, Finance and
Administration, Treasurer and Assistant Secretary; Frederick J. Ciaramaglia,
SQA's Vice President, Research and Development; James P. Cluchey, SQA's Vice
President, Managing Director of European Operations; William T. Dedrick, SQA's
Vice President, U.S. Sales; Roger A. Hodskins, SQA's Vice President, Enterprise
Partners; Eric L. Schurr, SQA's Vice President, Product Management and
Marketing; David J. Orfao, SQA's Senior Vice President, Worldwide Sales and
Support; Debra S. Turnove, SQA's Vice President, Human Resources; Highland
Capital Partners II, Limited Partnership; Aegis Select Limited Partnership;
Aegis II Limited Partnership; and North Bridge Venture Partners, L.P. (who own
an aggregate of 1,414,709 shares of SQA Common Stock and options exercisable
within 60 days of the SQA Record Date to purchase shares of SQA Common
Stock, representing approximately % of the votes entitled to be cast by
holders of shares of SQA Common Stock issued and outstanding as of the SQA
Record Date and % of such votes assuming the exercise of all options held by
such persons) has entered into a Participation Agreement with Rational.
Pursuant to the Participation Agreement, which is irrevocable, each of the
foregoing SQA stockholders has agreed to vote in favor of the Merger and
against approval of any proposal made in opposition or competition with
consummation of the Merger. See "Terms of the Merger--Participation Agreement."
Affiliate Agreements
Each of the members of the Board of Directors of SQA, certain officers of SQA
and certain other stockholders of SQA have entered into agreements restricting
sales, dispositions or other transactions reducing their risk of investment in
respect of the shares of SQA Common Stock held by them prior to the Merger and
10
<PAGE>
the shares of Rational Common Stock received by them in the Merger so as to
comply with the requirements of applicable federal securities and tax laws and
to help ensure that the Merger will be treated as a pooling of interests for
accounting and financial reporting purposes.
Interests of Certain Persons in the Merger
In considering the recommendation of the SQA Board with respect to the
Agreement, holders of SQA Common Stock should be aware that members of the SQA
Board and the executive officers of SQA have certain interests in the Merger
that are in addition to the interests of holders of SQA Common Stock generally.
See "Terms of the Merger--Interests of Certain Persons."
Appraisal Rights
Pursuant to Section 262 of the DGCL, holders of Rational Common Stock and
SQA Common Stock are not entitled to appraisal rights in connection with the
Merger because both companies are traded on the Nasdaq National Market.
11
<PAGE>
MARKET PRICE DATA
Rational Common Stock is traded on the Nasdaq National Market under the
symbol "RATL." The following table sets forth the range of high and low sale
prices reported on the Nasdaq National Market for Rational Common Stock for the
periods indicated:
<TABLE>
<CAPTION>
HIGH LOW
------ ------
<S> <C> <C>
FISCAL YEAR ENDED MARCH 31, 1997
Fourth Quarter (through January 9, 1997)...................... $40.50 $37.88
Third Quarter................................................. 43.75 30.25
Second Quarter................................................ 36.00 17.50
First Quarter................................................. 33.13 19.00
FISCAL YEAR ENDED MARCH 31, 1996
Fourth Quarter................................................ $20.75 $ 7.95
Third Quarter................................................. 12.00 6.82
Second Quarter................................................ 9.32 6.57
First Quarter................................................. 6.10 5.25
FISCAL YEAR ENDING MARCH 31, 1995
Fourth Quarter................................................ $ 6.00 $ 3.57
Third Quarter................................................. 4.03 2.82
Second Quarter................................................ 3.94 2.07
First Quarter................................................. 4.69 2.07
SQA Common Stock is traded on the Nasdaq National Market under the symbol
"SQAX." The following table sets forth the range of high and low sale prices
reported on the Nasdaq National Market for SQA Common Stock for the periods
indicated:
<CAPTION>
HIGH LOW
------ ------
<S> <C> <C>
FISCAL YEAR ENDED DECEMBER 31, 1997
First Quarter (through January 9, 1997)....................... $33.88 $32.25
FISCAL YEAR ENDED DECEMBER 31, 1996
Fourth Quarter................................................ $33.25 $21.75
Third Quarter................................................. 29.50 17.50
Second Quarter................................................ 39.75 27.00
First Quarter................................................. 27.75 18.00
FISCAL YEAR ENDED DECEMBER 31, 1995
Fourth Quarter (From December 16, 1995)....................... $24.00 $16.00
</TABLE>
12
<PAGE>
The following table sets forth the closing sale prices per share of Rational
Common Stock and SQA Common Stock on the Nasdaq National Market on November 12,
1996, which closing prices were quoted prior to the announcement on that date
of the proposed Merger, and on January 9, 1997, the latest practicable trading
day before the filing of this Prospectus/Joint Proxy Statement for which
information was obtainable, and the equivalent per share price for SQA Common
Stock. The "equivalent per share price" for SQA Common Stock as of such dates
equals the closing sale price per share of Rational Common Stock on such dates
multiplied by the Exchange Ratio of 0.86. See "Terms of the Merger."
<TABLE>
<CAPTION>
RATIONAL SQA EQUIVALENT
COMMON STOCK COMMON STOCK PER SHARE PRICE
------------ ------------ ---------------
<S> <C> <C> <C>
November 12, 1996 $41.00 $25.50 $35.26
January 9, 1997 37.88 32.32 32.57
</TABLE>
Rational and SQA believe that SQA Common Stock presently trades on the basis
of the value of the Rational Common Stock expected to be issued in exchange for
such SQA Common Stock in the Merger, discounted for the time value of money and
for the uncertainties associated with such a transaction. Apart from the
publicly disclosed information concerning Rational which is included and
incorporated by reference in this Prospectus/Joint Proxy Statement, Rational
cannot state with certainty what factors account for changes in the market
price of the Rational Common Stock.
SQA stockholders are advised to obtain current market quotations for Rational
Common Stock and SQA Common Stock. No assurance can be given as to the market
prices of Rational Common Stock or SQA Common Stock at any time before the
Effective Time or as to the market price of Rational Common Stock at any time
thereafter. Because the Exchange Ratio is fixed, the Exchange Ratio will not be
adjusted to compensate SQA stockholders for decreases in the market price of
Rational Common Stock which could occur before the Merger becomes effective. In
the event the market price of Rational Common Stock decreases or increases
prior to the Effective Time, the value at the Effective Time of the Rational
Common Stock to be received in the Merger in exchange for SQA Common Stock
would correspondingly decrease or increase.
Following the Merger, all SQA Common Stock will be owned by Rational and, as
a result, SQA Common Stock will no longer be listed on the Nasdaq National
Market.
Rational and SQA have never paid cash dividends on their respective shares of
Common Stock. Pursuant to the Merger Agreement, each of Rational and SQA has
agreed not to pay cash dividends pending the consummation of the Merger,
without the written consent of the other. Subject to completion of the Merger,
the SQA Board presently intends to continue a policy of retaining all earnings
to finance the expansion of its business. The Rational Board currently intends
to retain all earnings for use in the business of the combined companies and
has no present intention to pay cash dividends.
13
<PAGE>
SELECTED HISTORICAL AND SELECTED UNAUDITED
PRO FORMA COMBINED FINANCIAL DATA
The following selected historical financial information of Rational and SQA
has been derived from their respective historical consolidated financial
statements, and should be read in conjunction with such consolidated financial
statements and the notes thereto, certain of which are included in this
Prospectus/Joint Proxy Statement. The selected unaudited pro forma combined
financial information of Rational and SQA is derived from the unaudited pro
forma condensed combined financial statements included in this Prospectus/Joint
Proxy Statement, which give effect to the Merger as a pooling of interests, and
should be read in conjunction with such unaudited pro forma statements and the
notes thereto. For pro forma purposes, Rational's statements of operations for
the three fiscal years ended March 31, 1994, 1995 and 1996, and for the six
months ended September 30, 1995 and 1996 have been combined with the statements
of operations of SQA for the three fiscal years ended December 31, 1993, 1994
and 1995, and for the six months ended June 30, 1995 and 1996, respectively;
and Rational's balance sheet at September 30, 1996 has been combined with SQA's
balance sheet at September 30, 1996.
The unaudited pro forma financial information is presented for illustrative
purposes only and is not necessarily indicative of the operating results or
financial position that would have occurred if the Merger had been consummated
nor is it necessarily indicative of future operating results or financial
position.
Except as otherwise noted, all figures presented in this Prospectus/Joint
Proxy Statement have been restated to reflect stock splits by Rational through
September 30, 1996.
SELECTED HISTORICAL FINANCIAL DATA
RATIONAL
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
SIX MONTHS ENDED
YEAR ENDED MARCH 31, SEPTEMBER 30,
------------------------------------------- -----------------
1992 1993 1994 1995 1996 1995 1996
------- ------- -------- ------- ------- -------- --------
<S> <C> <C> <C> <C> <C> <C> <C>
CONSOLIDATED STATEMENT
OF OPERATIONS DATA:
Total revenues.......... $60,329 $71,003 $ 70,343 $72,899 $91,107 $ 41,399 $ 56,077
Income (loss) from
continuing
operations(1).......... (1,065) (2,163) (13,807) 4,678 (4,021) 3,360 8,996
Net income (loss)(2).... (761) (3,974) (13,982) 4,678 (4,021) 3,360 8,996
Income (loss) from
continuing operations
per share.............. $ (.04) $ (.09) $ (.57) $ .19 $ (.13) $ .11 $ .24
Net income (loss) per
share(2)............... (.03) (.16) (.57) .19 (.13) .11 .24
Shares used in per share
computations(3)........ 23,820 24,260 24,394 25,212 30,725 30,872 37,056
</TABLE>
<TABLE>
<CAPTION>
MARCH 31,
--------------------------------------- SEPTEMBER 30,
1992 1993 1994 1995 1996 1996(4)
------- ------- ------- ------- ------- -------------
<S> <C> <C> <C> <C> <C> <C>
CONSOLIDATED BALANCE
SHEET DATA:
Working capital......... $22,438 $22,921 $ 4,972 $ 7,742 $45,548 $56,933
Total assets ........... 53,727 50,836 39,343 38,000 85,674 91,157
Long-term obligations .. 5,392 5,683 7,809 3,675 2,189 1,656
Stockholders' equity ... 28,489 27,045 6,487 12,084 50,906 63,476
</TABLE>
- --------
(1) Amounts for 1993 and 1994 include merger and restructuring costs of
$2,500,000 and $9,922,000, respectively. Amounts for 1995 include expense
reversals of $1,100,000. Amounts for 1996 include approximately $14,500,000
of one-time charges and operating expenses primarily associated with
Rational's acquisition of Objectory AB and the subsequent restructuring and
shaping of Rational's business, including an $8,700,000 write-off of
acquired in-process research and development costs in connection with the
acquisition. See "Rational Management's Discussion and Analysis of
Financial Condition and Results of Operations" and Notes 3 and 5 of Notes
to Rational Consolidated Financial Statements.
(2) Amounts for 1992, 1993 and 1994 include income (loss) from discontinued
operations of $304,000, ($1,811,000) and ($175,000), respectively. See
"Rational Management's Discussion and Analysis of Financial Condition and
Results of Operations" and Note 4 of Notes to Consolidated Financial
Statements.
(3) Computed on the basis described in Note 1 of Notes to Rational Consolidated
Financial Statements.
(4) Does not reflect that, in October 1996, Rational sold 5,188,094 shares of
Common Stock in a public offering with net proceeds to Rational of
approximately $186,000,000, net of underwriting discounts and related
expenses.
14
<PAGE>
SQA
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
NINE MONTHS
ENDED
YEAR ENDED DECEMBER 31, SEPTEMBER 30,
----------------------------------------- ---------------
1991 1992 1993 1994 1995 1995 1996
----- ------- ------- ------- ------- ------ -------
<S> <C> <C> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS
DATA:
Total revenues.......... $ 213 $ 643 $ 1,655 $ 4,450 $12,845 $8,686 $16,752
Net income (loss)....... (517) (1,516) (1,686) (2,442) 431 (150) 3,297
Net income (loss) per
share(1)............... -- -- -- $ (.46) $ .07 $(0.03) $ 0.38
Shares used in per share
computations(1)........ -- -- -- 5,271 6,062 5,875 8,786
</TABLE>
<TABLE>
<CAPTION>
DECEMBER 31,
----------------------------------------- SEPTEMBER 30,
1991 1992 1993 1994 1995 1996
------ ------- ------- ------- ------- -------------
<S> <C> <C> <C> <C> <C> <C>
BALANCE SHEET DATA:
Working capital
(deficiency)........... $ 444 $ (989) $ 1,105 $ 1,608 $34,811 $40,069
Total assets............ 756 393 2,142 4,022 40,465 49,362
Redeemable preferred
stock.................. 1,021 1,021 4,866 7,896 -- --
Stockholders' equity
(deficit).............. 401 (1,867) (3,602) (6,046) 35,721 43,568
</TABLE>
- --------
(1) Net income (loss) per common and common equivalent share has not been
presented for the years ended December 31, 1991, 1992 or 1993. SEC rules
require that all stock issued after October 15, 1994 and stock issued
pursuant to stock options granted after October 15, 1994 be reflected as
outstanding for these prior periods. Because the number of shares and
options outstanding increased substantially in subsequent years, the
information which would result from the required calculation is not
considered to be relevant or meaningful.
RATIONAL AND SQA
SELECTED UNAUDITED PRO FORMA COMBINED FINANCIAL DATA
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
SIX MONTHS
YEAR ENDED MARCH 31, PRO FORMA(1)
-------------------------- ---------------
1994 1995 1996 1995 1996
-------- ------- -------- ------- -------
<S> <C> <C> <C> <C> <C>
UNAUDITED PRO FORMA COMBINED
STATEMENT OF OPERATIONS DATA:
Total revenues.................... $ 71,998 $77,349 $103,952 $46,644 $66,027
Income (loss) from continuing
operations....................... (15,493) 2,256 (3,590) 2,921 10,965
Net Income (loss)................. (15,668) 2,256 (3,590) 2,921 10,965
Income per share from continuing
operations....................... -- $ .08 $ (.10) $ .08 $ .25
Shares used in per share
computations..................... -- 29,745 35,938 35,895 44,510
</TABLE>
<TABLE>
<CAPTION>
SEPTEMBER 30,
1996(2)
-------------
<S> <C>
UNAUDITED PRO FORMA COMBINED BALANCE SHEET DATA:
Working capital................................................... $ 88,002
Total assets...................................................... 140,519
Long-term obligations............................................. 1,656
Total stockholders' equity(3)..................................... 98,044
</TABLE>
- --------
(1) The Rational and SQA selected unaudited pro forma combined statement of
operations data combines Rational's historical condensed consolidated
statements of operations for the fiscal years ended March 31, 1994, 1995
and 1996 and the six months ended September 30, 1995 and 1996 with the
fiscal years ended December 31, 1993, 1994 and 1995 and the six months
ended June 30, 1995 and 1996 of SQA, respectively
(2) Does not reflect that in October 1996, Rational sold 5,188,094 shares of
Common Stock in a public offering with proceeds to Rational of
approximately $186,000,000, net of underwriting discounts and related
expenses.
(3) Total pro forma stockholders' equity at September 30, 1996 reflects $9
million in estimated charges to operations expected to be incurred in
connection with the Merger, including $3 million in direct transaction
costs and the mid-point of $5 million to $7 million in additional
anticipated costs associated with integrating the two companies. See "Risk
Factors--Risks Related to the Merger--Costs of Integration; Transaction
Expenses" and "Rational Management's Discussion and Analysis of Financial
Condition and Results of Operations--Overview."
15
<PAGE>
COMPARATIVE PER SHARE DATA
The following table sets forth certain historical per share data of Rational
and SQA and unaudited pro forma combined per share data after giving effect to
the Merger on a "pooling of interests" basis assuming that eighty-six one-
hundredths (0.86) of one newly issued share of Rational Common Stock is issued
in exchange for each outstanding share of SQA Common Stock in the Merger. This
data should be read in conjunction with the selected financial data, the
unaudited pro forma condensed combined financial statements and the separate
historical financial statements of Rational and SQA and notes thereto, included
elsewhere in this Prospectus/Joint Proxy Statement. For pro forma purposes,
information relating to Rational's fiscal years ended March 31, 1994, 1995 and
1996, and for the six months ended September 30, 1995 and 1996 have been
combined with information relating to SQA for the three fiscal years ended
December 31, 1993, 1994 and 1995, and for the six months ended June 30, 1995
and 1996, respectively. The unaudited pro forma combined financial data are not
necessarily indicative of the operating results that would have been achieved
had the Merger been consummated as of the beginning of the periods presented
and should not be construed as representative of future operating results or
financial condition.
<TABLE>
<CAPTION>
SIX MONTHS ENDED
YEAR ENDED MARCH 31, SEPTEMBER 30,
------------------------- ------------------
1994 1995 1996 1995 1996
------- ------- ------- -------- --------
<S> <C> <C> <C> <C> <C>
HISTORICAL-RATIONAL
Net income (loss)............. $ (.57) $ .19 $ (.13) $ .11 $ .24
Book value(1)(2).............. 1.51 $ 1.82
<CAPTION>
SIX MONTHS ENDED
YEAR ENDED DECEMBER 31, JUNE 30,
------------------------- ------------------
1993 1994 1995 1995 1996
------- ------- ------- -------- --------
<S> <C> <C> <C> <C> <C>
HISTORICAL-SQA
Net income (loss)............. -- $ (.46) $ .07 $ (.08) $ .23
Book value(2)................. $ 4.66 $ 5.27
<CAPTION>
SIX MONTHS
YEAR ENDED MARCH 31, PRO FORMA
------------------------- ------------------
1994 1995 1996 1995 1996
------- ------- ------- -------- --------
<S> <C> <C> <C> <C> <C>
PRO FORMA COMBINED PER RATIONAL
SHARE
Net income (loss)............. $ (.64) $ .08 $ (.10) $ .08 $ .25
Book value(1)(2)(3)(4)........ $ 1.93 $ 2.35
EQUIVALENT PRO FORMA COMBINED
PER SQA SHARE(5)
Net income (loss)............. $ (.55) $ .07 $ (.9) $ .07 $ .22
Book value(1)(3)(4)........... $ 1.66 $ 2.02
</TABLE>
- --------
(1) Book value figures do not reflect that in October 1996 Rational sold
5,188,094 shares of Common Stock in a public offering with proceeds to
Rational of approximately $186,000,000, net of underwriting discounts and
related expenses.
(2) Historical book value per share is computed by dividing stockholders'
equity by the number of shares of common stock outstanding at the end of
each period. Rational pro forma combined book value per share is computed
by dividing pro forma stockholders' equity by the pro forma number of
shares of Rational Common Stock which would have been outstanding had the
Merger been consummated as of each balance sheet date.
(3) Pro forma book value reflects $9 million in estimated charges to operations
expected to be incurred in connection with the Merger, including $3 million
in direct transaction costs and the midpoint of $5 million to $7 million in
additional anticipated costs associated with integrating the two companies.
See "Risk Factors--Risks Related to the Merger--Costs of Integration;
Transaction Expenses" and "Rational Management's Discussion and Analysis of
Financial Condition and Results of Operations--Overview."
(4) During October 1996, Rational sold 5,188,094 shares of Rational 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. On a pro forma basis, assuming the offering closed on
September 30, 1996, the pro forma combined per Rational share book value
and the equivalent pro forma combined per SQA share book value would have
been $6.27 and $5.39, respectively.
(5) SQA equivalent pro forma combined amounts are calculated by multiplying the
Rational pro forma combined per share amounts by the Exchange Ratio of
0.86.
16
<PAGE>
PROPOSAL NO. 2 FOR RATIONAL SHAREHOLDERS' APPROVAL OF THE RATIONAL 1997 STOCK
OPTION PLAN
Rational's Board of Directors has deemed it to be in the best interest of
Rational that Rational adopt a 1997 Stock Option Plan (the "Plan") which
conforms to recent changes in federal securities laws. Upon stockholder
approval, there will be reserved for issuance under the Plan 1,000,000 shares
of Rational Common Stock, plus all shares of Rational Common Stock available
for issuance under existing Rational option plans (exclusive of the Stock
Option Plan for Directors) for which there are no options to purchase
outstanding at the time of the approval. Once the Plan is approved by
stockholders, no new options will be issued under pre-existing option plans.
See "Proposal No. 2 For Rational Stockholders: Approval of the 1997 Stock
Option Plan."
17
<PAGE>
INTRODUCTION
This Prospectus/Joint Proxy Statement is furnished in connection with the
solicitation of proxies to be used at the Rational Meeting and the SQA
Meeting. This Prospectus/Joint Proxy Statement is also furnished by Rational
to SQA stockholders in connection with the issuance of shares of Rational
Common Stock in connection with the Merger described herein.
The information set forth herein concerning Rational and Merger Sub has been
furnished by Rational and the information set forth herein concerning SQA has
been furnished by SQA.
RATIONAL SPECIAL MEETING
DATE, TIME AND PLACE OF RATIONAL MEETING
The Rational Meeting will be held at 2800 San Tomas Expressway, Santa Clara,
CA 95051 on February 26, 1997 at 9:00 a.m. local time.
PURPOSE
The purpose of the Rational Meeting is to approve the reservation and
issuance of shares of Rational Common Stock to the securityholders of SQA
pursuant to the Agreement and the adoption of the Rational 1997 Stock Option
Plan.
RECORD DATE AND OUTSTANDING SHARES
Only Rational stockholders of record at the close of business on January 10,
1997 (the "Rational Record Date") are entitled to notice of, and to vote at,
the Rational Meeting. As of the Rational Record Date, there were
stockholders of record of Rational Common Stock.
On or about January , 1997, a notice meeting the requirements of the DGCL
and accompanying a copy of this Prospectus/Joint Proxy Statement was mailed to
all stockholders of record as of the Rational Record Date.
VOTE REQUIRED
Each stockholder of record of Rational Common Stock on the Rational Record
Date will be entitled to cast one vote per share, exercisable in person or by
properly executed proxy, on each matter properly submitted for the vote of the
stockholders of Rational at the Rational Meeting.
Because the number of shares of Rational Common Stock to be issued or
reserved for issuance in connection with the Merger will exceed 20% of the
number of shares of Rational Common Stock outstanding prior to the Merger,
approval by holders of Rational Common Stock of the reservation and issuance
of Rational Common Stock pursuant to the Agreement is required under Nasdaq
rules. Under Nasdaq rules, the proposal to reserve and issue Rational Common
Stock pursuant to the Agreement must be approved by a majority of the votes
cast at the Rational Meeting. If holders of Rational Common Stock do not vote
to approve such reservation and issuance, the Merger will not be consummated.
Rational is not a constituent corporation to the Merger and, therefore,
specific approval of the Agreement by Rational's stockholders is not required
under the DGCL or the Rational Certificate of Incorporation or the Rational
Bylaws.
The proposal to adopt the Rational 1997 Stock Option Plan must be approved
by a majority of the votes cast at the Rational Meeting.
The presence, in person or by properly executed proxy, of the holders of a
majority of the outstanding shares of Rational Common Stock entitled to vote
at the Rational Meeting shall constitute a quorum for the transaction of
business.
If an executed Rational proxy is returned and the stockholder has
specifically abstained from voting on any matter, the shares represented by
such proxy will be considered present at the Rational Meeting for purposes of
determining a quorum and for purposes of calculating the vote, but will not be
considered to have been voted in favor of such matter. Therefore, an
abstention will have the same effect as a vote against the reservation and
issuance of shares of Rational Common Stock pursuant to the Agreement and/or
the adoption of the Rational 1997 Stock Option Plan. If an executed
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proxy is returned by a broker holding shares in street name which indicates
that the broker does not have discretionary authority as to certain shares to
vote on one or more matters, such shares will be considered present at the
meeting for purposes of determining a quorum, but will not be considered to be
represented at the meeting for purposes of calculating the votes cast with
respect to such matter.
PROXIES
Each of the persons named as proxies in the proxy relating to the Rational
Meeting is an officer of Rational. All shares of Rational Common Stock that
are entitled to vote and are represented at the Rational Meeting by properly
executed proxies received prior to or at the Rational Meeting and not duly and
timely revoked will be voted at the Rational Meeting in accordance with the
instructions indicated on such proxies. If no such instructions are indicated,
such proxies will be voted in favor of the approval of the reservation and
issuance of shares of Rational Common Stock in connection with the Merger and
the adoption of the Rational 1997 Stock Option Plan.
The Rational Board knows of no other matter to be presented at the Rational
Meeting. If any other matters are properly presented for consideration at the
Rational Meeting (or any adjournments or postponements thereof) including,
among other things, consideration of a motion to adjourn or postpone the
Rational Meeting to another time and/or place (including, without limitation,
for the purpose of soliciting additional proxies), the persons named in the
enclosed forms of proxy and voting thereunder will have the discretion to vote
on such matters in accordance with their best judgment.
Execution of a proxy does not in any way affect a stockholder's right to
attend the meeting and vote in person. Any proxy given pursuant to this
solicitation may be revoked by the person giving it at any time before it is
voted. Proxies may be revoked by (i) filing with the Secretary of Rational, at
or before the taking of the vote at the Rational Meeting, a written notice of
revocation bearing a later date than the proxy; (ii) duly executing a later-
dated proxy relating to the same shares and delivering it to the Secretary of
Rational before the taking of the vote at the Rational Meeting or (iii)
attending the Rational Meeting and voting in person (although attendance at
the Rational Meeting will not in and of itself constitute a revocation of a
proxy). Any written notice of revocation or subsequent proxy should be sent so
as to be delivered to Rational Software Corporation at 2800 San Tomas
Expressway, Santa Clara, California 95051, Attention: Secretary, or hand-
delivered to the Secretary of Rational, in each case at or before the taking
of the vote at the Rational Meeting.
SOLICITATION OF PROXIES; EXPENSES
All costs of solicitation of proxies relating to the Rational Meeting will
be borne by Rational. Brokers, custodians and fiduciaries will be requested to
forward proxy soliciting material to the owners of stock held in their names,
and Rational will reimburse them for their reasonable out-of-pocket costs. In
addition, proxies may also be solicited by certain directors, officers and
employees of Rational personally or by mail, telephone or telegraph following
the original solicitation. Such persons will not receive additional
compensation for such solicitation. Rational has retained ChaseMellon
Shareholder Services, an independent proxy solicitation firm, to assist in
soliciting proxies at an estimated fee of $6,000 plus reimbursement of
reasonable expenses.
RECOMMENDATION OF RATIONAL BOARD OF DIRECTORS
THE RATIONAL BOARD HAS APPROVED THE AGREEMENT AND THE TRANSACTIONS
CONTEMPLATED THEREBY BY THE UNANIMOUS VOTE OF ALL NON-INTERESTED DIRECTORS,
AND HAS DETERMINED THAT THE MERGER IS FAIR AND IN THE BEST INTERESTS OF
RATIONAL AND ITS STOCKHOLDERS. Daniel H. Case III, a member of the Rational
Board of Directors and the President and Chief Executive Officer of Hambrecht
& Quist, which is serving as Rational's financial advisor in connection with
the Merger, abstained from the voting on the Agreement and the transactions
contemplated thereby. AFTER CAREFUL CONSIDERATION, THE RATIONAL BOARD
RECOMMENDS A VOTE FOR THE ISSUANCE OF SHARES OF RATIONAL COMMON STOCK PURSUANT
TO THE AGREEMENT AND A VOTE FOR THE ADOPTION OF THE 1997 STOCK OPTION PLAN.
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SQA SPECIAL MEETING
DATE, TIME AND PLACE OF SQA MEETING
The SQA Meeting will be held at the offices of Testa, Hurwitz & Thibeault,
LLP, located at High Street Tower, 125 High Street, Boston, Massachusetts
02110 on February 26, 1997 at 12:00 p.m. local time.
PURPOSE
The purpose of the SQA Meeting is to approve and adopt the Agreement,
including the Certificate of Merger, and the Merger contemplated thereby.
RECORD DATE AND OUTSTANDING SHARES
Only stockholders of record of SQA Common Stock at the close of business on
January , 1997 (the "SQA Record Date") are entitled to notice of, and to vote
at, the SQA Meeting. As of the SQA Record Date, there were stockholders of
record holding an aggregate of approximately shares of SQA Common Stock.
On or about January , 1997, a notice meeting the requirements of the DGCL
and accompanying a copy of this Prospectus/Joint Proxy Statement was mailed to
all stockholders of record as of the SQA Record Date.
VOTE REQUIRED
Each stockholder of record of SQA Common Stock on the SQA Record Date will
be entitled to cast one vote per share, exercisable in person or by properly
executed proxy, on each matter properly submitted for the vote of the
stockholders of SQA at the SQA Meeting.
Pursuant to the DGCL, the SQA Amended and Restated Certificate of
Incorporation and the SQA Bylaws, approval and adoption of the Agreement
requires the affirmative vote of at least a majority of the outstanding shares
of SQA Common Stock entitled to vote at the SQA Meeting. Because the required
vote of the SQA stockholders is based upon the number of outstanding shares of
SQA Common Stock, rather than upon the shares actually voted, the failure by
the holder of any such shares to submit a proxy or to vote in person at the
SQA Meeting (including abstentions and "broker non-votes") will have the same
effect as a vote against approval and adoption of the Agreement and the
transactions contemplated thereby.
The representation, in person or by properly executed proxy, of at least a
majority of the outstanding shares of SQA Common Stock entitled to vote at the
SQA Meeting shall constitute a quorum for the transaction of business.
The members of the SQA Board, certain SQA officers and certain other SQA
stockholders have entered into Participation Agreement with Rational, pursuant
to which each such holder has agreed to vote (i) in favor of approval of the
Agreement and (ii) against approval of any proposal made in opposition to or
competition with consummation of the Merger. In addition, each such holder has
agreed pursuant to the Participation Agreement to grant to Rational, within
five days of Rational's written request, an irrevocable proxy to vote shares
as aforesaid. The outstanding shares of SQA Common Stock subject to the
Participation Agreement represent % of the votes entitled to be cast by
holders of shares of SQA Common Stock as of the SQA Record Date and %
assuming exercise of all exercisable options held by parties to the
Participation Agreement. See "Terms of the Merger--Participation Agreement."
PROXIES
Each of the persons named as proxies in the proxy relating to the SQA
Meeting is an officer of SQA. All shares of SQA Common Stock that are entitled
to vote and are represented at the SQA Meeting by properly executed proxies
received prior to or at the SQA Meeting and not duly and timely revoked will
be voted at the SQA Meeting in accordance with the instructions indicated on
such proxies. If no such instructions are indicated, such proxies will be
voted in favor of the approval of the Agreement.
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The SQA Board knows of no other matter to be presented at the SQA Meeting.
If any other matter upon which a vote may properly be taken should be
presented at the SQA Meeting, shares represented by all proxies received by
the SQA Board will be voted with respect thereto in accordance with the
judgement of the persons named as proxies in the proxies.
Execution of a proxy does not in any way affect a stockholder's right to
attend the meeting and vote in person. Any proxy may be revoked by a
stockholder at any time before it is exercised by delivering a written
revocation or a later-dated proxy to the Secretary of SQA, or by attending the
meeting and voting in person. Any written notice of revocation or subsequent
proxy should be sent so as to be delivered to SQA, Inc. at One Burlington
Woods, Burlington, MA 01803, Attention: Secretary, or hand-delivered to the
Secretary of SQA, in each case at or before the taking of the vote at the SQA
Meeting.
SOLICITATION OF PROXIES; EXPENSES
All costs of solicitation of proxies relating to the SQA Meeting will be
borne by SQA. Brokers, custodians and fiduciaries will be requested to forward
proxy soliciting material to the owners of stock held in their names, and SQA
will reimburse them for their reasonable out-of-pocket costs. In addition,
proxies may also be solicited by certain directors, officers and employees of
SQA personally or by mail, telephone or telegraph following the original
solicitation. Such persons will not receive additional compensation for such
solicitation. SQA has retained Georgeson & Co., Inc., an independent proxy
solicitation firm, to assist in soliciting proxies at an estimated fee of
$8,500 plus reimbursement of reasonable expenses.
RECOMMENDATION OF SQA BOARD OF DIRECTORS
THE SQA BOARD, BY THE UNANIMOUS VOTE OF ALL NON-INTERESTED DIRECTORS, HAS
APPROVED THE AGREEMENT, INCLUDING THE CERTIFICATE OF MERGER, AND THE MERGER
CONTEMPLATED THEREBY, AND HAS DETERMINED THAT THE MERGER IS FAIR TO, AND IN
THE BEST INTERESTS OF, SQA AND ITS STOCKHOLDERS. Mr. Nordin, a member of the
SQA Board and the President and Chief Executive Officer of SQA, who will be
employed by Rational and will join the Rational Board of Directors following
the Merger, abstained from voting on the proposal to approve the Agreement and
transactions contemplated thereby. AFTER CAREFUL CONSIDERATION, THE SQA BOARD
RECOMMENDS A VOTE FOR APPROVAL AND ADOPTION OF THE AGREEMENT, INCLUDING THE
CERTIFICATE OF MERGER, AND THE MERGER CONTEMPLATED THEREBY.
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PROPOSAL NO. 1: THE MERGER
RISK FACTORS
The following factors should be considered carefully in evaluating the
matters to be voted on at the Rational Meeting and the SQA Meeting and the
acquisition of the securities offered hereby. This Prospectus/Joint Proxy
Statement contains forward-looking statements that involve risks and
uncertainties. Actual results could differ materially from those discussed in
the forward-looking statements as a result of certain factors, including those
set forth below and elsewhere in this Prospectus/Joint Proxy Statement.
RISKS RELATED TO THE MERGER
Risks Associated with Integration of Operations.
General. Rational and SQA have entered into the Agreement 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. 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. 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 Combined Company's
business, results of operations and financial condition following the
Merger. In addition, 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.
Integration of Sales and Marketing. Historically, the sales models used
by Rational's and SQA's sales organizations have differed significantly.
Rational primarily employs a direct selling approach which couples sales of
its products with technical consulting services. SQA markets and sells its
products and services primarily through a telesales force supplemented by
field sales engineers, as well as indirectly through a network of
resellers. There can be no assurance that the Combined Company will be able
to take full advantage of the combined sales forces' efforts, or that the
sales approach and distribution channels of one company will be effective
in promoting the products of the other. Rational and SQA also use a number
of distribution channels in the various geographic locations in which their
respective products are sold and there can be no assurance that channel
conflicts will not develop following the Merger. In particular, both
Rational and SQA have exclusive distribution agreements with different
principals in Japan. There can be no assurance that this situation can be
resolved without short- to medium-term expense or disruption of revenue.
Integration of Products, Technologies and Engineering Teams. The Combined
Company plans to integrate certain of its products, if practicable.
Integration may include combining Rational's visual modeling products with
SQA's testing suite and potentially sharing certain technologies among
products. Among other product integration activities, certain features and
technologies of SQA products such as SQA Manager may be incorporated into
Rational's Visual Test product. There can be no assurance that such
integration can or will be accomplished in a timely manner or that it will
prove to be technologically feasible. There can be no assurance that either
company will retain its key technical personnel, that the engineering teams
of the two companies will successfully cooperate and realize any
technological benefits, or that the focus on product integration efforts
will not have an adverse impact on the development, introduction or
delivery of new or enhanced Rational or SQA products. Rational does not
have plans to relocate the SQA engineering team, and the geographic
separation of the companies' respective engineering teams following the
Merger may make technical integration of the companies' products more
difficult.
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Risks Associated with Effect of Merger on Resellers and Customers. The
announcement and consummation of the Merger could cause resellers and present
and potential customers of either company to delay or cancel orders for
products as a result of concerns and uncertainty over product evolution,
integration and support of Rational's and SQA's products following the Merger.
For example, Rational believes that confusion in the industry regarding the
Combined Company's product plans may be having a negative effect on sales of
the Visual Test product. Other Rational and SQA products may be similarly
impacted by the announcement of the Merger. Such a delay or cancellation of
orders could have a material adverse effect on the business, results of
operations and financial condition of Rational, SQA or the Combined Company.
In particular, such delays or cancellations could be expected to disrupt
revenue and earnings, which in turn would have a negative effect on the market
price of Rational Common Stock, SQA Common Stock or Combined Company Common
Stock.
Risks Associated with Fixed Exchange Ratio. Under the terms of the
Agreement, each outstanding share of SQA Common Stock will be converted into
the right to receive 0.86 shares of Rational Common Stock at the Effective
Time of the Merger. The Agreement does not provide for adjustment of the
Exchange Ratio based on fluctuations in the price of either Rational Common
Stock or SQA Common Stock. To the extent that the market price for Rational
Common Stock increases or decreases before the Effective Time, the market
value at the Effective Time of the Rational Common Stock to be received by SQA
stockholders in the Merger would correspondingly increase or decrease. SQA
stockholders will not be compensated for decreases in the market price of
Rational Common Stock which could occur prior to the Effective Time. The
market prices of Rational Common Stock and SQA Common Stock as of a recent
date are set forth herein under "Rational Stock Information--Rational Stock
Price and Dividend Information" and "SQA Stock Information--SQA Stock Price
and Dividend Information." Stockholders voting on the Merger are urged to
obtain recent market quotations for Rational Common Stock and SQA Common
Stock. The Rational Common Stock and the SQA Common Stock historically have
been subject to substantial price volatility. No assurance can be given as to
the market prices of Rational Common Stock or SQA Common Stock at any time
before the Effective Time or as to the market price of Combined Company Common
Stock at any time thereafter. See "--Risks Related to Rational and SQA--
Volatility of Stock Price."
Costs of Integration; Transaction Expenses. Rational 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. Rational expects to incur an additional charge to
operations of between $5 million and $7 million primarily in the quarter
ending March 31, 1997, the quarter in which the Merger is expected to be
consummated, to reflect costs associated with integrating the two companies.
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 Rational 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
Rational's quarter ending March 31, 1997, are expected to contribute to an
operating loss and a net loss for Rational's 1997 fiscal year, and could
negatively impact financial results in future periods for the reasons
discussed above.
Potential Conflicts of Interest. Certain members of the SQA management team
have interests in the transactions contemplated under the Agreement that may
present them with certain potential conflicts of interest. In particular,
certain of such individuals will enter into employment agreements with
Rational that will become effective upon consummation of the Merger. In
addition, Mr. Ronald Nordin, a member of the SQA Board and President and Chief
Executive Officer of SQA, will be employed by Rational and will be appointed
to the Rational Board of Directors as of the Effective Time of the Merger. The
Board of Directors of each of Rational and SQA was aware of these potential
conflicts at the time of its consideration and approval of the Merger.
Daniel H. Case III, a director and stockholder of Rational, is the President
and Chief Executive Officer of Hambrecht & Quist. Hambrecht & Quist is
providing financial advisory services to Rational in connection with the
Merger. Hambrecht & Quist was paid an initial payment of $250,000 upon
delivery of its fairness opinion in
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connection with the Merger. Hambrecht & Quist will be paid an additional
$750,000 upon consummation of the Merger. Hambrecht & Quist will also be
reimbursed for reasonable out-of-pocket expenses incurred in connection with
its services. See "Terms of the Merger--Interests of Certain Persons."
Dilution of Ownership Interest of Current Rational Stockholders. Following
the Merger, the current stockholders of Rational will own approximately 85% of
the outstanding shares of Combined Company Common Stock. This represents
substantial dilution of the ownership interest in Rational of Rational's
current stockholders. The issuance of additional shares of Rational Common
Stock pursuant to the SQA Stock Option Plans, the SQA Stock Purchase Plan and
outstanding SQA warrants being assumed by Rational will result in further
dilution to the current stockholders of Rational.
Shares Eligible for Future Sale. If the Merger is consummated, Rational will
issue to stockholders of SQA an aggregate of approximately 7.0 million shares
of Rational Common Stock, based on the number of shares of SQA Common Stock
outstanding as of November 11, 1996. Immediately upon consummation of the
Merger, approximately 5.1 million of such shares will be freely tradeable. As
a result, substantial sales of Combined Company Common Stock could occur after
the Merger. Following publication of financial results covering 30 days of
post-merger combined operations, an additional approximately 1.9 million
shares issued in the Merger to persons who may be deemed affiliates of SQA
could be publicly sold pursuant to Rule 145 under the Securities Act, subject
to the volume and other limitations thereof. In addition, based on the number
of SQA options and warrants outstanding and the level of employee stock
purchase plan participation as of November 11, 1996, approximately 2,000,000
additional shares of Rational Common Stock will be reserved for issuance
following the Merger. Of the shares of Rational Common Stock outstanding prior
to the Merger, approximately 39.2 million are freely tradeable, and
approximately 1,000,000 are subject to a lock-up expiring 90 days after the
effective date of Rational's October 1996 public offering. Future sales of a
substantial number of shares of Combined Company Common Stock could adversely
affect or cause substantial fluctuations in the market price of Combined
Company Common Stock.
RISKS RELATED TO RATIONAL AND SQA
Fluctuations in Operating Results; SQA History of Losses. Following the
Merger, the Combined Company's revenue will continue to be difficult to
forecast due to the fact that both Rational's and SQA's sales cycles, from
initial evaluation to purchase, vary substantially from customer to customer.
Both Rational and SQA typically have operated with little backlog because
software products generally are shipped as orders are received. As a result,
revenue in any quarter is substantially dependent on orders booked and shipped
in that quarter. Because staffing and operating expenses are based on
anticipated revenue levels, and a high percentage of the 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, both companies have earned a substantial portion of their
revenues in the last weeks of the quarter. To the extent this trend continues
following the Merger, the failure to achieve such revenues in the last weeks
of any given quarter will have a material adverse effect on the Combined
Company's financial results for that quarter.
Although Rational has experienced increasing revenues in each of the past
ten quarters, its 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. SQA is subject to similar
fluctuations. There can be no assurance that similar fluctuations will not
occur again in the future, or that the integration of SQA into Rational will
not reinforce this pattern.
SQA's quarterly operating results have been difficult to forecast for the
reasons noted above, as well as the fact that SQA's telesales, which by their
nature are not easily forecast, account for a substantial majority of its
revenue from direct sales activities. The limited operating history and
historical fluctuation in quarterly revenue and operating results of SQA make
it difficult to predict the impact that the integration of SQA will have on
Rational's operating results following the Merger. SQA incurred operating
losses in each of its fiscal years since inception in 1990, and as of
September 30, 1996, had an accumulated deficit of $2.7 million. Recently, SQA
has
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experienced substantial revenue growth and first achieved profitability in the
quarter ended June 30, 1995. There can be no assurance that SQA will sustain
revenue growth, remain profitable on a quarterly basis, or achieve
profitability on an annual basis.
Rational's earnings for the quarter ending December 31, 1996 will be reduced
by charges and operating expenses associated with the acquisition and
marketing of the Visual Test product. Rational will incur an additional
expense of approximately $1.3 million in the quarter ending December 31, 1996
in connection with its contractual commitment to reimburse selling
stockholders for the underwriting discount and certain other expenses related
to their sales of shares of Common Stock in Rational's October 1996 public
offering. As a result of these factors, Rational expects to incur a
significant net loss for the quarter ending December 31, 1996, and is expected
to incur a net loss for fiscal 1997. See "Rational Management's Discussion and
Analysis of Financial Condition and Results of Operations--Overview."
The growth in revenues and operating income (exclusive of nonrecurring
operating, restructuring and merger-related expenses) experienced by Rational
and SQA in recent quarters is not necessarily indicative of future results,
and period-to-period comparisons of their financial results should not be
relied upon as an indication of future performance. Fluctuations in operating
results may also result in volatility in the prices of Rational's Common Stock
and SQA's Common Stock prior to the Merger, and in the price of the Combined
Company's Common Stock following the Merger.
Transaction expenses associated with the Merger and costs of integrating the
two companies are anticipated to result in an operating loss and a net loss
for the Combined Company's quarter ending March 31, 1997, are expected to
contribute to an operating loss and a net loss for the Combined Company's 1997
fiscal year, and could negatively impact financial results in future periods
as well. See "--Risks Related to the Merger--Costs of Integration; Transaction
Expenses."
Volatility of Stock Price. The market prices of Rational's Common Stock and
SQA's Common Stock have been, and are likely to continue to be, volatile.
Factors such as new product announcements or changes in product pricing
policies by either company or their respective competitors, quarterly
fluctuations in operating results, announcements of technical innovations,
announcements relating to strategic relationships or acquisitions, changes in
earnings estimates by analysts, and general conditions or stock prices of
companies in the component-based software development and testing tools
industries, among other factors, may have a significant impact on the market
price of the companies' respective Common Stock prior to the Merger, and the
market price of the Combined Company Common Stock following the Merger. Should
the companies fail to introduce or enhance products on the schedules expected,
their stock prices could be adversely affected.
Due to analysts' expectation of continued growth and the recent high
price/earnings ratio at which Rational's Common Stock and SQA's Common Stock
have traded, any shortfall in anticipated operating results could have an
immediate and significant adverse effect on the market price of the Combined
Company's Common Stock. There can be no assurance that the Combined Company's
net income per share will not decrease as a result of the Merger, or that
potential business synergies of Rational and SQA would eventually offset any
such dilution or will be achieved. The Combined Company will incur substantial
Merger-related charges primarily in the quarter in which the Merger is
consummated. Rational and SQA currently expect the Merger to be accretive in
the quarter following the quarter in which the Merger is consummated. However,
this forward-looking statement is based upon numerous assumptions and risks,
including those set forth in "Risk Factors" and elsewhere in this
Prospectus/Joint Proxy Statement. There can be no assurance that the Merger
will not, in fact, prove to be dilutive due to unforseen changes, inaccurate
or incomplete assumptions regarding the current business or future prospects
of either or both of the companies, or other reasons. Any failure of the
Merger to meet expectations of being accretive in the first full fiscal
quarter following the Effective Time could have an immediate and significant
adverse effect on the market price of the Combined 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
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prices of securities issued by many companies for reasons unrelated to the
operating performance of the specific companies. These broad market
fluctuations may adversely affect the market price of the Rational Common
Stock and SQA Common Stock prior to the Effective Time of the Merger, and of
the Combined Company Common Stock thereafter.
Dependence Upon Growth of Emerging Industries. The Combined Company's future
growth and financial performance will depend in part upon continued growth in
the need for and sales of component-based development and testing tools. There
can be no assurance that sales of these products will continue to grow or that
the Combined Company will be able to respond effectively to evolving customer
requirements. The number of software developers using component-based
development technology and testing tools is relatively small compared to the
number of developers using more traditional technology. The adoption of
component-based development technology and testing tools 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 and
testing tools 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 and
testing tools rather than traditional programming techniques. Many of
Rational's and SQA's customers have purchased only small quantities of the
companies' products, and there can be no assurance that these or new customers
will broadly implement component-based development or testing technology or
purchase additional software development or testing tools.
Expansion of Product Lines; Dependence Upon New Product Introductions. The
continued success of the Combined Company 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 Combined Company to enhance the current Rational
products and to continue to develop and introduce new products. Rational and
SQA also believe that the Combined Company's continued success will become
increasingly dependent on its ability to support the Microsoft platform,
including Windows 95 and Windows NT. Rational and SQA believe that it will be
particularly important to successfully develop and market a broader line of
software development products for C++, Visual Basic, Java and other
implementation languages in order for the Combined Company to be successful in
its efforts to broaden its customer base and to further increase its share
within its existing market segments. There can be no assurance that the
Combined Company will be able to successfully develop and market such a broad
line of products, that the Combined Company will not encounter unexpected
difficulties and delays in integrating new products with existing product
lines, or that efforts to integrate Rational and SQA products will not have an
adverse impact on the development, introduction or delivery of new or enhanced
Rational or SQA products.
The continued success of the Combined Company will also depend in part upon
the successful expansion of SQA's existing product lines following the Merger.
Rational and SQA believe that it will be important to extend the capabilities
of SQA test products to include the Borland Delphi and Oracle Developer 2000
development environments, to enhance SQA load test products to support
simulated users for virtual testing, and to extend SQA client test and load
test products to include Internet and intranet environments. There can be no
assurance that these development efforts can be completed in a timely or cost-
effective manner, or that these initiatives will be successfully marketed by
the Combined Company.
Both Rational and SQA have plans to introduce new products during the next
few fiscal quarters. Delay in the start of shipment of new products would have
an adverse effect on the Combined Company's revenues, gross profit and
operating income. As a result of Rational's business alliance with Microsoft,
certain of Rational'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 Rational's revenues from new products.
Both Rational and SQA attempt to make adequate allowances in their new
product release schedules for both internal and beta-site testing of product
performance. Because of the complexity of the companies' products,
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however, the release of new products may be postponed should test results
indicate the need for redesign and retesting, or should the companies elect to
add product enhancements in response to beta customer feedback.
Dependence Upon Key Personnel. Both Rational and SQA believe that the hiring
and retaining of qualified individuals at all levels in the Combined Company
will be essential to the Combined Company's ability to manage growth
successfully, and there can be no assurance that the Combined Company will be
successful in attracting and retaining the necessary personnel. The Combined
Company will be particularly dependent upon the efforts and abilities of its
senior management personnel. The departure of any of the executive officers of
Rational named in "Rational Management" or of Ronald H. Nordin, Frederick J.
Ciaramaglia or Eric Schurr of SQA could have a material adverse effect on the
Combined Company's business, financial condition, or results of operations
depending upon the timing of the departure, changes in the Combined 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 Rational executive officers is
subject to any agreement not to compete or severance agreement with Rational
or the Combined Company. Prior to the Effective Time, each of Messrs. Nordin,
Ciaramaglia and Schurr shall have entered into an employment agreement with
Rational that will include, among other things, two year non-competition and
certain severance provisions. There can be no assurance that the non-
competition provisions of those agreements are enforceable. See "Terms of the
Merger--Employment Agreements," "Rational Management," and "SQA Management."
The rate at which the Combined Company can attract and retain the highly
trained technical personnel that are integral to its direct sales and product
development teams may limit the rate at which the Combined Company can
increase sales. Competition for qualified personnel in the software industry
is intense, and there can be no assurance that the Combined Company will be
successful in attracting and retaining such personnel. The proposed Merger may
have a destabilizing effect on employee retention at all levels within
Rational and SQA. Additions of new, and departures of existing, personnel,
particularly in key positions, can be disruptive and can result in departures
of other existing personnel, which in turn could have a material adverse
effect upon the Combined Company's business, operating results and financial
condition.
Risks Associated With Recent and Future Acquisitions. During the past three
years, Rational has made a number of strategic acquisitions. While SQA has not
consummated any material strategic acquisitions, it has in the past devoted
resources and attention to the consideration of potential business
combinations. 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 Rational's, SQA's or the Combined
Company's business, results of operations and financial condition.
Acquisitions 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 acquisitions other than
the Merger, Rational and SQA management have historically evaluated on an
ongoing basis the strategic opportunities available to them. Rational or the
Combined Company may in the near- or long-term future pursue acquisitions of
complementary products, technologies or businesses. Pursuant to the terms of
the Agreement, while the Merger is pending, SQA may not undertake material
acquisitions without first obtaining the consent of Rational. As a result,
future acquisition opportunities which the SQA Board might consider to be
advantageous to SQA could be materially more difficult to pursue, and could be
lost to competitors of SQA or Rational.
Rapid Technological Change. The software development and testing tools
industry 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 Combined 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 Combined Company to
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make substantial product development investments. Any failure by the Combined
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 acceptance.
In addition, rapid growth of interest in and use of Internet and intranet
environments is a recent and emerging phenomenon. The Combined 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
Combined 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 offered by
Rational and SQA often contain undetected errors, or "bugs," or 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, Rational's and SQA'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 Rational's or SQA's products could result in loss
of revenues or delays in customer acceptance, which could have a material
adverse effect on the Combined Company's business, operating results and
financial condition. Further, because Rational and SQA rely on their own
products in connection with the development of their respective software, any
such errors could make it more difficult to sell such products in the future.
Management of Growth. Each of Rational and SQA has recently experienced a
period of rapid growth and aggressive product introductions or enhancements to
existing products 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 or
enhancements to product lines, efforts to address broader markets and to
expand distribution channels, acquisitions of companies or technologies such
as the Merger and Rational's recent acquisitions of Objectory AB and the
Visual Test product, and business alliances such as Rational's recent
arrangement with Microsoft, when added to the day-to-day activities of the
Combined Company, will place a further strain on the Combined Company's
resources and personnel. If the Combined Company's management is unable to
effectively manage growth, the Combined Company's business, competitive
position, results of operations and financial condition will be materially and
adversely affected.
Dependence Upon Strategic Relationships. Rational's development, marketing
and distribution strategies rely increasingly on its ability to form long-term
strategic relationships with major software and hardware vendors, many of whom
are substantially larger than Rational. See "--Risks Related to Rational--
Business Alliance with Microsoft." Similarly, SQA has entered into a number of
agreements and informal relationships with software development tool
companies, such as Pure Atria Software Corporation, Sybase, PeopleSoft,
Microsoft, Oracle, Borland, and Centura. The business relationships with these
development tool companies consist of cooperative marketing programs, joint
customer seminars and lead referrals. SQA believes that these marketing
relationships and activities have significantly contributed to SQA's revenue
growth over the past three years. Although certain aspects of some of these
relationships are contractual in nature, many important aspects of these
relationships depend upon the continued cooperation of each party with SQA.
There can be no assurance that the Merger will not disrupt these relationships
or activities. Divergence in strategy between the Combined Company and any
given partner, a change in focus by any given partner, or competitive product
offerings introduced by any given partner, may interfere with the Combined
Company's ability to develop, market, sell or support its products, which in
turn would have a material adverse effect on the Combined Company's business,
results of operations and financial condition.
Competition. The software development and testing tools industry is
extremely competitive and rapidly changing. Both Rational and SQA believe that
the increased level of competition observed in the prior year and so far in
the current year will continue to increase. Bases of competition include
corporate and product reputation,
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breadth of integrated product line, product architecture, functionality and
features, product quality, performance, ease-of-use, quality of support,
availability of technical consulting services and price. Both Rational and SQA
face intense competition for each product within their respective product
lines, generally from both Windows and UNIX vendors. Because individual
product sales are often the first step in a broader customer relationship, the
Combined Company's success will depend in part upon its ability to
successfully compete with numerous competitors at each point within its
product line. Certain competitors are more experienced than Rational and SQA
in the development of software-engineering tools, databases, software-
development products and software testing products. Some competitors have, and
new competitors may have, larger technical staffs, more established
distribution channels and greater financial resources than the Combined
Company. Rational and SQA have encountered, and expect to continue to
encounter, 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 Rational's or SQA's
products or that achieve greater customer acceptance. The Combined Company's
future success will depend in large part upon its ability to increase its
share of its target market segments 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
Combined Company's business, results of operations and financial condition.
See "Rational Business--Competition" and "SQA Business--Competition."
Risks Associated with International Operations. International sales
accounted for approximately 31%, 34%, 36% and 36% of Rational's revenues in
fiscal 1994, 1995, 1996, and the six months ended September 30, 1996,
respectively, and represented 7%, 23%, 22% and 22% of SQA's revenues in fiscal
1993, 1994 and 1995, and the nine months ended September 30, 1996,
respectively. Both Rational and SQA expect that international sales will
continue to account for a significant portion of the Combined Company's
revenues in future periods. In addition, Rational 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
Combined Company's international business would be likely to materially and
adversely affect the Combined Company's business, operating results and
financial condition as a whole. Rational's and SQA's international sales are
generally denominated in foreign currencies and neither company currently
engages in any hedging activities. Gains and losses on the conversion of
foreign payments into U.S. dollars may contribute to fluctuations in the
Combined Company's results of operations. Although neither Company has
experienced any material adverse impact to date from fluctuations in foreign
currencies, there can be no assurance that the Combined Company will not
experience a material adverse impact on its financial condition and results of
operations from fluctuations in foreign currencies in the future.
Limited Protection of Intellectual Property and Proprietary Rights. Rational
and SQA rely on a combination of copyright, trademark and trade secret laws,
employee and third-party nondisclosure agreements and other methods to protect
their respective proprietary rights. Despite these precautions, it may be
possible for unauthorized third parties to copy certain portions of the
companies' respective products or reverse engineer or obtain and use
information that Rational or SQA regards as proprietary. Rational and SQA
generally license their respective software products to end-users on a "right
to use" basis pursuant to a perpetual license. Rational and SQA license their
respective 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 Combined Company increases its international activities,
its exposure to unauthorized copying and use of its products and proprietary
information will increase.
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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 Rational's or SQA's products. Rational
and SQA expect 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 Combined Company in the future or that such claims will not be successful.
The Combined 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
Combined 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 Combined Company and its customers may be required
to obtain one or more licenses from third parties. There can be no assurance
that the Combined 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 Combined Company's business, results of operations and financial
condition.
Each of Rational and SQA 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 Combined 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 Combined Company's business, operating results and financial condition.
RISKS RELATED TO RATIONAL
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
Rational 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 Rational and Microsoft will be able to work together
successfully over an extended period of time. In addition, there can be no
assurance that Microsoft will not use the information it gains in its
relationship with Rational to develop or market competing products. See
"Rational Business--Business Alliance with Microsoft."
Acquisition of the Visual Test Product. Rational 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 Rational'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 Rational will not encounter unanticipated concerns of Visual Test
customers that are different from the concerns of Rational's traditional
customers, or that Rational 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
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product in the software testing tools area. There can be no assurance that
Microsoft will not use such rights to create and distribute products that
compete with other products of the Combined Company, including without
limitation SQA testing tools. 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 or other products of the Combined Company could be
materially and adversely impacted. See "--Risks Related to Rational and SQA--
Fluctuations in Operating Results; SQA History of Losses," "Rational
Business--Products and Services," "--Visual Test: Software Testing Automation
Tools" and "--Business Alliance with Microsoft."
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. Rational's objective in entering into this
arrangement is to expose Rational's technology to a broader customer base, and
is not to generate direct product revenue from Microsoft. Rational expects
that changes in its pricing models and combinations of features within product
lines will be required to appeal to this customer base, and there can be no
assurance that such changes will achieve customer 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. See "Rational Business--Business Alliance with
Microsoft."
Adverse Impact of Promotional Product Versions on Actual Product
Sales. Rational'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 Rational's partners,
such as Microsoft. This strategy is designed to expose Rational's products to
a broader customer base than its historical customer base, and to encourage
potential customers to purchase an upgrade or other higher-priced product from
Rational. There can be no assurance that Rational 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
them from the promotional versions, particularly in cases where Rational's
partners are distributing versions of Rational's products with other desirable
features.
Development of Industry Standards. Rational'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 Rational's
ability to play a leading role in the establishment of those standards.
Rational believes that the UML 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 Rational's business,
operating results and financial condition.
Dependence Upon Sales Force and Other Channels of Distribution. Rational
currently distributes its products primarily through field sales personnel
teamed with highly trained technical support personnel. Rational 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 Rational's products, the services provided by these personnel
have historically yielded lower margins for Rational than its product
business. To the extent that these services constitute a higher proportion of
total revenues in the future, Rational's margins will be adversely affected.
Rational has also developed other direct and indirect sales
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channels, including telesales, the World Wide Web, and partnering with
external service providers and value-added resellers ("VARs"). There can be no
assurance that such channels will be successful in increasing sales of
Rational's products or in reducing its sales costs on a percentage basis.
Deferred Tax Assets. Based upon the weight of available evidence, which
includes Rational'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 Rational, Rational 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.
RISKS RELATED TO SQA
Dependence Upon Client/Server Environment. SQA's products are designed
primarily for use by organizations developing software applications in a
client/server environment. SQA's future financial performance will depend in
large part on continued growth in the number of organizations adopting
client/server environments and the number of applications developed for use in
those environments. There can be no assurance that sales of products designed
for these environments will continue to grow or that SQA will be able to
respond effectively to the evolving requirements of customers. If the
client/server development environment does not grow due to the increasing
acceptance of packaged software or other factors, grows more slowly than SQA
anticipates, if SQA fails to respond effectively to the evolving requirements
of customers, or if price erosion of client/server software occurs, SQA's
business, results of operations and financial condition would be materially
adversely affected.
Dependence Upon Microsoft's Windows Operating System. SQA's products are
currently designed for use on computers using Microsoft's Windows operating
system and to test Windows-based client/server applications. Any factor
adversely affecting the demand for, or use of, Microsoft's Windows operating
system could have an impact on demand for SQA's products, causing a material
adverse effect on SQA's business, results of operations and financial
condition. Additionally, any changes to the underlying components of the
Windows operating system that would require changes to SQA's products would
materially adversely affect SQA if it were not able successfully to develop or
implement such changes in a timely fashion. While SQA has adapted SQA Suite
for use with certain Windows 95 and Windows NT operating systems, there can be
no assurance that such versions will gain customer acceptance.
Dependence Upon Principal Products. SQA has derived substantially all of its
historical revenue from SQA Suite and related services. These products and
services are expected to continue to account for a substantial portion of
SQA's total revenue for the foreseeable future. The life cycle of these
products is difficult to estimate due in large measure to the recent emergence
of the software testing tools industry and the unknown future effect of
product enhancements and competition. As a result, any factor, such as price
reductions or declines in demand for SQA Robot and SQA Suite, which adversely
affects sales of SQA Robot and SQA Suite, would have a material adverse effect
on SQA. There can be no assurance that SQA will continue to be successful in
marketing these products or any new or enhanced products which supplement or
replace these products. In addition, competitive pressures or other factors
may result in significant price erosion that would have a material adverse
effect on SQA's results of operations and financial condition.
Expansion of Indirect Channels; Potential for Channel Conflict. SQA markets
its products directly through both a telesales and field sales force and
indirectly through marketing channels such as VARs and distributors. VARs and
distributors are an integral part of SQA's strategy to expand its indirect
marketing channels. SQA dedicates significant resources to develop indirect
marketing channels. There can be no assurance that SQA will be able to attract
and retain a sufficient number of qualified VARs and distributors to market
successfully SQA's products. The failure to attract and retain a sufficient
number of VARs and distributors would have a material adverse effect on SQA's
business, financial condition and results of operations.
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The relationship with the VARs and distributors is usually established
through a formal reseller agreement. In many cases, these agreements may be
terminated by either party at any time without cause. Therefore, there can be
no assurance that any VAR or distributor will continue to represent SQA's
products, and the inability to retain certain VARs or distributors could have
a material adverse effect on SQA's business, results of operations and
financial condition. In addition, if SQA is successful in increasing product
sales through these channels, SQA expects that any material increase in SQA's
indirect sales as a percentage of total revenues will materially and adversely
affect SQA's average selling prices and gross margins due to the lower unit
prices that SQA receives when selling through indirect channels.
Selling through indirect channels may limit SQA's contacts with its
customers. As a result, SQA's ability to accurately forecast sales, evaluate
customer satisfaction and recognize emerging customer requirements may be
hindered. SQA's strategy of marketing its products directly to end-users and
indirectly through VARs and distributors may result in distribution channel
conflicts. SQA's direct sales efforts may compete with those of its indirect
channels and, to the extent different resellers target the same customers,
resellers may also come into conflict with each other. Although SQA has
attempted to manage its distribution channels in a manner to avoid potential
conflicts, there can be no assurance that channel conflicts will not
materially and adversely affect its relationships with existing VARs or
distributors or adversely affect its ability to attract new VARs and
distributors.
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APPROVAL OF THE MERGER AND RELATED TRANSACTIONS
The following discussion summarizes the proposed Merger and related
transactions. The following is not, however, a complete statement of all
provisions of the Agreement and related agreements. Detailed terms of and
conditions to the Merger and certain related transactions are contained in the
Agreement, a copy of which is attached to this Prospectus/Joint Proxy
Statement as Annex A. Reference is also made to the Stock Option Agreement
attached to this Prospectus/Joint Proxy Statement as Annex B, and to the other
Annexes hereto. Statements made in this Prospectus/Joint Proxy Statement with
respect to the terms of the Merger and such related transactions are qualified
in their respective entireties by reference to the more detailed information
set forth in the Agreement and the other Annexes hereto.
This section contains forward-looking statements that involve risks and
uncertainties. Actual results could differ materially from those anticipated
in these forward-looking statements as a result of certain factors, including
those set forth in "Risk Factors" and elsewhere in this Prospectus/Joint Proxy
Statement.
JOINT REASONS FOR THE MERGER
Rational and SQA have identified several potential mutual benefits of the
Merger that they believe will contribute to the success of the Combined
Company. These reasons include the following:
Creating a Competitive Advantage by Combining Complementary Product
Lines. Rational offers an integrated family of tools that spans the
critical phases of the component-based software development process, from
initial analysis and design through delivery and maintenance. SQA offers
software tools that allow users to automate the testing of windows-based
client/server applications. Rational and SQA believe that by combining the
companies' product lines, the Merger will allow the Combined Company to
offer products that extend the benefits of visual modeling and automated
software quality tools through more of the software development lifecycle,
thereby creating an advantage over competitors whose product lines are less
inclusive. See "Risk Factors--Risks Related to the Merger--Risks Associated
with Integration of Operations," "--Risks Related to Rational and SQA--
Expansion of Product Lines; Dependence Upon New Product Introductions" and
"--Risks Related to Rational and SQA--Competition."
Accelerating Tighter Integration of Product Lines by Leveraging Combined
Software Development Teams and Technologies. By combining their existing
technologies and development teams, Rational and SQA believe that they will
be able to integrate their product lines to provide a more comprehensive
suite of tools more efficiently than if either company were to attempt to
expand its product line without the assistance of the other. In particular,
Rational plans to integrate its Rose visual modeling products with SQA's
testing suite by enabling Rose-generated design models to be used in the
creation of test plans, test designs and the test scripts that drive the
tests run by SQA tools. See "Risk Factors--Risks Related to the Merger--
Risks Associated with Integration of Operations" and "--Risks Related to
Rational and SQA--Expansion of Product Lines; Dependence Upon New Product
Introductions."
Accelerating Sales Force Development by Combining Rational's Direct,
Major-Account Sales Organization with SQA's Telesales Force. Rational
primarily employs a direct selling approach through its major-account sales
and technical consulting organization in the United States, Canada, Europe
and in the Asia/Pacific/Latin America region. Rational has begun building a
telesales organization, and is in the early stages of developing additional
channels such as original equipment manufacturers ("OEMs"), VARs and
independent software vendors ("ISVs"). The majority of SQA's revenues are
derived from its extensive direct telesales operation and its wide range of
partners and distributors in the United States and approximately 30 other
countries. Rational and SQA believe that the Merger will establish a more
comprehensive and pervasive worldwide distribution channel than either
company has today, without Rational being required to incur many of the
risks and expenses that would otherwise be necessary to expand its
telesales and indirect distribution channels, and without SQA being
required to incur many of the risks and expenses that would otherwise be
necessary to develop and expand a direct sales and technical consulting
force. See "Risk Factors--Risks Related to the Merger--Risks Associated
with Integration of Operations," "--Risks Associated with Effect of Merger
on Resellers and Customers," "--Risks Related
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to Rational and SQA--Dependence Upon Strategic Relationships," "--Risks
Associated with International Operations," "--Risks Related to Rational--
Dependence Upon Sales Force and Other Channels of Distribution" and "--
Risks Related to SQA--Expansion of Indirect Channels; Potential for Channel
Conflict."
Sharing Administrative and Operational Expenses. Rational and SQA believe
that the sharing of certain administrative and operational expenses will
permit cost savings through the elimination of certain duplicate costs.
However, Rational and SQA expect that near-term costs will increase as a
result of Merger and integration related expenses, and that cost savings
arising from reduced headcount and consolidation of facilities immediately
following the Merger will be less significant than long-term economies of
scale. See "Risk Factors--Risks Related to the Merger--Risks Associated
with Integration of Operations" and "--Costs of Integration; Transaction
Expenses."
RATIONAL'S REASONS FOR THE MERGER
In addition to the anticipated joint benefits described above, the Rational
Board believes that the following are reasons that the Merger will be
beneficial to Rational and for stockholders of Rational to vote FOR the
proposal set forth herein:
Maintaining Technology Leadership. Rational's business strategy includes
maintaining technology leadership by continuing to enhance its products and
integrate additional tools that strengthen and extend its support for
component-based development. Rational believes that the addition of SQA's
automated testing tools to its product line will further this strategy.
Complementing the Visual Test Acquisition with SQA Suite. Rational
believes that Visual Test, which it acquired from Microsoft in October
1996, addresses a different audience than that addressed by SQA Suite.
Rational believes Visual Test is used most extensively by ISVs for C and
C++ products, while SQA Suite is used most extensively by developers of
enterprise information systems using Visual Basic and PowerBuilder. By
offering both products, Rational believes that the Combined Company will be
able to reach a broader customer base than it could reach solely with
Visual Test. Moreover, Rational may be able to enhance the Visual Test
product by incorporating certain features and technologies from SQA
products into Visual Test. See "Risk Factors--Risks Related to the Merger--
Risks Associated with Integration of Operations" and "--Risks Related to
Rational--Acquisition of the Visual Test Product."
Expanding Market Penetration by Gaining Access to SQA Customer
Base. Rational believes that SQA has been successful in gaining market
penetration in the enterprise information customer base. Rational also
believes that sales of testing tools require less customer education and
reorientation than sales of other offerings in Rational's product lines.
Because individual products are often the first step in a broader customer
relationship, Rational believes that gaining access to existing and future
customers of SQA's testing tools will increase its opportunities to sell
additional Rational products. See "Risk Factors--Risks Related to the
Merger--Risks Associated with Effect of Merger on Resellers and Customers."
Expanding Presence in Windows Client/Server Market. Rational's business
strategy includes supporting the major UNIX platforms, Windows 95 and
Windows NT. The addition of SQA's products, which currently are designed
for use on computers using Microsoft's Windows operating system and for
testing Windows-based client/server applications, is expected to extend
Rational's reach into the Windows client/server market. See "Risk Factors--
Risks Related to SQA--Dependence Upon Client/Server Environment" and "--
Dependence Upon Microsoft's Windows Operating System."
Expanding and Strengthening Strategic Relationships. SQA has strategic
distribution and joint marketing relationships with Microsoft, PeopleSoft,
Borland, Mitsubishi, Sybase, Informix, Oracle, Centura and numerous VARs.
Rational believes that leveraging relationships already established by SQA
will be more successful than attempting to enter into similar arrangements
in the absence of such existing relationships. In addition, Rational and
SQA have certain joint marketing relationships with common business
partners. Rational believes that the Merger will allow such partners'
previously divided attention and resources to be focused on supporting the
Combined Company. See "Risk Factors--Risks Related to
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the Merger--Risks Associated with Effect of Merger on Resellers and
Customers" and "--Risks Related to Rational and SQA--Dependence on
Strategic Relationships."
In the course of its deliberations in meetings held on November 10, 1996,
November 11, 1996 and November 12, 1996, the Rational Board also considered a
number of factors relevant to the Merger in addition to the benefits of the
Merger outlined above under "--Joint Reasons for the Merger" and "--Rational's
Reasons for the Merger." In particular, (i) the Board considered historical
information concerning Rational's and SQA's respective businesses, financial
positions, results of operations, product development schedules and
technologies, including information filed with the SEC by SQA since its
initial public offering in December 1995; (ii) the Board considered Rational
management's view of the financial condition, results of operations and
business of SQA, based on Rational management's due diligence and on publicly
available industry analysts' reports and earnings estimates; (iii) the Board
considered information regarding the major companies in the software-testing
tools market, including information that had been acquired by Rational
management and the Board in connection with Rational's October 1996
acquisition of the Visual Test product; (iv) the Board considered, with the
assistance of Rational's financial advisor, the comparative stock prices of
Rational Common Stock and SQA Common Stock; current financial market
conditions; historical market prices, volatility and trading information with
respect to Rational Common Stock and SQA Common Stock; the premiums to market
and multiples paid in other comparable merger and acquisition transactions; an
analysis of the respective contributions to revenues, gross profits, operating
income and net income of the combined companies based on industry analysts'
reports and estimates; and an analysis of the impact of the proposed Merger on
Rational's earnings per share; (v) the Board considered the oral opinion of
Hambrecht & Quist delivered November 12, 1996, subsequently confirmed in
writing, that as of such date, the Exchange Ratio of 0.86 of a share of
Rational Common Stock for each outstanding share of SQA Common Stock is fair,
from a financial point of view, to Rational; (vi) the Board considered the
number of shares of SQA Common Stock that were currently, or could become
prior to the Effective Date, subject to outstanding options, warrants and
employee stock purchase plan rights, and the number of additional shares of
Rational Common Stock that would be necessary to satisfy such obligations
following the Merger; (vii) the Board considered the expectation that the
Merger will qualify for pooling of interests treatment for financial reporting
purposes; (viii) the Board considered the expectation that the Merger will be
tax free for federal income tax purposes; (ix) the Board considered, with the
assistance of Rational's legal counsel, the terms of the Agreement and the
Stock Option Agreement, including without limitation the break-up fee
provisions, Rational's ability to exercise its right to purchase SQA Common
Stock under the Stock Option Agreement, the circumstances under which either
Rational or SQA can terminate the Agreement and the conditions to closing the
Merger; (x) the Board considered the compatibility of the corporate cultures
and management teams of Rational and SQA, which the Rational Board considered
important for the successful integration of the companies; (xi) the Board
considered information provided by management, and legal, accounting and
financial advisors as to the results of their due diligence investigation of
SQA; and (xii) the Board considered that the consummation of the Merger
requires the approval of the majority of the votes cast at the Rational
Meeting and the majority of the shares of SQA Common Stock outstanding as of
the record date for the SQA Meeting.
The Rational Board also identified and considered a variety of potentially
negative factors in its deliberations concerning the Merger, including without
limitation the following factors: (i) the risk that, despite the intentions
and efforts of the parties, the benefits sought to be achieved in the Merger
will not be achieved, or that integration of the technologies, products, sales
organizations or other operations of the two companies, if possible at all,
may require more time, expense and management attention than anticipated;
(ii) the difficulties of integrating and managing operations at separate
geographic locations; (iii) the risk that the market price of Rational Common
Stock might be adversely affected by, and that customer and reseller confusion
could arise from, the public announcement of the Merger; (iv) the potential
dilutive effect of the issuance of Rational Common Stock in the Merger;
(v) the substantial charges expected to be incurred, primarily in the quarter
ending March 31, 1997, in connection with the Merger, including the
transaction expenses arising from the Merger and costs associated with
combining the operations of the two companies; (vi) the risk that, despite the
intentions and efforts of the parties, certain key technical, sales and
management personnel of SQA or Rational might leave before or after
consummation of the Merger; (vii) the adverse effects on Rational's business,
operating results
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and financial condition if the Merger were not consummated following public
announcement that the Agreement had been entered into; and (viii) the other
risks described above under "Risk Factors." The Rational Board believed that
these risks were outweighed by the potential benefits of the Merger.
SQA'S REASONS FOR THE MERGER
In addition to the anticipated joint benefits described above, the SQA Board
believes that the following are additional reasons the Merger will be
beneficial to SQA and for stockholders of SQA to vote FOR the proposal set
forth herein:
Expanding Product Offerings with Complementary Products. SQA believes
that the combination of Rational's and SQA's products will provide a
comprehensive solution to component-based development and testing of
software systems. The combined technological and engineering resources of
Rational and SQA are expected to allow the Combined Company an opportunity
to offer an integrated package of software development and testing tools
that perform together to meet customer needs.
Expanding Market Penetration. Rational has a sales force and distribution
system that are expected to complement SQA's sales and distribution
resources. Rational has established a major-account direct sales and
technical consulting organization based on a team-selling model. SQA
markets and sells it products and services primarily through (i) a
telesales force supplemented by field sales engineers and a direct sales
force and (ii) indirectly through an extensive network of resellers and
distributors. The combined sales resources may provide expanded
opportunities to market Rational's and SQA's products to new and existing
customers.
Focusing on Strategic Opportunities. SQA believes that integrating the
object-level testing it pioneered with Rational's component-based software
development tools will offer significant strategic advantages in the
software development and testing tools industry. SQA believes that the
Merger will strengthen its strategic position in the industry and that the
SQA stockholders will have the opportunity to participate in the potential
growth of the Combined Company after the Merger.
In the course of its deliberations during SQA Board meetings held on
November 10, 1996, November 11, 1996 and November 12, 1996, the SQA Board
reviewed with SQA management and considered, in addition to the benefits of
the Merger outlined above under "--Joint Reasons for the Merger" and "--SQA's
Reasons for the Merger," a number of factors relevant to the Merger, including
the following: (i) historical information concerning SQA's and Rational's
respective businesses, prospects, financial performance and condition,
operations, technology, management and competitive position, including public
reports concerning results of operations during the most recent fiscal year
and fiscal quarter for each company filed with the SEC; (ii) SQA management's
view as to the financial condition, results of operations and businesses of
Rational and SQA before and after giving effect to the Merger based on
management due diligence and publicly available financial information; (iii)
current financial market conditions and historical market prices, volatility
and trading information with respect to Rational Common Stock and SQA Common
Stock; (iv) the consideration to be received by SQA stockholders in the Merger
and the relationship between the market value of the Rational Common Stock to
be issued in exchange for each share of SQA Common Stock and a comparison of
comparable merger transactions; (v) the Board's assessment of the strengths
and capabilities of Rational's senior officers; (vi) the belief that the terms
of the Agreement, including the parties' representations, warranties and
covenants, and the conditions to their respective obligations, are reasonable;
(vii) SQA management's view as to the prospects of SQA as an independent
company; (viii) SQA management's view as to the potential for other third
parties to enter into strategic relationships with or to acquire SQA; (ix) the
impact of the Merger on SQA's customers and employees; and (x) reports from
management, legal, accounting and financial advisors as to the results of
their due diligence investigation of Rational. The SQA Board also considered
the terms of the proposed Agreement regarding SQA's right to consider and
negotiate other acquisition proposals in certain circumstances, as well as the
possible effects of the provisions regarding the termination fees and the
Stock Option Agreement. In addition, the SQA Board noted that the Merger is
expected to be accounted for as a pooling of interests and that no goodwill is
expected to be created on the books of the Combined Company as a result
thereof. The SQA
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Board considered the oral opinion of Robertson, Stephens & Company ("RS &
Co.") delivered at the November 12, 1996 meeting of the SQA Board of
Directors, subsequently confirmed in writing, which concluded that the
Purchase Price Value, as defined in RS & Co.'s written opinion, was fair to
SQA stockholders from a financial point of view on such date. A copy of RS &
Co.'s opinion is included as Annex D, and stockholders are urged to review
this opinion carefully.
The SQA Board also identified and considered a number of potentially
negative factors in its deliberations concerning the Merger, including, but
not limited to: (i) the risk that the potential benefits sought in the Merger
might not be fully realized; (ii) the possibility that the Merger would not be
consummated and the effect of the public announcement of the Merger on (a)
SQA's sales and operating results, (b) SQA's ability to attract and retain key
management, marketing and technical personnel and (c) progress of certain
development projects; (iii) the potential dilutive effect of the issuance of
Rational Common Stock in the Merger; (iv) the substantial charges to be
incurred, primarily in the quarter ending March 31, 1997 in connection with
the Merger, including costs of integrating the businesses and transactions
expenses arising from the Merger; (v) the risk that despite the efforts of the
Combined Company, key technical and management personnel may not remain
employed by the Combined Company; (vi) the difficulty of managing separate
operations at different geographic locations; and (vii) the other risks
described under "Risk Factors" herein. The SQA Board believed that these risks
were outweighed by the potential benefits of the Merger.
MATERIAL CONTACTS AND BOARD DELIBERATIONS
The market for software engineering tools is increasingly competitive and
rapidly changing. Rational believes that extending its product offerings with
automated software quality testing tools, such as those offered by SQA, will
assist it in maintaining its position as an industry leader. Similarly, the
automated software quality testing tools industry has also experienced
increasing competition, accompanied by a rapid trend toward consolidation. As
a result of these factors, both Rational and SQA frequently evaluate strategic
relationships of various forms, such as potential OEM arrangements, joint-
marketing relationships, and potential business combinations with other
companies in the same and closely related fields.
In July 1996, Microsoft raised with Rational the prospect that Rational
might acquire from Microsoft the Visual Test product in the context of a
broader relationship with Microsoft. In response, Rational's Board and
management began to further evaluate the possibilities of adding automated
software quality testing capabilities to the company's existing product lines.
In the summer of 1996, when Rational was evaluating the potential purchase
of the Visual Test product from Microsoft, the Rational Board and management
team considered technical, market and valuation comparisons with products from
leaders in the automated software testing tools market, including SQA, Pure
Atria Software Corporation, Mercury Interactive, Inc., and Segue Software,
Inc., among others. In addition, as part of its due diligence relating to the
Visual Test acquisition, Rational learned of a relationship between Microsoft
and SQA, including joint-marketing and joint seminars, and that a Microsoft
official had been quoted as favorably commenting on SQA in the SQA annual
report. In the course of these evaluations, the Rational Board and management
team gained heightened familiarity with the technology, products and
competitive position of SQA.
On August 30, Rational President Michael Devlin and SQA President Ronald
Nordin met at SQA headquarters in Burlington, Massachusetts to informally
introduce the two companies, to explore a possible joint- marketing
relationship and to discuss the scope of technical review of the companies
products necessary prior to commencing joint-marketing efforts. At the
completion of the meeting, Messrs. Devlin and Nordin agreed that some form of
joint-marketing relationship between the two companies might be mutually
advantageous, and that follow-up discussions would take place to determine
what, if any, form that relationship should take.
On September 20, Mr. Nordin and SQA Chief Financial Officer Thomas Bogan met
with Rational Chief Executive Officer Paul Levy, Mr. Devlin, and Rational
Chief Financial Officer Robert Bond in Santa Clara,
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California. At the meeting, each company's executives made presentations
covering their respective company's business strategy, technology, products,
sales and marketing resources, competition and operating results. In addition,
the SQA and Rational teams discussed joint-marketing options to capitalize on
potential synergies between the products of the two companies, including OEM
and VAR distribution strategies. Particular emphasis was placed on the
technical review that each company would need to conduct of the other's
products and technology prior to entering into any type of joint-marketing
arrangement.
On October 2, Rational acquired Visual Test from Microsoft.
On October 9, Mr. Devlin and one of Rational's product managers, Hugo
Sanchez, met at SQA headquarters with representatives of SQA's development and
marketing teams for demonstrations of each other's products and technical
review, as well as further discussion of potential joint-marketing efforts.
Throughout October, Messrs. Devlin and Nordin remained in contact by
telephone regarding the possibility of a joint-marketing alliance. Mr. Devlin
indicated that, while Rational was interested in pursuing a joint- marketing
relationship with SQA, Rational's immediate priority would be the successful
completion of the public offering of its Common Stock, announced on October 3.
On October 25, at a regularly scheduled meeting, the SQA Board received a
report from senior management, in response to a request from the SQA Board, on
the desirability of exploring long-term strategic relationships geared toward
expanding SQA's product offerings with complementary products, building and
strengthening SQA's domestic and international distribution channels and
investing in technologies relating to Internet and intranet environments. The
SQA Board discussed the possible use of acquisitions of complementary products
or technologies as part of SQA's overall business strategy, as well as the
importance of building sales and marketing infrastructure and investing in new
technologies. The SQA Board discussed the consolidation taking place within
the automated software quality products industry and the importance of
building a stronger organization through acquisitions and strategic
relationships.
On November 1, Mr. Devlin called Mr. Nordin to discuss how best to finalize
the proposed joint-marketing relationship between the two companies. Messrs.
Devlin and Nordin discussed the fact that the technical review conducted to
date had been satisfactory to both companies, that the sales and marketing
resources of the two companies appeared to be complementary, and that the
cultures of the two companies seemed to be compatible. Messrs. Nordin and
Devlin discussed that, given the consolidation occurring in the automated
software development and testing tools industries, it would be desirable to
consider a strategic combination of the Rational and SQA businesses. Messrs.
Devlin and Nordin agreed that any such consideration required the input of the
other senior executives of both companies, and agreed to schedule a follow-up
meeting for that purpose.
On November 6, Messrs. Nordin, Bogan, Levy, Devlin and Bond held a full-day
meeting in the San Francisco Bay area to consider a potential combination of
Rational's and SQA's businesses. To facilitate discussions of this potential
transaction, Rational and SQA entered into a mutual confidentiality and
standstill agreement, which provided that the information disclosed in
connection with such discussions would be used solely for the purpose of
evaluating a possible business transaction or strategic relationship, and that
for a period of 18 months following the date of the agreement, neither party
would participate in an unsolicited attempt to acquire the other. The Rational
and SQA executives discussed the companies' respective business strategies,
technologies and products, and focused on the feasibility of combining
operations, the compatibility of the companies' management teams, the
potential synergies of such a combination in terms of product lines and
competitive position, the relative financial positions of the two companies,
and the anticipated role of SQA within a combined company. The two teams also
began to explore basic terms for a potential transaction. Based on these
discussions, the Rational and SQA executives preliminarily discussed relative
valuations of the two companies and the range of premiums that would be
acceptable to both companies. The Rational and SQA teams agreed to promptly
engage their respective financial advisors to assist them in further due
diligence and to assist them in establishing an appropriate exchange ratio
should the companies decide to proceed with a combination following additional
due diligence.
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After the November 6 meeting, management of each company contacted their
respective legal counsel regarding the potential acquisition of SQA by
Rational, and discussed various structural alternatives and timing issues. On
November 7, Mr. Bond met with legal counsel to Rational to review issues and
requirements involved in the proposed acquisition, and to commence the
documentation process in parallel with further management discussions of terms
and conditions.
On November 7, Rational engaged Hambrecht & Quist to act as its financial
advisor in connection with the proposed business combination, and formally
entered into an engagement letter with Hambrecht & Quist on November 12. On
November 7, Mr. Bogan discussed with RS&Co. the organization of a team to
commence preliminary work on a valuation analysis. On November 8, SQA entered
into an engagement letter formally retaining RS&Co. to act as its financial
advisor in connection with the proposed business combination.
Between November 7 and November 12, representative of the two companies and
their respective legal, financial and accounting advisors met personally and
via numerous conference calls to conduct additional due diligence and to
explore further potential synergies and risks involved in the proposed
combination. Among the numerous meetings and conversations during this time
period, (i) Messrs. Levy and Devlin met with the SQA Board, as discussed in
more detail below, to discuss the proposed Merger and to address the Board's
questions and concerns; (ii) Messrs. Levy, Devlin and Bond held numerous
meetings and conversations with SQA management to discuss integration of
products, marketing strategies, sales forces, distribution channels, product
development plans, administrative organizations, personnel and employee
benefit plans; (iii) Mr. Devlin held a number of meetings with SQA management
team members to discuss their proposed post-Merger job responsibilities with
the Combined Company; (iv) a representative of Rational's financial advisor,
Hambrecht & Quist, conducted due diligence interviews with members of SQA's
management team and SQA's financial advisor, RS&Co.; (v) Mr. Bond had an
extensive conversation with a representative of RS&Co., during which he
reviewed in detail the information that had been prepared by Rational in
connection with its recent public offering, as well as published reports of
industry analysts; (vi) representatives of RS&Co. also conducted due diligence
interviews with Messrs. Levy and Devlin; (vii) representatives of SQA's
independent accountants, Arthur Andersen, LLP ("Arthur Andersen"), conducted
due diligence of Rational in the San Jose, California offices of Rational's
independent auditors, Ernst & Young LLP ("Ernst & Young"), during which Mr.
Bond was available and responded to questions of Arthur Andersen; (viii)
Messrs. Nordin and Bogan held numerous meetings with representatives of Arthur
Andersen, RS&Co. and legal counsel to review the status of due diligence and
valuation analysis of both companies; (ix) representatives of Ernst & Young
conducted due diligence of SQA in the Boston, Massachusetts offices of Arthur
Andersen, during and after which the representatives of Ernst & Young
communicated their findings to Mr. Bond, Timothy Brennan, Rational's Vice
President, Finance and Administration, and Brian Stang, Rational's Controller;
(x) attorneys from SQA's legal counsel, Testa, Hurwitz & Thibeault, LLP
("THT"), conducted due diligence concerning certain Rational agreements and
corporate records at the offices of Rational's legal counsel, Wilson Sonsini
Goodrich & Rosati, P.C. ("WSGR"), in Palo Alto, California, discussed by
telephone with attorneys at WSGR certain other legal matters pertaining to
Rational, reviewed reports filed by Rational with the SEC, and reported their
findings to SQA management; and (xi) attorneys from WSGR reviewed certain SQA
agreements and corporate records requested and received from THT, discussed by
telephone with attorneys at THT certain other legal matters pertaining to SQA,
reviewed reports filed by SQA with the SEC, and reported their findings to
Rational management. Also between November 7 and November 12, Rational's and
SQA's respective legal counsel, financial advisors, independent auditors and
executive officers had extensive meetings and conversations regarding the
terms of the Agreement and related documents, including without limitation the
terms of the proposed Stock Option Agreement, the Participation Agreement, the
circumstances under which Rational or SQA could terminate the Agreement, the
conditions upon which any break-up fees would be payable and the amount of
such fees, and the representations, warranties, covenants and conditions to
closing to be set forth in the Agreement.
On November 10, Rational provided a draft of the Agreement to SQA and its
counsel.
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On November 10, the SQA Board, with one attendee participating by telephone
and all other directors attending in person, reviewed with the senior
management of SQA various open issues and the status of SQA's due diligence
review of Rational. SQA's legal and financial advisors and accountants gave
reports on the status of their due diligence review. During the course of the
meeting, the Board had extensive discussions with Messrs. Levy and Devlin, who
were invited to attend a portion of the Board meeting to discuss the potential
synergies and risks of combining the two companies and the operational issues
associated with the proposed business combination, and to address questions
and comments of the SQA directors. SQA's legal counsel reviewed the Board's
fiduciary duties in considering the proposed strategic business combination.
The SQA Board then reviewed Rational financial information available from SEC
filings and published industry analysts' reports. The SQA Board engaged in
extensive discussion regarding the strategic advantages of the proposed
Merger, as well as a comparison of entering into the proposed business
combination as opposed to continuing as a separate company, with or without a
joint-marketing relationship with Rational. In particular, the Board discussed
the strength of the Rational management team and its likely compatibility with
the SQA management team, the advantage in product development and distribution
that a combined entity would likely have, and the complementary nature of the
product lines and marketing strategies already existing at each company. The
Board noted that the possibility of combining Rational's strength in modeling
with SQA's testing capabilities presented a mutually beneficial opportunity
for both companies. The Board also discussed in detail the proposed Exchange
Ratio, which had been determined through arms-length negotiations, noting that
the price being negotiated represented a significant premium over the
prevailing price of SQA Common Stock. The SQA Board also considered
potentially negative factors related to the proposed Merger, including without
limitation the difficulty and expense of integrating the two geographically
separated companies, the risk that the expected benefits of the Merger might
not be realized, the fact that Rational Common Stock had recently traded at
levels higher than its historical trading prices and the potential volatility
of the Rational Common Stock price, the destabilizing effect that a Merger
announcement could have on SQA personnel, customers and resellers, and the
potential risks to SQA if the Merger were not consummated following public
announcement of the proposed transaction. Open issues were summarized and
included without limitation (i) the terms of the proposed Merger, including
final determination and approval of the Exchange Ratio, conditions to closing,
fairness opinions, under what circumstances break-up fees would be paid, the
amounts of break-up fees, the terms of the proposed Stock Option Agreement and
the proposed Participation Agreement, and interim covenants and termination
events, (ii) potential market reaction to the proposed combination and (iii)
issues related to the integration of operations and products following a
merger. The SQA Board authorized and instructed SQA management to continue
discussions with representatives of Rational regarding the proposed Merger.
On November 10, the Rational Board met via telephone conference call, with
all directors participating, to discuss the elements of a potential
acquisition of SQA by Rational. Rational's legal counsel reviewed with the
Board its fiduciary obligations to stockholders in considering the
acquisition. In addition, Rational's legal counsel, financial advisors and
accountants gave reports on the status of their due diligence review of SQA.
Rational's financial advisor reviewed with the Board analyses of SQA financial
information available from documents filed with the SEC, as well as publicly
available industry analysts' reports on SQA. Rational's legal counsel and
management participated in a detailed discussion with the Board regarding the
proposed terms of the Agreement, the Stock Option Agreement and the
Participation Agreement. The Board then discussed the expected impact of the
proposed Merger on Rational's business strategy, including the strategic
advantages of the proposed Merger as it related to product development and
extension of product lines, sales and marketing efforts and organizational
structure, as well as the sharing of administrative and other expenses. The
Board noted in particular the apparent complementary product lines and sales
organizations and the potential economies of scale that could be achieved by
combining the Rational and SQA businesses. The Rational Board also considered
the advantages and disadvantages of pursuing the proposed business combination
as opposed to establishing a joint-marketing arrangement with SQA. The Board
considered the potentially negative factors associated with the Merger,
including without limitation the risk that the benefits sought to be achieved
in the Merger would not be realized, the potential dilutive effect of the
issuance of Rational Common Stock in the Merger, the expense and difficulty of
integrating the two geographically separated businesses, the adverse effect
that announcement of the Merger could have on Rational personnel, customer
confusion that could result from announcement of the
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Merger, and the adverse effects on Rational's business, operating results and
financial condition if the Merger were not consummated following public
announcement of the proposed transaction. The Board further discussed the
expected impact of the proposed Merger on Rational's anticipated revenues and
existing financial model, and whether the Merger was expected to be accretive
or dilutive. The Rational Board discussed additional considerations
surrounding the transaction as proposed by management, including without
limitation (i) the possibility and desirability of offering Mr. Nordin a
directorship with Rational effective as of the closing of the proposed Merger,
(ii) certain events, including material adverse changes, the occurrence or
non-occurrence of which would be a condition to consummation of the proposed
Merger, (iii) the financial strength and accounting procedures of SQA,
including the circumstances surrounding the change of SQA's Chief Financial
Officer in June 1996, (iv) issues relating to the acceleration of stock
options of certain SQA employees that would be triggered by the acquisition of
SQA, (v) the desirability of entering into employment agreements with certain
senior SQA personnel effective as of the closing of the proposed Merger, and
(vi) the sequence of events relating to further consideration and approval or
disapproval of the proposed acquisition. The Rational Board authorized and
instructed Rational management to continue discussions with representatives of
SQA regarding the proposed Merger.
On November 11, the Rational Board, with four directors participating by
telephone and all other directors attending in person, met in Boston,
Massachusetts, along with representatives of Rational's financial advisor.
Mr. Bond and Rational's legal counsel participated by telephone. Rational's
legal counsel began the meeting with a review of the issues relating to the
acquisition before the Board in the context of the Board's duty to meet
fiduciary obligations to Rational stockholders. Messrs. Levy and Devlin then
reported to the Rational Board on the meeting which they and Rational's
financial advisor had attended with SQA's Board on November 10, as well as
their meetings with various members of the SQA management team. Next,
Rational's financial advisor made a presentation regarding the fairness of the
terms under consideration to Rational stockholders, including (i) financial
analyses of the proposed acquisition, (ii) a discussion of the operations of
the two companies in the interim between signing the Agreement and the
Effective Time of the proposed Merger, (iii) lessons learned from other recent
business combinations in related industries, (iv) potential effects of the
announcement of the proposed Merger on each company's stock price, and (v)
certain employee matters relating to SQA. Next, management and legal counsel
reported to the Board and responded to the Board's questions on the status of
the negotiations on the Agreement and related documents. The Board considered
the principal remaining open issues to be the final determination and approval
of the Exchange Ratio, the circumstances under which SQA could consider
competing offers, the conditions under which Rational or SQA could terminate
the Agreement, break-up fee provisions, the terms of the proposed Stock Option
Agreement and Participation Agreement, and whether Mr. Nordin should be
offered a position on the Rational Board conditioned upon the effectiveness of
the proposed Merger.
On November 11, the SQA Board, with two attendees participating by telephone
and all other directors attending in person, met in Boston, Massachusetts,
with the members of senior management of SQA and SQA's legal counsel and
financial advisors to discuss the status of negotiations with Rational. SQA's
legal counsel held discussions regarding the SQA Board's fiduciary duties in
considering the proposed strategic business combination in the context of
issues before the SQA Board and reviewed for the SQA Board the proposed terms
of the Agreement and related documents, including without limitation the Stock
Option Agreement, the Participation Agreement, the ability to consider
competing offers, termination events and under what circumstances break-up
fees would be paid by the parties and the amount of such fees. The SQA Board
focused extensively on the terms of the proposed Stock Option Agreement. The
SQA Board also discussed the potential market reaction to the proposed
combination, and the impact of an Exchange Ratio based on the then current
trading prices for Rational Common Stock and SQA Common Stock, with a
potential premium of approximately 35% for the SQA stockholders. The SQA Board
instructed SQA's management team to continue negotiations with Rational, with
particular attention to protecting the interests of SQA stockholders with
respect to the issues discussed during the course of the meeting.
On November 12, the Rational Board, with three directors participating by
telephone and all other directors attending in person, met in Boston,
Massachusetts, with Rational's financial advisor to review and vote on the
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Agreement and the transactions contemplated thereby. Mr. Bond and Rational's
legal advisor participated by telephone. At this meeting, (i) management of
Rational reported on the agreement that had been reached with respect to the
principal remaining issues relating to the proposed acquisition, (ii)
management responded to questions regarding various aspects of the proposed
acquisition and (iii) Rational's legal counsel reviewed the proposed
definitive terms of the Agreement and related documents. Hambrecht & Quist
made a presentation to the Rational Board regarding the Exchange Ratio,
reviewed detailed financial analyses and pro forma and other information with
respect to the companies and delivered its oral opinion to the Rational Board
that the proposed Exchange Ratio of 0.86 of a share of Rational Common Stock
for each share of SQA Common Stock was fair to the stockholders of Rational
from a financial point of view as of such date. Mr. Bond reported that
Rational's accountants had confirmed that pooling-of-interests accounting
treatment was available for the proposed Merger. The Board then considered a
draft press release to announce the Merger, and engaged in extensive
discussion of the risks associated with announcing a proposed business
combination if the Merger were not ultimately consummated. The discussion
included a detailed review of the negotiated terms that increased and
decreased such risks, including the circumstances under which SQA could
consider competing offers or terminate the Agreement, the conditions to
closing the Merger, the amount and conditions to triggering break-up fees, the
terms of the Stock Option Agreement, and the terms and proposed parties to the
Participation Agreement. Rational's legal advisor commented on the legal
framework within which such terms could be and had been negotiated, including
relevant case law regarding the fiduciary duties of both the SQA Board and the
Rational Board. Rational's financial advisor commented on the comparability of
such terms to terms negotiated in similar transactions.
At the conclusion of the November 12 meeting, the Rational Board approved
the Agreement and related agreements. Daniel H. Case III, a member of the
Rational Board and President and Chief Executive Officer of Hambrecht & Quist,
Rational's financial advisor, participated in the discussions at all three
Rational Board meetings, but abstained from voting on the Agreement and
related agreements. See "Risk Factors--Risks Related to the Merger--Potential
Conflicts of Interest" and "Approval of the Merger and Related Transactions--
Opinion of Rational's Financial Advisor."
On November 12, the SQA Board, with two attendees participating by telephone
and all other directors attending in person, convened to consider and vote
upon the proposed Merger and related transactions. At this meeting, (i) senior
management of SQA reported that agreement had been reached with respect to the
Exchange Ratio, (ii) management responded to questions regarding various
aspects of the proposed Merger, and (iii) SQA's legal counsel reviewed in
detail the proposed definitive terms of the Agreement and related documents.
RS&Co. made a presentation to the SQA Board, reviewed detailed financial
analyses and pro forma and other information with respect to the companies and
delivered its oral opinion to the SQA Board that the Purchase Price Value, as
defined in RS&Co.'s written opinion, was fair to SQA from a financial point of
view as of such date. The Board discussed the terms of the Agreement and the
Stock Option Agreement, including the break-up fees, non-solicitation
provisions, conditions to closing and termination provisions, which were
arrived at through extensive arm's-length negotiations. The Board also
discussed the ability of SQA to exercise its fiduciary duties in the event of
an unsolicited competing bid prior to consummation of the Merger. In
particular, senior management and SQA's legal counsel reported that the open
issues the SQA Board had discussed at the November 11 Board meeting had been
resolved satisfactorily.
At the conclusion of the November 12 meeting, the SQA Board approved the
Agreement and related agreements. Mr. Nordin abstained from the vote, although
as President, Chief Executive Officer and a member of the Board of Directors
of SQA, he participated in the discussions at all three SQA Board meetings.
See "Risk Factors--Risks Related to the Merger--Potential Conflicts of
Interest" and "Approval of the Merger and Related Transactions--Opinion of
SQA's Financial Advisor."
On November 12, following final approval by the Rational Board and the SQA
Board, the Agreement and the Stock Option Agreement were executed by both
companies and Rational and SQA issued a joint press release announcing the
Merger.
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OPINION OF RATIONAL'S FINANCIAL ADVISOR
Rational retained Hambrecht & Quist to deliver a financial opinion letter in
connection with the Merger. Hambrecht & Quist was selected by Rational's Board
to provide an opinion (the "Hambrecht & Quist Opinion") based on Hambrecht &
Quist's qualifications, expertise and reputation, as well as Hambrecht &
Quist's investment banking relationship and familiarity with Rational.
The full text of the written Hambrecht & Quist Opinion dated November 12,
1996, which sets forth, among other things, assumptions made, procedures
followed, matters considered, and limitations on the scope of the review
undertaken by Hambrecht & Quist in rendering the Hambrecht & Quist Opinion, is
attached as Annex C to this Prospectus/Joint Proxy Statement. Rational
stockholders are urged to read the Hambrecht & Quist Opinion carefully and in
its entirety.
Rational engaged Hambrecht & Quist to act as its financial advisor in
connection with the Merger and to render an opinion as to the fairness from a
financial point of view to Rational of the consideration to be paid by
Rational in connection with the Merger. The Exchange Ratio was determined
through negotiations between Rational and SQA, and not by Hambrecht & Quist.
Hambrecht & Quist rendered its oral opinion, subsequently confirmed in
writing, on November 12, 1996, to Rational's Board of Directors that, as of
such date, the consideration to be paid by Rational pursuant to the Agreement
is fair to Rational from a financial point of view. No limitations were placed
on Hambrecht & Quist by the Board of Directors of Rational with respect to the
investigation made or the procedures followed in preparing and rendering its
opinion.
In its review of the Merger, and in arriving at its opinion, Hambrecht &
Quist, among other things: (i) reviewed the publicly available financial
statements of Rational for recent years and interim periods to date and
certain other relevant financial and operating data of Rational made available
to Hambrecht & Quist from published sources; (ii) discussed with certain
members of the management of Rational the business, financial condition and
prospects of Rational; (iii) reviewed the publicly available financial
statements of SQA for recent years and interim periods to date and certain
other relevant financial and operating data of SQA made available to Hambrecht
& Quist from published sources; (iv) discussed with certain members of the
management of SQA the business, financial condition and prospects of SQA; (v)
analyzed the pro forma impact of the Merger on earnings per share,
consolidated capital and other financial ratios of Rational and SQA; (vi)
reviewed and discussed with management of Rational and SQA, the strategic
rationale for the Merger; (vii) reviewed the recent reported prices and
trading activity for Rational's and SQA's Common Stock and compared such
information and certain financial information of Rational and SQA with similar
information for certain other companies engaged in businesses Hambrecht &
Quist considered comparable to those of Rational and SQA; (viii) reviewed the
financial terms, to the extent publicly available, of certain comparable
merger and acquisition transactions; (ix) reviewed the Agreement; (x)
discussed the tax and accounting treatment of the Merger with Rational and
Rational's legal counsel and accountants; and (xi) performed such other
analyses and examinations and considered such other information, financial
studies, analyses and investigations and financial, economic and market data
Hambrecht & Quist deemed relevant.
Hambrecht & Quist did not independently verify any of the information
concerning Rational or SQA considered in connection with their review of the
Merger and, for purposes of its opinion, Hambrecht & Quist assumed and relied
upon the accuracy and completeness of all such information. In connection with
its opinion, Hambrecht & Quist did not prepare or obtain any independent
evaluation or appraisal of any of the assets or liabilities of Rational or
SQA, nor did they conduct a physical inspection of the properties and
facilities of Rational or SQA. Hambrecht & Quist also assumed that neither
Rational nor SQA was a party to any pending transactions, including external
financings, recapitalizations or merger discussions, other than the Merger and
those in the ordinary course of conducting their respective businesses. For
purposes of their opinion, Hambrecht & Quist assumed that the Merger will
qualify as a tax-free reorganization under the Code for the stockholders of
Rational and that the Merger will be accounted for as a pooling of interests.
Hambrecht & Quist's opinion is necessarily based upon market, economic,
financial and other conditions as they existed and could be evaluated
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as of the date of the opinion and any subsequent change in such conditions
would require a reevaluation of such opinion.
The preparation of a fairness opinion is a complex process and is not
necessarily susceptible to partial analysis or summary description. The
summary of the Hambrecht & Quist analyses set forth below does not purport to
be a complete description of the presentation by Hambrecht & Quist to
Rational's Board of Directors. In arriving at its opinion, Hambrecht & Quist
did not attribute any particular weight to any analysis or factor considered
by it, but rather made qualitative judgments as to the significance and
relevance of each analysis and factor. Accordingly, Hambrecht & Quist believes
that its analyses and the summary set forth below must be considered as a
whole and that selecting portions of its analyses, without considering all
analyses, or of the following summary, without considering all factors and
analyses, could create an incomplete view of the processes underlying the
analyses set forth in the Hambrecht & Quist presentation to the Rational Board
of Directors and its opinion. In performing its analyses, Hambrecht & Quist
made numerous assumptions with respect to industry performance, general
business and economic conditions and other matters, many of which are beyond
the control of Rational and SQA. The analyses performed by Hambrecht & Quist
(and summarized below) are not necessarily indicative of actual values or
actual future results, which may be significantly more or less favorable than
suggested by such analyses. Additionally, analyses relating to the values of
businesses do not purport to be appraisals or to reflect the prices at which
businesses actually may be acquired.
The following is a brief summary of certain financial analyses performed by
Hambrecht & Quist in connection with providing its written opinion to
Rational's Board of Directors dated November 12, 1996:
Contribution Analysis: Hambrecht & Quist analyzed the contribution of each
of Rational and SQA to certain financial statement categories of the pro forma
combined company, including revenue, gross profit, operating income, and net
income. This contribution analysis was then compared to the pro forma
ownership percentage of Rational and SQA stockholders in the pro forma
combined company. Hambrecht & Quist examined the expected contributions to the
Combined Company's revenues, gross profit, operating income and pro forma net
income by Rational for fiscal 1997 and 1998 (i.e., the four quarters ending
March 31), derived from Hambrecht & Quist's analyst's published estimates, and
by SQA for calendar years 1996 and 1997 (i.e., the four quarters ending
December 31 and projected for the quarter ending March 1997), derived from
Wall Street's consensus estimates. For Rational, the net income estimates,
excluding one time charges, were $20.9 million for fiscal 1997 and $30.3
million for fiscal 1998, and for SQA, the estimates were $3.3 million for
calendar 1996 and $5.0 million for calendar 1997 and $3.6 million for fiscal
1997 and $5.7 million for fiscal 1998. Hambrecht & Quist observed that
Rational stockholders are expected to own approximately 85% of the Combined
Company equity at the close of the Merger, and the SQA stockholders are
expected to own approximately 15% of the Combined Company equity at the close
of the Merger. In fiscal 1997, it was estimated that Rational and SQA would
have contributed approximately 82% and 18%, respectively, of the combined
revenues; approximately 79% and 21%, respectively, of the combined gross
profit; approximately 84% and 16%, respectively, of the combined operating
income; and approximately 85% and 15%, respectively, of the combined pro forma
net income. With respect to fiscal 1998 financial performance, it was
estimated that Rational and SQA would have contributed approximately 80% and
20%, respectively, of the combined revenues; approximately 77% and 23%,
respectively, of the combined gross profit; approximately 81% and 19%,
respectively, of the combined operating income; and approximately 84% and 16%,
respectively, of the combined pro forma net income.
Pro Forma Merger Analysis: Hambrecht & Quist analyzed the pro forma impact
of the Merger using Hambrecht & Quist's analyst's published estimates,
excluding one time charges, of EPS for Rational in fiscal 1997 and fiscal 1998
of $0.53 and $0.70 (fully taxed $0.45 and $0.70), respectively, and for SQA in
those same periods of $0.41 and $0.62, respectively. The analysis indicated
that, after the first quarter of calendar year 1997, the earnings per share of
the pro forma Combined Company would be higher than for Rational as a stand-
alone company. The actual results and savings achieved by the Combined Company
resulting from the Merger may vary adversely from the projected results and
such adverse variations may be material.
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Premium Analysis: Hambrecht & Quist compared the implied price per share of
the offer as of November 12, 1996 to the last sale price of SQA Common Stock
on both November 11, 1996 and October 15, 1996 (the twenty-eighth business day
preceding the announcement of the proposed merger) to similar premiums for
certain technology transactions announced since January 1, 1994. Hambrecht &
Quist analyzed 30 such public company to public company technology
transactions and additionally analyzed a larger subset of public and private
company transactions in the software sector. Hambrecht & Quist observed that
the average one-day premium and four-week premiums paid in the selected public
company to public company technology transactions were 34% and 43%,
respectively. This compared with the proposed merger in which the one-day
premium offered was 37% and the four-week premium offered was 37%.
Discounted Cash Flow Analysis: Hambrecht & Quist analyzed the theoretical
valuation of SQA based on the unleveraged discounted cash flow of the
projected financial performance estimates of SQA derived from Wall Street's
consensus estimates. However, because of the nature of SQA's business and the
current market valuations for software companies, Hambrecht & Quist advised
Rational's Board of Directors that this analysis did not provide meaningful
information in the context of analyzing the fairness from a financial point of
view of the Merger.
Analysis of Publicly Traded Comparable Companies: Hambrecht & Quist compared
selected historical and projected financial information derived from Wall
Street's consensus estimates of SQA to publicly traded companies Hambrecht &
Quist deemed to be comparable to SQA. Such data and ratios included market
value, market value to historical net income, price per share to historical
and projected earnings per share, market value to historical book value, and
earnings per share growth rates. Hambrecht & Quist also examined the ratio of
the enterprise value (market value plus debt less cash) to the earnings before
interest and taxes and earnings before interest, taxes, depreciation and
amortization. Companies used as comparable included selected high growth
software companies including Business Objects, Integrated Systems, Intersolv,
Mercury Interactive, Platinum Technology, Pure Atria, Segue and Visigenic. The
foregoing multiples were applied to historical financial results of SQA for
the twelve-month period ended September 30, 1996 and projected financial
results of SQA derived from Wall Street analyst's published consensus
estimates of earnings per share for SQA of $0.37 in calendar 1996 and $0.55 in
calendar 1997. Hambrecht & Quist determined that the average multiple of the
last-twelve-months revenues for these companies was 8.5. Hambrecht & Quist
determined that the average multiple of book value for these companies was
7.8. Hambrecht & Quist determined that the average multiple of net income for
these companies was 89.5. Hambrecht & Quist determined that, for the expected
results for calendar year 1996, the average multiple of earnings per share for
these companies was 106.6. Hambrecht & Quist determined that, for the expected
results for calendar year 1997, the average multiple of earnings per share for
these companies was 40.5. Hambrecht & Quist determined that the average
multiple of earnings before interest and taxes or these companies was 74.4.
Hambrecht & Quist determined that the average multiple of earnings before
interest, taxes, depreciation and amortization for these companies was 58.2.
Based on the analysis of publicly traded comparable companies, SQA's implied
equity value ranged from approximately $218 million to approximately $349
million. This compared with an implied value of $313 million of SQA in the
Merger, based on the closing price of Rational Common Stock on November 12,
1996.
Analysis of Selected Merger and Acquisition Transactions: Hambrecht & Quist
compared the proposed Merger with selected comparable merger and acquisition
transactions. This analysis included 30 comparable public company to public
company software transactions. In examining these transactions, Hambrecht &
Quist analyzed certain income statement and balance sheet parameters of the
acquired company relative to the consideration offered. Multiples analyzed
included consideration offered to historical revenue, to historical cash flow
from operations, to historical earnings before depreciation, interest and
taxes, to historical earnings before interest and taxes, to historical income,
to historical book value, and to historical net operating assets. Selected
software transactions analyzed include Meta-Software/Avant!, Atria/Pure
Software, Tivoli Systems/IBM, Davidson & Associates/CUC International, Hogan
Systems/Continuum, Integrated Silicon Systems/Arcsys and Trinzinc/Platinum
Technology. The consideration offered in the foregoing transactions was an
average multiple of 6.5 times revenue, 30.7 times earnings before
depreciation, interest and taxes, 33.0 times earnings before
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interest and taxes, 50.4 times net income, 8.2 times book value and 41.2 times
cash flow from operations. Based on the analysis of selected merger and
acquisition transactions, SQA's implied equity value ranged from approximately
$132 million to $358 million. This compared with an implied value of $313
million of SQA in the Merger.
No company or transaction used in the above analyses is identical to
Rational or SQA or the Merger. Accordingly, an analysis of the results of the
foregoing is not mathematical; rather it involves complex considerations and
judgments concerning differences in financial and operating characteristics of
the companies and other factors that could affect the public trading values of
the companies or company to which they are compared.
The foregoing description of Hambrecht & Quist's opinion is qualified in its
entirety by reference to the full text of such opinion which is attached as
Annex C to this Prospectus/Joint Proxy Statement.
Hambrecht & Quist, as part of its investment banking services, is regularly
engaged in the valuation of businesses and their securities in connection with
mergers and acquisitions, corporate restructurings, strategic alliances,
negotiated underwriting, secondary distributions of listed and unlisted
securities, private placements and valuations for corporate and other
purposes. Hambrecht & Quist is familiar with Rational, having acted as advisor
in its merger with a publicly traded corporation formerly known as Verdix
Corporation in March 1994 and as managing underwriter of its follow-on
offerings in June 1995 and October 1996. Hambrecht & Quist received customary
compensation in connection with such transactions. In the ordinary course of
business, Hambrecht & Quist acts as a market maker and broker in the publicly
traded securities of Rational and receives customary compensation in
connection therewith, and also provides research coverage for Rational. In the
ordinary course of business, Hambrecht & Quist actively trades in the equity
and derivative securities of Rational for its own account and for the accounts
of its customers and, accordingly, may at any time hold a long or short
position in such securities. In addition, Daniel H. Case III, the President
and Chief Executive Officer of Hambrecht & Quist, is a Director of Rational.
Pursuant to an engagement letter dated November 12, 1996, Rational has
agreed to pay Hambrecht & Quist a fee ("Transaction Fee") equal to $1.0
million in connection with its services as financial advisor to Rational in
connection with the Merger, including the rendering of a fairness opinion.
Such Transaction Fee, with the exception of $250,000 payable to Hambrecht &
Quist at the time of the delivery of its Fairness Opinion which sum will be
credited against the Transaction Fee, is payable upon consummation of the
Merger. Rational also has agreed to reimburse Hambrecht & Quist for its
reasonable out-of-pocket expenses and to indemnify Hambrecht & Quist against
certain liabilities, including liabilities under the federal securities laws
or relating to or arising out of Hambrecht & Quist's engagement as financial
advisor.
OPINION OF SQA'S FINANCIAL ADVISOR
SQA retained RS & Co. to act as its financial advisor in connection with the
Merger and to render an opinion as to the fairness, from a financial point of
view, to SQA of the Purchase Price Value, as defined in RS & Co.'s written
opinion, to be paid. At the November 12, 1996 meeting of the SQA Board, RS &
Co. delivered an oral opinion, which was subsequently confirmed in writing,
that as of such date and based on the matters described therein, the Purchase
Price Value to be paid by Rational is fair to SQA from a financial point of
view. The complete text of the written opinion of RS & Co. dated November 12,
1996, which sets forth the assumptions made, procedures followed, matters
considered and scope of the review undertaken by RS & Co. in rendering its
opinion, is attached hereto as Annex D. SQA stockholders are urged to read RS
& Co's opinion in its entirety.
RS & Co. did not recommend to the SQA Board that any specific amount of
consideration constituted the appropriate consideration for the Merger. No
limitations were imposed by the SQA Board on RS & Co. with respect to the
investigations made or procedures followed by it in rendering its opinion. RS
& Co.'s opinion to the SQA Board addresses only the fairness from a financial
point of view of the Purchase Price Value to be paid
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to SQA, and does not constitute a recommendation to any SQA stockholder as to
how such stockholder should vote at the SQA Meeting. RS & Co. expressed no
opinion as to the tax consequences of the Merger, and RS & Co.'s opinion as to
the fairness of the Purchase Price Value to be paid does not take into account
the particular tax status or position of any holder of SQA Common Stock. In
rendering its opinion, RS & Co. was not engaged as an agent or fiduciary of
SQA stockholders or any other third party. The summary of the opinion of RS &
Co. set forth in this Prospectus/Joint Proxy Statement is qualified in its
entirety by reference to the full text of such opinion.
In connection with the preparation of its opinion dated November 12, 1996,
RS & Co., among other things: (i) reviewed financial information on SQA
furnished to RS & Co. by SQA, including certain internal financial analyses
and forecasts prepared by the management of SQA; (ii) reviewed publicly
available information; (iii) held discussions with the management of SQA and
Rational concerning the businesses, past and current business operations,
financial condition and future prospects of SQA and Rational; (iv) reviewed
the Agreement; (v) reviewed the stock price and trading history of SQA and
Rational; (vi) reviewed the valuations of publicly traded companies which RS &
Co. deemed comparable to SQA and Rational; (vii) compared the financial terms
of the Merger with other transactions which RS & Co. deemed relevant; (viii)
prepared a discounted cash flow analysis of SQA; (ix) analyzed the pro forma
earnings per share of the Combined Company; and (x) made such other studies
and inquiries, and reviewed such other data, as RS & Co. deemed relevant.
The following paragraphs summarize all material quantitative and qualitative
analyses performed by RS & Co. in arriving at its opinion and all such
analyses reviewed with the SQA Board but does not purport to be a complete
description of the analyses RS & Co. performed. RS & Co. used information on
the financial condition of SQA as of a date or dates shortly before the
Agreement was executed on November 12, 1996 and stock price information
through the close of the market on November 11, 1996.
Stock Price and Trading Analysis. RS & Co. reviewed the trading activity,
including share price and trading volume, of SQA Common Stock for the period
December 29, 1995 to November 11, 1996. RS & Co. noted that, since December
29, 1995, the daily closing prices of SQA Common Stock ranged from a high of
$38.000 on May 21, 1996 to a low of $18.250 on July 25, 1996. RS & Co. also
noted that the average closing price for the 20 trading days, 50 trading days,
100 trading days and 200 trading days up to and including November 11, 1996
was $25.625, $25.083, $24.448 and $26.642, respectively.
Comparable Company Analysis. RS & Co. compared certain financial data and
multiples of historical and projected income statement parameters for the
twelve months ended September 30, 1996 and the 1996 and 1997 calendar years
accorded to companies RS & Co. deemed comparable to SQA. These companies
included: Forte Software, Inc., Rational Software Corporation, Pure Atria
Corporation, Segue Software Inc. and Mercury Interactive Corporation (the
"Comparable Companies"). Financial data compared included equity value,
aggregate value (equity value less cash and equivalents plus debt) and
projected earnings per share growth rate as reported by Robertson, Stephens &
Company Institutional Research and third party sources. Multiples compared
included aggregate value to revenue, aggregate value to operating income and
price to earnings ratio.
Based on aggregate value to revenue multiples of approximately 8.0 to 17.0x
for the twelve months ended September 30, 1996, approximately 6.0 to 15.0x for
projected calendar 1996 and approximately 5.0 to 12.0x for projected calendar
1997 for the Comparable Companies and after adjusting for SQA's net cash and
equivalents, SQA's public market implied equity valuation ranged from $182
million to $481 million, or $20.58 to $54.33 per share.
Based on equity value to net income multiples of approximately 60-110x for
projected calendar 1996 and approximately 40-70x for projected calendar 1997
for the Comparable Companies, SQA's public market implied equity valuation
ranged from $195 million to $358 million, or $22.01 to $40.35 per share.
RS & Co. also valued SQA by applying a 25% and 50% acquisition premium to
the above noted two public market valuations derived from the Comparable
Companies. Based on those premiums, the public market implied
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equity valuation based on aggregate value to revenue multiples ranged from
$228 million to $722 million, or $25.73 to $81.50 per share and the public
market implied equity valuation based on equity value to net income multiples
ranged from $244 million to $536 million, or $27.51 to $60.52 per share.
Precedent Transaction Analysis. RS & Co. analyzed publicly available
information for selected announced or completed acquisitions and mergers RS &
Co. deemed comparable to the Merger. In examining these transactions, RS & Co.
analyzed certain financial parameters of the acquired company relative to the
consideration offered. Financial indicators compared included the equity
consideration plus net debt assumed ("aggregate consideration") to latest
twelve months revenue, equity consideration to latest twelve months net
income, premiums implied by the offer price per share compared to one day and
one month prior to announcement, latest twelve months revenue growth and
latest twelve months operating margin. The acquisitions reviewed were: Red
Pepper Software Company/ PeopleSoft, Inc.; Atria Software, Inc./Pure Software,
Inc; RSA Data Security, Inc./Security Dynamics Technologies, Inc.; Sierra On-
Line, Inc./CUC International, Inc.; Davidson & Associates, Inc./CUC
International, Inc.; Tivoli Systems, Inc./International Business Machines
Corporation, Integrated Silicon Systems, Inc./ArcSys, Inc.; Powersoft
Corporation/Sybase Inc.; and Intuit, Inc. / Microsoft Corporation (the
"Precedent Transactions").
Based on aggregate consideration offered to latest twelve months revenue
multiples of 8.0 to 15.0x and equity consideration offered to latest twelve
months net income multiples of 60.0 to 130.0x for the Precedent Transactions,
SQA's implied equity value ranged from $157 million to $348 million, or $17.76
to $39.25 per share.
Discounted Cash Flow Analysis. RS & Co. performed a discounted cash flow
analysis to estimate the present value of the stand-alone unlevered (before
interest expense) after-tax cash flows of SQA financial projections prepared
by the management of SQA. RS & Co. first discounted the projected, unlevered
after-tax cash flows through 2001 using a range of discount rates from 15% to
30%. SQA's unlevered after-tax cash-flows were calculated as the after-tax
operating earnings of SQA adjusted for the add-back of non-cash expenses and
the deduction of uses of cash not reflected in the income statement. RS & Co.
then added to the present value of the cash flows the terminal value of SQA in
the fiscal year 2001, discounted back at the same discount rate. The terminal
value was computed by multiplying SQA's projected operating income in the
fiscal year 2001 by terminal multiples ranging from 20.0 to 40.0x. The
discounted cash flow valuation indicated implied equity valuations from $176
million to $482 million, or $19.89 to $54.37 per share.
Pro Forma Acquisition Analysis. RS & Co. analyzed the pro forma annual
earnings per share of the combined company based on the Exchange Ratio and
published estimates of SQA's and Rational's financial performance. Such
analysis indicated that, in the absence of synergies, pro forma earnings per
share of the Combined Company, compared to Rational as a stand-alone entity,
would be increased by 0.7% and 1.1% for calendar years ending 1996 and 1997,
respectively, and would be decreased by 0.8% in the first calendar quarter of
1997, remain the same in the second calendar quarter of 1997, be increased by
1.9% in the third calendar quarter of 1997 and be increased by 2.6% in the
fourth calendar quarter of 1997.
Historical Exchange Ratio Analysis. RS & Co. compared the exchange ratios
implied by the average closing prices and volume weighted average closing
prices of SQA and Rational common stock for certain periods up to and
including November 11, 1996.
Based on the exchange ratios implied by historical daily closing stock
prices of SQA and Rational, RS & Co. noted that the Exchange Ratio represented
a premium of 27.0%, 33.6%, 33.0% and 17.3% over the 10 trading day, 20 trading
day, 30 trading day and 60 trading day averages up to and including November
11, 1996. RS & Co. also noted that the Exchange Ratio represented a premium of
34.0% over the approximate one month period beginning October 9, 1996 and
ending November 11, 1996 and discount of 28.4% over the period since SQA's
initial public offering on December 13, 1995.
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Based on the volume weighted exchange ratios implied by historical daily
closing stock prices and trading volumes of SQA and Rational, RS & Co. noted
that the Exchange Ratio represented a premium of 29.6%, 30.5%, 30.1% and 21.6%
over the 10 trading day, 20 trading day, 30 trading day and 60 trading day
averages up to and including November 11, 1996. RS & Co. also noted that the
Exchange Ratio represented a premium of 30.5% over the one month period
beginning October 9, 1996 and ending November 11, 1996 and discount of 19.2%
over the period since SQA's initial public offering on December 13, 1995.
The preparation of fairness opinions involves various determinations as to
the most appropriate and relevant quantitative and qualitative methods of
financial analyses and the application of those methods to the particular
circumstances; therefore, such opinions are not readily susceptible to summary
description. In arriving at its opinion, RS & Co. did not attribute any
particular weight to any analysis or factor considered by it, but rather made
qualitative judgments as to the significance and relevance of each analysis
and factor. Accordingly, RS & Co. believes its analyses must be considered as
a whole and that considering any portion of such analyses and current factors
could create a misleading or incomplete view of the process underlying the
preparation of fairness opinions. In its analyses, RS & Co. made numerous
assumptions with respect to industry performance, general business and other
conditions and matters, many of which are beyond the control of SQA and
Rational. Any estimates contained in these analyses are not necessarily
indicative of actual values or predictive of future results or values, which
may be significantly more or less favorable than as set forth therein. In
addition, analyses relating to the value of businesses do not purport to be
appraisals or to reflect the prices at which businesses actually may be sold.
Based on past activities, RS & Co. has a substantial degree of familiarity
with SQA. In addition, in the course of its engagement, RS & Co. conducted
further investigation of SQA. In arriving at its opinion, however, RS & Co.
did not independently verify any of the foregoing information and relied on
all such information being complete and accurate in all material respects.
Furthermore, RS & Co. did not obtain any independent appraisal of the
properties or assets of SQA. With respect to the financial and operating
forecasts (and the assumptions and bases thereof), estimates and analyses
provided to RS & Co. by SQA, RS & Co. assumed that such projections, estimates
and analyses were reasonably prepared in good faith and represent the best
currently available estimates and judgments of SQA management as to the future
financial performance of SQA. RS & Co. noted, among other things, that its
opinion is necessarily based upon market, economic and other conditions
existing as of the date of the opinion, and information available to RS & Co.
as of the date thereof.
RS & Co. was retained based on RS & Co.'s experience as a financial advisor
in connection with mergers and acquisitions and in securities valuations
generally as well as RS & Co.'s investment banking relationship and
familiarity with SQA. RS & Co. has provided financial advisory and investment
banking services to SQA from time to time, including acting as lead
underwriter for the initial public offering of SQA common stock. In addition,
RS & Co. maintains a market in shares of SQA common stock.
SQA engaged RS & Co. by means of an engagement letter, dated November 8,
1996. Pursuant to the engagement letter, RS & Co. provided a financial
fairness opinion in connection with the Merger and SQA has agreed to pay an
opinion related fee to RS & Co., a portion of which was due and payable upon
the rendering of its fairness opinion. SQA has also agreed to reimburse RS &
Co. for its out-of-pocket expenses and to indemnify RS & Co. for certain
liabilities relating to or arising out of services provided by RS & Co. as
financial advisor to SQA.
CERTAIN FEDERAL INCOME TAX CONSIDERATIONS
The following discussion summarizes the material federal income tax
considerations of the Merger that are generally applicable to holders of SQA
Common Stock. This discussion does not deal with all income tax considerations
that may be relevant to particular SQA stockholders in light of their
particular circumstances, such as stockholders who are dealers in securities,
foreign persons, stockholders who acquired their shares in connection with
previous mergers involving SQA or an affiliate, or stockholders who acquired
their shares in connection with stock option or stock purchase plans or in
other compensatory transactions. In addition, the
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following discussion does not address the tax consequences of transactions
effectuated prior to or after the Merger (whether or not such transactions are
in connection with the Merger), including without limitation transactions in
which shares of SQA Common Stock were or are acquired or shares of Rational
Common Stock were or are disposed of. Furthermore, no foreign, state or local
tax considerations are addressed herein. ACCORDINGLY, SQA STOCKHOLDERS ARE
URGED TO CONSULT THEIR OWN TAX ADVISORS AS TO THE SPECIFIC TAX CONSEQUENCES OF
THE MERGER, INCLUDING THE APPLICABLE FEDERAL, STATE, LOCAL AND FOREIGN TAX
CONSEQUENCES TO THEM OF THE MERGER.
The Merger is intended to constitute a "reorganization" within the meaning
of Section 368(a) of the Code, with each of Rational, Merger Sub and SQA
intended to qualify as a "party to the reorganization" under Section 368(b) of
the Code, in which case the following federal income tax consequences will
result (subject to the limitations and qualifications referred to herein):
(a) No gain or loss will be recognized by holders of Common Stock of SQA
solely upon their receipt of Rational Common Stock in the Merger (except to
the extent of cash received in lieu of a fractional share thereof) in
exchange therefor;
(b) The aggregate tax basis of the Rational Common Stock received in the
Merger by an SQA stockholder will be the same as the aggregate tax basis of
SQA Common Stock surrendered in exchange therefor;
(c) The holding period of the Rational Common Stock received in the
Merger by an SQA stockholder will include the period during which the
stockholder held the SQA Common Stock surrendered in exchange therefor,
provided that the SQA Common Stock is held as a capital asset at the time
of the Merger;
(d) Cash payments received by holders of SQA Common Stock in lieu of a
fractional share will be treated as if such fractional share of Rational
Common Stock had been issued in the Merger and then redeemed by Rational.
An SQA stockholder receiving such cash generally will recognize gain or
loss, upon such payment, measured by the difference (if any) between the
amount of cash received and the basis in such fractional share; and
(e) None of Rational, Merger Sub or SQA will recognize material amounts
of gain or loss solely as a result of the Merger.
The parties are not requesting a ruling from the Internal Revenue Service
("IRS") in connection with the Merger. Rational and SQA have each received an
opinion from their respective legal counsel, Wilson Sonsini Goodrich & Rosati,
Professional Corporation, and Testa, Hurwitz & Thibeault, LLP, respectively,
that, for federal income tax purposes, the Merger will constitute a
"reorganization" within the meaning of Section 368(a) of the Code. These
opinions, which are collectively referred to herein as the "Tax Opinions,"
neither bind the IRS nor preclude the IRS from adopting a contrary position.
In addition, the Tax Opinions are subject to certain assumptions and
qualifications and are based on the truth and accuracy of certain
representations made by Rational, Merger Sub and SQA, including
representations in certificates delivered to counsel by the respective
managements of Rational, Merger Sub and SQA. Of particular importance are
those assumptions and representations relating to the "continuity of interest"
requirement.
To satisfy the continuity of interest requirement, SQA stockholders must
not, pursuant to a plan or intent existing at or prior to the Merger, dispose
of or transfer so much of either (i) their Common Stock of SQA in anticipation
of the Merger or (ii) the Rational Common Stock to be received in the Merger
(collectively, "Planned Dispositions"), such that the SQA stockholders, as a
group, would no longer have a substantial proprietary interest in the SQA
business being conducted by Rational after the Merger. SQA stockholders will
generally be regarded as having retained a substantial proprietary interest as
long as the Rational Common Stock received in the Merger (after reduction for
any Planned Dispositions), in the aggregate, represents a substantial portion
of the entire consideration received by the SQA stockholders in the Merger. If
the continuity of interest requirement were not satisfied, the Merger would
not be treated as a "reorganization."
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A successful IRS challenge to the "reorganization" status of the Merger (as
a result of a failure of the "continuity of interest" requirement or
otherwise) would result in an SQA stockholder recognizing gain or loss with
respect to each share of SQA Common Stock surrendered equal to the difference
between the stockholder's basis in such share and the fair market value, as of
the Effective Time of the Merger, of the Rational Common Stock received in
exchange therefor. In such event, a stockholder's aggregate basis in the
Rational Common Stock so received would equal its fair market value and such
stockholder's holding period would begin the day after the Merger.
GOVERNMENTAL AND REGULATORY APPROVALS
Transactions such as the Merger are reviewed by the Department of Justice
and the Federal Trade Commission (the "FTC") to determine whether they comply
with applicable antitrust laws. Under the provisions of the Hart-Scott-Rodino
Antitrust Improvements Act of 1976, as amended (the "HSR Act"), the Merger may
not be consummated until such time as certain information has been furnished
to the Department of Justice and the FTC and the specified waiting period
requirements of the HSR Act have been satisfied. Premerger Notification and
Report Forms were filed with the Department of Justice and the FTC under the
HSR Act by each of Rational and SQA on November 27, 1996. The notification and
waiting period imposed under the HSR Act expires on , 1997.
At any time before or after the Effective Time, the Department of Justice,
the FTC, state attorneys general or a private person or entity could challenge
the Merger under the antitrust laws and seek, among other things, to enjoin
the Merger or to cause Rational to divest itself, in whole or in part, of
Rational and SQA. Based on information available to them, Rational and SQA
believe that the Merger will not violate federal or state antitrust laws.
However, there can be no assurance that a challenge to the Merger on antitrust
grounds will not be made or that, if such a challenge is made, Rational and
SQA will prevail or will not be required to accept certain conditions,
possibly including certain divestitures or hold-separate agreements, in order
to consummate the Merger.
Rational and SQA each conduct operations in a number of foreign countries
where regulatory filings may be required as a result of the Merger. Rational
and SQA will make such filings as they determine are necessary or appropriate.
Rational and SQA are aware of no other governmental or regulatory approvals
required for consummation of the Merger, other than compliance with the
federal securities laws and applicable securities and "blue sky" laws of the
various states.
ACCOUNTING TREATMENT
The Merger is intended to qualify as a pooling of interests for financial
reporting purposes in accordance with generally accepted accounting
principles. Consummation of the Merger is conditioned upon (i) receipt by SQA
of a letter from its independent auditors to the effect that SQA qualifies as
an entity that may be a party to a business combination for which the pooling-
of-interests method of accounting would be available and (ii) receipt by
Rational of a letter from its independent auditors regarding concurrence with
Rational management's conclusion as to the appropriateness of pooling-of-
interests accounting treatment for the Merger under APB No. 16, if consummated
in accordance with the Agreement.
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TERMS OF THE MERGER
The following discussion summarizes the definitive terms of the Agreement,
including the other agreements and transactions contemplated thereby. The
following is not, however, a complete statement of all provisions of the
Agreement and related agreements. Detailed terms of and conditions to the
Merger and certain related transactions are contained in the Agreement, a copy
of which is attached to this Prospectus/Joint Proxy Statement as Annex A.
Reference is also made to the Stock Option Agreement attached to this
Prospectus/Joint Proxy Statement as Annex B, and to the other Annexes hereto.
Statements made in this Prospectus/Joint Proxy Statement with respect to the
terms of the Merger and such related transactions are qualified in their
respective entireties by reference to the more detailed information set forth
in the Agreement and the other Annexes hereto.
EFFECTIVE TIME
The Merger will become effective upon the filing of the Certificate of
Merger with the Secretary of State of the State of Delaware or at such later
time as may be agreed in writing by Rational, SQA and Merger Sub (the
"Effective Time"). The Certificate of Merger is attached as Exhibit A to Annex
A of this Prospectus/Joint Proxy Statement. The Closing Date will occur at a
time and date to be specified by Rational, SQA and Merger Sub after the
satisfaction or waiver of the conditions to the Merger, or at such other time
as Rational, SQA and Merger Sub agree in writing. Assuming all conditions to
the Merger are met or waived prior thereto, it is anticipated that the Closing
Date and Effective Time will be on or about February 26, 1997.
MANNER AND BASIS OF CONVERTING SHARES
At the Effective Time of the Merger, Merger Sub will merge with and into SQA
and Rational will own all of the capital stock of SQA. As a result of the
Merger, each share of SQA Common Stock will be converted into the right to
receive 0.86 shares of Rational Common Stock, and each outstanding option or
right to purchase SQA Common Stock under the SQA Stock Option Plans and SQA
Stock Purchase Plan will be assumed by the Combined Company and will become an
option or right to purchase Combined Company Common Stock, with appropriate
adjustments to be made to the number of shares issuable thereunder and the
exercise price thereof based on the Exchange Ratio. Also as a result of the
Merger, each share of SQA Common Stock held in the treasury of SQA or owned by
Merger Sub, Rational or any wholly owned subsidiary of Rational or SQA, will
be cancelled and extinguished without conversion thereof.
No fractional shares will be issued by virtue of the Merger, but in lieu
thereof each holder of SQA Common Stock who would otherwise be entitled to a
fraction of a share of Rational Common Stock (after aggregating all fractional
shares to be received by such holder) will receive from the Combined Company
an amount of cash (rounded to the nearest whole cent) equal to the product of
(i) such fraction, multiplied by (ii) the average closing price of a share of
Rational Common Stock for the ten most recent days that Rational Common Stock
has traded ending on the trading day immediately prior to the Effective Time,
as reported on the Nasdaq National Market.
Promptly after the Effective Time, the Combined Company, acting through the
Exchange Agent, will deliver to each SQA stockholder of record a letter of
transmittal with instructions to be used by such stockholder in surrendering
certificates which, prior to the Merger, represented shares of SQA Common
Stock. CERTIFICATES SHOULD NOT BE SURRENDERED BY THE HOLDERS OF SQA COMMON
STOCK UNTIL SUCH HOLDERS RECEIVE THE LETTER OF TRANSMITTAL FROM THE EXCHANGE
AGENT. At the Effective Time, each then outstanding option or other right to
purchase SQA Common Stock, whether vested or unvested, will be assumed by the
Combined Company without any action on the part of the holder thereof. OPTION
AGREEMENTS AND WARRANTS NEED NOT BE SURRENDERED.
No later than five business days after the Closing Date, the Combined
Company will file a registration statement of Form S-8 under the Securities
Act covering the shares of Combined Company Common Stock issuable upon
exercise of options and other rights to purchase SQA Common Stock to be
assumed by Rational at the Effective Time.
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STOCK OWNERSHIP FOLLOWING THE MERGER
Based upon the capitalization of SQA as of the close of business on November
11, 1996 (including the number of shares of SQA Common Stock outstanding and
the number of shares issuable upon exercise of outstanding options, warranties
and rights to purchase SQA Common Stock) an aggregate of approximately 7.0
million shares of Rational Common Stock will be issued to SQA stockholders in
the Merger and Rational will assume options for up to approximately 2.0
million additional shares of Combined Company Common Stock. Based upon the
number of shares of Rational Common Stock issued and outstanding as of
November 11, 1996, and after giving effect to the issuance of Rational Common
Stock as described in the previous sentence, the former holders of SQA Common
Stock would hold, and have voting power with respect to, approximately 15% of
the Combined Company's total issued and outstanding shares, and holders of
former SQA options would hold options exercisable for approximately 5% of the
Combined Company's total issued and outstanding shares (assuming the exercise
of only such options). The foregoing numbers of shares and percentages are
subject to change in the event that the capitalization of either Rational or
SQA changes subsequent to November 11, 1996 and prior to the Effective Time,
and there can be no assurance as to the actual capitalization of Rational or
SQA at the Effective Time or of the Combined Company at any time following the
Effective Time.
As a result of the Merger and pursuant to the terms of the SQA Stock Option
Plans and/or certain agreements related to options granted thereunder, certain
outstanding options under such plans will accelerate and become fully
exercisable at the Effective Time of the Merger. Of the shares of SQA
Common Stock subject to outstanding options under the SQA Stock Option Plans,
shares would be exercisable as of , 1997 and, assuming the Merger is
consummated on such date, an additional shares would become exercisable as
a result of such acceleration provisions. See "--Interests of Certain
Persons."
CONDUCT OF COMBINED COMPANY FOLLOWING THE MERGER
Once the Merger is consummated, Merger Sub will cease to exist as a
corporation, and all of the business, assets, liabilities and obligations of
Merger Sub will be merged into SQA with SQA remaining as the surviving
corporation (the "Surviving Corporation"). Following the Merger, the
headquarters of the Combined Company will be in Santa Clara, California.
Pursuant to the Agreement, the Certificate of Incorporation of SQA in effect
immediately prior to the Effective Time will become the Certificate of
Incorporation of the Surviving Corporation and the Bylaws of SQA will become
the Bylaws of the Surviving Corporation. The Board of Directors of the
Surviving Corporation will consist of the directors who are serving as
directors of Merger Sub immediately prior to the Effective Time. The officers
of Merger Sub immediately prior to the Effective Time will remain as officers
of the Surviving Corporation, until their successors are duly elected or
appointed or qualified.
Immediately after the Effective Time, the Combined Company's Board of
Directors will consist of the seven existing directors of Rational (two of
whom will be Paul Levy and Mike Devlin and five of whom will be non-employee
directors and are expected to be James Campbell, Daniel Case III, Leslie
Denend, John Montague and Allison Schleicher), and Ronald H. Nordin, a
director of SQA, who, pursuant to the Agreement, will be appointed to the
Board of Directors of Rational contingent upon the consummation of the Merger.
Immediately after the Effective Time the Audit and Compensation Committees of
the Combined Company shall be the Audit and Compensation Committees of
Rational immediately prior to the Effective Time.
At the Effective Time, Paul Levy will be the Chairman of the Board and Chief
Executive Officer of the Combined Company, Michael Devlin will be the
President of the Combined Company, and Robert Bond will be the Senior Vice
President, Chief Financial Officer, Chief Operating Officer and Secretary of
the Combined Company.
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CONDUCT OF RATIONAL'S AND SQA'S BUSINESSES PRIOR TO THE MERGER
Pursuant to the Agreement, each of SQA and Rational have agreed (except to
the extent expressly contemplated by the Agreement or as consented to in
writing by the other), to carry on its and its subsidiaries' business in the
usual, regular and ordinary course in substantially the same manner as
heretofore conducted, to pay and to cause its subsidiaries to pay debts and
taxes when due subject to good faith disputes over such debts or taxes, to pay
or perform other obligations when due, and to use all reasonable efforts
consistent with past practice and policies to preserve intact its and its
subsidiaries' present business organizations, use its commercially reasonable
efforts consistent with past practice to keep available the services of its
and its subsidiaries' present officers and key employees and to preserve its
and its subsidiaries' relationships with customers, suppliers, distributors,
licensors, licensees, and others having business dealings with it or its
subsidiaries, it being the parties' intent that SQA's and its subsidiaries'
goodwill and ongoing businesses shall be unimpaired at the Effective Time.
Each of SQA and Rational agrees to use its best efforts to promptly notify the
other of any event or occurrence not in the ordinary course of its or its
subsidiaries' business, and of any event which would have a material adverse
effect. In addition, except as expressly contemplated by the Agreement,
neither SQA nor Rational nor any of their subsidiaries shall do, cause or
permit any of the following without the prior written consent of the other:
(i) cause or permit any amendments to its Certificate of Incorporation or
Bylaws, (ii) except as disclosed, declare or pay any dividends on or make any
other distributions (whether in cash, stock or property) in respect of any of
its capital stock, or split, combine or reclassify any of its capital stock or
issue or authorize the issuance of any other securities in respect of, in lieu
of or in substitution for shares of its capital stock, or repurchase or
otherwise acquire, directly or indirectly, any shares of its capital stock
except from former employees, directors and consultants in accordance with
agreements providing for the repurchase of shares in connection with any
termination of service to it or its subsidiaries, (iii) except as disclosed,
accelerate, amend or change the period of exercisability or vesting of options
or other rights granted under its employee stock plans or director stock plans
or authorize cash payments in exchange for any options or other rights granted
under any of such plans, (iv) take any action, which, to the knowledge of such
party would prevent Rational from accounting for the Merger as a pooling of
interests, or (v) intentionally take, or agree in writing or otherwise to take
any action which would make this proxy and registration statement or any of
its representations or warranties contained in the Agreement untrue or
incorrect or prevent it from performing or cause it not to perform its
covenants hereunder.
Further, prior to the earlier of the termination of the Agreement or the
Effective Time, except as expressly contemplated by the Agreement or consented
to in writing by Rational, neither SQA nor any of its subsidiaries shall do,
cause or permit any of the following, without the prior written consent of
Rational, which consent shall not be unreasonably withheld: (i) enter into any
partnership arrangements, joint development agreements, strategic alliances,
or other material contracts other than in the ordinary course of business
consistent with past practice, or violate, amend or otherwise modify or waive
any material contract which violation, amendment, modification or waiver would
have a material adverse effect on SQA's business or results of operations,
(ii) issue, deliver or sell or authorize or propose the issuance, delivery or
sale of, or purchase or propose the purchase of, any shares of its capital
stock or securities convertible into, or subscriptions, rights, warrants or
options to acquire, or other agreements or commitments of any character
obligating it to issue any such shares or other convertible securities, other
than the issuance of shares of its Common Stock pursuant to the exercise of
stock options, warrants or other rights therefor outstanding as of November
11, 1996, except that SQA may, in the ordinary course of business consistent
with past practice, grant options for the purchase of SQA Common Stock under
the SQA Option Plans (not to exceed an aggregate of 50,000 options to purchase
shares of SQA Common Stock granted after November 11, 1996), (iii) transfer to
any person or entity any rights to its intellectual property other than in the
ordinary course of business consistent with past practice, (iv) enter into or
amend any agreements pursuant to which any other party is granted exclusive
marketing or distribution rights with respect to any of its products or
technology, (v) sell, lease, license or otherwise dispose of or encumber any
of its properties or assets which are material, individually or in the
aggregate, to its and its subsidiaries' business, taken as a whole, except in
the ordinary course of business consistent with past practice, (vi) incur any
indebtedness for borrowed money or guarantee any such indebtedness or issue or
sell any debt securities or guarantee any
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debt securities of others, except in the ordinary course of business
consistent with past practice, (vii) enter into any operating lease, except in
the ordinary course of business consistent with past practice, (viii) pay,
discharge or satisfy any material claim, liability or obligation (absolute,
accrued, asserted or unasserted, contingent or otherwise) arising other than
in the ordinary course of business, other than the payment, discharge or
satisfaction of liabilities reflected or reserved against in the SQA Financial
Statements, (ix) make any material capital expenditures, capital additions or
capital improvements except in the ordinary course of business and consistent
with past practice, (x) materially reduce the amount of any material insurance
coverage provided by existing insurance policies, (xi) adopt or amend any
material employee benefit or stock purchase or option plan, or hire any new
officer or director level employee, pay any special bonus or special
remuneration to any employee or director, or increase the salaries or wage
rates of its employees, except in the ordinary course of business consistent
with past practice, (xii) grant any severance or termination pay to any
director or officer or to any other employee except (1) payments made pursuant
to standard written agreements outstanding on the date hereof or (2) grants
which are made in the ordinary course of business in accordance with its
standard past practice, (xiii) commence a lawsuit other than (1) for the
routine collection of bills, (2) in such cases where it in good faith
determines that failure to commence suit would result in the material
impairment of a valuable aspect of its business, provided that it consults
with Rational prior to the filing of such a suit, or (3) for a breach of the
Agreement, (xiv) acquire or agree to acquire by merging or consolidating with,
or by purchasing a substantial portion of the assets of, or by any other
manner, any business or any corporation, partnership, association or other
business organization or division thereof, or otherwise acquire or agree to
acquire any assets which are material, individually or in the aggregate, to
its and its subsidiaries' business, taken as a whole, or acquire or agree to
acquire any equity securities of any corporation, partnership, association or
business organization, (xv) other than in the ordinary course of business,
make or change any material election in respect of taxes, adopt or change any
accounting method in respect of taxes to the extent material to SQA or its
subsidiaries, enter into any material closing agreement, settle any material
claim or assessment in respect of taxes, or consent to any extension or waiver
of the limitation period applicable to any material claim or assessment in
respect of taxes, (xvi) fail to give all notices and other information
required to be given to the employees of SQA, any collective bargaining unit
representing any group of employees of SQA, and any applicable government
authority under the WARN Act, the National Labor Relations Act, the Code,
COBRA, and other applicable law in connection with the transactions provided
for in the Agreement, or (xvii) revalue any of its assets, including without
limitation writing down the value of inventory or writing off notes or
accounts receivable other than in the ordinary course of business.
NO SOLICITATION
Under the terms of the Agreement, SQA and its subsidiaries will not,
directly or indirectly through their officers, directors, employees, agents or
otherwise, (i) solicit, initiate or encourage any Takeover Proposal (as
defined below) or (ii) engage in negotiations with, or disclose any nonpublic
information relating to SQA or any of it subsidiaries to, or afford access to
the properties, books or records of SQA or any of its subsidiaries to, any
person that has indicated to SQA that it may be considering making, or that
has made, a Takeover Proposal; provided, nothing in the Agreement prohibits
SQA's Board of Directors from taking and disclosing to SQA's stockholders a
position with respect to a tender offer pursuant to Rules 14d-9 and 14e-2
promulgated under the Exchange Act.
Notwithstanding the immediately preceding sentence, if an unsolicited
Takeover Proposal, or an unsolicited written expression of interest that SQA
reasonably expects to lead to a Takeover Proposal, shall be received by the
Board of Directors of SQA, then, to the extent the Board of Directors of SQA
believes in good faith (after consultation with its financial advisor) (i)
that such Takeover Proposal would, if consummated, result in a transaction
that appears to be more favorable to SQA's stockholders from a financial point
of view than the transaction contemplated by the Agreement and (ii) after
reasonable inquiry by SQA, that the third party making such Takeover Proposal
is financially capable of consummating such Takeover Proposal (any Takeover
Proposal meeting such conditions being referred to in the Agreement as a
"Superior Proposal") and the Board of Directors of SQA determines in good
faith after consultation with outside legal counsel that it is necessary for
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the Board of Directors of SQA to comply with its fiduciary duties to
stockholders under applicable law, SQA and its officers, directors, employees,
investment bankers, financial advisors, attorneys, accountants and other
representatives retained by it may furnish in connection therewith information
and take such other actions as are consistent with the fiduciary obligations
of SQA's Board of Directors, and such actions shall not be considered a breach
of the Agreement; provided that (1) upon each such determination SQA notifies
Rational of such determination by the SQA Board of Directors and provides
Rational with a true and complete copy of the Superior Proposal received from
such third party, if the Superior Proposal is in writing, or a written summary
of all material terms and conditions thereof, if it is not in writing, (2) SQA
provides Rational no later than the time that such documents are provided to
such third party with all documents containing or referring to non-public
information of SQA that are supplied to such third party, to the extent not
previously supplied by SQA to Rational, and (3) SQA provides such non-public
information to any such third party pursuant to a non-disclosure agreement at
least as restrictive as to confidential information as the analogous agreement
signed with Rational.
SQA shall not, and shall not permit any of its officers, directors,
employees (acting on behalf of SQA) or other representatives to agree to or
endorse any Takeover Proposal unless SQA shall have terminated the Agreement
and paid Rational all amounts payable to Rational upon such event.
Notwithstanding anything in the Agreement to the contrary, SQA shall not
accept or recommend to its stockholders, or enter into any agreement
concerning, a Superior Proposal for a period of not less than 48 hours after
Rational's receipt of a true and complete copy of such Superior Proposal, if
the Superior Proposal is in writing, or a written summary of all material
terms and conditions thereof, if it is not in writing. SQA will promptly
notify Rational after receipt of any Takeover Proposal or any notice that any
person is considering making a Takeover Proposal or any request for non-public
information relating to SQA or any of its subsidiaries or for access to the
properties, books or records of SQA or any of its subsidiaries by any person
that has indicated to SQA that it may be considering making, or that has made,
a Takeover Proposal and will keep Rational fully informed of the status and
details of any such Takeover Proposal notice, request or any correspondence or
communications related thereto and shall provide Rational with a true and
complete copy of such Takeover Proposal notice or request or correspondence or
communications related thereto, if it is in writing, or a complete written
summary thereof, if it is not in writing.
"Takeover Proposal," as used throughout this "Terms of the Merger" section,
means any offer or proposal for, or any indication of interest in, a merger or
other business combination involving SQA or the acquisition of 20% or more of
the outstanding shares of capital stock of SQA, or the sale or transfer of any
material assets (excluding the sale or disposition of assets in the ordinary
course of business) of SQA, other than, (i) the transactions contemplated by
the Agreement and (ii) transactions by persons disclosing their beneficial
ownership of shares of SQA's Common Stock on Schedule 13G under the Exchange
Act.
TERMINATION OF THE AGREEMENT
At any time prior to the Effective Time, whether before or after approval of
the matters presented in connection with the Merger by the stockholders of SQA
and by the stockholders of Rational, the Agreement may be terminated: (i) by
mutual written consent duly authorized by the Board of Directors of Rational
and SQA, (ii) by either Rational or SQA, if, without fault of the terminating
party, the Closing shall not have occurred on or before April 15, 1997
(provided, a later date may be agreed upon in writing by the parties hereto,
and provided further that the right to terminate the Agreement shall not be
available to any party whose action or failure to act has been the cause of or
resulted in the failure of the Merger to occur on or before such date and such
action or failure to act constitutes a breach of the Agreement), (iii) by
Rational, (1) upon a breach of any representation, warranty, covenant or
agreement on the part of SQA set forth in the Agreement, or if any
representation or warranty of SQA shall have become untrue, provided that if
such inaccuracy in SQA's representations and warranties or breach by SQA is
curable by SQA through the exercise of its commercially reasonable efforts
within ten business days of receipt by SQA of written notice thereof, Rational
may not terminate the Agreement during such ten business day period, so long
as SQA continues to exercise such commercially reasonable efforts; (2) if the
Board of Directors of SQA shall have withdrawn or modified its recommendation
of the Agreement or the Merger in a manner adverse to Rational or shall have
resolved to do any of the foregoing; or (3) for any reason SQA fails to call
and hold the SQA Stockholders Meeting by April 15, 1997 and SQA is at that
time in
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<PAGE>
willful breach of the Agreement, provided that the rights to terminate the
Agreement described in this subsection (iii) by Rational shall not be
available to Rational where Rational is at that time in willful breach of the
Agreement, (iv) by SQA (1) upon a breach of any representation, warranty,
covenant or agreement on the part of Rational set forth in the Agreement, or
if any representation or warranty of Rational shall have become untrue,
provided that if such inaccuracy in Rational's representations and warranties
or breach by Rational is curable by Rational through the exercise of its
commercially reasonable efforts within ten business days of receipt by
Rational of written notice thereof, SQA may not terminate the Agreement during
such ten business day period, so long as Rational continues to exercise such
commercially reasonable efforts; (2) if the Board of Directors of Rational
shall have withdrawn or modified its recommendation of the Agreement or the
Merger in a manner adverse to SQA or shall have resolved to do any of the
foregoing; or (3) for any reason Rational fails to call and hold the Rational
Stockholders Meeting by April 15, 1997 and Rational is at that time in willful
breach of the Agreement, provided that the rights to terminate the Agreement
by SQA described in this subsection (iv) shall not be available to SQA where
SQA is at that time in willful breach of the Agreement; (v) by SQA if a
Trigger Event (as defined below) or Takeover Proposal shall have occurred and
the Board of Directors of SQA in connection therewith, after consultation with
its legal counsel, withdraws or modifies its approval and recommendation of
the Agreement and the transactions contemplated hereby after, in the case of
the termination by SQA, determining that to cause SQA to proceed with the
transactions contemplated hereby would not be consistent with the Board of
Directors' fiduciary duty to the stockholders of SQA, (vi) by Rational, if
following a Trigger Event or Takeover Proposal, the Board of Directors of SQA
shall withdraw or modify its recommendation of the Agreement and the
transactions contemplated thereby, (vii) by either Rational or SQA, if there
shall have occurred any material adverse effect with respect to the other
party since the date of the Agreement, (viii) by either Rational or SQA if (1)
any permanent injunction or other order of a court or other competent
authority preventing the consummation of the Merger shall have become final
and nonappealable or (2) any required approval of the stockholders of SQA or
the stockholders of Rational shall not have been obtained by reason of the
failure to obtain the required vote upon a vote held at a duly held meeting of
stockholders or at any adjournment thereof, or (ix) by SQA, in the event (1)
of the acquisition (except in certain transactions), by any person or group of
persons of beneficial ownership of 30% or more of the outstanding shares of
Rational Common Stock; (2) the Board of Directors of Rational accepts or
publicly recommends acceptance of an offer from a third party to acquire 50%
or more of the outstanding shares of Rational Common Stock or of Rational's
consolidated assets; or (3) Rational acquires or agrees to acquire by merging
or consolidating with, or by purchasing a substantial portion of the assets
of, or by any other manner, any business or any corporation, partnership,
association or other business organization or division thereof and such
acquisition requires the approval of the stockholders of Rational in
accordance with Delaware Law or the NASD Rules.
A "Trigger Event", as used throughout this "Terms of the Merger" section,
shall occur if any Person (other than a person disclosing its beneficial
ownership of shares of SQA's Common Stock on Schedule 13G under the Exchange
Act) acquires securities representing 20% or more, or commences a tender or
exchange offer following the successful consummation of which the offeror and
its affiliate would beneficially own securities representing 20% or more, of
the voting power of SQA.
BREAK UP FEES; EXPENSES
Whether or not the Merger is consummated, all costs and expenses incurred in
connection with the Agreement and the transactions contemplated thereby shall
be paid by the party incurring such expense, except (i) expenses incurred in
connection with the proxy materials and the registration statement and
expenses associated with compliance with applicable state securities laws in
connection with the Merger shall be shared equally by SQA and Rational and
(ii) as set forth below.
If (w) SQA terminates the Agreement pursuant to subsection (v) of the
previous section (captioned "Termination of the Agreement"), (x) Rational
terminates the Agreement pursuant to subsection (vi) of the previous section,
(y) either party terminates the Agreement pursuant to Subsection (viii)(2) of
the previous section and prior to SQA's stockholders meeting there has
occurred a Takeover Proposal or a Trigger Event, or
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(z) Rational terminates the Agreement pursuant to Subsection (iii)(3) of the
preceding section and there has been a Trigger Event or a Takeover Proposal,
then SQA must pay Rational up to $1,000,000 of out-of-pocket costs and
expenses incurred by Rational in connection with the Agreement and the
transactions contemplated thereby and in addition SQA must pay to Rational the
sum of $6,000,000 (such additional payment is the "SQA Break-Up Fee").
Otherwise, if SQA terminates the Agreement pursuant to subsection (iii) or
(vii)(2) of the preceding section, then SQA must reimburse Rational up to
$1,000,000 of out-of-pocket costs and expenses incurred by Rational in
connection with the Agreement and the transactions contemplated thereby.
If SQA terminates the Agreement pursuant to subsection (iv)(2), (iv)(3) or
(viii)(2) of the preceding section, then Rational must reimburse SQA up to
$1,000,000 of out-of-pocket costs and expenses incurred by SQA in connection
with the Agreement and the transactions contemplated thereby, and in addition
Rational must pay to SQA the sum of $20,000,000. If SQA terminates the
Agreement pursuant to subsection (iv)(2) of the preceding section, Rational
must reimburse SQA up to $1,000,000 of out-of-pocket costs and expenses
incurred by SQA in connection with the Agreement and the transactions
contemplated thereby.
STOCK OPTION AGREEMENT
The following discussion summarizes the terms of the Stock Option Agreement
(as defined below). The following is not, however, a complete statement of all
provisions of that agreement and the discussion herein is qualified in its
entirety by reference to the more detailed information set forth in that
agreement, attached to this Prospectus/Joint Proxy Statement as Annex B.
As an inducement to Rational to enter into the Agreement, SQA entered into a
Stock Option Agreement with Rational dated November 12, 1996 (the "Stock
Option Agreement") pursuant to which SQA granted Rational the right (the
"Stock Option"), under certain conditions, to purchase up to 1,213,296 shares
of SQA Common Stock by paying the cash price of $35.26 per share.
Subject to certain conditions, the Stock Option may be exercised in whole
but not in part, at any time, (i) upon the termination of the Agreement if any
of the events that require the payment of the SQA Break-Up have occurred, or
(ii) upon termination of the Agreement by Rational due to SQA's failure to
hold a Stockholder's Meeting by April 15, 1997 if, in such event, (1) prior to
such event, there shall have been a Trigger Event or Takeover Proposal or (2)
within 180 days after such event, there shall be a Trigger Event or a Takeover
Proposal (any of such events described in clause (i) or (ii) being referred to
herein as an "Exercise Event"). The Stock Option terminates upon the earliest
to occur of (i) the Effective Time, (ii) 180 days following the termination of
the Agreement, if an Exercise Event shall have occurred on or prior to the
date of such termination (or, if later, ten days following the event described
in clause (ii)(2) above), and (iii) the date on which the Agreement is
terminated if an Exercise Event shall not have occurred on or prior to such
date; provided, however, with respect to the preceding clause (ii) of this
sentence, that if, at the expiration of the period specified therein, the
Stock Option cannot be exercised by reason of any applicable judgment, decree,
order, laws or regulation, or because the waiting period related to the
issuance of the shares subject to the Stock Option under the Hart-Scott-Rodino
Antitrust Improvements Act of 1976, as amended (the "HSR Act"), if applicable,
shall not have expired or been terminated, then the Stock Option shall not
terminate until the tenth business day after such impediment to exercise shall
have been removed or shall have become final and not subject to appeal.
Notwithstanding the foregoing, the Stock Option may not be exercised if
Rational is in breach of any of its covenants or agreements contained in the
Agreement, or more than one year after the Exercise Event.
CONDITIONS TO THE MERGER
The respective obligations of each party to the Agreement to effect the
Merger shall be subject to the satisfaction at or prior to the Effective Time
of each of the following conditions any of which may be waived in writing: (i)
the Agreement and the Merger shall have been approved and adopted by the
requisite vote of the stockholders of SQA and the stockholders of Rational
under the DGCL and under the NASD Rules, (ii) the SEC shall have declared the
registration statement effective, and no stop order suspending the
effectiveness of the
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registration statement or any part thereof shall have been issued and no
proceeding for that purpose, and no similar proceeding in respect of the Proxy
Statement, shall have been initiated or threatened to either party by the SEC,
(iii) no temporary restraining order, preliminary or permanent injunction or
other order issued by any court of competent jurisdiction or other legal or
regulatory restraint or prohibition preventing the consummation of the Merger
shall be in effect, nor shall any proceeding brought by an administrative
agency or commission or other governmental authority or instrumentality,
domestic or foreign, seeking any of the foregoing be pending, nor shall there
be any action taken, or any statute, rule, regulation or order enacted,
entered, enforced or deemed applicable to the Merger, which makes the
consummation of the Merger illegal or prevents or prohibits the Merger, (iv)
all material authorizations, consents, orders or approvals of, or declarations
or filings with, or expiration of waiting periods imposed by, any governmental
entity necessary for the consummation of the transactions contemplated by the
Agreement shall have been filed, expired or been obtained, (v) Rational and
SQA shall have received substantially identical written opinions of Wilson
Sonsini Goodrich & Rosati, P.C., legal counsel to Rational, and Testa, Hurwitz
& Thibeault, LLP, legal counsel to SQA, respectively, in form and substance
reasonably satisfactory to them, to the effect that the Merger will constitute
a reorganization within the meaning of Section 368(a) of the Code, and such
opinions shall not have been withdrawn, (vi) the filing with the Nasdaq
National Market of a notification form for listing of additional shares with
respect to the shares of Rational Common Stock issuable upon conversion of the
SQA Common Stock in the Merger and upon exercise of the options under the SQA
Stock Option Plans assumed by Rational shall have been made, and (vii) each of
Rational and SQA shall have received a confirming letter from each of Ernst &
Young LLP, independent auditors, and Arthur Andersen LLP, independent
auditors, to the effect that the Merger will be accounted for as a pooling of
interests.
The obligations of SQA to consummate and effect the Merger shall be subject
to the satisfaction of each of the following conditions, any of which may be
waived, in writing, by SQA: (i) the representations and warranties of Rational
and Merger Sub contained in the Agreement shall be true and correct as of the
Effective Time, with the same force and effect as if made on and as of the
Effective Time, except for such inaccuracies as individually or in the
aggregate that would not have a material adverse effect on Rational, and SQA
shall have received a certificate to such effect signed on behalf of Rational
by the President and Chief Financial Officer of Rational, (ii) Rational and
Merger Sub shall have performed or complied in all material respects with all
covenants, obligations, conditions and agreements required by the Agreement to
be performed or complied with by them on or prior to the Effective Time and
SQA shall have received a certificate to such effect signed by the President
and Chief Financial Officer of Rational, (iii) SQA shall have received a legal
opinion from Wilson Sonsini Goodrich & Rosati, P.C., counsel to Rational, in a
form reasonably acceptable to SQA, (iv) no material adverse effect with
respect to Rational shall have occurred since the date of the Agreement, (v)
SQA shall have been furnished with evidence satisfactory to it of the consent
or approval of those persons whose consent or approval are required in
connection with the Merger under any material contract of Rational or any of
its subsidiaries or otherwise, except where the failure to obtain such consent
or approval would not have a material adverse effect on Rational, (vi) no
temporary restraining order, preliminary or permanent injunction or other
order issued by any court of competent jurisdiction or other legal or
regulatory restraint provision limiting or restricting Rational's business
following the Merger shall be in effect, nor shall any proceeding brought by
an administrative agency or commission or other governmental entity, domestic
or foreign, seeking the foregoing be pending except where the existence of any
of the foregoing items would not have a material adverse effect on Rational,
and (vii) Ronald Nordin shall have been appointed to the Board of Directors of
Rational, contingent upon the consummation of the Merger.
The obligations of Rational and Merger Sub to consummate and effect the
Merger shall be subject to the satisfaction at or prior to the Effective Time
of each of the following conditions, any of which may be waived, in writing,
by Rational: (i) the representations and warranties of SQA contained in the
Agreement shall be true and correct as of the Effective Time, with the same
force and effect as if made on and as of the Effective Time, except, for such
inaccuracies as individually or in the aggregate that would not have a
material adverse effect on SQA and Rational and Merger Sub shall have received
a certificate to such effect signed on behalf of SQA by the President and
Chief Financial Officer of SQA, (ii) SQA shall have performed or complied in
all material respects with all agreements, covenants, obligations and
conditions required by the Agreement to be performed
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or complied with by it on or prior to the Effective Time, and Rational and
Merger Sub shall have received a certificate to such effect signed by the
President and Chief Financial Officer of SQA, (iii) Rational shall have
received a legal opinion from Testa, Hurwitz & Thibeault, LLP, legal counsel
to SQA, in a form reasonably acceptable to Rational, (iv) Rational shall have
been furnished with evidence satisfactory to it of the consent or approval of
those persons whose consent or approval shall be required in connection with
the Merger under any material contract of SQA or any of its subsidiaries or
otherwise, except where the failure to obtain such consent or approval would
not have a material adverse effect on SQA, (v) no temporary restraining order,
preliminary or permanent injunction or other order issued by any court of
competent jurisdiction or other legal or regulatory restraint provision
limiting or restricting Rational's conduct or operation of the business of SQA
and its subsidiaries, following the Merger shall be in effect, nor shall any
proceeding brought by an administrative agency or commission or other
governmental entity, domestic or foreign, seeking the foregoing be pending,
except where the existence of any of the foregoing items would not have a
material adverse effect on SQA, (vi) no material adverse effect with respect
to SQA shall have occurred since the date of the Agreement, and (vii) Rational
shall have received from each of the affiliates of SQA an executed affiliate
agreement in a form reasonably acceptable to Rational.
PARTICIPATION AGREEMENT
Each of the members of the SQA Board (including Ronald H. Nordin, Edward T.
Anderson, Thomas Csathy, Ted R. Dintersmith, Jerald G. Fishman and Paul A.
Maeder); Thomas F. Bogan, SQA's Senior Vice President, Finance and
Administration, Treasurer and Assistant Secretary; Frederick J. Ciaramaglia,
SQA's Vice President, Research and Development; James P. Cluchey, SQA's Vice
President, Managing Director of European Operations; William T. Dedrick, SQA's
Vice President, U.S. Sales; Roger A. Hodskins, SQA's Vice President,
Enterprise Partners; Eric L. Schurr, SQA's Vice President, Product Management
and Marketing; David J. Orfao, SQA's Senior Vice President, Worldwide Sales
and Support; Debra S. Turnove, SQA's Vice President, Human Resources; Highland
Capital Partners II, Limited Partnership; Aegis Select Limited Partnership;
Aegis II Limited Partnership; and North Bridge Venture Partners, L.P. (who own
an aggregate of 1,414,709 shares of SQA Common Stock and options exercisable
within 60 days of the SQA Record Date to purchase shares of SQA Common
Stock, representing approximately % of the votes entitled to be cast by
holders of shares of SQA Common Stock issued and outstanding as of the SQA
Record Date and % of such votes assuming the exercise of all options held
by such persons) has entered into a Participation Agreement with Rational.
Pursuant to the Participation Agreement, which is irrevocable, each of the
foregoing SQA stockholders has agreed to vote in favor of the Merger and
against approval of any proposal made in opposition or competition with
consummation of the Merger.
AFFILIATE AGREEMENTS
Each of the members of the Board of Directors of SQA, certain officers of
SQA and certain other stockholders of SQA have entered into agreements
restricting sales, dispositions or other transactions reducing their risk of
investment in respect of the shares of SQA Common Stock held by them prior to
the Merger or acquired by them after entering into such agreements as well as
the shares of Rational Common Stock received by them in the Merger so as to
comply with the requirements of applicable federal securities law and to help
ensure that the Merger will be treated as a pooling of interests for
accounting and financial reporting purposes.
INTERESTS OF CERTAIN PERSONS
SQA Options
Pursuant to an offer letter dated July 7, 1992 to Ronald H. Nordin, SQA's
President, Chief Executive Officer and Director, 100% of Mr. Nordin's unvested
stock options will become fully vested upon a merger or acquisition of SQA.
Mr. Nordin currently holds options for 237,019 shares of SQA Common Stock, of
which options to purchase 144,146 shares were unvested as of November 11,
1996.
Pursuant to an offer letter dated November 8, 1995 to David J. Orfao, SQA's
Senior Vice President, Worldwide Sales and Support, 50% of Mr. Orfao's
unvested stock options will become fully vested upon his
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termination without cause within six months after a change of control of SQA
or if he is not offered a comparable position with SQA or its successor upon a
change of control of SQA. Mr. Orfao currently holds options for 100,000 shares
of SQA Common Stock, of which options to purchase 80,000 shares were unvested
as of November 12, 1996.
Pursuant to an offer letter dated July 3, 1996 to Thomas F. Bogan, SQA's
Senior Vice President, Finance & Administration, Chief Financial Officer,
Treasurer and Assistant Secretary, 50% of Mr. Bogan's unvested stock options
will become fully vested upon his termination without cause within six months
after a change of control of SQA or if he is not offered a comparable position
with SQA or its successor upon a change of control of SQA. Mr. Bogan currently
holds options for 100,000 shares of SQA Common Stock, of which options to
purchase 100,000 shares were unvested as of November 11, 1996.
Employment Agreements
Prior to the Effective Time, Rational shall enter into an Employment
Agreement with each of Ronald H. Nordin, Eric Schurr and Fred Ciaramaglia,
providing for, among other things, if any of the foregoing are terminated
without cause prior to the second anniversary of the Effective Time (the
"Second Anniversary Date") (i) a severance payment equal to the salary such
person would have received from the date of severance until the Second
Anniversary Date, (ii) immediate vesting of such stock options as would have
been vested at the Second Anniversary Date (unless such employee is entitled
to more favorable vesting under a pre-existing agreement with SQA, in which
case such employee would be entitled to the more favorable vesting
provisions), and (iii) a covenant not to compete with or solicit employees of
the Combined Company until the Second Anniversary Date.
Prior to the Effective Time, Rational shall enter into an Employment
Agreement with each of William Dedrick, James Cluchy, Rodger Hodskins, David
Orfao, Deb Turnove, and Thomas Bogan, providing that, among other things, if
any of the foregoing are terminated without cause prior to the first
anniversary of the Effective Time (the "First Anniversary Date"), such person
is entitled to (i) a severance payment equal to the salary such person would
have received from the date of severance until the "First Anniversary Date,"
(ii) immediate vesting of such stock options as would have been vested at the
First Anniversary Date (unless such employee is entitled to more favorable
vesting under a pre-existing agreement with SQA, in which case such employee
would be entitled to the more favorable vesting provisions), and (iii) a
covenant not to compete with or solicit employees of the Combined Company
until the First Anniversary Date.
Indemnification
After the Effective Time, Rational will, and will cause the Surviving
Corporation to, indemnify and hold harmless the present and former officers,
directors, employees and agents of SQA (the "Indemnified Parties") in respect
of acts or omissions occurring on or prior to the Effective Time to the extent
permitted by law and to the extent provided under SQA's Certificate of
Incorporation and Bylaws or any indemnification agreement with SQA officers
and directors to which SQA is a party, in each case in effect on the date
hereof; provided that such indemnification shall be subject to any limitation
imposed from time to time under applicable law. Without limitation of the
foregoing, in the event any such Indemnified Party is or becomes involved in
any capacity in any action, proceeding or investigation in connection with any
matter relating to the Agreement or the transactions contemplated thereby
occurring on or prior to the Effective Time, Rational shall, or shall cause
the Surviving Corporation to, pay as incurred such Indemnified Party's
reasonable legal and other expenses (including the cost of any investigation
and preparation) incurred in connection therewith.
Financial Advisory Fees
Daniel H. Case III, a director and stockholder of Rational, is the President
and Chief Executive Officer of Hambrecht & Quist. Hambrecht & Quist is
providing financial advisory services to Rational in connection with the
Merger. Hambrecht & Quist was paid an initial payment of $250,000 upon
delivery of its fairness opinion in connection with the Merger. Hambrecht &
Quist will be paid an additional $750,000 upon consummation of the Merger.
Hambrecht & Quist will also be reimbursed for reasonable out-of-pocket
expenses incurred in connection with its services.
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UNAUDITED PRO FORMA CONDENSED COMBINED FINANCIAL INFORMATION
The following unaudited pro forma condensed combined financial statements
assume a business combination between Rational and SQA accounted for on a
"pooling of interests" basis. The unaudited pro forma condensed combined
financial statements are based upon the respective historical financial
statements of Rational and SQA and should be read in conjunction with such
historical financial statements and the notes thereto, which are included
elsewhere in this Prospectus/Joint Proxy Statement. The unaudited pro forma
condensed combined balance sheet combines Rational's September 30, 1996
unaudited condensed consolidated balance sheet with SQA's September 30, 1996
unaudited condensed consolidated balance sheet. The unaudited pro forma
condensed combined statements of operations combine Rational's historical
condensed consolidated statements of operations for the fiscal years ended
March 31, 1994, 1995 and 1996 and the six months ended September 30, 1995 and
1996 with the fiscal years ended December 31, 1993, 1994 and 1995 and the six
months ended June 30, 1995 and 1996 of SQA, respectively.
The pro forma information is presented for illustrative purposes only and is
not necessarily indicative of the operating results or financial position that
would have occurred if the Merger had been consummated as presented in the
accompanying unaudited pro forma condensed combined financial information, nor
is it necessarily indicative of future operating results or financial
position.
These unaudited pro forma condensed combined financial statements should be
read in conjunction with the historical consolidated financial statements and
the related notes thereto of Rational and of SQA included elsewhere herein.
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UNAUDITED PRO FORMA CONDENSED COMBINED BALANCE SHEET
REFLECTING RATIONAL SOFTWARE CORPORATION
AFTER GIVING EFFECT TO THE MERGER
(IN THOUSANDS, EXCEPT FOR PER SHARE DATA)
<TABLE>
<CAPTION>
RATIONAL SQA
SEPTEMBER 30, SEPTEMBER 30, PRO FORMA PRO FORMA
1996 1996 ADJUSTMENTS COMBINED
------------- ------------- ----------- ---------
<S> <C> <C> <C> <C>
ASSETS
Cash and cash equivalents... $ 48,305 $40,382 $ 88,687
Short-term investments...... 6,763 -- 6,763
Accounts receivable, net.... 25,524 4,572 30,096
Prepaid expenses and other
assets..................... 2,366 909 3,275
-------- ------- --------
Total current assets...... 82,958 45,863 128,821
Property and equipment,
net........................ 6,338 3,307 9,645
Other assets, net........... 1,861 192 2,053
-------- ------- --------
Total assets................ $ 91,157 $49,362 $140,519
======== ======= ========
LIABILITIES AND
STOCKHOLDERS' EQUITY
Accounts payable............ $ 2,366 $ 1,307 $ 3,673
Accrued employee benefits... 6,866 -- 6,866
Other accrued expenses...... 5,415 1,808 7,223
Accrued merger and
restructuring expenses,
current portion............ 537 -- 9,000 9,537
Deferred revenue............ 10,810 2,679 13,489
Current portion of long-term
debt and lease
obligations................ 31 -- 31
-------- ------- ------- --------
Total current
liabilities.............. 26,025 5,794 9,000 40,819
Accrued rent................ 594 -- 594
Accrued merger and
restructuring expenses,
long-term.................. 1,062 -- 1,062
-------- ------- ------- --------
Total liabilities......... 27,681 5,794 9,000 42,475
Commitments and
contingencies
Stockholders' equity:
Common Stock.............. 348 80 (11) 417
Additional paid-in
capital.................. 117,583 46,102 11 163,696
Treasury stock............ (1,340) -- (1,340)
Accumulated deficit....... (52,999) (2,614) (9,000) (64,613)
Cumulative translation
adjustment............... (116) -- (116)
-------- ------- ------- --------
Total stockholders'
equity................. 63,476 43,568 (9,000) 98,044
-------- ------- ------- --------
Total liabilities and
stockholders' equity....... $ 91,157 $49,362 $ -- $140,519
======== ======= ======= ========
</TABLE>
See accompanying notes to unaudited pro forma condensed combined financial
statements.
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UNAUDITED PRO FORMA CONDENSED COMBINED INCOME STATEMENT
REFLECTING RATIONAL SOFTWARE CORPORATION
AFTER GIVING EFFECT TO THE MERGER
(IN THOUSANDS, EXCEPT FOR PER SHARE DATA)
<TABLE>
<CAPTION>
SIX-MONTH
YEAR ENDED MARCH 31, PRO FORMA
---------------------------- ----------------
1994 1995 1996 1995 1996
-------- -------- -------- ------- --------
<S> <C> <C> <C> <C> <C>
Net product revenue............ $ 43,194 $ 42,611 $ 64,743 $28,915 $ 41,701
Consulting and support
revenue....................... 28,804 34,738 39,209 17,729 24,326
-------- -------- -------- ------- --------
Total revenue.................. 71,998 77,349 103,952 46,644 66,027
Cost of product revenue........ 12,007 7,148 7,826 3,351 4,216
Cost of consulting and support
revenues...................... 13,758 18,875 20,823 9,591 12,003
-------- -------- -------- ------- --------
Total cost of revenue.......... 25,765 26,023 28,649 12,942 16,219
-------- -------- -------- ------- --------
Gross margin................... 46,233 51,326 75,303 33,702 49,808
Research and development
expenses.................... 20,971 13,914 18,305 7,633 10,692
Sales and marketing
expenses.................... 22,949 28,454 41,000 18,824 22,307
General and administrative
expenses.................... 7,778 7,892 11,690 4,743 6,135
Charges for acquired in-
process research and
development................. -- -- 8,700 -- --
Merger and restructuring
casts....................... 9,922 (1,100) -- -- --
-------- -------- -------- ------- --------
Total operating expenses....... 61,620 49,160 79,695 31,200 39,134
-------- -------- -------- ------- --------
Operating income (loss)........ (15,387) 2,166 (4,392) 2,502 10,674
Other income, net(1)........... 123 496 1,830 711 2,070
-------- -------- -------- ------- --------
Income (loss) before income
taxes......................... (15,264) 2,662 (2,562) 3,213 12,744
Provision for income taxes..... 404 406 1,028 292 1,779
-------- -------- -------- ------- --------
Net income (loss).............. (15,668) $ 2,256 $ (3,590) $ 2,921 $ 10,965
======== ======== ======== ======= ========
Net income (loss) per share.... $ -- $ .08 $ (.10) $ .08 $ .25
======== ======== ======== ======= ========
Equivalent Shares used in
computing net income (loss)
per share..................... -- 29,745 35,938 35,895 44,510
======== ======== ======== ======= ========
</TABLE>
- --------
(1) Includes $175,000 of loss on disposal of business in fiscal 1994.
See accompanying notes to unaudited pro forma condensed combined financial
statements.
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NOTES TO UNAUDITED PRO FORMA CONDENSED COMBINED
FINANCIAL STATEMENTS
1. The pro forma condensed combined financial statements reflect the issuance
of up to 7,000,000 shares of Rational Common Stock for all of the
outstanding shares of SQA Common Stock in connection with the Merger based
on an exchange rate of 0.86 shares of Rational Common Stock for each
outstanding share of SQA Common Stock.
2. There were no material transactions between Rational and SQA during any
period presented. In addition, it is currently expected that the impact of
any conforming accounting policies will not be material.
3. The Combined Company expects to incur charges to operations currently
estimated to be between $8.0 million and $10.0 million, primarily in the
quarter in which the Merger is consummated, to reflect direct transaction
fees and costs incident to the Merger of $3 million, and additional
anticipated costs of $5.0 million to $7.0 million 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. An
estimated charge, at the midpoint of the above range, of $9.0 million is
reflected in the pro forma condensed combined balance sheet as a reduction
to retained earnings and an increase to accrued liabilities. The estimated
charge is not reflected in the pro forma condensed combined statement of
operations data. The amount of this charge is a preliminary estimate and
therefore is subject to change.
4. For the three months ended September 30, 1996, SQA reported net income of
$1.3 million ($0.15 per share) on total revenues of $6.8 million compared
to net income $0.3 million ($.05 per share) on total revenues $3.4 million
for the comparable 1995 quarter.
5. The pro forma condensed combined financial statements do not reflect that,
in October 1996, Rational sold 5,188,094 shares of Common Stock with
proceeds to Rational of approximately $186,000,000, net of underwriting
discounts and related expenses. On a pro forma basis, assuming the offering
closed on September 30, 1996, pro forma combined total stockholders' equity
would be $284,044,000.
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RATIONAL BUSINESS
The following is a general discussion of the business of Rational and does
not specifically contemplate the integration of SQA's business with
Rational's. For a discussion of SQA's business, see "SQA Business." For a
discussion of the anticipated effects of the proposed Merger, see "Risk
Factors--Risks Related to the Merger," "--Risks Related to Rational and SQA,"
"--Risks Related to Rational," "--Risks Related to SQA," "Approval of the
Merger and Related Transactions--Joint Reasons for the Merger," "--Rational's
Reasons for the Merger," "--SQA's Reasons for the Merger," "Terms of the
Merger--Conduct of the Combined Company Following the Merger," "--Conduct of
Rational's and SQA's Business Prior to the Merger."
Rational develops, markets and supports a comprehensive solution for the
component-based development of software systems. Rational's objective is to
ensure the success of customers in developing and managing software systems
that are strategically important to their businesses. Rational provides an
integrated family of tools that spans the critical phases of the software
development process from initial analysis and design through delivery and
maintenance. In addition, Rational provides technical consulting, training and
support services. By supporting controlled iterative development, visual
modeling and an architecture-driven process, Rational's products and services
enable customers to reduce the risk of project failure, improve the quality of
the software systems they develop, increase developer productivity, reduce
time-to-market and increase software reusability.
INDUSTRY BACKGROUND
Traditional software development techniques have not kept pace with advances
in computer processor technology, with the development of new platforms such
as the Internet or company-specific intranets, or with the general demand for
distributed software systems such as multi-tiered client/server applications.
Software, therefore, has increasingly become the constraint on performance,
quality, and time-to-market for many organizations. The ability to quickly and
cost-effectively create complex software applications that perform as desired
and that are easy to maintain and reuse in related applications and products
can be a critical competitive differentiator. As the number and complexity of
software applications continues to expand, it is becoming increasingly
important for businesses to migrate to a more effective approach to software
development.
The Growth of Software Systems
Software permeates products and processes encountered in almost every aspect
of daily life. Many companies base their businesses on enterprise-wide
information systems which are increasingly built as distributed systems
exploiting a company-specific intranet or the Internet. Software is at the
core of business applications ranging from equity-trading systems to inventory
management. The telecommunications business is highly dependent on software in
areas as diverse as call routing, switching, rate setting and billing.
Software is the central element of command-and-control systems in submarines
and military aircraft. Software governs the operation of machines from
ordinary office copiers and cellular phones to life-saving medical devices. As
organizations seek competitive advantage by exploiting the ongoing
improvements in microprocessor technology and the emergence of new computing
platforms, software is becoming more pervasive and more sophisticated. The
success of businesses around the world depends increasingly on their ability
to construct and modify software systems that match their changing business
needs.
The Challenge of Developing Software Systems
As demand for software applications continues to grow, managers and
technical personnel face increasing difficulty controlling the complexity of
software, coordinating ever-expanding teams of developers, supporting
development and deployment on multiple hardware platforms and operating
systems, and delivering systems that meet the needs of the users on time and
on budget. Software development projects across a wide range of industries and
application types suffer from a high rate of failure, resulting in project
cancellation, substantial cost overruns or significant delays to market. An
enormous amount of time and energy is wasted by organizations building
software systems that fail or fall short of user expectations.
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As software development becomes more complex, traditional methods are
becoming increasingly inadequate to respond to the following challenges faced
by many developers:
Addressing hard-to-define and constantly changing customer
requirements. When a software system is first specified, the specification
is often incomplete, ambiguous, or contradictory and evolves while the
system is being built.
Coordinating teams of developers. Team members, who often are
geographically distributed, must work in parallel on different elements of
an overall system without interfering with one another's work. As the size
of the development team increases, difficulties in communication and
coordination among team members typically increase at an even greater rate.
Reusing software on a large scale. The ability to reuse software
components on a large scale to enhance existing products and build
additional products offers organizations the opportunity to further
leverage their investments in software development and decrease the cost
and time-to-market of new products.
Adhering to stringent reliability and certification standards. Customers
often require that software systems meet stringent performance and
reliability specifications. In addition, software developers are often
required to formalize, document and improve their software development
processes in order to gain market entry to industries regulated by the
Federal Aviation Administration, the Department of Defense, the Food and
Drug Administration or other certifying bodies that review the software
components of regulated products.
Developing and deploying new software in combination with existing
software on multiple platforms and operating systems. Software developers
creating different elements of the same project often work on different
hardware platforms and operating systems, such as in the development of
client/server systems. Furthermore, purchasers of software developed for
one platform or operating system often require the ability to deploy the
software on new platforms or operating systems. In addition, developers are
often required to incorporate elements of existing software systems into
new projects.
Organizations have tried, often without success, to address these challenges
with a variety of development products and processes. Typical approaches have
included structured analysis and design, the use of numerous stand-alone tools
from various vendors to address various aspects of programming, the use of
CASE (Computer- Aided Software Engineering) tools to automate portions of the
software development process, and numerous management approaches such as
design review and code "walk-throughs." However, none of these solutions
offered a fully integrated approach. For example, traditional CASE tools
required users to adopt methods that were difficult to use and that did not
track the typical software development process.
Many large organizations have responded to the absence of a satisfactory
commercial solution by attempting to create ad hoc software development tools
and processes in-house. However, because such organizations typically are not
in the primary business of creating software development tools, such in-house
efforts frequently are hampered by a lack of understanding of the complexity
involved, a lack of relevant expertise within the organization, and limits on
the amount of resources available for efforts that will benefit only a single
product line or organization.
Commercial and in-house efforts often are further hampered by their reliance
on traditional sequential development methods. In applying these methods, the
analysis, design, coding, unit testing, software integration and delivery
phases of a software development project take place sequentially. The end
product is not delivered until the very end of the process, often months or
years later. Traditional sequential methods are poorly suited to responding to
specifications that evolve during the development process. They also involve a
high degree of risk that flaws in the system will not be discovered until the
end of the development process, requiring significant, and often unplanned,
time, effort and expense to produce a working product.
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The Emergence of Component-Based Development
Component-based development is a way of constructing software systems by
combining and integrating pre-engineered and pre-tested software components.
Component-based development has emerged as a powerful technique to simplify
the construction of software systems and to improve their quality. Software
components can be designed, developed, and tested once, and then combined
multiple times by other users to create new software systems in a manner
analogous to combining hardware integrated circuits to create a new electronic
device. By increasing software re-use, this approach reduces the amount of
source code that must be created in connection with the development of a new
software system, helping to reduce risk, time-to-market and cost, as well as
to improve the quality of the resulting software.
Rudimentary forms of software components have been used for several decades,
starting with the use of subroutines in the first programming languages. The
increasing adoption of object-oriented development during the 1990s has
fostered a higher level of software component use. In object-oriented
programming, "objects" are used as building blocks to model real-world
processes. Each object is a collection of data and code that performs
operations on that data. Details of how the object is implemented are
"encapsulated," or hidden, from all but the developer of the object, thus
enabling the developer or team responsible for the object to modify it without
impacting the work of other developers. Reducing or eliminating unnecessary
interdependencies among objects enables the efficient re-use of objects on a
modular basis.
Component-based development builds on the foundation provided by object-
oriented programming, using components with more functionality to provide a
higher level of abstraction with greater capability. Often, a complete program
will serve as a component in a larger system. By raising the level of
abstraction and re-use of components, component-based development offers
higher leverage and return on investment than previous techniques.
The growing interest in and increasing usage of component-based development
are driven by several major industry trends that emphasize the development of
separate but complete programs that work together as part of a larger system.
These include the growth of the Internet, company-specific intranets, and
distributed multi-tier client/server systems. Component-based development is
also driven by the widespread adoption of implementation languages such as
Visual Basic, Java(TM), and related technologies such as CORBA and Microsoft's
ActiveX, each of which provides mechanisms necessary for distributed
components to work together.
Major software vendors including Microsoft, Oracle, Hewlett-Packard, Sun
Microsystems and Netscape Communications have begun to use internally, and
some have publicly endorsed, component-based development. For example, Java
applets are separate, self-contained, pre-existing programs (components) that
can be automatically downloaded from an Internet site and run on a user's
system. In addition, Rational believes that Microsoft's strategy for
supporting customers that are building enterprise information systems is based
on component-based development. Much of Microsoft's technology infrastructure
is aimed at providing ways of allowing complete programs to serve as software
components that can be integrated with other components.
THE RATIONAL APPROACH(TM)
Rational provides extensive support for component-based development through
each of the major phases of the software development lifecycle. The Rational
Approach consists of three elements: a flexible software development process,
a set of integrated products and technical consulting services. This approach
enables customers to reduce the risk of failure, improve the quality of the
software systems they develop, increase developer productivity, reduce time-
to-market and increase software reusability.
The first element of the Rational Approach, a flexible software development
process, includes several software development concepts:
Controlled iterative development: Reducing risk, cost and time-to-
market. Rational's tools support controlled iterative development, which
Rational believes is more economical and predictable than
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traditional sequential development, significantly reducing the risk and
cost of developing software. In controlled iterative development, the
objectives for a software system are specified and used to drive the
creation of a series of partial but increasingly functional systems. Risk
is reduced because each iteration provides an opportunity for developers to
identify problems in system functionality, performance and user interface,
and to obtain user and customer feedback. The need for unplanned,
unbudgeted fixes can be significantly reduced or eliminated. Controlled
iterative development also provides a significant time-to- market
advantage. Because working iterations are available over much of the
project lifecycle, developers have the option of shipping a high-quality
system even before full functionality is implemented, if necessary to take
advantage of a market window, and to add functionality as new iterations
are completed.
Visual modeling: Managing complexity. Visual modeling is a technique in
which software components and the relationships among them are described
graphically. The model captures information about business processes or
software requirements, and the software components and architectures
necessary to implement them. The model raises the level of abstraction from
source code to a visual programming approach, which Rational believes is
more intuitive than non-graphical approaches for most software developers.
Visual modeling is an essential element of using component-based
development on a large scale.
Architectural approach: Enhancing quality and re-use. Rational's tools
help software developers build applications that have a sound architecture,
thereby maintaining the flexibility to make modifications or add new
modules. This, in turn, can increase reusability and thereby decrease time-
to-market for future products. Software architecture refers to the basic
structure and foundation of a software program. Designing a robust
architecture early in the development process, verifying the soundness of
the architecture with early development iterations, and enforcing the
integrity of the architecture over the lifetime of the project produce an
architecture that is adaptable in the face of changes driven by customer
feedback or changing business conditions. A well-designed architecture also
allows the developer to identify and package reusable software components.
Unless consistently enforced, system architecture can begin to break down
as the original architecture is violated or circumvented, either by
accident or in response to development time pressures.
The second element of the Rational Approach is a comprehensive set of
integrated software-development products that automate the activities of
software managers, designers and developers throughout the software lifecycle.
Rational's products include Rational Rose, Visual Test, Rational Apex,
Rational Summit and SoDA. Rational's products support visual modeling of the
basic business processes and objects necessary for implementing enterprise-
wide information systems and developing software components. Rational's
products further support the definition of software architecture, coding,
testing, debugging, software change management, software process enforcement
and documentation of components and entire software systems.
The third element of the Rational Approach is to provide customers with
technical consulting, training and support services. These services help
customers apply the elements of the flexible software development process and
use Rational's tools effectively. Rational's services are designed to minimize
customers' risks and maximize their ability to achieve their business
objectives.
RATIONAL'S BUSINESS STRATEGY
Rational's strategy is to ensure the success of its customers in developing
and managing software systems that are strategically important to their
businesses. Key components of Rational's strategy are to:
Maintain technology leadership. Rational offers a comprehensive family of
software products that enable component-based development throughout the
critical phases of the software development process. Rational has pioneered
the tight integration of individual tools to support controlled iterative
development and an architecture-driven process throughout the software
development lifecycle. Rational plans to continue enhancing its products
and integrating additional tools that strengthen and extend Rational's
support for component-based development.
Support the major platforms and implementation languages. Rational's
strategy is to offer products that support component-based development on
the major UNIX platforms, Windows 95, and Windows NT.
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Rational believes that in order to reach a wide market for its products it
is important to support the major implementation languages used for
software development. Rational currently supports Visual Basic, C++ and
PowerBuilder, and has announced plans to introduce products, currently in
beta testing, that support Java and Forte. Rational plans to adapt and
extend its technology to support additional implementation languages as
they become widely used.
Leverage the business alliance with Microsoft. On October 2, 1996,
Rational and Microsoft announced the formation of a business alliance that
will consist of four major elements: technology cross-licensing, joint
development, joint marketing and Rational's acquisition of Microsoft's
Visual Test product. Rational believes that the strategies of the two
companies in relation to the enterprise information systems market are
complementary, and the parties have announced that the alliance is intended
to allow Microsoft to focus on development environments like Visual Basic,
Visual C++ and Visual J++ and Rational to focus on lifecycle tools for
analysis and design, testing, documentation and change management. Rational
believes that this alliance will facilitate the integration of its products
with Microsoft's technology, leading to products that are more appealing to
software developers using Windows 95 and Windows NT. Further, Rational
believes that its alliance with Microsoft will enable the introduction of
Rational's products to software developers using Microsoft's products. See
"--Business Alliance with Microsoft."
Drive the industry standard for visual modeling. Rational believes that
its UML has become the de facto standard language for visual modeling of
business processes and for the development of software systems. Rational,
Microsoft, Oracle, Hewlett-Packard, MCI Systemhouse, Texas Instruments and
IntelliCorp have announced plans to submit a joint proposal for inclusion
of the UML in the OMG's Object Analysis and Design Facility specification.
Rational believes that the existence of an official standard will help
accelerate the rate of adoption of object technology by reducing the
uncertainty and confusion that stem from a lack of standards. Rational's
believes that it is well-positioned as the developer of the UML standard
and as a market leader in visual modeling tools. See "Risk Factors--Risks
Associated with Rational and SQA--Dependence Upon Growth of Emerging
Industries" and "--Risks Associated with Rational--Development of Industry
Standards."
Build comprehensive distribution capabilities. Rational intends to
continue leveraging its worldwide presence to provide tools to customers
whose businesses depend on developing and maintaining software systems.
Rational's direct sales force, supported by highly-skilled technical
personnel in the field, allows to work closely with its customers to help
ensure their success. In fiscal 1996, Rational's established new sales
channels, including telesales, service providers and VARs, which it intends
to expand. In addition, Rational plans to make extensive use of the
Internet for marketing, selling and customer support, with the objective of
reaching a larger potential market while reducing selling costs.
The discussion of Rational's strategy above contains forward-looking
statements that are based upon Rational's current intentions and that involve
risks and uncertainties. Actual results and future actions taken by Rational
could differ materially from those discussed in the forward-looking statements
as a result of certain factors, some of which are beyond Rational's control
and are dependent upon future market developments. See "Risk Factors--Risks
Associated with Rational and SQA--Dependence Upon Growth of Emerging
Industries," "--Expansion of Product Lines," "--Risks Associated with
Rational--Development of Industry Standards," "--Business Alliance with
Microsoft," and "--Dependence Upon Sales Force and Other Channels of
Distribution," as well as the other risks set forth in "Risk Factors" and
elsewhere in this Prospectus.
PRODUCTS AND SERVICES
Rational supports component-based development with an extensive family of
software products covering critical phases of the software development
lifecycle, from initial analysis of requirements through detailed design,
coding, testing, debugging and maintenance. Rational's products support
individual designers and developers, development teams and project managers.
The major components of Rational's product line are Rational Rose, for visual
modeling; Rational Apex, for managing development teams and the components
they generate; Rational Summit, for software change management and process
enforcement; SoDA, for automated
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documentation generation, and Visual Test, for automated software testing on
Windows 95 and Windows NT. These tools work together to support controlled
iterative development, visual modeling and an architecture-driven process in a
consistent manner.
Rational Rose: Visual Modeling Tools
Rational Rose is a software-engineering tool that allows users to develop,
verify and document the analysis and design model of their software
graphically. Rational Rose keeps the analysis and design model consistent
through the entire software lifecycle, making controlled iterative development
feasible. The first Rational Rose product was shipped in 1992. Rational Rose
is used in the construction of enterprise information systems, packaged
software products, systems integration activities, and for the construction of
technical systems in industries such as telecommunications, medical
instruments, transportation and aerospace. Over 20,000 licenses of Rational
Rose family products have been sold worldwide. Rational Rose has been the
recipient of industry product-excellence awards.
The Rational Rose product line supports major platforms, including UNIX,
Windows 95 and Windows NT, and implementation languages, including C++, Visual
Basic and Power Builder, that are widely used today. Rational has also
announced plans to introduce Rose/Java and Rose/Forte, which are currently in
beta testing. Rational Rose generally supports round-trip engineering, in
which the user can go from graphical design to generation of source code,
modify the resulting source code, reverse engineer the new source code to
generate a graphical depiction of the system as it exists after being
modified, and merge any changes made in the source code back into the model or
vice versa. By keeping the graphical analysis and design model consistent with
the source code, Rational Rose supports controlled iterative development over
the lifetime of the project. Rational believes that Rational Rose is unique in
its ability to support an unlimited number of "round-trips" with no loss of
information.
Rational Apex: Integrated Development Environment Tools
Rational Apex is a software-engineering environment for control of software
projects. It effectively controls large-scale development efforts, helping
customers improve time-to-market while reducing risk and cost. It also makes
large-scale software re-use possible by directly managing software
architecture, significantly improving the efficiency of the overall software
development process. The product was first shipped in 1993, replacing
Rational's first-generation programming environment, and over 7,500 licenses
have been sold to date. Rational Apex runs on UNIX platforms and is available
in versions that support the C/C++ and Ada programming languages. Rational has
announced that the next release of its Apex C/C++ product will provide
architectural control and build/release management for Java.
Rational Apex gives users architectural control, a way of expressing and
enforcing automatically the overall architecture of a software system
throughout the lifetime of the project, allowing users to replace manual
mechanisms of expressing and enforcing a software system's architecture. The
product provides a construct that enforces the boundaries of the architecture
automatically. It detects, reports and eliminates violations of the
architecture, preventing the decay or degradation of the architecture that can
occur over the lifetime of a project.
Rational Apex also provides extensive support for day-to-day configuration
management and version control. It supports parallel development within and
among development teams. It generates an audit trail of changes to the
software, capturing the specifics of every change made over the course of the
project. The building and releasing of each iteration of a software system is
automated, thereby providing the team and project management support that is
essential for controlled iterative development.
The Apex family also includes the VADS line of Ada compilers, debuggers, and
related tools for the development of highly-reliable, high-performance
embedded systems. VADS was first shipped in 1984 and over 7,000 licenses have
been shipped to date. The VADS family runs on major UNIX platforms, and the
VADS cross-compiler product family supports major embedded system targets
including the PowerPC, Motorola 680x0 and Intel architecture.
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Rational Summit: Software Change-Management Tools
Rational Summit is an integrated software change-management tool that helps
manage the overall software change process, including change identification,
change policy enforcement, and measurement and management of software
development progress. Rational Summit allows users to group a number of
related software changes into a task, which can then be explicitly managed.
These changes may collectively be necessary, for example, to fix a software
bug or to add a requested feature. Rational Summit can be customized and
configured to meet specific change-management needs of organizations.
Rational Summit is available on major UNIX platforms. Rational Summit was
first shipped in May 1996 and approximately 750 licenses have been sold.
Summit supports integration with the leading desktop project-management tools,
such as Microsoft Project and Microsoft Excel.
SoDA: Software Document Automation Tools
SoDA allows users to generate documentation automatically and incrementally
using graphical and textual information taken from many external sources. SoDA
also can be tailored to a variety of documentation formats and can be used on
projects regardless of the implementation language. SoDA is available on UNIX,
Windows 95 and Windows NT. SoDA was first shipped in June 1994, and over 1,500
licenses have been sold to date.
Visual Test: Software Testing Automation Tools
Visual Test, an automated, language-independent, software testing tool, is
designed to increase developers' and testers' productivity by rapidly creating
tests for applications of virtually any size and created in any implementation
language by capturing those tests for later re-use. These capabilities enhance
the ability of organizations to deploy applications for the Windows 95 and
Windows NT operating systems. Visual Test includes a Scenario Recorder used to
create test cases interactively, and may be used to test individual software
components or entire systems, including "stress tests" of large client/server
applications. Visual Test supports testing of the latest technologies, such as
ActiveX Controls, which helps developers to ensure the quality of their
applications while realizing the productivity benefits of component software.
Visual Test is integrated with Microsoft Developer Studio, a desktop
development environment.
Visual Test was first shipped by Microsoft in 1992. Microsoft has announced
the shipment of over 75,000 licenses since the product's introduction.
Rational acquired Visual Test on October 2, 1996 from Microsoft.
Technical Consulting and Customer Support Services
Rational views its technical consulting services as an important part of its
strategy of offering a complete, integrated solution for customers who are
developing complex software systems, as well as a way to promote higher-margin
product sales. Rational approaches the delivery of its technical consulting
services as a partnership with its customers. Customers often request
Rational's guidance to help them improve their approach to software
development, to realize the benefits of the Rational Approach and to
efficiently use Rational's products.
Rational's services include consulting and training that enable customers to
adopt advanced software processes and to use component-based development
effectively. Consulting services range from helping customers implement large-
scale software re-use, to working with customers to develop the right
architecture for their software systems, to helping a customer's development
team work through the first few iterations of the controlled iterative
development process. Rational also offers several standard consulting packages
and training courses that assist customers in the implementation of controlled
iterative development and the use of component-based development.
Rational complements its products and professional services with an
experienced team that allows it to maintain strong relationships with its
customers and further promote its products and services. Rational provides
telephone, electronic mail and fax-based customer support through Rational
Customer Support Services
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organization. Members of Rational's software support team typically have
several years experience in areas such as software engineering, software
testing, or tool development.
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. See "Risk Factors--Risks Associated with
Rational-- Business Alliance with Microsoft," "--Acquisition of the Visual
Test Product," "--Licensing of Rose Technology to Microsoft," and "Rational
Management's Discussion and Analysis of Financial Condition and Results of
Operations--Overview."
In connection with this alliance, Rational acquired from Microsoft the
Visual Test product, a leading software testing tool. Microsoft has announced
the shipment of over 75,000 licenses since the product's introduction in 1992.
Rational intends to release new versions of the Visual Test product that
extend its support for component-based development and Internet applications.
Microsoft has retained rights to continue using Visual Test in its own
software development, and the companies have agreed to work together to
specify and develop new product features and updated releases to exploit new
releases of Microsoft's operating system and tools products. Rational has also
granted Microsoft a five-year option to obtain a license to incorporate
certain elements of Visual Test technology in Microsoft's development tool
products, including Visual Basic, Visual C++ and Visual J++. See "--Products
and Services--Visual Test: Software Testing Automation Tools."
The cross-licensing element of the alliance includes a five-year license to
Rational to develop and distribute, as part of Rational's products,
Microsoft's Developer Studio, an integrated development environment for
Windows 95 and Windows NT. Rational plans to integrate its visual modeling
tools into Developer Studio. In addition, Rational has licensed the rights to
the future Microsoft repository, and Rational plans to integrate its products
with Visual Source Safe, Microsoft's version control system, introducing
capabilities for change management and process automation.
Rational has entered into a two-year agreement to develop a visual modeling
product, including certain elements of Rational Rose, for distribution in
certain Microsoft development tools which run on Windows 95 and Windows NT.
Rational will be obligated to provide timely product updates to maintain
compatibility with changes in Microsoft operating systems. Following
expiration of the agreement, Microsoft will have the option to obtain a
perpetual, non-exclusive right to source code for the product, including
certain aspects of Rational's Rose technology.
Rational's objective in acquiring the Visual Test product and partnering
with Microsoft is to extend Rational's product line and to increase the use of
component-based development by providing visual modeling capabilities to
developers using Microsoft's visual tools. In addition, Rational believes that
its arrangement with Microsoft will expose Rational's technology to potential
customers outside of its historical customer base. Rational expects that
changes in its pricing models and combinations of features within product
lines will be required to encourage these potential customers to purchase
Rational products. Rational's objective in entering into the cross-licensing
arrangements with Microsoft was not to generate direct product revenue from
Microsoft, and Rational does not expect such arrangements to directly result
in a material increase in product revenue.
Joint development efforts include Rational developers and testers working
with Microsoft personnel on site at Microsoft in Redmond, Washington, to
integrate Rational's products with the Microsoft infrastructure, including
DCOM, ActiveX, BackOffice and the Microsoft visual tool products. The joint
development efforts also include testing of Rational products in Microsoft's
Usability Labs.
Plans for joint-marketing activities include use of the Internet and the
World Wide Web, co-sponsored seminars, joint press conferences, direct mail
campaigns and other promotional activities.
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PRODUCT DEVELOPMENT
Rational believes that its success will depend largely upon its ability to
enhance existing products and develop new products that meet the needs of a
rapidly evolving marketplace and increasingly sophisticated and demanding
customers. Rational intends to extend and strengthen its lifecycle support for
component-based development by expanding its product offerings, introducing
new products, and offering higher levels of integration among its products.
Rational uses its own software processes and tools extensively in its own
software development activities. While Rational has primarily developed
products internally, it may, based on timing and cost considerations, acquire
technologies or products from third parties.
Rational's research and development staff, including product development,
product support and technical writing personnel consists of 127 employees as
of September 30, 1996. Rational's total research and development expenses were
approximately $20.2 million, $12.2 million and $15.9 million in fiscal years
1994, 1995, and 1996, respectively.
CUSTOMERS AND APPLICATIONS
Over 40,000 licenses of Rational's software products, exclusive of Visual
Test, have been sold to over 2,500 customers worldwide. No single customer
accounted for 10% or more of revenues in fiscal 1996. One customer, LM
Ericsson and related companies, accounted for approximately 10% of Rational's
revenues in the six months ended September 30, 1996. Rational's comprehensive
solution of software development tools and professional services is used by
major organizations in many industry segments to design, build and maintain
complex software systems.
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The following customers were among Rational's largest customers in fiscal
1996 and the first half of fiscal 1997 in the areas listed:
ENTERPRISE INFORMATION SYSTEMS FINANCIAL SERVICES
AT&T Aetna
Automobiles Peugeot American Express
Daimler-Benz Chase Manhattan Bank
Dow Chemical Deutsche Bank
Eastman Kodak Fidelity Investments
Knight-Ridder Liberty Mutual
MCI London Stock Exchange
NBC Merrill Lynch
Nynex MetLife
Osaka Gas Information Systems Morgan Guaranty
Reuters Nomura International
WorldCom Republic National Bank
Xerox Standard Life Assurance
Union Bank of Switzerland
TELECOMMUNICATIONS USF&G
USAA
Alcatel Zurich Cantonal Bank
Bell Sygma Telecom
British Telecom AEROSPACE/DEFENSE
Broadband Technologies
Deutsche Telekom Boeing
LM Ericsson Hughes
Lucent Technologies Lockheed Martin
Mitel Corporation Raytheon Company
Nortel Texas Instruments
Qualcomm TRW
Siemens
TRANSPORTATION
INDEPENDENT SOFTWARE VENDORS AND SYSTEMS
INTEGRATORS British Airways
GEC-Alsthom
Attachmate Honeywell
CSC Hughes Air Traffic Systems
Cognos, Inc. Rockwell-Collins
EDS
IBM
Microsoft
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SALES AND MARKETING
Rational primarily employs a direct selling approach which couples sales of
its integrated software tools with high-value technical consulting services.
Rational has established a major-account direct sales and technical consulting
organization in the United States, Canada, Europe, and in the
Asia/Pacific/Latin America region. Rational's major-account direct sales and
technical consulting organization is based on a team-selling model organized
around an Account Representative and an average of three Software Engineering
Specialists. Rational's Software Engineering Specialists provide pre- and
post-sales support, and are the primary delivery mechanism for Rational's
high-value technical consulting services. Rational believes that its major-
account sales and technical consulting organization is a powerful asset,
giving Rational the resources to form lasting relationships with its major
customers. See "Risk Factors--Risks Related to Rational--Dependence Upon Sales
Force and Other Channels of Distribution."
Rational's major-account direct sales and technical consulting organization
is focused on large customers that directly depend on their capability to
develop software. Rational believes that additional opportunities exist which
may be pursued by Rational's direct sales force in partnership with external
service providers and VARs. Rational also believes that it can exploit
additional revenue opportunities by developing channels such as telesales and
the use of the World Wide Web for direct marketing, sales and customer
support. Rational believes that the development of these additional channels
will allow it to reach a broader base of customers and maintain direct contact
with them at a lower cost than other sales efforts.
Rational's North American sales, marketing and professional service
organization consists of 329 individuals, operating out of corporate
headquarters in Santa Clara, California, field offices in other locations
throughout North America, the United Kingdom, France, Germany, Sweden,
Australia, Taiwan, India, South Korea and Brazil. Rational's direct
international operations are staffed almost exclusively by local personnel.
Rational also has distributors and resellers in North America and additional
distributors in Spain, Italy, Israel, Singapore, Korea, China, Japan and South
Africa.
Rational has established a partnership with Osaka Gas Information Systems
Research Institute ("OGIS-RI"), a subsidiary of Osaka Gas and a provider of
object-oriented programming expertise in the Japanese market. OGIS-RI has
localized certain of Rational's tools, including the Windows and UNIX versions
of Rational Rose/C++, for the Japanese market, along with training materials
on software process and object technology. OGIS-RI currently markets, sells
and offers an extensive range of technical consulting and training services to
support the Rational Rose product line in Japan.
In support of its sales efforts, Rational's marketing department conducts
comprehensive programs which include maintenance of an extensive home page on
the World Wide Web, an electronic subscription service for news announcements
about Rational, print advertising, direct mail, public relations, trade shows
and ongoing customer communications programs. Rational also keeps its
customers informed of advances in the field through a customer newsletter,
technical papers and other mailings.
PRODUCT PRICING
Rational's software licenses are normally perpetual, fully-paid-up floating
licenses. The floating license limits the number of simultaneous users in a
network instead of being associated with a specific user or computer. Rational
also offers other kinds of licenses, such as node-locked licenses that limit a
software license to a single computer and project licenses that provide
selected Rational tools to all the developers working on a specific project.
The bulk of Rational's net product revenue in fiscal 1996 was derived from
sales of its Rose and Apex product families. Elements of the Rose family range
in price from $495 for a single-user PC version of Rational Rose, to $2,400
for Rational Rose/Visual Basic on a PC, to $8,400 for a floating license of
Rational Rose/C++ on a UNIX workstation. Elements of the Apex family range in
price from $7,500 for an Apex C++ license on
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UNIX to $22,000 for an Apex Ada license on UNIX. Rational's products are often
sold in multiple quantities to teams of software developers working together
in a client/server environment. Rational offers standard discounts based on
dollar volume in a single purchase order.
Rational also offers a support program which entitles a licensee to receive
all enhancements and upgrades to the licensed product that are published in
the succeeding twelve month period, as well as certain other support services.
Annual fees for support generally range from 15% to 20% of the software
license fee.
Rational's packaged training courses are offered in the form of open-
enrollment public courses and in-house courses at customer facilities, and
range from $1,750 per person for a typical four-day course, to between $3,000
to $12,500 for in-house courses depending on the length of the course and the
maximum number of students in the class. Rational's packaged consulting
services range from approximately $50,000 to several hundred thousand dollars.
Currently, custom consulting is priced on a time-and-materials basis, although
Rational plans to bill more of its custom consulting on a project-by-project
basis in the future. Discounts are offered for engagements of 1,000, 2,000 and
6,000 hours of consulting in a calendar year.
COMPETITION
The marketplace for software engineering tools is intensely competitive.
Given the breadth of Rational's product lines, each product faces competition
from one or more sources. See "Risk Factors--Risks Related to Rational and
SQA--Competition."
Rational faces competition from software development tools and processes
developed internally by customers, including ad hoc integrations of numerous
stand-alone development tools. Rational believes that its solution is superior
to such in-house efforts, which are frequently hampered by a lack of
understanding of the complexity involved in software development, a lack of
relevant expertise within the organization, limits on the amount of resources
made available for efforts that will benefit only a single product line or
organization and a reliance on traditional sequential development methods.
Rational's faces competition from Intersolv, Inc., Platinum Technology,
Inc., Select Software Tools plc and numerous privately held tool suppliers
offering traditional CASE tools that compete with the Rational Rose approach
to visual modeling and component-based development. Rational's Visual Test
product faces competition from SQA, Inc., Mercury Interactive Corporation,
Segue Software, Inc. and several private companies offering testing automation
tools. Rational Apex for C/C++ faces competition from major UNIX platform
vendors such as Sun Microsystems Inc., Hewlett-Packard Company and Digital
Equipment Corporation, which have C/C++ compilers and debuggers and in some
cases programming environments for their platforms. In addition, numerous
privately held companies offer compilers, debuggers and programming
environments which compete with Rational Apex. The Rational Summit product
line faces competition from Pure Atria Corporation and other suppliers
offering change management systems. Rational's Apex Ada and VADS product lines
face competition from Thomson Software Products, Green Hills Software, Inc.
and a large number of other suppliers offering Ada products for native and
embedded systems.
Rational believes that the major competitive factors in its markets are
corporate and product reputation, breadth of coverage by an integrated product
line, product architecture, functionality and features, product quality,
performance, ease of use, quality of support, availability of technical
consulting services and price. Rational believes that its combination of an
integrated family of products supporting component-based development
throughout the software development lifecycle and its emphasis on controlled
iterative development, visual modeling and an architecture-driven process,
coupled with its extensive major-account direct sales and technical consulting
organization and the supporting channels such as VARs, telesales and the World
Wide Web, are effective selling tools.
Rational believes that the increased level of competition it observed in
fiscal 1996 and the first half of fiscal 1997 will continue to increase.
Because individual product sales are often the first step in a broader
customer
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relationship, Rational's success depends in part upon its ability to
successfully compete with numerous competitors at each point within its
product line. Certain of Rational's competitors are more experienced than
Rational in the development of software-engineering tools, databases or
software-development products. Rational encounters substantial competition
from in-house software tools developers for large organizations. Some of
Rational's competitors have, and new competitors may have, larger technical
staffs, more established distribution channels and greater financial resources
than Rational. There can be no assurance that either existing or new
competitors will not develop products that are superior to Rational's products
or that achieve greater market acceptance. Rational'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
have a material adverse effect on Rational's results of operations.
INTELLECTUAL PROPERTY
Rational regards its software as proprietary and attempts to protect it
under a combination of copyright, trademark and trade secret laws, employee
and third-party non-disclosure agreements and other methods of protection.
Despite these precautions, it may be possible for unauthorized third parties
to copy certain portions of Rational's products or to reverse engineer or
obtain and use information Rational regards as proprietary. While Rational's
competitive position may be affected by its ability to protect its proprietary
information, Rational believes that trademark and copyright protections are
less significant to Rational's success than other factors, such as trade
secret protection, the knowledge, ability and experience of Rational's
personnel, name recognition and ongoing product development and support.
Rational's software products are generally licensed to end users on a "right
to use" basis pursuant to a perpetual license. Rational 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 provisions of such licenses, including provisions
protecting against unauthorized use, copying, transfer and disclosure of the
licensed program, may be unenforceable under the laws of certain
jurisdictions. In addition, the laws of some foreign countries do not protect
Rational's proprietary rights to the same extent as do the laws of the United
States.
As the number of software products in the industry increases and the
functionality of these products further overlaps, Rational believes that
software programs will increasingly become subject to infringement claims.
There can be no assurance that third parties will not assert infringement
claims against Rational in the future with respect to current or future
products. Any such assertion could require Rational to enter into royalty
arrangements or result in costly litigation. See "Risk Factors--Risks Related
to Rational and SQA--Limited Protection of Intellectual Property and
Proprietary Rights."
EMPLOYEES
As of September 30, 1996, Rational employed 540 full-time personnel,
including 127 in product development, 329 in sales, marketing and technical
consulting and 84 in finance and administration. Rational's employees are not
represented by any collective bargaining organization, and Rational has never
experienced a work stoppage. Rational believes its success will depend in part
on its continued ability to attract and retain highly qualified personnel in a
competitive market for experienced and talented software engineers and sales
and marketing personnel. See "Risk Factors--Risks Related to Rational and
SQA--Dependence Upon Key Personnel."
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FACILITIES
Rational's headquarters are located in a leased facility, located in Santa
Clara, California, consisting of approximately 94,000 square feet of office
space occupied under a lease expiring in January 2001, with a renewal option
for an additional five years. Rational also leases approximately 16,300 square
feet of office space in Aloha, Oregon under a lease expiring in January 1999,
and approximately 22,900 square feet of office space in McLean, Virginia under
a lease expiring in February 2001. Rational leases additional facilities and
offices, including locations in Alabama, California, Connecticut, Florida,
Maryland, Massachusetts, New York, Ohio, Pennsylvania, Virginia, Washington,
Wisconsin, London, Melbourne, Munich, Paris, Sao Paolo, Seoul, Stockholm,
Taipei and Canada. Rational believes that its existing facilities and offices,
together with additional space available to it, are adequate to meet its
requirements for the foreseeable future.
LEGAL PROCEEDINGS
On December 1, 1995, Interactive Development Environments ("IDE") filed an
action against Rational in the San Francisco County Superior Court seeking
monetary damages in excess of $3 million and other relief for Rational'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 Rational'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 Rational was obligated to tell IDE of Rational's
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
January 1997, although the parties have signed a stipulation extending the
trial date to March 1997 and Rational anticipates the Court will so order.
Rational believes IDE's complaints are without merit and intends to defend the
case vigorously, although Rational makes no assurance that it will be
successful in defending the action. There are no other material pending legal
proceedings to which Rational is a party or to which any of Rational's
property is subject.
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RATIONAL MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following is Rational management's discussion and analysis of the
financial condition and results of operations of Rational and does not
specifically contemplate the integration of SQA's operations with Rational's.
For a discussion of SQA's financial condition and results of operations, see
"SQA Management's Discussion of Financial Condition and Results of
Operations." For a discussion of the anticipated effects of the proposed
Merger, see "Risk Factors--Risks Related to the Merger," "--Risks Related to
Rational and SQA," "--Risks Related to Rational," "--Risks Related to SQA,"
"Approval of the Merger and Related Transactions--Joint Reasons for the
Merger," "--Rational's Reasons for the Merger," "--SQA's Reasons for the
Merger," "Terms of the Merger--Conduct of the Combined Company Following the
Merger," "--Conduct of Rational's and SQA's Business Prior to the Merger."
The statements contained in Rational Management's Discussion and Analysis of
Financial Condition and Results of Operations include "forward-looking"
information within the meaning of Section 27A of the Securities Act of 1933
and Section 21E of the Securities Exchange Act of 1934, as amended, and are
subject to the safe harbor created by those sections. Rational's actual future
results could differ materially from those projected in the forward-looking
information. Some factors that could cause future actual results to differ
materially from Rational's recent results or those projected in the forward-
looking information are discussed elsewhere in this Prospectus/Joint Proxy
Statement. See "Risk Factors." Rational assumes no obligation to update the
forward-looking information or such factors.
OVERVIEW
Rational'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, Rational 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. Rational's license agreements generally do
not provide a right of return, and reserves are maintained for potential
credit losses, of which there have been only immaterial amounts.
Rational estimates that Rational and SQA will incur an aggregate of
approximately $3 million in direct transaction costs in connection with the
Merger contemplated by this Prospectus/Joint Proxy Statement, which will be
charged to operations upon consummation of the Merger. Rational expects to
incur an additional charge to operations of between $5 million and $7 million
primarily in the quarter ending March 31, 1997, the quarter in which the
Merger is expected to be consummated, 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 Rational's
quarter ending March 31, 1997, and are expected to contribute to an operating
loss and a net loss for Rational's 1997 fiscal year. See "Risk Factors--Risks
Related to the Merger--Costs of Integration; Transaction Expenses."
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, joint development projects
and joint-marketing programs. The purchase price of the Visual Test product
consisted of a single $23 million cash payment, which will be accounted for
using the purchase method. Rational's operating results for the quarter ending
December 31, 1996 will be reduced by charges and operating expenses associated
with the acquisition of the Visual Test product, including an expected charge
to operations for acquired in-process research and development of between $15
million and $19 million, as well as increased marketing expenditures related
to the promotion of the Visual Test product. Such charges and expenses will
result in a significant net loss for the quarter ending December 31, 1996, and
are expected to contribute to a net loss for fiscal 1997. 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
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had not yet reached the point of technological feasibility and does not have an
alternative future use. Rational plans to continue devoting effort to
developing commercially viable products from the acquired in-process research
and development. More specifically, Rational intends to exploit networked
computing resources to accelerate the testing process. 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. Rational's
objective in entering into the cross-licensing arrangements with Microsoft was
not to generate direct product revenue from Microsoft, and Rational does not
expect such arrangements to directly result in a material increase in product
revenue. See "Risk Factors--Risks Related to Rational--Business Alliance with
Microsoft," "--Acquisition of the Visual Test Product," "--Licensing of Rose
Technology to Microsoft," and "Rational Business--Business Alliance with
Microsoft."
On October 22, 1996, Rational effected a public offering of 5,188,094 shares
of its Common Stock, resulting in proceeds to Rational, net of underwriting
discounts and other related expenses, of approximately $186,000,000. Rational
will incur an expense of approximately $1,200,000 in the quarter ending
December 31, 1996 in connection with its contractual commitment to reimburse
certain of its stockholders for the underwriting discount applicable to the
684,631 shares of Common Stock sold by them in the October 1996 public
offering, as well as certain of such stockholders' other fees and expenses in
connection therewith. Such expenses will further increase Rational's expected
net loss for the quarter ending December 31, 1996, and will increase the
anticipated net loss for fiscal 1997.
In October 1995, Rational signed a definitive agreement to purchase all the
outstanding stock of Objectory AB, a Swedish software development company, in
exchange for 1,496,718 shares of Common Stock. The acquisition was accounted
for using the purchase method and, accordingly, the operating results of
Objectory AB are included in Rational's consolidated results from the date of
acquisition. In addition, in the third quarter of fiscal 1996, Rational
incurred approximately $14.5 million of one-time charges and operating expenses
primarily associated with Rational's acquisition of Objectory AB and the
subsequent restructuring and shaping of Rational's business, including an $8.7
million write-off of acquired in-process research and development costs in
connection with the Objectory AB acquisition. The in-process research and
development amount represents the present value of the estimated cash flow
expected to be generated by the Objectory AB 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 plans to continue devoting
effort to developing commercially viable products from the acquired in-process
research and development. Specifically, Rational intends to integrate the
Objectory technology with its existing technology. See Note 3 of Notes to
Consolidated Financial Statements.
On March 31, 1994, Rational Software Corporation, a publicly traded
corporation formerly known as Verdix Corporation, completed the merger with
Rational, a privately held corporation (old Rational), and changed its name to
Rational Software Corporation. The transaction was accounted for as a pooling-
of-interests business combination and involved the issuance of approximately
14.3 million additional shares of Common Stock. Merger-related expenses of $9.9
million were recorded in fiscal 1994 as a result of the closing of facilities,
severance costs, administrative costs and the write-off of capitalized software
costs related to overlapping product lines. Fiscal 1995 results reflected
expense reductions of $1.1 million relating to the reversal of fiscal 1994 rent
accrual adjustments associated with the closing of facilities. The remaining
facilities accrual is $1,706,000 at June 30, 1996. See Notes 3 and 5 of Notes
to Consolidated Financial Statements.
International sales accounted for 31%, 34%, 36% and 36% of Rational's
revenues in fiscal 1994, 1995, 1996, and the six months ended September 30,
1996, respectively, and Rational expects that international sales will continue
to account for a significant portion of Rational's revenues in future periods.
See "Risk Factors--Risks Related to Rational and SQA--Risks Associated with
International Operations."
In the fiscal year ended March 31, 1996 and the six month period ended
September 30, 1996, Rational's revenues from consulting and support grew at a
slower rate than revenues from product sales, contributing to increasing gross
margins. There can be no assurance that this trend will continue in future
periods. See "Risk Factors--Risks Related to Rational and SQA--Expansion of
Product Lines; Dependence on New Product Introductions" and "Risks Related to
Rational--Dependence Upon Sales Force and Other Channels of Distribution."
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Although Rational has experienced increasing revenues in each of the past
ten quarters, Rational's sales compensation structure has historically
contributed to 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 Rational will continue to experience increasing revenues or
that similar fluctuations will not occur again in the future. See "Risk
Factors--Risks Related to Rational and SQA--Fluctuations in Operating Results;
SQA History of Losses" and "--Expansion of Product Lines; Dependence Upon New
Product Introductions."
RESULTS OF OPERATIONS
The following table sets forth for the periods indicated the percentage of
total revenue represented by certain line items from Rational's Consolidated
Statements of Operations:
<TABLE>
<CAPTION>
SIX MONTHS
FISCAL YEAR ENDED
ENDED MARCH 31, SEPTEMBER 30,
---------------------- ---------------
1994 1995 1996 1995 1996
----- ----- ----- ------ ------
<S> <C> <C> <C> <C> <C>
Net product revenue................ 59 % 54% 61 % 64% 63%
Consulting and support revenue..... 41 46 39 36 37
----- ----- ----- ------ ------
Total revenue.................... 100 100 100 100 100
Cost of product revenue............ 17 9 8 9 7
Cost of consulting and support
revenue........................... 19 25 21 19 19
----- ----- ----- ------ ------
Total cost of revenue............ 36 34 29 28 26
----- ----- ----- ------ ------
Gross profit..................... 64 66 71 72 74
Operating expenses:
Research and development........... 29 17 17 15 16
Sales and marketing................ 30 34 38 39 31
General and administrative......... 10 10 11 10 9
Charges for acquired in-process
research and development.......... -- -- 10 -- --
Merger and restructuring costs..... 14 (1) -- -- --
----- ----- ----- ------ ------
Total operating expenses......... 83 60 76 64 56
----- ----- ----- ------ ------
Income (loss) from continuing
operations...................... (19) 6 (5) 8 18
Other income, net(1)............... -- 1 2 2 2
----- ----- ----- ------ ------
Income (loss) before provision for
income taxes...................... (19) 7 (3) 10 20
Provision.......................... 1 1 1 1 3
----- ----- ----- ------ ------
Net income (loss).................. (20)% 6% (4)% 9% 17%
===== ===== ===== ====== ======
</TABLE>
- --------
(1) Amount for 1994 includes a loss from discontinued operations of $175,000.
See Note 4 of Notes to Consolidated Financial Statements.
SIX MONTHS ENDED SEPTEMBER 30, 1996 AND 1995
Total revenue increased 35% for the six-month period ended September 30,
1996 from the comparable prior year period. Rational's revenue is derived from
product license fees and charges for services including training, consulting,
and customer support.
Net product revenue increased by 39% for the six-month period ended
September 30, 1996 from the comparable prior year period. The increase in net
product revenue was due in part to continued strong customer acceptance of
Rational's object modeling tools (the Rational Rose family), as well as the
introduction of new versions of the Rational's Apex product for C/C++
application construction.
Consulting and support revenue increased 30% in the fiscal 1997 six-month
period versus the same fiscal 1996 period. These increases reflected higher
demand for Rational's consulting expertise in object modeling and advanced
software development practices, and, to a lesser extent, increased training
and customer support revenues.
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Cost of product revenue consists principally of materials, packaging and
freight, and royalties. Cost of product revenue increased 25% for the six-
month period of fiscal 1997 compared to the corresponding period of fiscal
1996. These costs represented 11% of total product revenue for the six-month
period of fiscal 1997 compared to 12% for the corresponding period of fiscal
1996. The decrease in product cost as a percentage of product revenue was due
mainly to lower royalty expense resulting from a decrease in third party
product sales.
Cost of consulting and support revenue consists principally of personnel
costs for training, consulting and customer support. Cost of consulting and
support increased 22% for the six-month period of fiscal 1997 compared to the
corresponding period of fiscal 1996. These costs represented 52% of total
consulting and support revenue for the six-month period of fiscal 1997
compared to 55% for the corresponding period of fiscal 1996. The decrease in
cost as a percentage is primarily due to more efficient management of
Rational'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 increased 39% for the six-
month period of fiscal 1997 compared to the corresponding period of fiscal
1996. Research and development costs represented 16% of total revenue for the
six-month period of fiscal 1997 compared to 16% for the corresponding period
of fiscal 1996. This increase is attributable to the cost of additional
personnel and related costs incurred in maintaining existing products and
developing new product releases.
Sales and marketing expenses increased 11% for the six-month period of
fiscal 1997 compared to the corresponding period of fiscal 1996. These
expenses represented 32% of total revenue for the six-month period of fiscal
1997 compared to 39% for the corresponding period of fiscal 1996. The fiscal
1997 increase in sales and marketing expenses reflect the additional
personnel, commissions and related costs required in sales and marketing to
expand Rational's sales channels, penetrate new markets and increase its
market share in core markets.
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 33% for the six-month period of fiscal 1997
compared to the corresponding period of fiscal 1996. General and
administrative expenses represented 9% of total revenue for the six-month
period of fiscal 1997 compared to 9% for the corresponding period of fiscal
1996. The increased expense for the fiscal 1997 period resulted from increased
employee-related expenses associated with staffing requirements needed to
support Rational's expanding business and increased amortization of goodwill
arising from the Objectory purchase.
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 operating results, the
amount of cash available for investment in interest-bearing accounts and the
extent of foreign currency transactions. Other income, net increased $593,000
and for the six-month period of fiscal 1997 compared to the corresponding
period of fiscal 1996. The increase is the result of earnings on the
additional cash generated by operating activities as compared to the prior
period as well as a full six months of interest income earned on cash
generated from Rational's secondary public offering which was completed in
June 1995, versus four months of interest income for the fiscal 1996 six-month
period.
The provision for income taxes for the first six months of fiscal 1997 and
1996 is based on the estimated annual effective tax rate and includes current
federal, state and foreign income 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 higher tax rate in fiscal 1997 is primarily attributable
to higher state taxes due to utilization of remaining state net operating
losses in 1996, as well as federal minimum tax.
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<PAGE>
FISCAL YEARS ENDED MARCH 31, 1996, 1995 AND 1994
REVENUE
Total revenue increased 25% in fiscal 1996 and 4% in fiscal 1995 after a 1%
decrease in fiscal 1994.
Net product revenue. Net product revenue increased 43% in fiscal 1996
compared to decreases of 6% and 10% in fiscal 1995 and 1994, respectively. The
increase in net product revenue in fiscal 1996 was due to continued strong
customer acceptance of Rational's visual modeling tools (the Rational Rose
family) and the introduction of new versions of Rational's Rational Apex
product for C/C++ application construction. Rational's visual modeling tools
revenue grew in excess of 100% during fiscal 1996 from the prior year. The
decline in net product revenue in fiscal 1995 and 1994 was due principally to
the transition from software products designed for proprietary hardware to
software products designed for open systems and to the elimination of
overlapping product lines following the March 1994 merger. In fiscal 1996 and
fiscal 1995 Rational received no revenue from hardware sales compared to $3.5
million for fiscal 1994. Assuming the elimination of hardware sales from
fiscal 1994, net product sales increased 3% in fiscal 1995 compared to fiscal
1994. Declines in fiscal 1995 net product revenue were partially offset by
increases in the Rational Rose product line.
Consulting and support revenue. Consulting and support revenue increased 5%,
18% and 15% in fiscal 1996, 1995 and 1994, respectively. These increases
reflected higher demand for Rational's consulting expertise in object modeling
and advanced software-development practices, and, to a lesser extent,
increased training and customer-support revenues. In fiscal 1996, the decline
in year-over-year growth from fiscal 1995 was due primarily to Rational's
decision to forgo certain consulting revenue opportunities with existing
customers in favor of presales investment with new customers.
International sales. During fiscal 1996, 1995 and 1994, international
revenues from product sales and related consulting and customer support were
$33.2 million, $24.8 million, and $21.5 million, representing 36%, 34% and 31%
of total revenues, respectively. The growth in international sales in each of
the last three years was due principally to increased sales and marketing
activities in international markets. Rational's international sales are priced
in foreign currencies. 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 foreign currencies. At March
31, 1996, Rational had no forward exchange contracts. Rational's results of
operations during fiscal 1996 and 1995 were favorably impacted by changes in
foreign exchange rates. The impact of using actual exchange rates throughout
the year compared to exchange rates at the beginning of the year was to
increase income from operations by approximately $100,000 and $500,000 in
fiscal 1996 and 1995, respectively.
COST OF REVENUE
Cost of product revenue. Cost of product revenue increased 3% in fiscal 1996
after decreasing 41% in fiscal 1995 and increasing 16% in fiscal 1994. These
costs represented 13%, 18%, and 28% of total product revenue in fiscal 1996,
1995 and 1994, respectively. In fiscal 1996, the decrease in product cost as a
percentage of product revenue was due mainly to lower royalty expense
resulting from a decrease in third party product sales. In fiscal 1995, the
decline in cost as a percentage of product revenues was due mainly to the
discontinuance of proprietary hardware sales, which resulted in lower material
cost, and to a lesser extent, to the change in the product mix to higher-
margin products and the elimination of overlapping product lines.
Cost of consulting and support revenue. Cost of consulting and support
increased 7%, 34% and 19% in fiscal 1996, 1995 and 1994, respectively. These
costs represented 55%, 54% and 47% of consulting and support revenue in fiscal
1996, 1995 and 1994, respectively. These increases were the result of
additional personnel and personnel-related expenses needed to perform
professional services in object modeling, advanced software-development
practices, and business process engineering. The increases as a percentage of
consulting and support revenue resulted from an increase in consulting
services compared to support services because of the cost of providing
consulting services compared to the costs of providing customer-support
services.
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<PAGE>
OPERATING EXPENSES
Research and development. Total expenditures for research and development
increased 31% in fiscal 1996 after decreasing 40% in fiscal 1995. Total
expenditures for research and development increased 6% in fiscal 1994.
Research and development costs represented 17%, 17% and 29% of total revenue
in fiscal 1996, 1995 and 1994, respectively. The increase in fiscal 1996 was
due primarily to expenses incurred following the October 1995 acquisition of
Objectory AB. The decrease in fiscal 1995 was the result of personnel
reductions implemented as part of the 1994 merger and the elimination of
redundant development efforts. The increase in fiscal 1994 was due primarily
to increased staffing and support required to expand and enhance Rational's
product line.
Rational did not capitalize any software-development costs in fiscal 1996
and 1995 because eligible costs were not material. Rational capitalized
software-development costs of $1.9 million in fiscal 1994. Those costs have
since been amortized to cost of product sales. Rational expects that the
amount of software-development costs capitalized in future periods will be
immaterial to Rational's results of operations and financial position because
the time period and the engineering effort required between demonstration of a
product's economic and technological feasibility and the date of product
release has been very short.
Sales and marketing. Sales and marketing expenses increased 39% in fiscal
1996 and 18% in fiscal 1995 after decreasing 2% in fiscal 1994. These expenses
represented 38%, 34% and 30% of total revenue in fiscal 1996, 1995 and 1994,
respectively. The fiscal 1996 increase in sales and marketing expenses reflect
the additional personnel, commissions and related costs required in sales and
marketing to expand Rational's sales channels, to penetrate new markets, and
to increase its market share in core markets. Fiscal 1996 also included
expenses associated with Objectory AB since the acquisition in October 1995.
The increase in fiscal 1995 was primarily due to expansion of Rational's
worldwide sales and marketing infrastructure to support greater direct sales,
both in major accounts and geographic territories, expansion of Rational's
telesales channel and penetration of new markets such telecommunications,
banking and financial services, and transportation.
General and administrative. General and administrative expenses increased
36% in fiscal 1996 after decreasing 3% and 4% in fiscal 1995 and 1994,
respectively. General and administrative expenses represented 11%, 10% and 10%
of total revenue in fiscal 1996, 1995 and 1994, respectively. The increase in
general and administrative expenses in fiscal 1996 is due primarily to
expenses associated with Objectory AB since the acquisition in October 1995,
to amortization of goodwill and other purchased intangibles resulting from the
Objectory acquisition, and to an increase in the reserve for doubtful
accounts. The decrease in general and administrative expenses in absolute
dollars in fiscal 1995 and 1994 is primarily attributable to economies of
scale and increased efficiencies in Rational's administrative operations
following the March 1994 merger of Verdix and old Rational.
Charges for acquired in-process research and development. In connection with
the acquisition of Objectory AB, acquired in-process research and development
of $8.7 million was charged to operations during Rational's third fiscal
quarter. In-process research and development represents the present value of
the estimated cash flow expected to be generated by Objectory AB related
technology which at the acquisition date has not yet reached the point of
technological feasibility and does not have an alternative future use.
Merger and restructuring costs. Merger-related expenses of $9.9 million were
recorded in fiscal 1994 as a result of the closing of facilities, severance
costs, administrative costs, and the write-off of capitalized software costs
related to overlapping product lines. The actions related to severance,
administrative and capitalized software costs are complete. During fiscal 1995
Rational recorded expense reductions of $1.1 million relating to the reversal
of the rent accrual associated with the closing of facilities. The accrual was
reduced as a result of greater-than-anticipated recoveries through subleases
of certain facilities reserved at the time of the merger. The remaining
facilities accrual is $1.7 million as of March 31, 1996.
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OTHER INCOME, NET
Other income has fluctuated as a result of operating results, the amount of
cash available for investment in interest-bearing accounts, and the extent of
foreign currency transactions. Other income, net, increased $1.2 million to
$1.6 million in fiscal 1996 from $0.4 million in fiscal 1995. The increase is
due primarily to interest earned on cash generated from Rational's public
offering, which was completed in June 1995.
INCOME TAXES
The provision for income taxes consists primarily of foreign income taxes as
well as federal and state minimum taxes. The effective tax rate for 1996
differs from the federal statutory income tax rate due primarily to the impact
of non-tax deductible charges for acquired in-process research and
development, utilization of net operating loss carryforwards, and foreign and
state taxes. As of March 31, 1996, Rational had net operating loss
carryforwards for federal income tax purposes of approximately $47.4 million
that expire in 1997 through 2011. In addition, Rational had approximately $3.1
million of tax credit carryforwards which expire in years 1997 through 2010 if
not utilized. As a result of the common stock sale in June 1995, Rational
incurred a change in ownership as defined under Section 382 of the Code.
Accordingly, approximately $34 million of Rational's net operating loss
carryforwards and all of the tax credit carryforwards will be subject to an
annual limitation of approximately $8.7 million regarding their utilization
against taxable income in future periods. In addition, as a result of the
merger with old Rational and provisions in the Code, utilization of
approximately $4.6 million of net operating loss carryforwards are further
limited to the future income of Rational. Under Statement of Financial
Accounting Standards No. 109 (FAS 109), deferred tax assets and liabilities
are determined based on differences between financial reporting and tax bases
of assets and liabilities and are measured using the enacted tax rates and
laws that will be in effect when the differences are expected to reverse.
Based upon the weight of available evidence, which includes Rational's
historical operating performance, the reported cumulative net losses 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 Rational, Rational 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. Rational intends to evaluate the
realizability of the deferred tax asset on a quarterly basis. See Note 8 of
Notes to Consolidated Financial Statements.
LIQUIDITY AND CAPITAL RESOURCES AT SEPTEMBER 30, 1996
As of September 30, 1996, Rational had cash, cash equivalents and short-term
investments of $55,068,000 and working capital of $56,933,000. Net cash
provided by operating activities for the period ending September 30, 1996 was
composed primarily of net income offset by an increase in accounts receivable
and decreases in accrued employee benefits and deferred revenue.
On October 2, 1996, Rational 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 in-process research and development estimated at
$15,000,000 to $19, 000,000.
During October 1996, Rational 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 Rational from the offering will be used for working
capital and general corporate purposes.
Rational 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.
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RATIONAL MANAGEMENT
The executive officers and directors of Rational and their ages as of
January 6, 1996 are as follows:
<TABLE>
<CAPTION>
NAME AGE POSITION
---- --- --------
<S> <C> <C>
Paul D. Levy............ 41 Chairman of the Board and Chief Executive Officer
Michael T. Devlin....... 42 President and Director
Robert T. Bond.......... 53 Senior Vice President, Chief Operating Officer, Chief
Financial Officer, and Secretary
David H. Bernstein...... 44 Senior Vice President and General Manager, Products
John R. Lovitt.......... 51 Senior Vice President Worldwide Field Operations
Stephen F. Zeigler...... 45 Senior Vice President and General Manager, UNIX
Application Construction Products
Timothy A. Brennan...... 41 Vice President, Finance and Administration
Kevin J. Harr........... 40 Vice President, Major Accounts, North American Field
Operations
Ivar Jacobson........... 57 Vice President, Business Engineering
Joseph N. Marasco....... 51 Vice President and General Manager, Windows Application
Construction Products
Gregory L. Meyers....... 40 Vice President and General Manager, Object Modeling
Products
Richard P. Reitman...... 44 Vice President, Process and Project Management Products
Gerard J. Rudisin....... 43 Vice President, Corporate Marketing
James S. Campbell(2).... 69 Director
Daniel H. Case III(2)... 39 Director
Leslie G. Denend(1)..... 55 Director
John E. Montague(2)..... 42 Director
Allison R. 52 Director
Schleicher(1)..........
</TABLE>
- --------
(1) Member of Compensation Committee
(2) Member of Audit Committee
Paul D. Levy co-founded Rational in 1981. He is currently Chairman of the
Board and Chief Executive Officer. Prior to September 1996, Mr. Levy served as
President and Chief Executive Officer of Rational. Mr. Levy received a B.S.
degree in economics from the United States Air Force Academy and an M.S.
degree in engineering-economic systems from Stanford University. Mr. Levy is a
director of Peerless Systems Corporation. Mr. Levy is the son-in-law of Mr.
Campbell.
Michael T. Devlin co-founded Rational in 1981. He is currently President and
a director. Prior to September 1996, Mr. Devlin served as Chairman of the
Board of Rational. Mr. Devlin received a B.S. degree in computer science from
the United States Air Force Academy and an M.S. degree in computer science
from Stanford University.
Robert T. Bond joined Rational in 1983 as Vice President of Marketing. In
1990, he was named Senior Vice President and General Manager of International
Field Operations. In April, 1996 he was named Senior Vice President, Chief
Operating Officer, Chief Financial Officer and Secretary of Rational. Mr. Bond
has a B.S. degree in engineering from Case Institute of Technology.
David H. Bernstein joined Rational in 1982 as Vice President, Product
Development. Mr. Bernstein was named Vice President and General Manager,
Object Technology Products, and Senior Vice President and General Manager,
Object Technology Products in 1994 and 1995, respectively. In May 1996, Mr.
Bernstein was named Senior Vice President and General Manager, Products. Mr.
Bernstein received a B.S. degree in electrical engineering from the
Massachusetts Institute of Technology.
John R. Lovitt joined Rational as a Regional Manager responsible for sales
and marketing in 1986. In 1990, he was promoted to Vice President, and
subsequently Senior Vice President, North American Field Operations.
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<PAGE>
In November 1996, Mr. Lovitt was promoted to Senior Vice President, Worldwide
Field Operations where he is responsible for worldwide field marketing and
technical services. Mr. Lovitt received a B.S. degree in aeronautical
engineering from Wichita State and an M.S. degree in computer science from the
University of Missouri.
Stephen F. Zeigler joined Rational in 1983 as an Engineering Manager. Mr.
Zeigler was named Vice President, Ada Products and Senior Vice President, Ada
Products in 1987 and 1994, respectively. Since April 1996, Mr. Ziegler has
served as Senior Vice President and General Manager, UNIX Application
Construction Products. He received his B.A. in math, physics, and chemistry
from Illinois College, his M.S. in computer science from Indiana University
and his doctorate in computer science from the University of Wisconsin.
Timothy A. Brennan is Vice President, Finance and Administration. He joined
Rational as Corporate Controller in 1994. From 1987 to 1994, Mr. Brennan held
various financial management and controllership positions with The ASK Group,
Inc. Mr. Brennan received a B.S.C. in accounting from Santa Clara University.
He is a certified public accountant in the State of California.
Kevin J. Haar is Vice President, Major Accounts, North American Field
Operations. He joined Rational in 1986 as an account representative in the
field sales force. Since then, he has held a number of positions, most
recently District Manager and Eastern Regional Manager. Mr. Haar received a
B.S. in electrical engineering and an M.B.A. from Washington University in St.
Louis.
Ivar Jacobson joined Rational as Vice President, Business Engineering in
1995, when Rational acquired Objectory AB. Prior to joining Rational, Mr.
Jacobson served as President of Objectory AB from 1990 to 1991, and as Vice
President of Objectory AB from 1991 to 1995. Mr. Jacobson received an M.S. in
electrical engineering from Chalmers Institute of Technology, Gothenberg and
his doctorate in computer systems from the Royal Institute of Technology in
Stockholm.
Joseph N. Marasco is Vice President and General Manager, Windows Application
Construction Products. He joined Rational in 1986 as a product manager. He has
since held various positions in Rational, including Director of Product
Marketing, Director of Consulting Services and Director of Engineering for the
Apex product line. He has an M.S. degree in physics from State University of
New York at Stony Brook and a Ph.D. in physics from the University of Geneva,
Switzerland.
Gregory L. Meyers joined Rational as Director of Rose Development in 1995,
when Rational acquired Palladio Software Corporation. In April 1996, Mr.
Meyers was named Vice President and General Manager, Object Modeling Products.
Prior to joining Rational, Mr. Meyers served as Project Manager at General
Electric Medical Systems from 1990 to 1992, and as Chief Architect, Software
Tools at Palladio Software Corporation from 1992 to 1995. Mr. Meyers received
his B.S. in engineering from the University of Iowa.
Richard P. Reitman joined Rational in 1982. From 1991 to 1993, he served as
Product Architect, and from 1993 until 1996 he served as Chief Product
Architect of Rational. Mr. Reitman now serves as Vice President, Process and
Project Management Products. Mr. Reitman received a B.A. in mathematics from
State University of New York, New Paltz, New York, an M.S. in computer science
and his doctorate in computer science from Cornell University. Since March
1996, Mr. Reitman has also been Chairman and Secretary of Reitman Corp.
Medical Regulatory Consulting, a business consulting firm unaffiliated with
Rational.
Gerard J. Rudisin joined Rational in 1991 as Director of Marketing for
Rational's Ada products. In 1993 he was named Vice President, Corporate
Marketing. Mr. Rudisin received a B.S. degree in electrical engineering from
the Massachusetts Institute of Technology and an M.S. degree in computer
science from University of California, Los Angeles.
James S. Campbell has been a director of Rational since 1990. Since 1987, he
has been the Managing Director of Management Partners International
Corporation, a management and consulting firm specializing in
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<PAGE>
technology companies. He serves on the national board of directors of United
We Stand America, Inc. and is a Director of Applied Voice Technology, Inc. Mr.
Campbell is the father-in-law of Mr. Levy.
Daniel H. Case III has been a director of Rational since 1993. Since 1994,
he has been President and Chief Executive Officer of Hambrecht & Quist Group,
an investment banking firm. From 1992 to 1994 he served as President and Co-
Chief Executive Officer of Hambrecht & Quist Group. Previously he held various
positions with Hambrecht & Quist Group. He is a director of Hambrecht & Quist
Group and Electronics Arts, Inc.
Leslie G. Denend has been a director of Rational since 1993. Since 1993, he
has been the President and Chief Executive Officer of Network General
Corporation, a supplier of local and wide area computer network communications
management systems. From 1990 to 1992, he was President of Vitalink
Communications. He is a director of Network General Corporation, McAfee
Corporation and Proxim, Inc.
John E. Montague has been a director of Rational since 1994. Since March 15,
1995, he has been Vice President, Financial Strategies at Lockheed Martin
Corporation. Previously, he was Vice President, Corporate Development and
Investor Relations at Martin Marietta Corporation. From 1988 to 1991, he was
Director, Corporate Development at Martin Marietta Corporation.
Allison R. Schleicher has been a director of Rational since 1990. Since
1967, he has been with IBM Corporation in various executive and management
positions. Most recently in 1994, he was appointed Vice President, Finance of
IBM Credit Corporation. Mr. Schleicher is a director of IBM Credit
Corporation.
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RATIONAL STOCK INFORMATION
RATIONAL PRINCIPAL STOCKHOLDERS
The following table sets forth the beneficial ownership of Rational's Common
Stock as of January 6, 1997, by (i) all persons known to Rational to be the
beneficial owners of more than 5% of Rational's Common Stock, (ii) Rational's
Chief Executive Officer and the four most highly compensated executive
officers other than the Chief Executive Officer, (iii) each of Rational's
directors and (iv) all directors and executive officers as a group. The
information on beneficial ownership in the table and the footnotes below is
based upon Rational's records, Schedule 13D and 13G filings and information
supplied to Rational by the listed person or entity.
The following table has been prepared in accordance with Rule 13d-3 of the
Exchange Act and discloses all securities beneficially owned by the named
persons as of January 6, 1997, plus all securities which such persons have a
right to acquire through the exercise of options or other rights within 60
days of January 6, 1997. Certain individuals in the table below have the right
to acquire additional shares after such 60-day period, as indicated in the
footnotes to the table.
<TABLE>
<CAPTION>
SHARES BENEFICIALLY
OWNED PERCENTAGE
-------------------------AFTER THE
DIRECTORS, OFFICERS AND 5% STOCKHOLDERS NUMBER PERCENT MERGER(1)
--------------------------------------- ----------- --------------------
<S> <C> <C> <C>
Putnam Investments......................... 16.88% 14.38%
One Post Office Square
Boston, MA 02109
Attn: Frederick S. Marins 6,790,644
Chancellor(2).............................. 3,740,600 9.3% 7.92%
Ivar Jacobson(3)........................... 507,500 1.26% 1.07%
Ericsson Inc.(4)........................... 272,087 * *
Paul D. Levy(5)............................ -- * *
Michael T. Devlin(6)....................... -- * *
Robert T. Bond(7).......................... 118,583 * *
David H. Bernstein(8)...................... 56,666 * *
Kevin J. Harr(9)........................... 63,240 * *
Daniel H. Case III(10)..................... 36,329 * *
Leslie G. Denend(11)....................... 38,053 * *
Allison R. Schleicher(12).................. 21,498 * *
James S. Campbell(13)...................... 15,248 * *
John E. Montague(14)....................... 600 * *
All current directors and current executive
officers
as a group (18 persons)(15)............... 1,385,867 3.39% 2.9%
</TABLE>
- --------
*Less than one percent.
(1) Calculated assuming 7,000,000 million shares of Rational Common Stock are
issued upon conversion of SQA Common Stock.
(2) Includes shares of Rational's Common Stock held by Chancellor LGT Asset
Management, Inc. and Chancellor LGT Trust Company as investment advisors
for various fiduciary accounts and LGT Asset Management, Inc. as the
holding company for Chancellor LGT Management, Inc.
(3) Includes 7,500 shares purchasable by Mr. Jacobson within 60 days of
January 6, 1997, upon exercise of outstanding stock options. Mr. Jacobson
holds additional options for the purchase of 22,500 shares of Rational's
Common Stock, which vest at various times following such 60-day period.
(4) Ericsson Inc. is a subsidiary of LM Ericsson, which originally acquired
these shares in connection with Rational's acquisition of Objectory AB,
and transferred these shares to Ericsson, Inc. in October 1996.
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<PAGE>
(5) Mr. Levy holds options for the purchase of 675,000 shares of Rational's
Common Stock, which vest at various times following the 60-day period
commencing on January 6, 1997.
(6) Mr. Devlin holds options for the purchase of 675,000 shares of Rational's
Common Stock, which vest at various times following the 60-day period
commencing on January 6, 1997.
(7) Includes 98,111 shares purchasable by Mr. Bond within 60 days of January
6, 1997, upon exercise of outstanding stock options. Mr. Bond holds
additional options for the purchase of 207,221 shares of Rational's
Common Stock, which vest at various times following such 60-day period.
(8) Includes 26,666 shares purchasable by Mr. Bernstein within 60 days of
January 6, 1997, upon exercise of outstanding stock options. Mr.
Bernstein holds additional options for the purchase of 143,334 shares of
Rational's Common Stock, which vest at various times following such 60-
day period.
(9) Includes 56,331 shares purchasable by Mr. Haar within 60 days of January
6, 1997, upon exercise of outstanding stock options. Mr. Haar holds
additional options for the purchase of 73,001 shares of Rational's Common
Stock, which vest at various times following such 60-day period.
(10) Includes 32,498 shares purchasable by Mr. Case within 60 days of January
6, 1997, upon exercise of outstanding stock options. Mr. Case holds
additional options for the purchase of 37,834 shares of Rational's Common
Stock, which vest at various times following such 60-day period.
(11) Includes 38,053 shares purchasable by Mr. Denend within 60-days of
January 6, 1997, upon exercise of outstanding stock options. Mr. Denend
holds additional options for the purchase of 46,723 shares of Rational's
Common Stock, which vest at various times following such 60-day period.
(12) Includes 21,498 shares purchasable by Mr. Schleicher within 60 days of
January 6, 1997, upon exercise of outstanding stock options. Mr.
Schleicher holds additional options for the purchase of 62,834 shares of
Rational's Common Stock, which vest at various times following such 60-
day period.
(13) Includes 14,582 shares purchasable by Mr. Campbell within 60 days of
January 6, 1997, upon exercise of outstanding stock options. Mr. Campbell
holds additional options for the purchase of 50,334 shares of Rational's
Common Stock, which vest at various times following such 60-day period.
(14) Mr. Montague holds options for the purchase of 68,000 shares of
Rational's Common Stock, which vest at various times following the 60-day
period commencing on January 6, 1997.
(15) Includes 631,760 shares purchasable within 60 days of January 6, 1997,
upon exercise of outstanding stock options. Such persons also hold
additional options for the purchase of an aggregate of 2,094,160 shares
of Rational's Common Stock, which vest at various times following such
60-day period.
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RATIONAL STOCK PRICE AND DIVIDEND INFORMATION
Rational's Common Stock is traded on the Nasdaq National Market under the
symbol RATL. The following table sets forth for the periods indicated the high
and low sale price for the Common Stock. All prices have been adjusted to give
effect to the two-for-one stock split effected by Rational on September 10,
1996.
<TABLE>
<CAPTION>
FISCAL YEAR HIGH LOW
----------- ------ ------
<S> <C> <C>
1997
4th Quarter (through January 9, 1997)....................... $40.50 $37.88
3rd Quarter................................................. $43.75 $30.25
2nd Quarter................................................. 36.00 17.50
1st Quarter................................................. 33.13 19.00
1996
4th Quarter................................................. 20.75 7.95
3rd Quarter................................................. 12.00 6.82
2nd Quarter................................................. 9.32 6.57
1st Quarter................................................. 6.10 5.25
1995
4th Quarter................................................. 6.00 3.57
3rd Quarter................................................. 4.03 2.82
2nd Quarter................................................. 3.94 2.07
1st Quarter................................................. 4.69 2.07
</TABLE>
On , 1997, the last reported sale price for Rational's Common Stock was
$ per share. As of , 1997, there were holders of record of
Rational Common Stock.
Rational has not paid any cash dividends since its inception and does not
anticipate paying cash dividends in the foreseeable future. Rational currently
intends to retain available future earnings to finance the operations of its
business.
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SQA BUSINESS
The following is a general discussion of the business of SQA as a separate
company and does not specifically contemplate the effect of the proposed
Merger. For a description of Rational's business, see "Rational Business." For
a discussion of the anticipated effects of the proposed Merger, see "Risk
Factors--Risks Related to the Merger," "--Risks Related to Rational and SQA,"
"--Risks Related to Rational," "Risks Related to SQA", "Approval of the Merger
and Related Transactions--Joint Reasons for the Merger," "--Rational's Reasons
for the Merger," "--SQA's Reasons for the Merger," "Terms of the Merger--
Conduct of the Combined Company Following the Merger" and "--Conduct of
Rational's and SQA's Businesses Prior to the Merger."
SQA develops and markets integrated software products for the automated
testing and quality management of Windows-based client/server applications.
SQA's products are designed to improve software quality, reduce development
costs and shorten time-to-deployment for large organizations building mission-
critical client/server applications. SQA's comprehensive SQA Suite is used by
developers, quality assurance ("QA") engineers and project managers during the
application lifecycle, including development, deployment and maintenance.
SQA's objective is to be the leading supplier of automated testing and
quality management solutions for organizations building enterprise-wide
applications. SQA's strategy is to build on its early position in the market
for the automated testing of Windows-based client/server applications and
extend that position to support enterprises building Internet and intranet
applications. SQA intends to continue focusing on strategic platforms and
technology, offering comprehensive end-to-end testing, integrating its
products with leading development tools and related products, and supporting a
broad range of users.
SQA was incorporated in Delaware on March 8, 1990 under the name "Software
Quality Automation, Inc." On April 6, 1995, SQA was renamed "SQA, Inc." SQA's
principal executive offices are located at One Burlington Woods, Burlington,
MA 01803 and its telephone number is (617) 229-3500.
INDUSTRY BACKGROUND
Large enterprises depend on the reliable operation of their software
applications. These applications are increasingly deployed in client/server
and Internet computing environments consisting of distributed desktop
computers (or clients) networked to shared servers. Forrester Research has
reported that approximately 65% of Fortune 1000 companies are implementing
some form of client/server system, an increase from approximately 30% in 1990.
As client/server systems have become more widely implemented, Microsoft's
Windows has emerged as the dominant client operating system. Organizations
have responded to the demand for client/server applications by increasingly
using a variety of rapid application development ("RAD") tools such as Visual
Basic, PowerBuilder, SQLWindows, Delphi and Developer 2000.
Although RAD tools have reduced the time required to create applications,
they have not addressed the need to improve the testing of the resulting
applications, and therefore have shifted the bottleneck in the delivery of
client/server applications from development to test. Several characteristics
of client/server systems greatly complicate the testing of applications. These
characteristics include:
. Use of GUIs. The graphical user interface ("GUI") built into most
client/server applications makes the applications easier to use but much
more complex and harder to test.
. Multiple Hardware and Software Components. Client/server systems employ a
variety of different hardware and software components, each the product
of a different vendor, and are inherently less stable. The complex
interoperation among these disparate components increases the risk of
failure.
. Dynamic, Changing Environment. New and enhanced versions of the hardware
and software components of client/server systems are introduced
frequently. Each introduction of a new or enhanced component requires
developers to re-validate previously deployed applications and
components.
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. Scalability. As client/server applications are deployed across the
enterprise, they should be tested for use in an environment consisting of
multiple users with diverse computing platforms. The applications need to
be tested to validate compatibility and performance requirements.
SQA believes that these characteristics tend to increase the software defect
rate of a client/server application. One industry analyst has concluded that
client/server applications suffer from higher defect rates than mainframe
applications. In response to these defect rates, organizations have begun to
place a greater emphasis on building a formal, effective testing capability.
Historically, software developers have used ad hoc methods, primarily manual
techniques or internal tools, to test applications. Manual testing of
client/server applications is often performed at the end of the development
process when mistakes are more costly to resolve. In addition, manual testing
is slow, tedious and error-prone, and difficult to repeat in an iterative or
systematic manner.
As a result of these shortcomings, large organizations have begun to turn to
commercially-available test tools. International Data Corp. anticipates that
the market for GUI and client/server test tools will grow 60% per year through
the end of the decade, resulting in worldwide revenues of $1 billion by 2000,
up from $98 million in 1995. Historically, most commercially-available test
tools were built to be used by programmers working at ISVs on platforms other
than Windows. Suppliers of these test tools have ported their products to
Windows and are promoting them to the IS departments of business
organizations. SQA believes that these tools are not ideally engineered for
the Windows environment and lack the features and ease-of-use desired by
corporate users. Consequently, IS professionals within large organizations
need productive, comprehensive test tools to automate and manage the testing
of their Windows-based client/server applications. Today, SQA and other
vendors provide comprehensive tools for testing applications in client/server
environments. Increasingly, organizations want additional testing support for
their Internet and intranet applications.
PRODUCTS AND SERVICES
SQA Suite includes: SQA Robot, which allows users to create and run
automated tests; SQA Manager, which allows users to plan, manage and measure
the progress of testing projects; SQA LoadTest, which allows users to test
client/server applications under different load, stress and multi-user
scenarios; and SQA Process, which is a methodology for the automated testing
of Windows client/server applications. SQA Suite is built on the SQA Test
Repository, an open, networked database that facilitates work flow management
and defect tracking. SQA's products work with Windows application development
tools and provide advanced testing features for leading rapid application
development ("RAD") tools, including Microsoft's Visual Basic, Sybase's
PowerBuilder, Borland's Delphi, Oracle's Developer 2000 and Centura's
SQLWindows.
SQA Suite provides comprehensive end-to-end testing of client/server
applications. SQA Suite is designed to be used by IS professionals as follows:
. While the developers refine the application specification, the QA team
uses SQA Manager to define the application test requirements in
accordance with the framework in SQA Process. SQA Manager stores all test
requirements in the network SQA Test Repository so it is accessible by
every member of the project team.
. As the developers deliver early versions of the application, the
developers and/or QA team use SQA Robot to develop automated tests that
validate the application. SQA Robot stores all test scripts in the SQA
Test Repository so they can be shared and reused by any member of the
team.
. As new versions of the application are delivered--sometimes on a daily
basis--the QA team uses SQA Robot and SQA LoadTest to run the automated
tests that validate the integrity of each new version. Testing that would
have traditionally taken hours or days using manual testing methods is
shortened to minutes or hours.
. The tests log their results into the SQA Test Repository. The QA team
uses SQA Manager to analyze the test results, identify and prioritize any
defects. Each defect is assigned to a developer for resolution.
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. As defects are passed among team members for resolution, SQA Manager
sends automatic e-mail messages to individuals informing them about
changes in the defect's status or ownership. Each team member uses SQA
Manager to track the status of the defects, ensuring that every defect is
resolved.
. Each new version of the application is re-tested, validating that
previously-detected defects have been eliminated and no new defects have
been introduced. At various stages, SQA LoadTest is used to test the
application on many machines under varying load, stress, and multi-user
scenarios to identify and eliminate any bottlenecks.
. Project and QA managers use SQA Manager to measure the progress of the
testing effort, generating reports and graphs that analyze the large
amount of test data generated by automated testing. After the application
meets the test requirements, it is approved for deployment.
. The automated tests continue to deliver value even after the application
is deployed. If the production environment is changed, the automated
tests are rerun to ensure the application operates properly and at
acceptable performance levels in the new environment.
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CUSTOMERS
SQA targets its products and services to major corporate and governmental
organizations worldwide. Many of SQA's customers are using a mix of RAD tools
to develop applications for their client/server computing environments. No
single distributor or end-user customer of SQA accounted for more than 10% of
SQA's total revenues in 1994, 1995 or the nine months ended September 30,
1996. The following is a partial list of SQA's customers as of September 30,
1996 each of which has purchased more than $25,000 of software licenses or
services relating to SQA's products:
Financial Services Pharmaceutical and Health Care
AIG Abbott Laboratories
Automated Data Processing, Inc. Eli Lilly and Company
Bankers Trust New York Corporation Pfizer Corporation
Chase Manhattan Corporation United HealthCare Corporation
Citibank
Deloitte & Touche LLP Consumer
Internationale Nederladen Groep N.V.
J.P. Morgan & Co. Incorporated Anheuser Busch Companies, Inc.
Lloyds Bank PLC Circuit City Stores, Inc.
The Dreyfus Corporation EMI Records
The New England McGraw-Hill, Inc.
The Royal Bank of Scotland PLC MTV Networks
Pepsico, Inc.
Telecommunications Volvo Cars of North America, Inc.
AT&T Corporation Manufacturing
British Telecommunications PLC
MCI Communications Corp. TRW, Inc.
Nynex Corporation Weyerhaeuser Company
Singapore Telecom W.W. Grainger, Inc.
Southwestern Bell Corp.
Energy and Transportation
Computing and Related Services
Boston Edison Company
A.C. Nielsen Company Pacific Gas and Electric Company
Caci International Inc. Union Pacific Railroad Company
Computer Associates International, Inc.
Datalogix International, Inc.
Dun & Bradstreet Software
Mitsubishi Corporation
PeopleSoft Inc.
Unisys Corporation
Within these organizations, SQA's products are used by internal IS groups,
who are assisted in some cases by external consultants, systems integrators,
and VARs. SQA's typical customer is a professional in an IS department or
someone otherwise contributing to the QA function. SQA's products are designed
to improve software quality, reduce development costs and shorten time-to-
deployment for large organizations building mission-critical client/server
applications.
SALES AND MARKETING
SQA markets and sells its products and services directly through both a
telesales and a field sales force and indirectly through channels such as VARs
and distributors. SQA strives to coordinate its marketing and sales
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efforts. SQA designs its marketing programs to establish and reinforce the
recognition of its corporate and product names through investments in
advertising, direct mail, seminars and other promotional activities. SQA's
sales effort is then designed to capture, qualify and respond effectively to
the leads generated by marketing programs.
SQA's marketing programs include advertising, direct mail, public relations,
seminars, and trade shows. These programs have been instrumental in creating
end-user awareness and interest in SQA's products. A key element of SQA's lead
generating program is its use of advertising and direct mail to promote its
extensive seminar series. This seminar covers general issues of client/server
and Internet testing and specific applications of SQA's products. Frequently,
SQA utilizes one or more third parties to co-sponsor, co-promote and/or
deliver the seminars.
SQA maintains an active program of market research based on customer visits,
surveys, and frequent canvassing of resellers. This program helps guide SQA in
setting priorities for product development, customer support, and other
functional areas. Also, SQA's nationwide seminar series and multi-day training
classes are effective vehicles for soliciting customer feedback.
SQA believes that the coordinated, effective use of multiple worldwide
selling channels is required to reach the diverse and growing base of
prospective customers. SQA's initial distribution channels included its direct
telesales force and an extensive network of indirect channels. More recently,
SQA has begun to establish a direct field sales force in North America.
Direct Sales. SQA's direct sales effort consists of a telesales force
supplemented by field sales engineers and a direct field sales force that SQA
began to establish in 1994. To date, telesales have accounted for a majority
of SQA's revenue from direct sales. Telesales are typically generated by
inbound inquiries stimulated by SQA's marketing programs. For its current
products, SQA believes that telesales has been a cost-effective means of
distributing its products and gaining initial customer acceptance.
Since 1994, SQA has opened a limited number of direct field sales offices in
North America to complement its telesales effort. SQA believes that its direct
field sales force will allow it to build deeper relationships with large
organizations that initially licensed SQA products through the telesales or
reseller channel.
Indirect Sales. SQA's extensive set of resellers is a key component of SQA's
sales and marketing strategy. SQA has invested considerable resources in
building an extensive network of resellers as a channel for selling and
supporting its products. SQA's network of VARs and systems integrators
throughout North America provide substantial leverage to SQA's sales and
marketing organization. In addition to reselling products purchased from SQA
at a discount, these organizations have on staff trained personnel capable of
providing technical support and consultation to end users. SQA's sales force
compensation program has been structured to minimize channel conflict between
each party involved in an end-user sale. SQA has carefully selected its
resellers in order to leverage its internal sales effort while effectively
establishing its products as a leading solution for the testing of Windows
client/server applications. In North America, most of SQA's resellers are
successful systems integrators or consultants who are retained by large
organizations for assistance with implementing client/server systems and
applications. Many of these resellers have a record of success in reselling
one or more client/server application development tools.
Strategic Relationships. SQA also has an extensive set of relationships with
ISVs, including Microsoft PeopleSoft, Sybase, Oracle, Informix, Centura,
Intersolv, LBMS, Symantec and Borland. These companies work closely with SQA
on marketing and technology programs, providing customers with a
comprehensive, easy-to-use development and test solution. The marketing
relationships often involve one or more of the following programs: joint
advertising campaigns, exchange of mailing lists, reciprocal use of logos in
marketing literature and joint ventures, seminars or trade show presentations.
In December 1995, SQA entered into a software development and distribution
agreement with Mitsubishi Corporation pursuant to which SQA granted an
exclusive license to Mitsubishi to market, distribute and support
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localized versions of SQA's products to authorized resellers and end users
located in Japan. Mitsubishi is also authorized on a non-exclusive basis to
market, distribute and support U.S. versions of SQA's products to authorized
resellers and end users located in Japan.
International Sales. SQA believes that international sales will increase as
a percentage of total revenues as SQA establishes a direct sales effort
internationally or extends its international coverage through distributors.
Indirect sales, primarily through distributors, have comprised substantially
all of SQA's international revenues to date. For international markets, SQA
uses a network of distributors and resellers in 31 countries. These
organizations generally are technically trained on SQA's product line,
experienced in client/server development tools, and provide strong customer
coverage in their respective locations. In 1995, SQA established an office in
Europe, headquartered in Bracknell, England.
PRODUCT DEVELOPMENT
Since its inception, SQA has made substantial investments in research and
development. SQA believes that its future performance will depend in large
part on its ability to maintain and enhance its current product line, develop
new products, maintain technological competitiveness and meet an expanding
range of customer requirements. SQA currently has a number of initiatives
underway that it believes will contribute substantially to its product
development:
. SQA Suite. SQA is currently adding support for the Borland Delphi and
Oracle Developer 2000 independent development environments ("IDE's") to
its testing product. SQA believes that the addition of these IDE's will
broaden the appeal of SQA's products by providing additional potential
markets for SQA's products.
. Internet Extensions. SQA has adopted an "embrace and extend" strategy to
the Internet. By using this strategy, SQA plans to "Internet enable" most
of its products by extending them to support Internet technologies such
as Java(TM), Java Script(TM), ActiveX, VB Script, HTML, DCOM, plug-ins,
Navigator and Internet Explorer.
. Virtual Testing. SQA plans to enhance its load test products by adding
"virtual testing" support. Virtual testing allows users to simulate many
"virtual" users on one physical machine. SQA believes that the addition
of virtual testing support will broaden the appeal of the product.
The client/server software market is characterized by rapid technological
change, changes in customer requirements, frequent new product introductions
and enhancements and emerging industry standards. The introduction of products
embodying new technologies and the emergence of new industry standards and
practices can render existing products obsolete and unmarketable. SQA's future
success will depend on its ability to enhance its existing products, to
develop new products that address the increasingly sophisticated needs of its
customers, to develop products for additional development tools and operating
systems and to respond to technological advances and emerging industry
standards and practices. The development of new products and enhanced versions
of current products entails significant technical risks. There can be no
assurance that SQA will be successful in developing, introducing and marketing
product enhancements and new products, or will not experience difficulties
that could delay or prevent the successful development, introduction or
marketing of these products, or that its new products and product enhancements
will adequately meet the requirements of the marketplace and achieve market
acceptance. Delays in the commencement of commercial shipments of new products
and enhancements may result in customer dissatisfaction and delay or loss of
product revenues.
SQA's total research and development expense for 1993, 1994, 1995 and nine
months ended September 30, 1996 were $750,000, $1.7 million, $2.4 million and
$3.0 million, respectively. SQA anticipates that it will continue to commit
substantial resources to product development in the future. To date, SQA has
expensed all product development expenses in the period in which they were
incurred.
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COMPETITION
The market for software testing tools developed by ISV's is intensely
competitive and rapidly changing. SQA believes its ability to compete depends
upon many factors within and without its control, including the timing and
market acceptance of new products and enhancements developed by SQA and its
competitors, product functionality, integration with leading client/server
application development tools, ease of use, pricing, reliability, customer
service and support, sales and marketing efforts and product distribution
channels. SQA believes that it currently competes favorably overall with
respect to these factors.
SQA faces direct and indirect competition for its products from several
publicly traded as well as privately held companies. SQA's test products
compete directly with offerings from Mercury Interactive and Segue Software
Inc. as well as Rational Software's Visual Test (formerly owned by Microsoft).
SQA's load test product competes with products from Pure Atria Software,
Mercury Interactive as well as offerings from privately held companies. In
addition to direct competition for SQA's products, SQA faces indirect
competition from existing and future customers, many of whom use internally
designed test tools.
INTELLECTUAL PROPERTY
SQA's success is heavily dependent on its proprietary technology. SQA views
its software as proprietary, and relies on a combination of trade secret,
copyright and trademark laws, non-disclosure agreements and contractual
provisions to establish and protect its proprietary rights. SQA has no patents
or patents pending, and has not to date registered any of its copyrights. SQA
has obtained or is currently seeking registrations in the United States for
the following trademarks: SQA, SQA Suite, SQA Robot, SQA LoadTest, SQA
Manager, SQA Process, SQA Test Repository, Object Testing, Software Quality
Automation, Object Oriented Recording and RAD/QA. In addition, SQA is
currently seeking to register certain of these trademarks in principal foreign
jurisdictions. SQA uses a printed "shrink-wrap" license for users of its
products in order to protect its copyrights and trade secrets. Since these
licenses are not signed by the licensee, many authorities believe that they
may not be enforceable under many state laws and the laws of many foreign
jurisdictions. The laws of Massachusetts, which the printed shrink-wrap
licenses purport to make the governing law, are unclear on this subject.
Despite SQA's efforts to protect its proprietary rights, unauthorized
parties may attempt to copy aspects of SQA's products or to obtain and use
information that SQA regards as proprietary. Policing unauthorized use of
SQA's products is difficult, and while SQA is unable to determine the extent
to which piracy of its software products exists, such piracy can be expected
to be a persistent problem, particularly in international markets and as a
result of the growing use of the Internet. In addition, the laws of some
foreign countries either do not protect SQA's proprietary rights or offer only
limited protection for those rights. There can be no assurance that the steps
taken by SQA to protect its proprietary rights will be adequate or that SQA's
competitors will not independently develop technologies that are substantially
equivalent or superior to SQA's technologies or products.
There has been substantial litigation in the software industry involving
intellectual property rights. Although SQA does not believe that it is
infringing the intellectual property rights of others, there can be no
assurance that such claims, if asserted, would not have a material adverse
effect on SQA's business, financial condition and results of operations. In
addition, as SQA may acquire or license a portion of the software included in
its products from third parties, its exposure to infringement actions may
increase because SQA must rely upon such third parties for information as to
the origin and ownership of such acquired or licensed software. Although SQA
would intend to obtain representations as to the origins and ownership of such
acquired or licensed software and obtain indemnification to cover any breach
of any such representations, there can be no assurance that such
representations will be accurate or that such indemnification will provide
adequate compensation for any breach of such representations. In the future,
litigation may be necessary to enforce and protect trade secrets, copyrights
and other intellectual property rights of SQA. SQA may also be subject to
litigation to defend against claimed infringement of the rights of others or
to determine the scope and validity of the intellectual property rights of
others. Any such litigation could be costly and divert management's attention,
either of which could have a
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material adverse effect on SQA's business, financial condition and results of
operations. Adverse determinations in such litigation could result in the loss
of SQA's proprietary rights, subject SQA to significant liabilities, require
SQA to seek licenses from third parties and prevent SQA from selling its
products, any one of which could have a material adverse effect on SQA's
business, financial condition and results of operations.
EMPLOYEES
As of September 30, 1996 SQA had a total of 131 full-time employees. SQA's
employees are not represented by any collective bargaining organization, and
SQA has never experienced a work stoppage and considers its relations with its
employees to be good.
PROPERTIES
SQA corporate headquarters to located in Burlington, Massachusetts
consisting of approximately 43,000 square feet of office space. SQA intends to
expand its facility in 1997. SQA's leases additional facilities and offices,
including locations in the United States, Canada and the United Kingdom.
LEGAL PROCEEDINGS
SQA is not a party to any material legal proceedings.
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SQA MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following is SQA management's discussion and analysis of the financial
condition and results of operations of SQA as a separate company and does not
specifically contemplate the effect of the proposed Merger. For a description
of Rational's financial condition and results of operations, see "Rational
Management's Discussion and Analysis of Financial Condition and Results of
Operations." For a discussion of the anticipated effects of the proposed
Merger, see "Risk Factors--Risks Related to the Merger," "--Risks Related to
Rational and SQA," "--Risks Related to Rational," "Risks Related to SQA",
"Approval of the Merger and Related Transactions--Joint Reasons for the
Merger," "--Rational's Reasons for the Merger," "--SQA's Reasons for the
Merger," "Terms of the Merger--Conduct of the Combined Company Following the
Merger" and "--Conduct of Rational's and SQA's Businesses Prior to the
Merger."
OVERVIEW
SQA develops and markets integrated software products for the automated
testing and quality management of Windows-based client/server applications.
SQA also provides a comprehensive range of customer support services,
including training, remote support and on-site consulting. SQA commenced
volume shipments of its first product in the quarter ended December 31, 1992,
and first achieved quarterly profitability in the quarter ended June 30, 1995.
SQA's revenue is derived from license fees for use of its software products
by customers and from charges for services. For all periods presented, SQA has
recognized revenue in accordance with Statement of Position 91-1, "Software
Revenue Recognition," issued by the American Institute of Certified Public
Accountants. See Note 2 to SQA Consolidated Financial Statements.
SQA's revenues have increased each quarter in comparison to the immediately
preceding quarter, primarily as a result of an increasing number of units
shipped. In view of SQA's significant revenue growth since its inception in
1990 and the recent achievement of quarterly profitability, management
believes that period-to-period comparisons of its financial results should not
be relied upon as an indication of future performance.
SQA has historically derived substantially all of its license fees revenue
from SQA Robot and SQA Suite. The increase in license fees revenue for the
nine month period ended September 30, 1996 as compared to 1995 was more
specifically attributable to SQA Suite 5.0, which operates in both the 16-bit
and 32-bit Microsoft Windows environment. SQA anticipates that SQA Suite 5.0
will be its principal source of license fees revenue for the foreseeable
future. There can be no assurance, however, that this version of the product
will continue to increase revenue in future quarters. SQA's future financial
performance will depend in part on the continued market dominance of the
Windows operating system, and the successful development, introduction and
customer acceptance of SQA's existing and new or enhanced products. There can
be no assurance that SQA will continue to be successful in marketing its
existing or any new or enhanced products. The market in which SQA operates is
characterized by intense competition and many of SQA's current and prospective
competitors have significantly greater financial, technical, manufacturing and
marketing resources than SQA. These companies may introduce products that are
competitive with those of SQA, and there can be no assurance that SQA's
products would compete effectively with such products.
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RESULTS OF OPERATIONS
The following table sets forth for the periods indicated the percentage of
total revenue represented by certain line items from SQA's Consolidated
Statement of Operations:
<TABLE>
<CAPTION>
NINE MONTHS
ENDED
YEARS ENDED DECEMBER 31, SEPTEMBER 30,
-----------------------------------------
1993 1994 1995 1995 1996
-------- -------- -------------- ------
<S> <C> <C> <C> <C> <C>
Revenue:
License fees...................... 89.3% 76.2% 68.9% 68.7% 67.7%
Services.......................... 10.7% 23.8% 31.1% 31.3% 32.3%
-------- ------- ------- ------ ------
Total revenue................... 100.0% 100.0% 100.0% 100.0% 100.0%
-------- ------- ------- ------ ------
Cost of revenue:
License fees...................... 8.8% 4.3% 4.9% 4.2% 3.6%
Services.......................... 16.0% 17.5% 11.6% 12.4% 10.2%
-------- ------- ------- ------ ------
Total cost of revenue........... 24.8% 21.8% 16.5% 16.6% 13.8%
-------- ------- ------- ------ ------
Gross profit........................ 75.2% 78.2% 83.5% 83.4% 86.2%
-------- ------- ------- ------ ------
Operating expenses:
Sales and marketing............... 97.3% 75.4% 46.7% 49.2% 43.2%
Research and development.......... 45.3% 38.8% 18.4% 20.1% 17.6%
General and administrative........ 35.3% 20.2% 17.0% 17.7% 11.6%
-------- ------- ------- ------ ------
Total operating expenses........ 177.9% 134.4% 82.1% 87.0% 72.4%
-------- ------- ------- ------ ------
Income (loss) from operations....... (102.7%) (56.2%) 1.4% (3.6%) 13.8%
Other income........................ 0.8% 1.8% 1.9% 1.9% 7.8%
-------- ------- ------- ------ ------
Income (loss) before provisions for
taxes.............................. (101.9%) (54.4%) 3.3% (1.7%) 21.6%
Provision for income taxes.......... 0.0% 0.0% 0.0% 0.0% 2.0%
-------- ------- ------- ------ ------
Net income (loss)................... (101.9%) (54.4%) 3.3% (1.7%) 19.6%
</TABLE>
NINE MONTHS ENDED SEPTEMBER 30, 1996 AND 1995
Revenue
License fees revenue increased 90.1% from $5,964,000 for the nine months
ended September 30, 1995 to $11,335,000 for the nine months ended September
30, 1996. This increase is primarily attributable to: (i) increased unit
shipments as a result of expanded market acceptance of SQA's products and
continued growth in the market for automated testing of Windows client/server
applications, (ii) the introduction of new products and product upgrades,
(iii) expanded sales and marketing activities, including an increase in the
number of resellers of SQA's products, and (iv) increases in the list prices
of SQA's products.
Service revenue increased 99.0% from $2,722,000 for the nine months ended
September 30, 1995 to $5,417,000 for the nine months ended September 30, 1996.
This increase is primarily attributable to the expansion of SQA's customer
base, renewals of annual service contracts by existing customers, and SQA's
continued emphasis on the sale and marketing of services. To date, a
substantial majority of SQA's customers have purchased annual service
contracts and/or training and consulting services at the time of purchasing
SQA's products. SQA's success to date has depended to a significant extent
upon a number of key management and technical employees, and SQA's ability to
manage growth will require it to continue to recruit and retain senior
management personnel and to motivate and effectively manage an increasing
number of employees providing services related to SQA's products.
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International revenue accounted for 22.2% of total revenue for the nine
months ended September 30, 1996, versus 21.1% of total revenues in the
comparable periods of 1995. This increase is attributable to SQA's increasing
focus on international markets and its entry into new markets such as Japan.
SQA expects that international revenue will continue to represent a
significant portion of total revenue. However, the percentage of total revenue
derived internationally may fluctuate on a quarterly basis in the future based
on the timing of orders from international distributors and end users, the
addition of new international distributors, and the development of new
features designed to address the needs of users in international markets.
In general, revenues are difficult to forecast because the market for
software testing products is evolving rapidly and SQA's sales cycle, from the
customer's initial evaluation through purchase of product and related support
services, varies substantially from customer to customer. License fees revenue
from quarter to quarter is difficult to forecast, as no significant order
backlog exists at the end of any quarter, since SQA's products are typically
shipped and revenues recognized upon receipt of customers' orders.
Accordingly, license fees revenue in any quarter is dependent substantially on
orders received, booked and shipped in that quarter. In addition, SQA has
historically derived a substantial portion of its license fees revenue from
direct sales activities, including telesales activities, for which forecasts
are inherently difficult. There can be no assurance that these sales efforts
will continue to be successful in future quarters.
Gross Profit
Gross profit for the nine months ended September 30, 1996 increased to
86.2%, from 83.4% for the comparable period of 1995. This increase is
primarily attributable to the costs of both license fees revenue and service
revenue decreasing as a percentage of related revenue.
A substantial portion of SQA's cost of services revenue is related to
personnel, facilities, support and service programs, the spending on which
cannot be adjusted quickly and is therefore fixed in the short term. The level
of these expenses is based largely on SQA's expectations of future revenue
levels. Accordingly, future gross profit levels are highly dependent on future
revenue levels being sufficient to cover service costs. If actual revenue
levels on a quarterly basis are below management's expectations, gross profit
levels, as well as overall results of operations, would likely be adversely
affected.
Sales and Marketing Expenses
Sales and marketing expenses increased 69.3% to $7,233,000 for the nine
months ended September 30, 1996 from $4,272,000 in the comparable period of
1995. The increase in dollar amount is due to: (i) the hiring of additional
sales and marketing personnel, (ii) increased commissions due to the higher
revenue levels, and (iii) increases in the number of marketing seminars and
other promotional activities. Sales and marketing expenses as a percentage of
total revenue decreased due to enhanced productivity and efficiencies
associated with higher revenue levels.
SQA intends to continue to invest in its sales and marketing organization in
the future. There can be no assurance that such investments will result in
increased revenues. A substantial portion of sales and marketing expenses is
related to personnel, facilities, and marketing programs, the spending on
which cannot be adjusted quickly and is therefore fixed in the short term. The
level of these expenses is based largely on SQA's expectations of future
revenue levels. Accordingly, future operating results are highly dependent on
future revenue levels being sufficient to cover these expenses. If actual
future revenue levels are below management's expectations, operating results
would likely be adversely affected.
Research and Development Expenses
Research and development expenses increased 69.7% to $2,956,000 for the nine
months ended September 30, 1996 from $1,742,000 in the comparable period of
1995. The increase in dollar amount is due to increases in the number of
software engineers and technical personnel for both the development of new
products, as well as
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<PAGE>
the enhancement and support of existing products. Research and development
expenses decreased as a percentage of total revenue due to operating
efficiencies associated with higher revenue levels. The decrease in research
and development expenses as a percentage of total revenue for the nine months
ended September 30, 1996 was lower than expected due primarily to increased
spending in the third quarter of 1996 related to hiring of engineers and
technical personnel earlier in the quarter than originally planned. While
research and development personnel levels as of September 30, 1996, are in
line with SQA's plan, the fact that certain hires were made sooner than
planned resulted in the increase in research and development expenses as a
percentage of total revenue. SQA does not presently expect research and
development expenses as a percentage of total revenue to increase in the
future.
SQA intends to continue to invest in research and development for the
continued development of new products as well as the continued enhancement and
support of existing products. There can be no assurance that such investments
will result in increased revenues. A substantial portion of research and
development expenses is related to personnel and facilities, the spending on
which cannot be adjusted quickly and is therefore fixed in the short term. The
level of these expenses is based largely on SQA's expectations of future
revenue levels. Accordingly, future operating results are highly dependent on
future revenue levels being sufficient to cover these expenses. If actual
future revenue levels are below management's expectations, operating results
would likely be adversely affected.
General and Administrative Expenses
General and administrative expenses increased 25.8% to $1,936,000 for the
nine months ended September 30, 1996 from $1,539,000 in the comparable period
of 1995. The increase in dollar amount is due to an increase in administrative
personnel and related costs associated with the need to support SQA's growth.
The decrease in general and administrative expenses as a percentage of total
revenue is due to operating efficiencies associated with higher revenue
levels.
SQA intends to continue to invest in the development of its administrative
infrastructure necessary to support SQA's growth. A substantial portion of
general and administrative expenses is related to personnel and facilities,
the spending on which cannot be adjusted quickly and is therefore fixed in the
short term. The level of these expenses is based largely on SQA's expectations
of future revenue levels. Accordingly, future operating results are highly
dependent on future revenue levels being sufficient to cover these expenses.
If actual future revenue levels are below management's expectations, operating
results would likely be adversely affected.
Other Income
Other income, which consists primarily of interest income generated from
SQA's short-term investments, increased to $1,315,000 for the nine month
period ended September 30, 1996, from $162,000 in the comparable period of
1995. This increase is primarily due to an increase in the level of short-term
investments as a result of SQA's initial public offering in December 1995 and
an increase in cash generated from operations.
Provision for Income Taxes
As a result of the utilization of net operating loss carryforwards in
accordance with Statement of Financial Accounting Standards No. 109, SQA
expects that its effective tax rate for 1996 will approximate 9--10%.
Accordingly, for the nine months ended September 30, 1996, SQA has provided
$338,000 for income taxes.
As of December 31, 1995, SQA had established a full valuation allowance
against its deferred tax asset due to SQA's belief at that time it was more
likely than not that SQA would not earn sufficient taxable income in future
periods to recognize the benefit of its deferred tax asset. However, during
1996, SQA recognized a portion of its deferred tax asset based on SQA's
expected 1996 taxable income level. SQA will continue to evaluate its
operations to determine the extent to which its deferred tax asset should be
recognized.
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<PAGE>
FISCAL YEARS ENDED DECEMBER 31, 1995, 1994 AND 1993
Revenue
Total revenue consists of license fees revenue and services revenue. License
fees revenue consists of revenue from the granting of perpetual licenses to
use SQA's products. Services revenue consists of revenue from product support
and maintenance, training and consulting. International revenue accounted for
approximately 7.2%, 23.3% and 22.4% of total revenue in 1993, 1994 and 1995
respectively. SQA expects that international revenue will increase as a
percentage of total revenue as SQA increases its international sales and
marketing capabilities.
License fees revenue increased 129.4% from $1.5 million in 1993 to $3.4
million in 1994, and increased 160.9% to $8.8 million in 1995. These increases
in license fees revenue are primarily the result of increased unit shipments
in each of the respective periods, as well as increases in the list price for
SQA's license fee products in each of 1993, 1994 and 1995. These price
increases took effect in April 1993 and in September 1994 and 1995. There can
be no assurance that in the future SQA will be able to increase prices for its
products or avoid pressure to lower prices. Management believes that the
increased unit shipments were due to an increase in the total market for
automated testing of Windows client/server applications, the introduction by
SQA of new and upgraded products, increased market acceptance of SQA's
products, primarily SQA Robot, as evidenced in particular by additional sales
to existing licensees; and expanded sales and marketing activities by SQA,
including an increase in the number of resellers of SQA's products. SQA
accounts for product returns and allowances at the time of shipment. Through
December 31, 1995, returns and allowances were immaterial.
Revenue from services increased 498.9% from $177,000 in 1993 to $1.1 million
in 1994, and increased 277.5% to $4.0 million in 1995. The increases in
revenue from services are principally the result of increased volume from
support and training services, primarily due to the expansion of the installed
customer base, as well as a strong renewal rate from the existing customer
base. To date a substantial majority of SQA's customers have purchased annual
service contracts and/or training and consulting services at the time of
ordering software products.
Gross Profit
Gross profit increased to 83.5% of total revenues in 1995, from 78.2% in
1994 and 75.2% in 1993. These increases are primarily attributable to: (i)
significant increases in revenues derived from license fees, as the cost of
such revenues in nominal, and (ii) operating efficiencies in the service
organization associated with the increased revenue levels.
A substantial portion of SQA's cost of services revenue is related to
personnel, facilities, support and service programs, the spending on which
cannot be adjusted quickly and is therefore fixed in the short term. The level
of these expenses is based largely on SQA's expectations of future revenue
levels. Accordingly, future gross profit levels are highly dependent on future
revenue levels being sufficient to cover service costs. If actual revenue
levels on an annual basis are below management's expectations, gross profit
levels, as well as overall results of operations would likely be adversely
affected.
Sales and Marketing Expenses
Sales and marketing expenses consist principally of salaries, commissions
and related costs for SQA personnel, marketing seminars and other promotional
expenses. As a percentage of total revenue, sales and marketing expenses were
97.3%, 75.4% and 46.7% in 1993, 1994 and 1995, respectively. The principal
reasons for the absolute dollar increases in sales and marketing expenses in
all periods were increases in the number of sales personnel, increases in
commissions as a result of higher revenue levels, increases in the number of
marketing seminars conducted and increases in other promotional activities.
Sales and marketing expenses as a percentage of total revenue has decreased in
each of the periods presented due to increases in the effectiveness
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<PAGE>
of the sales organization. SQA increased the amount of expenditures for sales
and marketing, both domestically and internationally in 1996. There can be no
assurance that such expenditures will result in increased revenues or
continued improvement in the effectiveness of SQA's sales organization.
Research and Development Expenses
Research and development expenses consist primarily of the employment-
related costs for engineering and technical personnel associated with
developing new products or enhancing existing products. To date, all of SQA's
costs for research and development of software products have been charged to
operations as incurred, since the amount of software development costs
incurred subsequent to the establishment of technological feasibility has been
immaterial. As a percentage of total revenue, research and development
expenses were 45.3%, 38.8% and 18.4% in 1993, 1994 and 1995, respectively. The
dollar increases in all periods are attributable to increases in the number of
engineers and technicians employed in the development of new products and the
enhancement of existing products. SQA intends to employ additional research
and development staff and therefore the cost of research and development in
absolute dollars continued to increase in 1996.
General and Administrative Expenses
General and administrative expenses consist of employment-related costs for
administrative personnel, professional and other general corporate expenses.
As a percentage of total revenue, general and administrative expenses were
35.3%, 20.2% and 17.0% in 1993, 1994 and 1995, respectively. The dollar
increases in general and administrative expenses are attributable to increased
employment of finance and administrative personnel and increases in
professional and other general corporate expenses. General and administrative
expenses have been increasing during the periods presented at a rate less than
the rate of increase in total revenue. Therefore, general and administrative
expenses as a percentage of total revenue has decreased during the periods
presented. General and administrative expenses increased in 1996 in absolute
dollars in part due to the increased costs associated with its becoming a
publicly-held company.
Other Income
Other income is primarily composed of interest income from cash and cash
equivalents. SQA generally invests in U.S. Government treasury bills and money
market accounts. The amount of interest income fluctuates based upon the
amount of funds available for investment and prevailing interest rates.
Provision for Income Taxes
For the years ended December 31, 1993, 1994 and 1995, SQA did not recognize
the benefit of its deferred tax asset and accordingly established a full
valuation allowance due to SQA's history of operating losses and SQA's belief
at that time it was more likely than not that SQA would not earn sufficient
taxable income in future periods to realize the benefit of its deferred tax
asset.
LIQUIDITY AND CAPITAL RESOURCES
To date, SQA has satisfied its cash requirements principally with the
proceeds of equity financings and cash provided from operations. SQA completed
an initial public offering of 2,000,000 shares of its Common Stock at a price
of $16 per share, in December 1995. Total cumulative net proceeds from these
financings is approximately $44 million. Cash and cash equivalents totaled
$40,382,000 at September 30, 1996 compared to $36,444,000 at December 31,
1995.
Net cash provided by operations was $2,301,000 for the nine months ended
September 30, 1996 compared to $45,000 in the comparable period of 1995. The
increase in cash provided by operations is attributable to the increased
operating income in 1996 versus 1995, and the timing of changes in working
capital in 1996 compared to 1995. Net cash used in SQA's investing activities
was $2,909,000 and $420,000 for the nine months ended September 30, 1996 and
1995, respectively. The increase in cash used in investing activities in 1996
was due to the expansion of SQA's employee base, in addition to SQA's
relocation to a larger corporate headquarters. SQA anticipates that additional
purchases of equipment will need to be made as SQA's employee base continues
to grow.
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<PAGE>
In 1993 and 1994, operating activities used $1.5 million and $1.4 million of
cash, respectively, primarily related to significant net losses as well as
increases in accounts receivable. In 1995, operating activities provided $1.0
million in cash, primarily related to increases in net income, accounts
payable, accrued expenses and deferred revenue, offset in part by increases in
accounts receivable. SQA used $98,000, $140,000 and $806,000 in 1993, 1994 and
1995, respectively, for investing activities. The net cash used for investing
activities in each period relates primarily to the purchase of property and
equipment, principally computers and related software.
As of September 30, 1996 SQA had working capital of $40,069,000 compared
with $34,811,000 at December 31, 1995. SQA does not have a bank line of
credit. SQA believes that as of September 30, 1996, its cash and cash
equivalents, together with its cash flows from operations will be sufficient
to meet its working capital and capital expenditure requirements for the
foreseeable future.
FUTURE OPERATING RESULTS
SQA does not provide forecasts of its future financial performance. Certain
information provided by SQA or statements made by its employees may contain
"forward-looking" information which include substantial risks and
uncertainties concerning SQA's future results of operations. SQA makes such
forward-looking statements under the provisions of the "safe harbor" section
of the Private Securities Litigation Reform Act of 1995. Depending on a
variety of factors, SQA's actual future results may differ materially from
those which could be inferred from certain forward-looking statements
contained herein. Such factors include, but are not limited to, the following:
limited history of profitability, fluctuations in quarterly results,
dependence on the client/server environment, an emerging market for software
testing tools, dependence on Microsoft's Windows operating system, dependence
on principal products, dependence on third parties for compatibility with
development tool architecture, competition, rapid technological change,
potential for new product delays and defects, dependence on proprietary
technology, management of change, international operations, and fluctuations
in economic and market conditions. The market price of SQA's common shares
could be subject to significant fluctuations in response to quarter-to-quarter
variations in SQA's operating results, announcements of technological
innovations or new products by SQA or its competitors and other events or
factors. In addition, the stock market in recent years has experienced extreme
price and volume fluctuations that have particularly affected the market
prices of many technology companies. These fluctuations, as well as general
economic and market conditions, may materially and adversely affect the market
price of SQA's common shares. Because of these and other factors, past
financial performance should not be considered an indicator of future
performance.
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SQA MANAGEMENT
MANAGEMENT
<TABLE>
<CAPTION>
NAME AGE POSITION
---- --- --------
<S> <C> <C>
Ronald H. Nordin............. 46 President, Chief Executive Officer and
Director
Thomas Bogan................. 45 Senior Vice President, Finance &
Administration, Chief Financial Officer,
Treasurer and Assistant Secretary
Frederick J. Ciaramaglia..... 49 Vice President, Research and Development
James P. Cluchey............. 49 Vice President, Managing Director of European
Operations
William T. Dedrick........... 40 Vice President, U.S. Sales
Roger A. Hodskins............ 41 Vice President, Enterprise Partners
Eric L. Schurr............... 38 Vice President, Product Management and
Marketing
David J. Orfao............... 38 Senior Vice President, Worldwide Sales and
Support
Debra S. Ternove............. 40 Vice President, Human Resources
Edward T. Anderson (1)(2).... 46 Director
Thomas I. Csathy (2)......... 65 Director
Ted R. Dintersmith (1)....... 44 Director
Jerald G. Fishman (1)........ 50 Director
Paul A. Maeder (2)........... 42 Director
</TABLE>
- --------
(1) Member of Compensation Committee.
(2) Member of Audit Committee.
Ronald H. Nordin has served as President and Chief Executive Officer of SQA
since August 1992, and as a Director of SQA since October 1992. Prior to
joining SQA, Mr. Nordin was Senior Vice President, Marketing at Cognos, Inc.
("Cognos") and held various other positions at Cognos from 1983 to 1992. From
1978 to 1983, Mr. Nordin was Regional Sales Manager and Manager, Consulting
Services, for Quasar Systems, Ltd. From 1974 to 1978, Mr. Nordin was a
management consultant with Touche Ross & Partners.
Thomas F. Bogan has served as Senior Vice President, Finance &
Administration, Chief Financial Officer, Treasurer, and Assistant Secretary
since July 1996. Prior to joining SQA, Mr. Bogan was President and Chief
Executive Officer of Pacific Data Products, Inc., a printer peripherals and
networking vendor from 1993 to 1996. From 1987 to 1993, Mr. Bogan was
President and Chief Executive Officer of Avatar Corporation, a provider of
Macintosh networking and connectivity solutions. Mr. Bogan is a director of
American Service Group, Inc.
Frederick J. Ciaramaglia joined SQA in March 1994 as Vice President,
Research and Development. From 1992 to 1994, Mr. Ciaramaglia served as Senior
Vice President, Development at Clinical Information Advantages, Inc., a
computerized patient record software products company. Mr. Ciaramaglia was a
founder of Softbridge Microsystems, Inc., a software development company and
served as its Senior Vice President, Technology from 1983 to 1992.
James P. Cluchey joined SQA in January 1995 as Vice President, Managing
Director of European Operations. From 1993 to 1995, Mr. Cluchey served as Vice
President Europe of ST Europe PLC, a sales force automation software company
and a subsidiary of the Dun and Bradstreet group. From 1991 to 1993, Mr.
Cluchey served as Vice President Europe of Datalogix Europe, the European
division of Datalogix International, Inc., a software applications company.
Mr. Cluchey served as Vice President and General Manager of Cognos Europe from
1986 to 1991.
William T. Dedrick joined SQA in 1993 as Vice President, U.S. Sales. From
1992 to 1993, Mr. Dedrick served as Vice President, North America Sales of
Easel Corporation, a software development company. From 1984 through 1991, Mr.
Dedrick held several positions at Index Technology Corporation, most recently
as Vice President, North American Sales.
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<PAGE>
Roger A. Hodskins joined SQA in February 1992 as the Director of Alternate
Channels and was appointed Vice President, Enterprise Partners in January
1995. In January 1996, Mr. Hodskins was appointed Vice President, Strategic
Alliances. From 1988 to 1992, Mr. Hodskins served as Manager, Geographic
Information Systems and Senior International Marketing Manager of Wang
Laboratories, Inc. From 1986 through 1988, Mr. Hodskins served as Product
Manager of ITS, Inc.
Eric L. Schurr joined SQA in November 1992 as the Director of Marketing and
was appointed as Vice President, Product Management and Marketing in April
1994. From 1983 to 1992, Mr. Schurr held various field, technical and
marketing positions at Cognos, most recently as Director, Marketing Support.
From 1980 through 1983, Mr. Schurr was an analyst at The Standard Oil Company.
David J. Orfao joined SQA in November 1995 as the Senior Vice President,
Worldwide Sales and Support. From July 1993 to October 1995, Mr. Orfao served
as Senior Vice President, Sales Operation and Support of Claris Corporation.
From May 1988 to June 1993, Mr. Orfao served as Senior Vice President,
Sales/Operation of FrameTech.
Debra S. Ternove joined SQA in October 1996 as Vice President, Human
Resources. Prior to joining SQA, Ms. Ternove was self-employed as a Human
Resources Consultant from 1995 to 1996. From 1993 to 1995, Ms. Ternove was
Vice President, Human Resources for Aetna Professional Management Corporation.
From 1989 to 1993, Ms. Ternove held various positions at Pizza Hut, a
subsidiary of PepsiCo, including Director, Human Resources for the Texas
Division and the Metro New York Market, and Regional Human Resources Manager
for the North Atlantic Division.
Edward T. Anderson has served as a Director of SQA from March 1990 to June
1990 and from September 1991 to present. Mr. Anderson is the managing general
partner of the general partner of North Bridge Venture Partners, L.P., a
stockholder of SQA. In addition, Mr. Anderson has been a general partner of
Calvert Capital, L.P., a partnership that has an ownership interest in, and
has voting and investment control over, ABS Ventures III Limited Partnership,
a venture capital fund which is a stockholder of SQA. Mr. Anderson is also a
limited partner of Brown Technology Associates Limited Partnership, a
stockholder of SQA, and as such has no voting or investment control over Brown
Technology Associates Limited Partnership.
Thomas I. Csathy has served as a Director of SQA since September 1995. Mr.
Csathy is President of T.I. Csathy Associates Inc., a consulting company. From
1986 to 1989, Mr. Csathy was President of Cognos, an application development
software tools company. Mr. Csathy also currently serves as Chairman of the
Board of Directors of Fulcrum Technologies, Inc., Vice Chairman and a director
of Mosaid Technologies, Inc. and a director of Andyne Computing Limited.
Ted R. Dintersmith has served as a Director of SQA since June 1991. Since
1989, Mr. Dintersmith has been a general partner of Aegis II Limited
Partnership and Aegis Select Limited Partnership, venture capital funds and
stockholders of SQA. Mr. Dintersmith also currently serves as a director of
IBIS Technology Corporation.
Jerald G. Fishman has served as a Director of SQA since September 1995. Mr.
Fishman has been with Analog Devices, Inc. for more than five years, and
currently serves as its President and Chief Executive Officer since November
1991. Mr. Fishman also currently serves as a director of Augat, Inc. and
Kollmorgen Corporation.
Paul A. Maeder has served as a Director of SQA since June 1993. Mr. Maeder
has been a managing general partner of the general partner of Highland Capital
Partners II Limited Partnership, a stockholder of SQA, and affiliated venture
capital partnerships and has been an employee of Highland Capital Partners,
Inc., a venture capital firm, since 1988. Mr. Maeder also currently serves as
a director of Avid Technology, Inc. and The Providence Journal Company.
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<PAGE>
SQA STOCK INFORMATION
The following table sets forth certain information regarding beneficial
ownership of SQA's Common Stock as of January 6, 1997 by: (i) each person who
is known by SQA to own beneficially more than 5% of the outstanding shares of
Common Stock; (ii) each director of SQA; (iii) SQA's Chief Executive Officer
and each of SQA's four other most highly compensated executive officers for
fiscal year ended December 31, 1995; and (iv) all directors and executive
officers of SQA as a group.
<TABLE>
<CAPTION>
AMOUNT AND NATURE PERCENTAGE OF COMMON PERCENTAGE AFTER
NAME OF BENEFICIAL OWNER OF OWNERSHIP(1) STOCK OUTSTANDING(2) THE MERGER(3)
------------------------ ----------------- -------------------- ----------------
<S> <C> <C> <C>
Rational Software 2,815,296 29.64% --
Corporation(4).....
2800 San Tomas
Expressway
Santa Clara, CA
95051-0951
Highland Capital 1.14%
Partners II Limited 628,180 7.75%
Partnership(5).....
Two International
Place
Boston, MA 02110
Attn: Mr. Paul A.
Maeder
North Bridge Venture 506,363 6.24% *
Partners, L.P.(6)..
404 Wyman Street,
Suite 365
Waltham, MA 02154
Attn: Mr. Edward T.
Anderson
Ronald H.
Nordin(7).......... 154,856 1.88% *
Frederick J.
Ciaramaglia(8)..... 18,120 * *
William T.
Dedrick(9)......... 3,065 * *
Roger A.
Hodskins(10)....... 5,594 * *
James P.
Cluchey(11)........ 18,000 * *
Edward T. 891,853 11.00% 1.62%
Anderson(12).......
c/oNorth Bridge
Venture Partners,
L.P.
404 Wyman Street,
Suite 365
Waltham, MA 02154
Thomas I.
Csathy(13)......... 1,000 * *
Ted R.
Dintersmith(14).... 123,932 1.53% *
Paul A. Maeder(15).. 702,012 8.66% 1.28%
c/oHighland Capital
Partners II Limited
Partnership
Two International
Place
Boston, MA 02110
All executive
officers and
directors as a
group (14
persons)(16)....... 1,948,762 23.52% 3.54%
</TABLE>
- --------
* Less than one percent of the outstanding Common Stock.
(1) The persons named in the table have sole voting and investment power with
respect to all shares shown as beneficially owned by them, except as
noted in the footnotes below.
(2) The number of shares of Common Stock deemed outstanding on November 12,
1996 includes (i) 8,110,523 shares of Common Stock outstanding on such
date and (ii) all options that are currently exercisable or will become
exercisable within 60 days of January 6, 1997 by the person or group in
question.
(3) Represents percentage interest in Rational after the Merger, calculated
assuming the issuance of 7,000,000 shares of Rational Common Stock upon
the conversion of SQA Common Stock.
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<PAGE>
(4) Includes 1,213,296 shares that Rational has the right to acquire under
certain circumstances pursuant to the Stock Option Agreement. If
acquired, Rational will have sole voting power and sole dispositive power
over such shares. Also includes 1,602,000 shares as to which Rational
shares voting power with SQA directors, certain officers, and certain
stockholders of SQA, pursuant to the Participation Agreement. Rational
does not have shared dispositive power with respect to such shares. If
the Merger is consummated, Rational's option to purchase SQA Common Stock
will not have become exercisable, and the Participation Agreement will
have terminated. See "Terms of the Merger--Stock Option Agreement" and
"Participation Agreement."
(5) Paul A. Maeder, James L. McLean, and Robert F. Higgins, the general
partners of Highland Management Partners II Limited Partnership, may be
deemed to share voting and investment power with respect to such shares.
Highland Management Partners II Limited Partnership, Mr. Maeder, Mr.
McLean and Mr. Higgins disclaim beneficial ownership with respect to the
shares held by Highland Capital Partners II Limited Partnership, except
to the extent of their proportionate pecuniary interests therein.
(6) North Bridge Venture Management, L.P., the sole general partner of North
Bridge Venture Partners, L.P., and Edward T. Anderson, Richard A. D'Amore
and Robert Walkingshaw, the general partners of North Bridge Venture
Management, L.P., may be deemed to share voting and investment power with
respect to such shares. North Bridge Venture Management, L.P., Mr.
Anderson, Mr. D'Amore and Mr. Walkingshaw disclaim beneficial ownership
with respect to such shares, except to the extent of their proportionate
pecuniary interests therein.
(7) Includes 114,826 shares of Common Stock issuable pursuant to stock
options that are currently exercisable or will become exercisable within
60 days of January 6, 1997. Includes 12,000 shares held by Mr. Nordin's
spouse, as to which shares Mr. Nordin disclaims beneficial ownership.
(8) Includes 13,670 shares of Common Stock issuable pursuant to stock options
that are currently exercisable or will become exercisable within 60 days
of January 6, 1997.
(9) Includes 425 shares of Common Stock issuable pursuant to presently
exercisable stock options that are currently exercisable or will become
exercisable within 60 days of January 6, 1997.
(10) Includes 2,675 shares of Common Stock issuable pursuant to presently
exercisable stock options that are currently exercisable or will become
exercisable within 60 days of January 6, 1997.
(11) Includes 17,400 shares of Common Stock issuable pursuant to presently
exercisable stock options that are currently exercisable or will become
exercisable within 60 days of January 6, 1997.
(12) Includes 506,363 shares of Common Stock held by North Bridge Venture
Partners, L.P. and 346,762 shares of Common Stock held by ABS Ventures
III Limited Partnership.
(13) Includes 1,000 shares of Common Stock held by Mr. Csathy's spouse, as to
which shares Mr. Csathy disclaims beneficial ownership.
(14) Includes 65,654 shares of Common Stock held by Aegis Select Limited
Partnership and 43,636 shares of Common Stock held by Aegis II Limited
Partnership.
(15) Includes 628,180 shares of Common Stock held by Highland Capital Partners
II Limited Partnership.
(16) Includes 175,626 shares of Common Stock issuable pursuant to stock
options that are currently exercisable or will become exercisable within
60 days of January 6, 1997.
112
<PAGE>
SQA STOCK PRICE AND DIVIDEND INFORMATION
SQA's Common Stock is quoted on Nasdaq under the symbol "SQAX." The
following table sets forth for the periods indicated the high and low sale
prices for SQA's Common Stock.
<TABLE>
<CAPTION>
FISCAL YEAR HIGH LOW
----------- ------ ------
<S> <C> <C>
Fiscal 1997
First Quarter (through January 9, 1997)....................... $33.88 $32.25
------ ------
Fiscal 1996
Fourth Quarter.............................................. $33.25 $21.75
------ ------
Third Quarter............................................... 29.50 17.50
------ ------
Second Quarter.............................................. 39.75 27.00
------ ------
First Quarter............................................... 27.75 18.00
------ ------
Fiscal 1995
Fourth Quarter (from December 16, 1995)..................... 24.00 16.00
------ ------
</TABLE>
On , 1997, the last reported sale price for SQA's Common Stock was $
per share. As of , 1997, there were holders of record of SQA Common
Stock.
SQA has not paid any cash dividends since its inception and does not
anticipate paying cash dividends in the foreseeable future. SQA currently
intends to retain available future earnings to finance the operation of its
business.
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<PAGE>
COMPARISON OF CAPITAL STOCK
DESCRIPTION OF RATIONAL CAPITAL STOCK
The authorized capital stock of Rational consists of 75,000,000 shares of
Common Stock, $0.01 par value per share.
Rational Common Stock
As of the Rational Record Date, there were approximately shares of
Rational Common Stock outstanding held of record by
approximately stockholders. Rational Common Stock is listed on Nasdaq under
the symbol "RATL." Holders of Rational Common Stock are entitled to one vote
per share on all matters to be voted upon by the stockholders. The
stockholders may take action by written consent in accordance with the DGCL,
but do not have the right to cumulate votes in connection with the election of
Directors. The Rational Board is divided into three classes, each of which is
elected for a three year term. The term of one class of Directors terminates
at each annual meeting of stockholders. The holders of Rational Common Stock
are entitled to receive ratably such dividends, if any, as may be declared
from time to time by the Board of Directors out of funds legally available
therefor. In the event of a liquidation, dissolution or winding up of
Rational, the holders of Rational Common Stock are entitled to share ratably
in all assets remaining after payment of liabilities. The Rational Common
Stock has no preemptive, conversion rights or other subscription rights and
there are no redemption or sinking fund provisions applicable to the Rational
Common Stock. All outstanding shares of Rational Common Stock are fully paid
and non-assessable, and the shares of Rational Common Stock to be outstanding
upon completion of the Merger will be fully paid and non-assessable.
Transfer Agent and Registrar
The Transfer Agent and Registrar for the Rational Common Stock is
ChaseMellon Shareholder Services and its telephone number is (415) 954-9512.
DESCRIPTION OF SQA CAPITAL STOCK
The authorized capital stock of SQA consists of 18,000,000 shares of SQA
Common Stock, $0.01 par value per share, and 3,000,000 shares of Preferred
Stock, $.01 par value per share (the "Preferred Stock").
SQA Common Stock
As of the SQA Record Date, there were approximately shares of SQA Common
Stock outstanding held of record by approximately stockholders. SQA Common
Stock is listed on Nasdaq under the trading symbol "SQAX." Holders of SQA
Common Stock are entitled to one vote per share on all matters to be voted
upon by the stockholders. The stockholders do not have the right to take any
action by written consent, nor may they cumulate votes in connection with the
election of directors. The SQA Board is divided into three classes, each of
which is elected for a three year term. The term of one class of Directors
expires at each annual meeting of stockholders. Subject to any rights of the
Preferred Stock, the stockholders are entitled to receive such lawful
dividends as may be declared by SQA's Board of Directors. In the event of the
liquidation, dissolution or winding up of SQA, the holders of shares of SQA
Common Stock will be entitled to share ratably in SQA's assets available for
distribution to the holders of Common Stock. The SQA Common Stock has no pre-
emptive or conversion or other subscription rights, and there are no
redemption or other sinking fund provisions applicable to the SQA Common
Stock. All outstanding shares of SQA Common Stock are fully paid and
nonassessable.
Preferred Stock
The SQA Board has the authority, without any further vote or action by the
stockholders, to provide for the issuance of up to 3,000,000 shares of
Preferred Stock in series, to establish from time to time the number of
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<PAGE>
shares to be included in each such series, to fix the designations,
preferences, limitations and relative, participating, optional or other
special rights and qualifications or restrictions of the shares of each
series, and to determine the voting powers, if any, of such shares. The
issuance of Preferred Stock could adversely affect, among other things, the
rights of existing stockholders or could delay or prevent a change in control
of SQA without further action by the stockholders. The issuance of Preferred
Stock could decrease the amount of earnings and assets available for
distribution to holders of SQA Common Stock. In addition, any such issuance
could have the effect of delaying, deferring or preventing a change in control
of SQA and could make the removal of the present management of SQA more
difficult. The SQA Board has no current plans to issue any Preferred Stock.
The Transfer Agent and Registrar for SQA Common Stock is First National Bank
of Boston, and its telephone number is (617) 575-2000.
COMPARISON OF CAPITAL STOCK
After consummation of the Merger, the holders of SQA Common Stock who
receive Rational Common Stock under the terms of the Agreement will become
stockholders of Rational. Because SQA and Rational are both Delaware
corporations, SQA stockholders' rights will continue to be governed by the
DGCL. Additionally, as stockholders of SQA, their rights are presently
governed by the SQA Certificate of Incorporation, as amended (the "SQA
Charter") and the SQA Bylaws (the "SQA Bylaws"). As stockholders of Rational,
their rights will be governed by the Rational Certificate of Incorporation
(the "Rational Charter") and Rational Bylaws (the "Rational Bylaws"). The
following discussion summarizes only the material differences between the
rights of holders of Rational Common Stock and holders of SQA Common Stock
under the charters and bylaws of Rational and SQA. Because the rights of the
SQA Preferred Stock are as yet undetermined, and because the SQA Board has no
present intent to determine them, except as otherwise stated the following
discussion will compare Rational Common Stock with the SQA Common Stock, and
will only identify those areas where there are material differences. This
summary does not purport to be complete and is qualified in its entirety by
reference to the Rational Charter and Bylaws, the SQA Charter and Bylaws and
the relevant provisions of the DGCL.
Preferred Stock
The SQA charter authorizes the SQA Board to issue one or more series of
preferred stock of as yet undetermined characteristics. The Rational Charter
authorizes no such class of preferred stock. The absence of a class of
undesignated preferred means that, unlike the SQA Board, the Rational Board
cannot, without shareholder approval, issue shares of stock that could have
conversion and/or voting rights that could adversely affect the rights of the
Common Stock. In addition, the Rational Board cannot issue such a class of
stock for the purpose of delaying, deferring or preventing a change of control
of the company.
Charter Amendments
The Rational Charter provides that Charter amendments must be approved by
the Rational Board of Directors and a simple majority vote of the outstanding
Common Stock. The SQA Charter requires approval of the SQA Board of Directors
and a supermajority vote of sixty-six and two thirds percent of the
outstanding capital stock, voting together as a class, to approve any
amendment relating to (i) the reduction in the number or elimination of the
Common Stock or the Preferred Stock, (ii) any changes to the rights and
privileges of the Common Stock or the Preferred Stock, (iii) any change to the
perpetual existence of SQA, (iv) any changes to the definition, limitation, or
regulation of the powers of the SQA Board of Directors or the SQA
stockholders, (v) any changes to the size, classification of and certain other
matters relating to the SQA Board of Directors, (vi) limitation on the
liability of directors, and (vii) indemnification of directors. Other
amendments to the SQA Charter require only SQA Board approval and a simple
majority vote of the SQA stockholders.
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Bylaws Amendments
The SQA Charter provides that the Bylaws of the corporation may be amended
by the Board of Directors or by a supermajority vote of sixty-six and two-
thirds percent of the stockholders. The Rational Charter and Bylaws allow for
the amendment of the Bylaws by the Board of Directors or by a simple majority
of the stockholders.
Special Meetings of the Stockholders
The SQA Charter provides that special meetings of stockholders may be called
by the SQA President, Chairman of the Board of Directors, or by a majority of
the Board of Directors. The Rational Bylaws provide that a special meeting of
the stockholders may be called by the President, the Chairman of the Board of
Directors, or by any stockholder or stockholders holding at least 10% of the
shares of stock entitled to vote at such meeting.
Actions By Written Consent
Rational stockholders have the right to take actions by written consent in
lieu of a meeting, pursuant to the DGCL. The SQA Charter does not allow
stockholders to take actions by written consent in lieu of a meeting.
Removal of Directors
The SQA Charter requires a seventy-five percent vote of the shares of stock
entitled to vote to remove a director without cause, and a simple majority
vote to remove a director with cause. The Rational Bylaws require only a
simple majority vote of stockholders to remove a director with or without
cause.
Stockholder Business at Meetings
The Rational Charter and Bylaws place no restrictions on the rights of
stockholders to raise business at an annual meeting. The SQA Bylaws provide
that for business to be timely brought before an annual meeting of the
stockholders, notice of such business must be made to the Secretary of the
corporation no later than the 120th day nor earlier than the 150th day prior
to the first anniversary of the date of delivery of the proxy statement to
stockholders for the prior year annual meeting, except under certain
circumstances. Except for nominations to the Board of Directors, The SQA
Bylaws provide that only such business as is proposed by the Board of
Directors may be raised at any special meeting of the stockholders.
Indemnification of Directors and Officers
The Rational Charter allows the company to indemnify its directors and
officers to the fullest extent allowable under the DGCL, and the Rational
Bylaws provide that Rational shall so indemnify its directors and officers.
The SQA Charter provides that SQA shall indemnify its directors and officers
to the fullest extent allowable under the DGCL. See "--Charter Amendments."
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<PAGE>
PROPOSAL NO. 2 FOR RATIONAL STOCKHOLDERS:
APPROVAL OF THE 1997 STOCK OPTION PLAN
On January 10, 1997, the Rational Board of Directors adopted the 1997 Stock
Option Plan (the "Plan") and reserved one million (1,000,000) shares of
Rational Common Stock for issuance thereunder subject to stockholder approval.
As of the mailing hereof no options or rights to purchase stock had been
granted pursuant to the Plan. In addition, as of January 10, 1997, there were
available for issuance under previous Rational stock option plans (exclusive
of the Stock Option Plan for Directors) (the "Previous Plans") 665,276 shares
of Rational Common Stock for which no options to purchase were outstanding.
Upon approval of the Plan, no new options will be granted for shares pursuant
to the Previous Plans, and those shares remaining available under Previous
Plans for which no options were outstanding will be added to the reserved
option pool under the Plan.
At the Rational meeting, the stockholders are being asked to approve the
Plan and the reservation of shares thereunder.
SUMMARY OF THE PLAN
General. The purpose of the Plan is to attract and retain the best available
personnel for positions of substantial responsibility with Rational, to
provide additional incentive to the employees and consultants of Rational and
to promote the success of Rational's business. Options and stock purchase
rights may be granted under the Plan. Options granted under the Plan may be
either "incentive stock options," as defined in Section 422 of the Internal
Revenue Code of 1986, as amended (the "Code"), or nonstatutory stock options.
Administration. The Plan may be administered by the Rational Board of
Directors or a committee of the Rational Board (the "Administrator"), which
Administrator shall, in the case of options intended to qualify as
"performance-based compensation" within the meaning of Section 162(m) of the
Code, consist of two or more "outside directors" within the meaning of Section
162(m) of the Code. The Administrator has the power to determine the terms of
the options or stock purchase rights granted, including the exercise price,
the number of shares subject to each option or stock purchase right, the
exercisability thereof, and the form of consideration payable upon such
exercise. In addition, the Administrator has the authority to amend, suspend
or terminate the Plan, provided that no such action may affect any share of
Rational Common Stock previously issued and sold or any option previously
granted under the Plan.
Eligibility; Limitations. Nonstatutory stock options and stock purchase
rights may be granted under the Plan to employees and consultants of Rational
and any parent or subsidiary of Rational. Incentive stock options may be
granted only to employees. The Administrator, in its discretion, selects the
employees and consultants to whom options and stock purchase rights may be
granted, the time or times at which such options and stock purchase rights
shall be granted, and the number of shares subject to each such grant.
Section 162(m) of the Code places limits on the deductibility for federal
income tax purposes of compensation paid to certain executive officers of
Rational. In order to preserve Rational's ability to deduct the compensation
income associated with options and stock purchase rights granted to such
persons, the Plan provides that no employee may be granted, in any fiscal year
of Rational, options and stock purchase rights to purchase more than 500,000
shares of Common Stock (as appropriately adjusted for changes in the
capitalization of Rational). Notwithstanding this limit, however, in
connection with an employee's initial employment, he or she may be granted
options or stock purchase rights to purchase up to an additional 500,000
shares of Common Stock (as appropriately adjusted for changes in the
capitalization of Rational).
Terms and Conditions of Options. Each option is evidenced by a stock option
agreement between Rational and the optionee, and is subject to the following
additional terms and conditions:
(a) Exercise Price. The Administrator determines the exercise price of
options at the time the options are granted. The exercise price of an
incentive stock option may not be less than 100% of the fair market
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<PAGE>
value of the Common Stock on the date such option is granted; provided,
however, the exercise price of an incentive stock option granted to a 10%
stockholder may not be less than 110% of the fair market value of the
Common Stock on the date such option is granted. The fair market value of
the Common Stock is generally determined with reference to the closing sale
price for the Common Stock (or the closing bid if no sales were reported)
on the last market trading day prior to the date the option is granted.
(b) Exercise of Option; Form of Consideration. The Administrator
determines when options become exercisable, and may in its discretion,
accelerate the vesting of any outstanding option. Stock options granted
under the Plan generally vest and become exerciseable over four (4) years.
The means of payment for shares issued upon exercise of an option is
specified in each option agreement. The Plan permits payment to be made by
cash, check, promissory note, other shares of Common Stock of Rational
(with some restrictions), cashless exercises, a reduction in the amount of
any Company liability to the optionee, any other form of consideration
permitted by applicable law, or any combination thereof.
(c) Term of Option. The term of an incentive stock option may be no more
than ten (10) years from the date of grant; provided that in the case of an
incentive stock option granted to a 10% stockholder, the term of the option
may be no more than five (5) years from the date of grant. No option may be
exercised after the expiration of its term.
(d) Termination of Employment. If an optionee's employment or consulting
relationship terminates for any reason (other than death or disability),
then all options held by the optionee under the Plan expire on the earlier
of (i) the date set forth in his or her notice of grant or, in the absence
thereof, three (3) months after the date of termination or (ii) the
expiration date of such option. To the extent the option is exercisable at
the time of such termination, the optionee may exercise all or part of his
or her option at any time before termination.
(e) Death or Disability. If an optionee's employment or consulting
relationship terminates as a result of death or disability, then all
options held by such optionee under the Plan expire on the earlier of (i)
the date set forth in his or her notice of grant or, in the absence
thereof, 12 months from the date of such termination or (ii) the expiration
date of such option. The optionee (or the optionee's estate or the person
who acquires the right to exercise the option by bequest or inheritance),
may exercise all or part of the option at any time before such expiration
to the extent that the option was exercisable at the time of such
termination.
(f) Nontransferability of Options: Options granted under the Plan are not
transferable other than by will or the laws of descent and distribution,
and may be exercised during the optionee's lifetime only by the optionee.
(g) Other Provisions: The stock option agreement may contain other terms,
provisions and conditions not inconsistent with the Plan as may be
determined by the Administrator.
Stock Purchase Rights. A stock purchase right gives the purchaser a period
as determined by the Administrator from the date of grant to purchase Common
Stock. A stock purchase right is accepted by the execution of a restricted
stock purchase agreement between Rational and the purchaser, accompanied by
the payment of the purchase price for the shares. Unless the Administrator
determines otherwise, the restricted stock purchase agreement shall give
Rational a repurchase option exercisable upon the voluntary or involuntary
termination of the purchaser's employment or consulting relationship with
Rational for any reason (including death and disability). The purchase price
for any shares repurchased by Rational shall be the original price paid by the
purchaser. The repurchase option lapses at a rate determined by the
Administrator. A stock purchase right is nontransferable other than by will or
the laws of descent and distribution, and may be exercised during the
optionee's lifetime only by the optionee.
Adjustments Upon Changes in Capitalization. In the event that the stock of
Rational changes by reason of any stock split, reverse stock split, stock
dividend, combination, reclassification or other similar change in the capital
structure of Rational effected without the receipt of consideration,
appropriate adjustments shall be made
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in the number and class of shares of stock subject to the Plan, the number and
class of shares of stock subject to any option or stock purchase right
outstanding under the Plan, and the exercise price of any such outstanding
option or stock purchase right.
In the event of a liquidation or dissolution, any unexercised options or
stock purchase rights will terminate. The Administrator may, in its discretion
provide that each optionee shall have the right to exercise all of the
optionee's options and stock purchase rights, including those not otherwise
exercisable, until the date ten (10) days prior to the consummation of the
liquidation or dissolution, or that any rights of repurchase in Rational with
respect to Stock Purchase Rights shall lapse provided the proposed dissolution
or liquidation takes place at the time and in the manner anticipated.
In connection with any merger, consolidation, acquisition of assets or like
occurrence involving Rational, each outstanding option or stock purchase right
shall be assumed or an equivalent option or right substituted by the successor
corporation. If the successor corporation refuses to assume the options and
stock purchase rights or to substitute substantially equivalent options and
stock purchase rights, the optionee shall have the vested right to exercise
the option or stock purchase right as to all the optioned stock, including
shares not otherwise vested or exercisable. In such event, the Administrator
shall notify the optionee that the option or stock purchase right is fully
exercisable for fifteen (15) days from the date of such notice and that the
option or stock purchase right terminates upon expiration of such period.
Amendment and Termination of the Plan. The Board may amend, alter, suspend
or terminate the Plan, or any part thereof, at any time and for any reason.
However, Rational shall obtain stockholder approval for any amendment to the
Plan to the extent necessary to comply with Rule 16b-3, Section 162(m) and
Section 422 of the Code, or any similar rule or statute. No such action by the
Board or stockholders may alter or impair any option or stock purchase right
previously granted under the Plan without the written consent of the optionee.
Unless terminated earlier, the Plan shall terminate ten years from the date of
its approval by the stockholders or the Board of Rational, whichever is
earlier.
FEDERAL INCOME TAX CONSEQUENCES
Incentive Stock Options. An optionee who is granted an incentive stock
option does not recognize taxable income at the time the option is granted or
upon its exercise, although the exercise may subject the optionee to the
alternative minimum tax. Upon a disposition of the shares more than two years
after grant of the option and one year after exercise of the option, any gain
or loss is treated as long-term capital gain or loss. If these holding periods
are not satisfied, the optionee recognizes ordinary income at the time of
disposition equal to the difference between the exercise price and the lower
of (i) the fair market value of the shares at the date of the option exercise
or (ii) the sale price of the shares. Any gain or loss recognized on such a
premature disposition of the shares in excess of the amount treated as
ordinary income is treated as long-term or short-term capital gain or loss,
depending on the holding period. A different rule for measuring ordinary
income upon such a premature disposition may apply if the optionee is also an
officer, director, or 10% stockholder of Rational. Rational is entitled to a
deduction in the same amount as the ordinary income recognized by the
optionee.
Nonstatutory Stock Options. An optionee does not recognize any taxable
income at the time he or she is granted a nonstatutory stock option. Upon
exercise, the optionee recognizes taxable income generally measured by the
excess of the then fair market value of the shares over the exercise price.
Any taxable income recognized in connection with an option exercise by an
employee of Rational is subject to tax withholding by Rational. Rational is
entitled to a deduction in the same amount as the ordinary income recognized
by the optionee. Upon a disposition of such shares by the optionee, any
difference between the sale price and the optionee's exercise price, to the
extent not recognized as taxable income as provided above, is treated as long-
term or short-term capital gain or loss, depending on the holding period.
Stock Purchase Rights. Stock purchase rights will generally be taxed in the
same manner as nonstatutory stock options. However, restricted stock is
generally purchased upon the exercise of a stock purchase right. At
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the time of purchase, restricted stock is subject to a "substantial risk of
forfeiture" within the meaning of Section 83 of the Code. As a result, the
purchaser will not recognize ordinary income at the time of purchase. Instead,
the purchaser will recognize ordinary income on the dates when a stock ceases
to be subject to a substantial risk
of forfeiture. The stock will generally cease to be subject to a substantial
risk of forfeiture when it is no longer subject to Rational's right to
repurchase the stock upon the purchaser's termination of employment with
Rational. At such times, the purchaser will recognize ordinary income measured
as the difference between the purchase price and the fair market value of the
stock on the date the stock is no longer subject to a substantial risk of
forfeiture.
The purchaser may accelerate to the date of purchase his or her recognition
of ordinary income, if any, and the beginning of any capital gain holding
period by timely filing an election pursuant to Section 83(b) of the Code. In
such event, the ordinary income recognized, if any, is measured as the
difference between the purchase price and the fair market value of the stock
on the date of purchase, and the capital gain holding period commences on such
date. The ordinary income recognized by a purchaser who is an employee will be
subject to tax withholding by Rational. Different rules may apply if the
purchaser is also an officer, director, or 10% stockholder of Rational.
THE FOREGOING IS ONLY A SUMMARY OF THE EFFECT OF FEDERAL INCOME TAXATION
UPON OPTIONEES, HOLDERS OF STOCK PURCHASE RIGHTS, AND RATIONAL WITH RESPECT TO
THE GRANT AND EXERCISE OF OPTIONS AND STOCK PURCHASE RIGHTS UNDER THE PLAN. IT
DOES NOT PURPORT TO BE COMPLETE, AND DOES NOT DISCUSS THE TAX CONSEQUENCES OF
THE EMPLOYEE'S OR CONSULTANT'S DEATH OR THE PROVISIONS OF THE INCOME TAX LAWS
OF ANY MUNICIPALITY, STATE OR FOREIGN COUNTRY IN WHICH THE EMPLOYEE OR
CONSULTANT MAY RESIDE.
REQUIRED VOTE
At the Rational Meeting, the stockholders are being asked to approve the
adoption of the 1997 Plan. The affirmative vote of the holders of a majority
of the shares entitled to vote at the Rational Meeting will be required to
approve the adoption of the Plan.
THE RATIONAL BOARD OF DIRECTORS RECOMMENDS THAT STOCKHOLDERS VOTE "FOR" THE
APPROVAL OF RATIONAL'S PLAN.
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EXPERTS
The consolidated financial statements of Rational Software Corporation at
March 31, 1995 and 1996, and for each of the three years in the period ended
March 31, 1996, included in this Prospectus/Joint Proxy Statement, have been
audited by Ernst & Young LLP, independent auditors, as set forth in their
report appearing elsewhere herein, and are included in reliance upon such
report given upon the authority of such firm as experts in accounting and
auditing.
The consolidated financial statements of SQA, Inc. as of December 31, 1994
and 1995, and for each of the years ended December 31, 1993, 1994 and 1995
appearing in this Prospectus/Joint Proxy Statement have been audited by Arthur
Andersen, LLP, independent auditors, as set forth in their report thereon
appearing elsewhere herein and are included in reliance on the report, given
upon the authority of such firm as experts in accounting and auditing.
LEGAL MATTERS
The validity of the Rational Common Stock issuable pursuant to the Merger
will be passed on by Wilson Sonsini Goodrich & Rosati, Professional
Corporation, Palo Alto, California. Testa, Hurwitz & Thibeault, LLP, Boston,
Massachusetts, is acting as counsel for SQA in connection with certain legal
matters relating to the Agreement and the transactions contemplated thereby.
FUTURE STOCKHOLDER PROPOSALS
If any stockholder of the Combined Company intends to present a proposal at
the 1997 Combined Company annual meeting and wishes to have such proposal
considered for inclusion in the proxy materials for such meeting, such holder
must submit the proposal to the Secretary of the Combined Company in writing
so as to be received at the executive officers of the Combined Company by
March 14, 1997. Such proposals must also meet the other requirements of the
rules of the SEC relating to stockholders' proposals, as well as the
requirements of the Combined Company's Bylaws. In the event the Merger is not
consummated, stockholder proposals will be eligible to be considered for
inclusion in the proxy materials for the 1997 annual meetings of Rational and
SQA (i) if duly submitted to the Secretary of Rational by March 14, 1997 or
(ii) if they had been duly submitted to the Secretary of SQA on or prior to
November 28, 1996, as the case may be, as provided in the respective 1996
Annual Meeting Proxy Statements of Rational and SQA.
ACCOUNTANTS' REPRESENTATIVES
It is expected that representatives of Ernst & Young LLP, Rational's
independent accountants, will be present at the Rational Meeting and
representatives of Arthur Andersen LLP, SQA's independent auditors, will be
present at the SQA Meeting where each will have an opportunity to respond to
appropriate questions of Rational's and SQA's stockholders, respectively, and
to make a statement if they so desire.
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INDEX TO FINANCIAL STATEMENTS
<TABLE>
<S> <C>
Rational Software Corporation and Subsidiaries:
Report of Independent Auditors.......................................... F-2
Consolidated Statements of Operations................................... F-3
Consolidated Balance Sheets............................................. F-4
Consolidated Statements of Stockholders' Equity......................... F-5
Consolidated Statements of Cash Flows................................... F-6
Notes to Consolidated Financial Statements.............................. F-7
SQA, Inc. and Subsidiaries:
Independent Auditors' Report............................................ F-18
Consolidated Balance Sheets............................................. F-19
Consolidated Statements of Operations................................... F-20
Consolidated Statements of Cash Flows................................... F-21
Consolidated Statements of Redeemable Convertible Preferred Stock and
Stockholders' Equity (Deficit)......................................... F-22
Notes to Consolidated Financial Statements.............................. F-23
</TABLE>
F-1
<PAGE>
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Board of Directors and Stockholders
Rational Software Corporation
We have audited the accompanying consolidated balance sheets of Rational
Software Corporation as of March 31, 1996 and 1995, and the related
consolidated statements of operations, stockholders' equity, and cash flows
for each of the three years in the period ended March 31, 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 consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position
of Rational Software Corporation at March 31, 1996 and 1995, and the
consolidated results of its operations and its cash flows for each of the
three years in the period ended March 31, 1996, in conformity with generally
accepted accounting principles.
Ernst & Young LLP
San Jose, California
April 22, 1996
F-2
<PAGE>
RATIONAL SOFTWARE CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
SIX MONTHS
FISCAL YEARS ENDED MARCH 31, ENDED SEPTEMBER 30,
-------------------------------- -------------------
1994 1995 1996 1995 1996
---------- --------- --------- --------- ---------
(UNAUDITED)
<S> <C> <C> <C> <C> <C>
Net product revenue...... $ 41,716 $ 39,221 $ 55,899 $ 25,269 $ 35,171
Consulting and support
revenue................. 28,627 33,678 35,208 16,130 20,906
---------- --------- --------- --------- ---------
Total revenue*......... 70,343 72,899 91,107 41,399 56,077
---------- --------- --------- --------- ---------
Cost of product revenue.. 11,862 6,955 7,196 3,129 3,906
Cost of consulting and
support revenue......... 13,494 18,095 19,336 8,928 10,932
---------- --------- --------- --------- ---------
Total cost of revenue.. 25,356 25,050 26,532 12,057 14,838
---------- --------- --------- --------- ---------
Gross profit............. 44,987 47,849 64,575 29,342 41,239
Operating expenses:
Research and
development............ 20,221 12,187 15,939 6,456 8,955
Sales and marketing..... 21,338 25,100 35,000 16,083 17,882
General and
administrative......... 7,194 6,995 9,511 3,777 5,037
Charges for acquired in-
process research and
development............ -- -- 8,700 -- --
Merger and restructuring
costs.................. 9,922 (1,100) -- -- --
---------- --------- --------- --------- ---------
Total operating
expenses.............. 58,675 43,182 69,150 26,316 31,874
---------- --------- --------- --------- ---------
Income (loss) from
continuing operations... (13,688) 4,667 (4,575) 3,026 9,365
Other income, net........ 285 417 1,582 626 1,219
---------- --------- --------- --------- ---------
Income (loss) from
continuing operations
before provision for
income taxes............ (13,403) 5,084 (2,993) 3,652 10,584
Provision for income
taxes................... 404 406 1,028 292 1,588
---------- --------- --------- --------- ---------
Income (loss) from
continuing operations... (13,807) 4,678 (4,021) 3,360 8,996
Discontinued operations:
Loss from the disposal
of the secure-products
business.............. (175) -- -- -- --
---------- --------- --------- --------- ---------
Net income (loss)...... $ (13,982) $ 4,678 $ (4,021) $ 3,360 $ 8,996
========== ========= ========= ========= =========
Income (loss) from
continuing operations
per common share........ $ (.57) $ .19 $ (.13) $ .11 $ .24
Net income (loss) per
common share............ (.57) .19 (.13) .11 .24
Shares used in computing
per share amounts....... 24,394 25,212 30,725 30,872 37,056
*Revenue from related
parties................. $ 8,852 $ 3,324 $ 4,000 $ 1,619 $ --
</TABLE>
See Notes to Consolidated Financial Statements.
F-3
<PAGE>
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(IN THOUSANDS)
<TABLE>
<CAPTION>
COMMON STOCK ADDITIONAL CUMULATIVE TOTAL
--------------- PAID-IN TREASURY ACCUMULATED TRANSLATION STOCKHOLDERS'
SHARES AMOUNTS CAPITAL STOCK DEFICIT ADJUSTMENT EQUITY
------ ------- ---------- -------- ----------- ----------- -------------
<S> <C> <C> <C> <C> <C> <C> <C>
Balance at March 31,
1993................... 24,592 $246 $ 69,756 $ -- $(42,957) $ -- $ 27,045
Exercise of common stock
options................ 138 1 339 -- -- -- 340
Repurchase of stock..... (2) -- (2) -- -- -- (2)
Recovery of pooling
shares................. (38) -- -- -- -- -- --
Purchase of treasury
shares................. -- -- -- (1,394) -- -- (1,394)
Net loss................ -- -- -- -- (13,982) -- (13,982)
Net transactions of old
Rational eliminated
during period from
December 26, 1993 to
March 31, 1994......... 68 1 192 -- (5,713) -- (5,520)
------ ---- -------- ------- -------- ----- --------
Balance at March 31,
1994................... 24,764 248 70,285 (1,394) (62,652) -- 6,487
Exercise of common stock
options................ 220 2 636 -- -- -- 638
Issuance of common
stock.................. 66 1 226 -- -- -- 227
Issuance of treasury
stock.................. -- -- -- 54 -- -- 54
Net income.............. -- -- -- -- 4,678 -- 4,678
------ ---- -------- ------- -------- ----- --------
Balance at March 31,
1995................... 25,050 251 71,147 (1,340) (57,974) -- 12,084
Issuance of common
stock, net of expenses
of $852................ 5,759 57 29,888 -- -- -- 29,945
Issuance of common stock
for the acquisition of
Objectory AB........... 1,497 15 8,754 -- -- -- 8,769
Exercise of common stock
options................ 1,167 12 3,305 -- -- -- 3,317
Issuance of common stock
under Employee Stock
Purchase Plan.......... 150 1 448 -- -- -- 449
Compensation expense for
stock option grants.... -- -- 229 -- -- -- 229
Cumulative translation
adjustments............ -- -- -- -- -- 134 134
Net loss................ -- -- -- -- (4,021) -- (4,021)
------ ---- -------- ------- -------- ----- --------
Balance at March 31,
1996................... 33,623 336 113,771 (1,340) (61,995) 134 50,906
Exercise of common stock
options (unaudited).... 806 8 2,558 -- -- -- 2,566
Issuance of common stock
under Employee Stock
Purchase Plan
(unaudited)............ 369 4 1,200 -- -- -- 1,204
Compensation expense for
stock options grants
(unaudited)............ -- -- 54 -- -- -- 54
Cumulative translation
adjustment
(unaudited)............ -- -- -- -- -- (250) (250)
Net income (unaudited).. -- -- -- -- 8,996 -- 8,996
------ ---- -------- ------- -------- ----- --------
Balance at September 30,
1996 (unaudited)....... 34,798 $348 $117,583 $(1,340) $(52,999) $(116) $ 63,476
====== ==== ======== ======= ======== ===== ========
</TABLE>
See Notes to Consolidated Financial Statements
F-5
<PAGE>
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
<TABLE>
<CAPTION>
MARCH 31, MARCH 31, SEPTEMBER 30,
1996 1996 1996
--------- --------- -------------
(UNAUDITED)
<S> <C> <C> <C>
ASSETS:
Cash and cash equivalents................. $ 9,440 $ 43,934 $ 48,305
Short-term investments.................... 1,036 8,711 6,763
Accounts receivable, net of allowance for
doubtful accounts of $478, $1,042 and
$1,046 at March 31, 1995, 1996 and
September 30, 1996, respectively:
Trade receivables......................... 18,204 23,408 25,524
Trade receivables from related parties.... 537 -- --
Prepaid expenses and other assets......... 766 2,074 2,366
-------- -------- --------
Total current assets.................. 29,983 78,127 82,958
Property and equipment, at cost:
Computer, office and manufacturing
equipment.............................. 25,467 22,779 25,152
Office furniture........................ 2,725 2,109 1,891
Leasehold improvements.................. 1,264 1,209 1,221
-------- -------- --------
29,456 26,097 28,264
Accumulated depreciation and
amortization........................... (23,339) (20,715) (21,926)
-------- -------- --------
Property, and equipment, net.......... 6,117 5,382 6,338
Other assets.............................. 1,900 2,165 1,861
-------- -------- --------
Total assets.......................... $ 38,000 $ 85,674 $ 91,157
======== ======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Accounts payable.......................... $ 2,331 $ 2,983 $ 2,366
Accrued employee benefits................. 5,619 8,476 6,866
Accrued royalties......................... 1,665 799 408
Other accrued expenses.................... 1,824 3,486 5,007
Accrued merger and restructuring
expenses................................. 449 575 537
Deferred revenue.......................... 7,781 15,606 10,810
Current portion of long-term debt and
lease obligations:
Related parties......................... 2,163 -- --
Other................................... 409 654 31
-------- -------- --------
Total current liabilities............. 22,241 32,579 26,025
Accrued rent.............................. 1,260 880 594
Long-term accrued merger and restructuring
expenses................................. 1,764 1,309 1,062
Long-term debt and lease obligations, less
current portion:
Related parties......................... 488 -- --
Other................................... 163 -- --
-------- -------- --------
Total liabilities..................... 25,916 34,768 27,681
Commitments and contingencies
Stockholders' equity:
Common Stock, $.01 par value, 75,000
shares authorized (see Note 11), issued
and outstanding 25,050, 33,623 and
34,798 shares as of March 31, 1995 and
1996 and September 30, 1996,
respectively........................... 251 336 348
Additional paid-in capital................ 71,147 113,771 117,583
Treasury stock............................ (1,340) (1,340) (1,340)
Accumulated deficit....................... (57,974) (61,995) (52,999)
Cumulative translation adjustment......... -- 134 (116)
-------- -------- --------
Total stockholders' equity............ 12,084 50,906 63,476
-------- -------- --------
Total liabilities and stockholders'
equity............................... $ 38,000 $ 85,674 $ 91,157
======== ======== ========
</TABLE>
See Notes to Consolidated Financial Statements.
F-4
<PAGE>
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
<TABLE>
<CAPTION>
FISCAL YEARS ENDED SIX MONTHS
MARCH 31, ENDED SEPTEMBER 30,
------------------------- --------------------
1994 1995 1996 1995 1996
-------- ------ ------- --------- ---------
(UNAUDITED)
<S> <C> <C> <C> <C> <C>
OPERATING ACTIVITIES:
Net income (loss)............. $(13,982) $4,678 $(4,021) $ 3,360 $ 8,996
Adjustments to reconcile net
income to net cash provided
by operating activities:
Charges for acquired in-
process research and
development................ -- -- 8,700 -- --
Depreciation and
amortization............... 10,056 4,980 4,577 1,986 1,958
Compensation expense for
stock option grants........ -- -- 229 -- 72
Deferred income taxes....... 478 -- -- -- --
Loss from the disposal of
discontinued operations.... 175 -- -- -- --
Loss on disposal of property
and equipment, net of
accumulated depreciation... 306 -- -- -- --
Other....................... 40 -- -- -- --
Sale of discontinued
operations................. 778 -- -- -- --
(Increase) decrease in assets:
Accounts receivable......... 4,427 (3,738) (2,830) (3,898) (2,116)
Prepaid expenses and other
assets..................... 1,447 385 (520) (571) (292)
Net assets of discontinued
operations................. (688) -- -- -- --
Increase (decrease) in
liabilities:
Accounts payable............ (29) 915 (1,640) (241) (617)
Other accrued expenses...... 4,204 (2,135) 1,570 (2,183) (1,016)
Accrued merger and
restructuring expenses..... 6,275 (4,062) (329) (399) (285)
Deferred revenue............ 1,323 678 7,825 (318) (4,796)
Net decrease in cash and cash
equivalents of old Rational
for the period from December
26, 1993 to March 31,1994.... (4,722) -- -- -- --
-------- ------ ------- --------- ---------
Total adjustments......... 24,070 (2,977) 17,582 (5,624) (7,092)
-------- ------ ------- --------- ---------
Net cash provided by (used
in) operating activities... 10,088 1,701 13,561 (2,264) 1,904
INVESTING ACTIVITIES:
Purchase of short-term
investments.................. (6,891) (2,369) (11,124) (2,469) (6,316)
Maturities and sales of short-
term investments............. 10,024 7,581 3,449 3,449 8,264
Cash acquired from purchase of
subsidiary................... -- -- 279 -- --
Additions to computer software
costs........................ (1,931) (154) -- -- --
Purchase of property and
equipment.................... (5,280) (3,222) (2,812) (1,130) (2,610)
-------- ------ ------- --------- ---------
Net cash provided by (used
in) investing activities... (4,078) 1,836 (10,208) (150) (662)
Financing activities:
Principal payments under long-
term debt and capital
leases....................... (1,345) (2,455) (2,569) (1,240) (623)
Proceeds from the issuance of
common stock................. 529 865 33,710 31,392 3,752
Repayment of notes payable.... (1,687) -- -- -- --
Issuance (purchase) of
treasury stock............... (1,394) 54 -- -- --
Other......................... (238) -- -- -- --
-------- ------ ------- --------- ---------
Net cash provided by (used
in) financing activities... (4,135) (1,536) 31,141 30,152 3,129
-------- ------ ------- --------- ---------
Net increase in cash and cash
equivalents.................. 1,875 2,001 34,494 27,738 4,370
Cash and cash equivalents at
the beginning of the year.... 5,564 7,439 9,440 9,440 43,934
-------- ------ ------- --------- ---------
Cash and cash equivalents at
the end of the year.......... $ 7,439 $9,440 $43,934 $ 37,178 $ 48,305
======== ====== ======= ========= =========
</TABLE>
See Notes to Consolidated Financial Statements.
F-6
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 1996
(INFORMATION AT SEPTEMBER 30, 1996 AND FOR THE SIX MONTHS ENDED
SEPTEMBER 30, 1996 AND 1995 IS UNAUDITED)
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES.
Organization and basis of presentation. Rational Software Corporation (the
Company) was incorporated under the laws of Delaware on July 28, 1982. The
Company develops, markets and supports a comprehensive solution for the
component-based development of software systems. The Company changed its name
from Verdix Corporation on March 31, 1994.
In October 1995, the Company acquired Objectory AB of Stockholm, Sweden, a
provider of business and systems-engineering solutions based on object
technology. The transaction was recorded using the purchase method. In March
1994, the Company merged with Rational (old Rational), a provider of software
products, technical consulting, and support services for software developers.
The merger was accounted for as a pooling of interests, and accordingly, the
Company's consolidated financial statements have been restated, for all
periods prior to the merger, to include the results of operations, financial
position, and cash flows from old Rational.
The accompanying consolidated financial statements include the accounts of
the Company and its wholly-owned subsidiaries. All intercompany transactions
and balances have been eliminated.
Interim financial information. The consolidated financial statements for the
six months ended September 30, 1995 and 1996 are unaudited but include all
adjustments (consisting of normal recurring entries) which the Company
considers necessary for fair presentation. Operating results for the six
months ended September 30, 1996 are not necessarily indicative of the results
that may be expected for any future periods.
Use of estimates. The preparation of the financial statements in conformity
with generally accepted accounting principles requires management to make
estimates and assumptions that affect the amounts reported in the financial
statements and accompanying notes. Actual results could differ from those
estimates.
Revenue recognition. The Company recognizes revenue and related costs from
the sale of its software products and systems upon shipment. Revenue from
software royalties, whether they are advance payments that are nonrefundable
or minimum royalty guarantees payable over a fixed period, is recorded when
the earnings process is complete and collection is considered probable.
Revenue from consulting services is recognized when earned. Customer support
revenue is deferred and recognized on a straight-line basis over the period
covered by the customer-support agreement. Contract revenue, which generally
is special or custom engineering development under milestone payments, is
recognized in conformity with Accounting Research Bulletin No. 45, "Long-Term
Construction Type Contracts," using the relevant guidance in SOP 81-1,
"Accounting for Performance of Construction-Type and Certain Production-Type
Contracts."
Software capitalization. Computer software development costs are capitalized
after the economic and technological feasibility of a new product is
established. Capitalized costs are amortized on a product basis over the
estimated economic life of a general-release product, which generally does not
exceed three years. The annual amortization is the greater of the amount
computed using the straight-line method or the amount computed using the ratio
of current revenue to the total of current and anticipated future revenues.
Capitalized software-development costs are also written down periodically to
net realizable value based on an analysis of anticipated future revenues.
Research and development costs prior to the establishment of the economic and
technological feasibility of a product are expensed as incurred.
Capitalized software development costs are included in other assets in the
consolidated balance sheets. The unamortized balance of capitalized software
development costs as of March 31, 1996 and 1995, is $0 and
F-7
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
$329,000, respectively. For the years ended March 31, 1996, 1995, and 1994,
software amortization was $329,000, $472,000, and $5,287,000, respectively.
The 1994 amortization included $1,879,000 of previously capitalized software
costs related to duplicate product lines as a result of the merger.
Translation of foreign currencies. Accounts denominated in foreign
currencies have been translated in accordance with Statement of Financial
Accounting Standards No. 52. The functional currency for the Company's
international sales operations is the U.S. dollar, with the exception of the
Swedish subsidiary whose functional currency is the local currency. Gains and
losses resulting from the remeasurement of the sales operations' foreign
currency financial statements into U.S. dollars are included in other income.
Gains and losses resulting from foreign currency translation of the Swedish
subsidiary are accumulated as a separate component of stockholders' equity.
Other income. During the year ended March 31, 1996, other income consisted
primarily of interest earned on the Company's excess cash balances and
marketable securities and interest expense. It also included gains and losses
on foreign currency transactions. During the years ended March 31, 1995 and
1994, other income consisted primarily of gains and losses on foreign currency
transactions, net of interest income.
Net income (loss) per share. Net loss per share is computed using the
weighted average number of common shares outstanding during the period. Net
income per share is computed using the weighted average number of common and
dilutive common equivalent shares outstanding during the period. Common stock
equivalents consist of stock options using the treasury stock method.
Cash, cash equivalents and short-term investments. Cash equivalents are
highly liquid investments with original maturity dates of three months or less
at the date of acquisition. Investments with maturity dates between three and
twelve months are considered to be short-term investments.
All of the Company's cash equivalents and short term investments are
classified as available-for-sale under the provisions of Statement of
Financial Accounting Standards No. 115 (FAS 115), "Accounting for Certain
Investments in Debt and Equity Securities." Amortized cost approximates
estimated fair value based on quoted market prices at March 31, 1995 and 1996,
and September 30, 1996.
Under FAS 115, management classifies investments as trading, available-for-
sale, or held-to-maturity at the time of purchase and periodically reevaluates
such designation. Debt securities are classified as held-to-maturity when the
Company has the positive intent and ability to hold the securities to
maturity. Held-to-maturity securities are stated at amortized cost with
corresponding premiums or discounts amortized over the life of the investment
to interest income. Debt securities not classified as held-to-maturity are
classified as available-for-sale and reported at fair market value.
Unrecognized gains or losses on available-for-sale securities are included in
equity, net of tax, until their disposition. Realized gains and losses and
declines in value judged to be other than temporary on available-for-sale
securities are included in interest income. The cost of securities sold is
based on the specific identification method.
F-8
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Available-for-sale securities and cash consist of the following (in
thousands):
<TABLE>
<CAPTION>
MARCH 31,
---------------- SEPTEMBER 30,
1995 1996 1996
------- -------- -------------
(UNAUDITED)
<S> <C> <C> <C>
Cash and cash equivalents:
Money market funds.......................... $ 5,019 $ 35,470 $ 36,545
Cash........................................ 4,421 4,994 5,804
Commercial paper............................ -- 3,470 5,956
------- -------- --------
Total..................................... 9,440 43,934 48,305
======= ======== ========
Short-term investments:
U.S. government............................. -- 4,745 4,745
Commercial paper............................ -- 3,908 1,960
Municipal obligations....................... 980 -- --
Certificates of deposit..................... 56 58 58
------- -------- --------
Total..................................... $ 1,036 $ 8,711 $ 6,763
======= ======== ========
</TABLE>
Realized gains or losses on sales of available-for-sale securities were
immaterial for the years ended March 31, 1995 and 1996. There were no
unrealized holding gains or losses on such securities at March 31, 1995 and
1996, and September 30, 1996.
Statements of cash flows. The Company paid, net of amounts capitalized,
interest of $172,000, $97,000, $103,000, $26,000 and $8,000 during fiscal
years 1994, 1995 and 1996, and the six months ended September 30, 1995 and
1996, respectively. The Company paid income taxes of $1,152,000, $199,000,
$355,000, $143,000 and $239,000 during fiscal years 1994, 1995 and 1996, and
the six months ended September 30, 1995 and 1996, respectively. The Company
also had capital lease additions of $715,000, and $119,000 during fiscal years
1994 and 1995, respectively. In addition, the Company received income tax
refunds of $523,000 and $123,000 in fiscal year 1995 and 1996, respectively.
In fiscal 1996, the Company issued $8,770,000 of Common Stock for the purchase
of Objectory AB.
Fair value of financial instruments. The carrying amounts reported in the
balance sheet for cash and cash equivalents and short-term investments
approximate fair value. The fair value of short-term investments is based on
quoted market prices.
The carrying amount of the Company's long-term debt approximates fair
value. The fair value of the Company's long-term debt is estimated using
discounted cash-flow analyses, based on the Company's current incremental
borrowing rate for similar types of borrowing arrangements.
Concentrations of credit risk. Financial instruments that potentially
subject the Company to concentrations of credit risk consist primarily of cash
equivalents and accounts receivable. The Company's investment policy limits
its exposure to concentrations of credit risk for cash equivalents. The
Company sells its products primarily to major corporations, including systems
integrators, that serve a wide variety of U.S. and foreign markets. Collateral
or deposits generally are not required from customers who demonstrate a
positive credit record and sound financial condition. The concentrations of
credit risk are considered limited for trade receivables.
Property and equipment. The Company's property and equipment are recorded at
cost, which is generally depreciated over a three- to five-year period using
the straight-line method. The cost of furniture and equipment under capital
leases is recorded at the lower of the present value of the minimum lease
payments or the fair value of the asset and is amortized over the shorter of
the term of the related lease or the estimated useful life of the asset.
Leasehold improvements are depreciated over the remaining life of the lease.
F-9
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Advertising costs. The Company expenses advertising costs as incurred.
Advertising costs totaled $889,000, $1,372,000 and $1,012,000 for the years
ended March 31, 1994, 1995 and 1996, respectively.
Reclassifications. Certain prior year amounts have been reclassified to
conform with current year presentation.
Recent pronouncements. In October 1995, the Financial Accounting Standards
Board issued Statement of Financial Accounting Standards No. 123 (FAS 123),
"Accounting for Stock-Based Compensation," which established a fair-value-
based method of accounting for stock-based compensation plans and requires
additional disclosures for those companies who elect not to adopt the new
method of accounting. The Company will be required to adopt FAS 123 in fiscal
1997. The Company's intention is to continue to account for employee stock
awards in accordance with APB Opinion No. 25 and to adopt the disclosure only
alternative described in FAS 123.
In March 1995, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 121 (FAS 121), "Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of,"
which requires the Company to review for impairment of long-lived assets
certain identifiable intangibles and goodwill related to those assets whenever
events or changes in circumstances indicate that the carrying amount of an
asset might not be recoverable. In certain situations, an impairment loss
would be recognized. FAS 121 will become effective for the Company's year
ending March 31, 1997. The Company has studied the implications of FAS 121
and, based on its initial evaluation, does not expect its adoption to have a
material impact on the Company's financial condition or results of operations.
Common Stock. 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. The stock dividend was
distributed to stockholders on September 10, 1996. All shares and per share
information have been adjusted to reflect this change.
2. RISKS DUE TO CONCENTRATIONS.
International sales. International sales currently account for approximately
one-third of the Company's revenues, and the Company expects that
international sales will continue to account for a significant portion of the
Company's revenues in future periods. Any material adverse effect on the
Company's international business would have a material adverse effect on the
Company's financial statements. Also, the Company's international sales are
generally denominated in foreign currencies. Losses on the conversion of
foreign-denominated receivables into U.S. dollars may have a material adverse
effect on the Company's financial statements.
3. MERGERS AND ACQUISITIONS.
Objectory. In October 1995, the Company signed a definitive agreement to
purchase all the outstanding stock of Objectory AB, a Swedish software
development company, in exchange for 1,496,718 shares of common stock. The
acquisition was accounted for using the purchase method, and, accordingly, the
operating results of Objectory AB are included in the consolidated results of
the Company from the date of acquisition. The consolidated balance sheets
include the assets and liabilities of Objectory AB at March 31, 1996.
The total purchase price was allocated as follows (in thousands):
<TABLE>
<S> <C>
Property and equipment............................................ $ 188
Intangible assets................................................. 1,216
Severance and facility closure accruals........................... (312)
Net liabilities assumed........................................... (1,022)
In-process research and development............................... 8,700
-------
$ 8,770
=======
</TABLE>
F-10
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Intangible assets include assembled workforce and customer base. The
estimated average useful life of these assets is three years. Accumulated
amortization of intangible assets totaled $281,000 at March 31, 1996. In-
process research and development represents the present value of the estimated
cash flow expected to be generated by the Objectory AB related technology,
which at the acquisition date had not yet reached the point of technological
feasibility and does not have an alternative future use. Therefore, in
accordance with generally accepted accounting principles, the in-process
research and development was written off and charged to operations during the
quarter ended December 31, 1995.
The following pro forma combined results of operations for the year ended
March 31, 1996 are presented as if the acquisition had occurred at the
beginning of the period. The charges associated with in-process research and
development have not been reflected in the following pro forma summary as they
are nonrecurring.
<TABLE>
<CAPTION>
MARCH 31,
-------------------------
1995 1996
------------ ------------
(UNAUDITED, IN THOUSANDS,
EXCEPT PER SHARE DATA)
<S> <C> <C>
Net revenue...................................... $ 80,112 $ 95,763
Net income....................................... $ 3,011 $ 3,401
Net income per share............................. $ .12 $ .10
</TABLE>
The pro forma results of operations are not necessarily indicative of the
actual results of operations that would have been obtained had the acquisition
occurred at the beginning of the years presented, nor are they intended to be
a projection of future results.
Old Rational. On March 31, 1994, the Company merged with old Rational and
acquired all of the common stock of old Rational in exchange for 14,349,572
shares of the Company's common stock. Old Rational developed, marketed and
provided software products, technical consulting, and support services for
software developers. The merger was accounted for as a pooling-of-interests,
and, accordingly, the Company's Consolidated Financial Statements and Notes to
Consolidated Financial Statements have been restated to include the results of
old Rational for all periods presented.
Separate results of operations for the periods prior to the merger are as
follows:
<TABLE>
<CAPTION>
MERGER-
RELATED,
THE COMPANY OLD RATIONAL EXPENSES COMBINED
----------- ------------ -------- --------
(IN THOUSANDS)
<S> <C> <C> <C> <C>
Year ended March 31, 1994
(Old Rational as of December
25, 1993)
Net revenue.................. $20,963 $49,380 $ -- $ 70,343
Net income (loss)............ $(4,780) $ 720 $(9,922) $(13,982)
</TABLE>
The Consolidated Financial Statements for all prior periods include results
of the Company's operations and balance sheets data on a March 31 fiscal year
basis and old Rational's results on a December 25, 1993 basis. Old Rational's
separate results for fiscal 1993 have not been restated to conform to the
twelve months ended March 31, 1994. Old Rational's separate results of
operations for the three months ended March 31, 1994, are not reflected in the
Consolidated Statements of Operations. Unaudited revenue and net loss of old
Rational for the three months ended March 31, 1994 were $7,799,000 and
($5,713,000), respectively.
F-11
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
4. DISCONTINUED OPERATIONS.
On March 26, 1993, the Board of Directors approved the disposition of the
operations of the secure-products business. This business was sold in January
1994 for $778,000 cash and a note for $215,000, which has been paid in full.
The total loss from the disposal of the secure-products business was $662,000,
of which $175,000 was recognized in fiscal 1994, with the balance accrued for
in prior years. There were no revenues from discontinued operations during
fiscal 1994.
5. RESTRUCTURING OF OPERATIONS.
As part of the business combination with old Rational the Company incurred
substantial merger and restructuring costs. Included in the accompanying
Consolidated Statement of Operations for the year ended March 31, 1994, are
merger-related expenses totaling $9,922,000 consisting primarily of charges of
$3,321,000 incurred as a result of the closing of duplicate facilities,
severance costs of $2,589,000, merger-related administrative costs of
$2,254,000, and write-downs of $1,758,000 of capitalized software costs and
other costs related to duplicate product lines. During the year ended March
31, 1995, the Company reversed $1,100,000 of the duplicate facilities charge
as a result of greater-than-anticipated recoveries through subleasing. The
accrual at March 31, 1996 represents remaining facilities lease obligations,
net of anticipated sublease proceeds.
6. LONG-TERM DEBT AND CAPITAL OBLIGATIONS.
In November 1989, the Company entered into a product development and loan
agreement with International Business Machines Corporation (IBM) whereby the
Company received interest-free loans of $8,700,000 to develop certain
proprietary software products in which the Company retains full ownership
rights. In exchange, the Company granted IBM distribution and marketing rights
to the products under development, the right to evaluate all of the Company's
technology for a period of five years, and an agreement to refrain from
undertaking any other development that would impair its ability to perform
under the agreement. The Company also provides consulting to IBM in certain
technology areas. The Company has repaid a total of $8,212,000 through March
31, 1996.
The Company leases certain equipment and furniture under capitalized lease
obligations. The related obligations under capital leases represent the
present value of future minimum lease payments. Assets capitalized under
leases totaled $3,942,000 at March 31, 1995 and 1996. Accumulated amortization
of these leased assets was $3,433,000 and $3,848,000 at March 31, 1995 and
1996, respectively. Long-term debt and capitalized lease obligations consist
of the following at March 31:
<TABLE>
<CAPTION>
1995 1996
-------- -------
(IN THOUSANDS)
<S> <C> <C>
Long-term debt to IBM.................................... $ 2,438 $ 488
Present value of capitalized lease obligation to related
parties................................................. 81 --
Lease obligation to others............................... 572 166
Note payable to former shareholders...................... 132 --
-------- ------
3,223 654
Less current portion of capitalized lease obligations and
debt.................................................... (2,572) (654)
-------- ------
Due after one year....................................... $ 651 $ --
======== ======
</TABLE>
F-12
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
The overall weighted average of the interest rates on capital leases
approximated 8.2% at March 31, 1996. Future minimum payments at March 31, 1996
are as follows:
<TABLE>
<CAPTION>
LONG-TERM LEASE
DEBT OBLIGATIONS
--------- -----------
(IN THOUSANDS)
<S> <C> <C>
1997................................................... $ 488 $172
----- ----
Total minimum payments................................. 488 172
Amount representing interest........................... -- (4)
----- ----
$ 488 $168
===== ====
</TABLE>
7. COMMITMENTS AND CONTINGENCIES.
Commitments. The Company leases its office space at all locations under
operating leases. Rental expense for facilities was approximately $3,129,000,
$1,970,000, $2,520,000, $1,093,000 and $1,355,000 in the years ended March 31,
1994, 1995, 1996, and for the six months ended September 30, 1995 and 1996,
respectively. Future minimum rental payments, net of sublease income, at March
31, 1996 are as follows (in thousands):
<TABLE>
<S> <C>
1997............................................................... 3,225
1998............................................................... 3,148
1999............................................................... 3,036
2000............................................................... 2,386
2001............................................................... 1,466
-------
$13,261
=======
</TABLE>
As a result of the merger with old Rational on March 31, 1994, the Company
relocated its corporate headquarters into the facility occupied by old
Rational's corporate headquarters. At March 31, 1996, the Company has accrued
$2,611,000 of estimated costs of future rent associated with the excess office
space in both the Herndon and Santa Clara facilities as part of the merger-
related expenses. Total future rents from sublease agreements are $919,000,
$484,000, $345,000 and $115,000 in fiscal 1997, 1998, 1999 and 2000,
respectively.
Legal actions. 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 the Company'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 the Company's 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 January 1997, although the
parties have signed a stipulation extending the trial date to March 1997 and
the Company anticipates the Court will so order. The Company believes IDE's
complaints are without merit and intends to defend the case vigorously,
although the Company makes no assurance that the Company 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.
F-13
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
8. INCOME TAXES.
Pretax income (loss) from continuing operations is as follows at March 31:
<TABLE>
<CAPTION>
1994 1995 1996
-------- ------- --------
(IN THOUSANDS)
<S> <C> <C> <C>
Domestic...................................... $(13,881) $ 4,826 $ (4,433)
Foreign....................................... 478 258 1,440
-------- ------- --------
Total....................................... $(13,403) $ 5,084 $ (2,993)
======== ======= ========
The Company received approximately $220,000, $200,000 and $1,600,000 of
revenue from foreign sources in 1996, 1995 and 1994, respectively, that was
subject to foreign royalty withholding tax.
The provision for income taxes consists of the following at March 31:
<CAPTION>
1994 1995 1996
-------- ------- --------
(IN THOUSANDS)
<S> <C> <C> <C>
Current
Federal..................................... $ (276) $ 100 $ 28
State....................................... (84) 70 52
Foreign..................................... 286 236 948
-------- ------- --------
(74) $ 406 1,028
Deferred
Federal..................................... 478 -- --
State....................................... -- -- --
-------- ------- --------
478 -- --
-------- ------- --------
Total..................................... $ 404 $ 406 $ 1,028
======== ======= ========
The provision for income taxes differs from the amount of income tax
determined by applying the applicable U.S. statutory federal income tax rate
as a result of the following differences at March 31:
<CAPTION>
1994 1995 1996
-------- ------- --------
(IN THOUSANDS)
<S> <C> <C> <C>
Income tax (benefit) at the federal statutory
rate......................................... $ (4,691) $ 1,780 $ (1,048)
Net operating loss carryforwards not utilized
(utilized)................................... 4,253 (1,568) (1,465)
Nondeductible charges for acquired in-process
research and development..................... -- -- 3,045
State income taxes (benefit).................. (55) 46 52
Foreign taxes................................. 152 148 444
Merger related costs.......................... 745 -- --
-------- ------- --------
Total....................................... $ 404 $ 406 $ 1,028
======== ======= ========
</TABLE>
For the six month periods ended September 30, 1995 and 1996, income taxes
have been provided based upon estimated annualized effective tax rates of 8%
and 15%, respectively, applied to the earnings for the period. The provision
for income taxes reflect the tax benefits of utilizing net operating loss
carryforwards offset by certain foreign and state taxes.
F-14
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Significant components of the Company's deferred tax assets are as follows
at March 31:
<TABLE>
<CAPTION>
1995 1996
-------- --------
(IN THOUSANDS)
<S> <C> <C>
Deferred tax assets
Net operating loss carryforwards....................... $ 13,045 $ 16,700
Tax credit carryforwards............................... 2,778 3,131
Inventory valuation accounts........................... 1,108 --
Lease reserve.......................................... 1,340 1,379
Compensation accruals.................................. 974 1,120
Deprecation............................................ 1,201 1,323
Other.................................................. 1,274 1,303
-------- --------
Total deferred tax assets............................ 21,720 24,956
Valuation allowance for deferred tax assets.......... (21,595) (24,956)
-------- --------
Deferred tax assets.................................... 125 --
Deferred tax liabilities
Computer software.................................... 125 --
-------- --------
Total deferred tax liabilities....................... 125 --
-------- --------
Net deferred tax assets................................ $ -- $ --
======== ========
</TABLE>
Under Statement of Financial Accounting Standards No. 109 (FAS 109),
deferred tax assets and liabilities are determined based on differences
between financial reporting and tax bases of assets and liabilities and are
measured using the enacted tax rates and laws that will be in effect when the
differences are expected to reverse. 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 at this time it is more likely than not that the deferred tax assets
will not be realized. The valuation allowance increased by $3,361,000 and
$7,031,000 in 1996 and 1994, respectively, and decreased by $1,685,000 in
1995. Approximately $4,200,000 of the valuation allowance is attributable to
stock options, the benefit of which will be credited to additional paid-in
capital when realized.
At March 31, 1996, the Company had net operating loss carryforwards for
federal income tax purposes of approximately $47,400,000 that expire in 1997
through 2011. In addition, the Company had approximately $3,100,000 of tax
credit carryforwards expiring in 1997 through 2010. As a result of the sale of
common stock in June 1995, the Company incurred a change in stock ownership as
defined under Section 382 of the Internal Revenue Code of 1986. Accordingly,
approximately $34,000,000 of the Company's net operating loss carryforwards
and all of the tax credit carryforwards will be subject to an annual
limitation regarding their utilization against taxable income in future years.
Such losses and credits will be available to offset the income tax liability
attributable to annual taxable income of approximately $8,700,000. In
addition, as a result of the merger with old Rational and provisions in the
Internal Revenue Code, utilization of approximately $4,600,000 of net
operating loss carryforwards are further limited to the future income of the
Company.
9. STOCKHOLDERS' EQUITY.
Common stock. On May 22, 1995, pursuant to approvals obtained from the
Company's Board of Directors and stockholders, the Company effected a one-for-
three reverse stock split. All share and per share information have been
adjusted to reflect this change. In the same action, and pursuant to the same
approvals, the Company increased the number of post-reverse-split shares of
authorized common stock from 20,000,000 to 25,000,000 shares.
F-15
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
During June 1995, the Company sold 5,758,000 shares of common stock in a
public offering. Net proceeds from the sale were $29,945,000 after deducting
underwriting discounts, commissions, and other related expenses.
Stock options. The Company provides equity incentives to employees and
directors by means of incentive stock options and nonstatutory options under
its two 1983 Incentive Stock Option Plans, 1986 Stock Option Plan, Non-
Employee Director Stock Option Plan, 1993 Stock Option Plan, and 1994 Stock
Option Plan. Stock options generally vest over a period of four years. Under
these plans, the Company may grant either nonstatutory or incentive stock
options and the option price per share cannot be less than 85% of fair market
value in the case of nonstatutory stock options, or 100% of fair market value
in the case of incentive stock options, determined on the date the option is
granted. Under these plans, the Company has reserved 5,186,950 shares for
issuance at March 31, 1996. Options expire at various dates ranging from 5 to
10 years from the date of grant.
On July 25, 1995, an amendment was approved during the annual meeting by the
Company's stockholders that established a new formula for determining the size
of director grants and that lengthened the vesting period of director grants.
The compensation expense recognized during fiscal 1996 as a result of this
change was $229,000.
At September 30, 1996, options for 1,477,490 shares of common stock were
exercisable at an aggregate exercise price of $4,703,623. Activity under all
plans is summarized as follows:
<TABLE>
<CAPTION>
SHARES UNDER
OUTSTANDING OPTIONS
SHARES AVAILABLE ---------------------------
FOR GRANT OPTIONS PRICE PER SHARE
---------------- ---------- ---------------
<S> <C> <C> <C>
Balance at March 31, 1993...... 1,466,792 2,429,398 $2.07-$6.66
Additional shares authorized... 3,333,332 -- --
Expiration of plan............. (869,398) -- --
Granted...................... (1,419,942) 1,419,942 3.95- 5.34
Exercised.................... -- (138,970) 2.07- 4.46
Canceled..................... 632,276 (632,276) 2.07- 6.66
Net transactions of old Ratio-
nal during the period from De-
cember 26, 1993 to March 31,
1994
(see Note 3).................. (325,454) (189,398) 2.82- 3.29
---------- ---------- -----------
Balance at March 31, 1994...... 2,817,606 2,888,696 2.07- 6.57
Granted...................... (2,416,126) 2,416,126 2.45- 5.25
Exercised.................... -- (220,170) 2.16- 4.46
Canceled..................... 333,492 (333,492) 2.25- 6.47
Expired...................... (448,620) -- --
---------- ---------- -----------
Balance at March 31, 1995...... 286,352 4,751,160 2.07- 6.57
Additional shares authorized... 1,333,332 -- --
Granted...................... (1,245,568) 1,245,568 2.54-18.47
Exercised.................... -- (1,167,034) 2.07- 6.57
Canceled..................... 156,122 (156,122) 2.54-11.19
Expired...................... (16,860) -- --
---------- ---------- -----------
Balance at March 31, 1996...... 513,358 4,673,572 2.07-18.47
Additional shares authorized
(unaudited)................... 2,000,000 -- --
Granted (unaudited).......... (1,152,379) 1,152,379 19.75-34.50
Exercised (unaudited)........ -- (806,351) 2.07- 8.38
Canceled (unaudited)......... 60,716 (60,716) 2.54-31.06
Expired (unaudited).......... (38,979) -- --
---------- ---------- -----------
Balance at September 30, 1996
(unaudited)................... 1,382,958 4,958,884 2.07-34.50
========== ========== ===========
</TABLE>
F-16
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Employee stock purchase plan. The Company has an employee stock purchase
plan under which substantially all employees may purchase common stock through
payroll deductions at a price equal to 85% of the lower of the fair market
values as of the beginning or end of the offering period. Stock purchases
under the plan are limited to the lesser of 10% of an employee's compensation,
$25,000 per year. At September 30, 1996, 519,000 shares had been issued under
the Plan and shares totaling 481,000 were reserved for issuance.
10. MAJOR CUSTOMERS, RELATED PARTIES, AND INTERNATIONAL SALES.
IBM divested its shares of the Company's outstanding stock during the
secondary offering in the first quarter of fiscal 1996. IBM owned
approximately 13% of the Company's outstanding stock at the end of 1994 and
1995 and accounted for 11% and 3% of the Company's revenue in 1994 and 1995,
respectively. Sales to Lockheed Martin Corporation, which had a representative
on the Board through September 1995, accounted for 1%, 2%, and 4% of the
Company's revenue in 1994, 1995, and 1996, respectively.
One customer accounted for approximately 10% of the Company's revenue in the
six months ended September 30, 1996.
The Company also derives revenue from the sale of its products to customers
in international geographic areas, including Western Europe, the Asia/Pacific
region, and Canada. Total revenue from international sales and related
consulting and customer support was $21,493,000, $24,839,000, $33,242,000,
$15,995,000 and $19,986,000 for the years ended March 31, 1994, 1995 and 1996
and for the six months ended September 30, 1995 and 1996, respectively.
Sales into Western Europe accounted for $10,141,000, $12,153,000,
$23,396,000, $11,936,000 and $14,898,000 of total international revenue for
the years ended March 31, 1994, 1995, 1996 and for the six months ended
September 30, 1995 and 1996, respectively, with sales into Canada accounting
for an additional $7,282,000, $7,012,000, $4,674,000, $1,453,000 and
$1,723,000 for the years ended March 31, 1994, 1995, 1996 and the six months
ended September 30, 1995 and 1996, respectively.
11. EVENTS SUBSEQUENT TO REPORT OF INDEPENDENT AUDITORS.
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.
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, which will be allocated to the fair value of the assets
acquired, including in-process research and development. The company's
earnings for the quarter ended December 31, 1996 will be reduced by an
expected charge to operations for acquired in-process research and development
expense of approximately $15,000,000 to $19,000,000. 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 plans to continue devoting effort to developing commercially viable
products from the acquired in-process research and development. More
specifically, Rational intends to exploit networked computing resources to
accelerate the testing process.
F-17
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
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.
On November 12, 1996, the Company and SQA, Inc., 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. 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. Completion of the
transaction is subject to customary conditions, including approval by the
stockholders of the Company and SQA and HSR review. The merger is expected to
close in the fourth quarter of fiscal 1997.
F-18
<PAGE>
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Stockholders and Board of Directors of SQA, Inc.
We have audited the accompanying consolidated balance sheets of SQA, Inc. (a
Delaware corporation) and its subsidiary as of December 31, 1994 and 1995, and
the related consolidated statements of operations, redeemable convertible
preferred stock and stockholders' equity (deficit), and cash flows for each of
the three years in the period ended December 31, 1995. 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 SQA, Inc. and subsidiary as
of December 31, 1994 and 1995, and the results of their operations and their
cash flows for each of the three years in the period ended December 31, 1995,
in conformity with generally accepted accounting principles.
Boston, Massachusetts
January 26, 1996
F-19
<PAGE>
SQA, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
<TABLE>
<CAPTION>
DECEMBER 31,
---------------- SEPTEMBER 30,
1994 1995 1996
------- ------- -------------
(UNAUDITED)
<S> <C> <C> <C> <C>
ASSETS
------
Current assets:
Cash and cash equivalents................ $ 2,806 $36,444 $40,382
Accounts receivable, less reserves of
$92, $244 and $252 in 1994, 1995 and
1996, respectively...................... 915 2,635 4,572
Prepaid expenses and other current
assets.................................. 59 476 909
------- ------- -------
Total current assets................... 3,780 39,555 45,863
------- ------- -------
Property and equipment, net................ 207 865 3,307
Other assets............................... 35 45 192
------- ------- -------
Total assets........................... $ 4,022 $40,465 $49,362
======= ======= =======
LIABILITIES AND STOCKHOLDERS' EQUITY
(DEFICIT)
------------------------------------
Current liabilities:
Accounts payable......................... $ 515 $ 819 $ 1,307
Accrued expenses......................... 920 1,646 1,808
Deferred revenue......................... 737 2,279 2,679
------- ------- -------
Total current liabilities.............. 2,172 4,744 5,794
------- ------- -------
Commitments and contingencies (Note 9)
Redeemable convertible preferred stock
(Note 4).................................. 7,896 -- --
------- ------- -------
Stockholders' equity (deficit):
Common stock, $.01 par value--
Authorized--18,000,000 shares; Issued
and outstanding--129,014 shares,
7,660,699 shares, and 8,041,189 shares
in 1994, 1995 and 1996, respectively.... 1 77 80
Additional paid-in capital............... 294 41,554 46,102
Accumulated deficit...................... (6,341) (5,910) (2,614)
------- ------- -------
Total stockholders' equity (deficit)... (6,046) 35,721 43,568
------- ------- -------
Total liabilities and stockholders'
equity (deficit)...................... $ 4,022 $40,465 $49,362
======= ======= =======
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
F-20
<PAGE>
SQA, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
NINE MONTHS ENDED
YEARS ENDED DECEMBER 31, SEPTEMBER 30,
---------------------------- -------------------
1993 1994 1995 1995 1996
-------- -------- -------- -------- ---------
(UNAUDITED)
<S> <C> <C> <C> <C> <C>
Revenue:
License fees............... $ 1,478 $ 3,390 $ 8,844 $ 5,964 $ 11,335
Services................... 177 1,060 4,001 2,722 5,417
-------- -------- -------- -------- ---------
Total revenue............ 1,655 4,450 12,845 8,686 16,752
-------- -------- -------- -------- ---------
Cost of revenue:
License fees............... 145 193 630 366 603
Services................... 264 780 1,487 1,079 1,704
-------- -------- -------- -------- ---------
Total cost of revenue.... 409 973 2,117 1,445 2,307
-------- -------- -------- -------- ---------
Gross profit............... 1,246 3,477 10,728 7,241 14,445
-------- -------- -------- -------- ---------
Operating expenses:
Sales and marketing........ 1,611 3,354 6,000 4,272 7,233
Research and development... 750 1,727 2,366 1,742 2,956
General and
administrative............ 584 897 2,179 1,539 1,936
-------- -------- -------- -------- ---------
Total operating
expenses................ 2,945 5,978 10,545 7,553 12,125
-------- -------- -------- -------- ---------
Income (loss) from
operations.................. (1,699) (2,501) 183 (312) 2,320
Other income, net............ 13 79 248 162 1,315
-------- -------- -------- -------- ---------
Income (loss) before
provision for income taxes.. (1,686) (2,422) 431 (150) 3,635
Provision for income taxes... -- -- -- -- 338
-------- -------- -------- -------- ---------
Net income (loss)............ $ (1,686) $ (2,422) $ 431 $ (150) $ 3,297
======== ======== ======== ======== =========
Net income (loss) per share.. $ (0.46) $ 0.07 $ (0.03) $ 0.38
Shares used in computing net
income (loss) per share..... 5,271 6,062 5,875 8,786
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
F-21
<PAGE>
SQA, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
<TABLE>
<CAPTION>
NINE MONTHS ENDED
YEARS ENDED DECEMBER 31, SEPTEMBER 30,
---------------------------- ------------------
1993 1994 1995 1995 1996
-------- -------- -------- -------- --------
(UNAUDITED)
<S> <C> <C> <C> <C> <C>
Cash flows from operating
activities:
Net income (loss)........... $ (1,686) $ (2,422) $ 431 $ (150) $ 3,297
Adjustments to reconcile net
income (loss) to net cash
flows (used in) provided by
operating activities--
Depreciation and
amortization.............. 49 59 138 84 320
Interest on demand notes to
shareholders.............. 27 -- -- -- --
Changes in assets and
liabilities--
Accounts receivable....... (372) (407) (1,720) (1,507) (1,937)
Prepaid expenses and other
current assets........... (60) 18 (417) (217) (433)
Accounts payable.......... 121 246 304 (49) 440
Accrued expenses.......... 204 571 726 706 70
Deferred revenue.......... 214 503 1,542 1,178 544
-------- -------- -------- -------- --------
Net cash (used in)
provided by operating
activities.............. (1,503) (1,432) 1,004 45 2,301
-------- -------- -------- -------- --------
Cash flows from investing
activities:
Purchases of property and
equipment.................. (94) (139) (796) (412) (2,762)
Decrease in other assets.... (4) (1) (10) (8) (147)
-------- -------- -------- -------- --------
Net cash used in
investing activities.... (98) (140) (806) (420) (2,909)
-------- -------- -------- -------- --------
Cash flows from financing
activities:
Proceeds from sale of
redeemable convertible
preferred stock, net of
issuance costs............. 2,876 3,008 4,435 4,435 --
Proceeds from sale of common
stock in initial public
offering, net of issuance
costs...................... 28,952 -- 4,372
Proceeds from exercise of
stock options.............. -- -- 53 50 179
Borrowings (payments) on
capital lease obligations.. 25 (8) -- 5 (5)
Proceeds from sale/leaseback
of equipment............... 53 -- -- -- --
Payments on term note
payable to a bank.......... (32) (19) -- -- --
-------- -------- -------- -------- --------
Net cash provided by
financing activities.... 2,922 2,981 33,440 4,490 4,546
-------- -------- -------- -------- --------
Net increase in cash and cash
equivalents................. 1,321 1,409 33,638 4,115 3,938
Cash and cash equivalents,
beginning of period......... 76 1,397 2,806 2,806 36,444
-------- -------- -------- -------- --------
Cash and cash equivalents,
end of period............... $ 1,397 $ 2,806 $ 36,444 $ 6,921 $ 40,382
======== ======== ======== ======== ========
Supplemental disclosure of
cash flow information:
Cash paid for interest...... $ 13 $ 4 $ 4 $ 3 $ 2
======== ======== ======== ======== ========
Supplemental disclosure of
noncash investing and
financing activities:
Conversion of Series A to
Series A1 redeemable
convertible preferred
stock...................... $ 1,021 $ -- $ -- $ -- $ --
======== ======== ======== ======== ========
Conversion of demand notes,
accrued interest and
warrants to redeemable
convertible preferred
stock...................... $ 920 $ -- $ -- $ -- $ --
======== ======== ======== ======== ========
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
F-22
<PAGE>
SQA, INC.
CONSOLIDATED STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED STOCK AND
STOCKHOLDERS' EQUITY (DEFICIT)
(IN THOUSANDS, EXCEPT SHARE DATA)
<TABLE>
<CAPTION>
STOCKHOLDERS' EQUITY (DEFICIT)
-------------------------------------------------
REDEEMABLE
CONVERTIBLE
PREFERRED STOCK COMMON STOCK
-------------------- ------------------
ADDITIONAL
NUMBER OF NUMBER OF $.01 PAR PAID-IN ACCUMULATED
SHARES AMOUNT SHARES VALUE CAPITAL DEFICIT TOTAL
---------- -------- --------- -------- ---------- ----------- -------
<S> <C> <C> <C> <C> <C> <C> <C>
Balance, December 31, 1992....................... 242,990 $ 1,021 127,997 $ 1 $ 365 $(2,233) $(1,867)
Issuance of Series A1 preferred stock............ 2,872,579 2,095 -- -- (28) -- (28)
Issuance of Series B preferred stock............. 1,605,505 1,750 -- -- (21) -- (21)
Exercise of options.............................. 48 -- -- -- --
Net loss......................................... -- -- -- -- -- (1,686) (1,686)
---------- -------- --------- --- ------- ------- -------
Balance, December 31, 1993....................... 4,721,074 4,866 128,045 1 316 (3,919) (3,602)
Issuance of Series C preferred stock............. 2,525,000 3,030 -- -- (22) -- (22)
Exercise of options.............................. -- -- 969 -- -- -- --
Net loss......................................... -- -- -- -- -- (2,422) (2,422)
---------- -------- --------- --- ------- ------- -------
Balance, December 31, 1994....................... 7,246,074 7,896 129,014 1 294 (6,341) (6,046)
Issuance of Series D preferred stock............. 1,620,000 4,455 -- -- (20) -- (20)
Issuance of common stock in initial public
offering, net of issuance costs of $808......... -- -- 2,000,000 20 28,932 -- 28,952
Conversion of preferred stock to common stock.... (8,866,074) (12,351) 5,319,634 53 12,298 -- 12,351
Exercise of stock options........................ -- -- 212,051 3 50 -- 53
Net income....................................... -- -- -- -- -- 431 431
---------- -------- --------- --- ------- ------- -------
Balance, December 31, 1995....................... -- -- 7,660,699 77 41,554 (5,910) 35,721
Issuance of common stock in initial public
offering, net of issuance costs of $64
(unaudited)..................................... -- -- 300,000 3 4,369 -- 4,372
Exercise of stock options (unaudited)............ -- -- 80,490 -- 179 -- 179
Net income (unaudited)........................... -- -- -- -- -- 3,296 3,296
---------- -------- --------- --- ------- ------- -------
Balance, September 30, 1996 (unaudited).......... -- $ -- 8,041,189 $80 $46,102 $(2,614) $43,568
- --------------------------------------------------
========== ======== ========= === ======= ======= =======
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
F-23
<PAGE>
SQA
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) THE COMPANY
SQA, Inc. (the Company) develops and markets integrated software products
for the automated testing and quality management of Windows-based clint/server
applications. The Company also provides a comprehensive range of customer
support services, including training, support and on-site consulting. The
Company sells its products to companies (end users), that develop customized
software applications using standardized development software provided by
others, and to distributors, which remarket the Company's products to end
users. The Company's revenue is derived from license fees for use of its
software products by end users and from services provided to end users.
The Company was incorporated as Software Quality Automation, Inc. under the
laws of the State of Delaware in March 1990. The name of the Company was
changed to SQA, Inc. in April 1995.
(2) SIGNIFICANT ACCOUNTING POLICIES
The accompanying consolidated financial statements reflect the application
of certain significant accounting policies, as discussed below and elsewhere
in the notes to consolidated financial statements. The preparation of these
consolidated financial statements in confirmity with generally accepted
accounting principles requires management to make estimates and assumptions
that affect the reported amounts of assets and liabilities and disclosures of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
(a) Basis of Presentation
The accompanying consolidated financial statements include the accounts of
SQA, Inc. and its wholly owned subsidiary. All significant intercompany
balances and transactions have been eliminated.
On October 23, 1995, the Board of Directors approved a three-for-five
reverse stock split of the common stock of the Company. All shares of common
stock and common share equivalents and the per share amounts have been
restated to reflect the reverse stock split.
(b) Interim Financial Information
The consolidated financial statements for the nine months ended September
30, 1996 are unaudited but include all adjustments (consisting of normal
recurring entries) which the Company considers necessary for the fair
presentation. Operating results for the nine months ended September 30, 1996
are not necessarily indicative of the results that may be expected for any
future periods.
(c) Revenue Recognition
The Company recognizes revenue in accordance with the American Institute of
Certified Public Accountants Statement of Position (SOP) 91-1, Software
Revenue Recognition. Software license fees are recognized upon shipment to the
customer if collection is probable and remaining Company obligations are
insignificant. The Company provides for potential product returns and
allowances at the time of shipment. Historically, product returns and
allowances have been immaterial. Training and consulting revenue is recognized
as services are performed. Revenue for maintenance is recognized ratably over
the term of the support period. Unrecognized amounts are recorded as deferred
revenue in the accompanying consolidated balance sheets.
(d) Short-term Investments
The Company accounts for its investments in accordance with Statement of
Financial Accounting Standards (SFAS) No. 115, Accounting for Certain
Investments in Debt and Equity Securities effective January 1, 1994. SFAS No.
115 established the accounting and reporting requirements for investments in
equity securities that
F-24
<PAGE>
SQA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
have readily determinable fair values and for all investments in debt
securities. SFAS No. 115 requires that all affected investments be classified
as held-to-maturity, trading or available-for-sale. Accordingly, the Company's
investments are classified as held-to-maturity and are recorded at amortized
cost. The adoption of SFAS No. 115 had no material impact on the Company's
financial position.
(e) Cash and Cash Equivalents
The Company classifies all highly liquid investments with original
maturities at purchase of three months or less as cash equivalents.
(f) Depreciation and Amortization
The Company provides for depreciation and amortization, using the straight-
line method, by charges to operations in amounts estimated to allocate the
cost of property and equipment over their estimated useful lives as follows:
<TABLE>
<CAPTION>
ESTIMATED
USE LIFE
---------
<S> <C>
Computer equipment and related software........... 3-5 Years
Furniture and fixtures............................ 5 Years
Leasehold improvements............................ Life of lease
Office equipment.................................. 5 Years
Equipment under capital lease..................... Shorter of lease term
or estimated useful life
</TABLE>
(g) Research and Development Expenses for Software Products
In accordance with SFAS No. 86, Accounting for the Costs of Computer
Software To Be Sold, Leased or Otherwise Marketed, the Company will capitalize
software development costs incurred after technological feasibility of the
software development projects is established and the realizability of such
capitalized costs through future operations is expected if such costs become
material. To date, all of the Company's costs for research and development of
software products have been charged to operations are incurred, as the amount
of software development costs incurred subsequent to the completion of a
working model, which is the Company's basis for determining technological
feasibility, has been immaterial.
(h) Postretirement Benefits
The Company has no obligations for postretirement benefits.
(i) Concentration of Credit Risk
SFAS No. 105, Disclosure of Information About Financial Instruments with
Off-Balance Sheet Risk and Financial Instruments with Concentration of Credit
Risk, requires disclosure of any significant off-balance-sheet and credit risk
concentrations. Financial instruments, which potentially subject the Company
to concentrations of credit risk, are principally cash and cash equivalents
and accounts receivable. The Company places its investments in highly rated
institutions. Concentration of credit risk with respect to accounts receivable
is limited to certain customers (end users and distributors) to whom the
Company makes substantial sales. To reduce risk, the Company routinely
assesses the financial strength of its customers and, as a consequence,
believes that its accounts receivable credit risk exposure is limited. The
Company maintains an allowance for potential credit losses but historically
has not experienced any significant losses related to individual customers or
groups of customers in any particular industry or geographic area.
F-25
<PAGE>
SQA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
(j) Net Income (Loss) per Common Share
Net income (loss) per common and common equivalent share is computed using
the pro forma weighted average number of common and dilutive common equivalent
shares outstanding during each period, assuming conversion of all classes of
Redeemable Convertible Preferred Stock into common stock. Stock issued after
October 15, 1994 and common stock issuable pursuant to stock options granted
after October 15, 1994 have been reflected as outstanding for all periods
presented, before the Company's initial public offering of common stock (see
Note 4), using the treasury stock method required by the Securities and
Exchange Commission. Other shares of stock issuable pursuant to stock options
have been included where their effect is dilutive. Fully diluted earnings per
common share are not presented, as they are not materially different from
primary earnings per share. Net income (loss) per common and common equivalent
share has not been presented for the year ended December 31, 1993. SEC rules
require that all stock issued after October 15, 1994 and stock issued pursuant
to stock options granted after October 15, 1994 be reflected as outstanding as
of the year ended December 31, 1993. Because the number of shares and options
outstanding increased substantially in subsequent years, the information which
would result from the required calculation is not considered to be relevant or
meaningful.
(3) PROPERTY AND EQUIPMENT
Property and equipment is stated at cost, less accumulated depreciation and
amortization. Property and equipment consists of the following:
<TABLE>
<CAPTION>
DECEMBER 31,
-------------
1994 1995
----- ------
(IN THOUSANDS)
<S> <C> <C> <C>
Computer equipment and related software................. $ 248 $ 956
Furniture and fixtures.................................. 24 83
Leasehold improvements.................................. 11 19
Office equipment........................................ 29 44
Equipment under capital lease........................... 31 37
----- ------
343 1,139
Accumulated depreciation and amortization............... (136) (274)
----- ------
$ 207 $ 865
===== ======
</TABLE>
(4) REDEEMABLE CONVERTIBLE PREFERRED STOCK
Redeemable convertible preferred stock consists of the following:
<TABLE>
<CAPTION>
DECEMBER 31,
--------------
1994 1995
------- ------
(IN THOUSANDS)
<S> <C> <C> <C>
Series A1, $.01 par value--
Authorized--3,115,569 shares; Issued and outstanding--
3,115,569 shares ($3,115,569 preference in liquidation
at December 31, 1994)................................. $ 3,116 --
Series B, $.01 par value--
Authorized--1,651,926 shares; Issued and outstanding--
1,605,505 shares ($1,992,938 preference in liquidation
at December 31, 1994)................................. 1,750 --
Series C, $.01 par value--
Authorized--2,525,000 shares; Issued and outstanding--
2,525,000 shares ($3,210,804 preference in liquidation
at December 31, 1994)................................. 3,030 --
------- ----
$ 7,896 $
======= ====
</TABLE>
F-26
<PAGE>
SQA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Upon the closing of the Company's initial public offering, all outstanding
shares of the Redeemable Convertible Preferred Stock were converted into
5,319,634 shares of common stock.
(5) STOCKHOLDERS' EQUITY (DEFICIT)
(b) Initial Public Offering
In December 1995, the Company sold, through an underwritten public offering,
2,000,000 shares of its common stock at $16 per share. In January 1996, an
additional 300,000 shares were sold, also at $16 per share, pursuant to an
underwriters over-allotment provision.
(b) Stock Option Plan
During 1990, the Board of Directors approved the 1990 Incentive and
Nonqualified Stock Option Plan (the 1990 Plan), which provided for the
issuance of incentive stock options (ISOs) and nonqualified stock options. In
October 1995, the Board of Directors and stockholders approved the 1995 Stock
Plan (the 1995 Plan) and the 1995 Non-employee Director Stock Option Plan (the
1995 Director Plan) under which the Board of Directors may grant up to an
aggregate of 720,000 stock options to purchase shares of common stock. As a
result of the adoption of the 1995 Plan, no additional options may be granted
pursuant to the 1990 Plan. The exercise price of each ISO may not be less than
100% of the fair market value of the Common Stock at the date of grant. The
Company may grant ISOs to eligible employees and directors. Nonqualified stock
options may be granted to any employee, officer, director or consultant of the
Company. The exercise price of each nonqualified stock option is determined by
the Board of Directors. To date, all stock options have been granted with
exercise prices equal to the fair market value of the Company's Common Stock
at the time of grant. Stock options are exercisable over a 48-month period,
commencing one year after the date of grant, at varying vesting rates and
expire 10 years from the date of grant.
Activity under these plans for the three years ended December 31, 1995 and
the nine months ended September 30, 1996 is summarized as follows:
<TABLE>
<CAPTION>
NUMBER
OF OPTIONS EXERCISE PRICE
---------- --------------
<S> <C> <C>
Outstanding at December 31, 1992................ 30,750 $ .83
Granted....................................... 404,095 .25
Exercised..................................... (48) .83
Canceled...................................... (32,214) .25- .83
--------- -------------
Outstanding at December 31, 1993................ 402,583 .25
Granted....................................... 357,270 .25
Exercised..................................... (969) .25
Canceled...................................... (5,331) .25
--------- -------------
Outstanding at December 31, 1994................ 753,553 .25
Granted....................................... 504,490 .25- 17.75
Exercised..................................... (212,051) .25
Canceled...................................... (103,317) .25
--------- -------------
Outstanding at December 31, 1995................ 942,675 .25- 17.75
Granted....................................... 463,980 19.63- 32.75
Exercised..................................... 73,592 .25- 11.67
Canceled...................................... 38,161 .25- 29.50
--------- -------------
Outstanding at September 30, 1996............... 1,294,902 $ .25-$32.75
========= =============
Exercisable at September 30, 1996............... 195,902 $ .25-$11.67
========= =============
</TABLE>
F-27
<PAGE>
SQA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Shares issued in connection with the 1990 Plan are subject to a stock
restriction agreement, whereby if the holder of shares purchased under the
1990 Plan has an offer to sell any or all shares, the Company has the right to
purchase these shares at the lower of the fair market value of the shares, as
determined by the Board of Directors, or the price of the offer. These
restrictions expire on the closing of the Company's initial public offering.
(c) Stock Purchase Plan
In October 1995, the Company established the 1995 Employee Stock Purchase
Plan, which allows substantially all employees to purchase up to an aggregate
of 285,000 shares of the Company's Common Stock. Semiannually, on January 1,
and July 1, employees can purchase shares of Common Stock at the lesser of 85%
of the fair market value price on the first or last day of the Plan period.
During the nine months ended September 30, 1996, 6,898 shares were issued
under the plan at $17.00 per share. There were no shares issued under the plan
prior to 1996.
(6) WARRANTS
During 1993, in connection with the Company's operating lease arrangement,
the Company granted warrants to purchase 46,421 shares of Series B convertible
preferred stock at an exercise price of $1.09 per share. The warrants become
exercisable on the grant date and expire in 2000. As of September 30, 1996, no
warrants have been exercised.
(7) EMPLOYEE BENEFIT PLAN
The Company maintains an employee benefit plan under Section 401(k) of the
Internal Revenue Code. The plan is available to all employees who have
completed two months of service with the Company and who are at least 21 year
of age. The plan allows for employees to make contributions up to a specified
percentage of their compensation. Under the plan, the Company is required to
match 20% of the employees' contributions up to a maximum annual match of 5%
of each employee's salary. The Company contributed $13,000, $25,000, $41,000
and $45,000 during the years ended December 31, 1993, 1994, and 1995 and the
nine months ended September 30, 1996, respectively.
(8) INCOME TAXES
The Company follows the provisions of SFAS No. 109, Accounting for Income
Taxes, whereby a deferred tax liability is measured by the enacted tax rates
that would be in effect when any differences between the financial statement
basis and tax basis of assets reverse. The deferred tax liability can be
reduced by net operating losses being carried forward for tax purposes.
As of September 30, 1996, the Company has available net operating loss
carryforwards of approximately $3,823,000 and research and development credit
carryforwards of approximately $270,000 to reduce future federal and state
income taxes, if any. These carryforwards expire through 2100 and are subject
to review and possible adjustment by the Internal Revenue Service.
The Tax Reform Act of 1986 contains provisions that may limit the amount of
net operating loss and credit carryforwards that the Company may utilize in
any one year in the event of certain cumulative changes in ownership over a
three-year period in excess of 50%, as defined.
F-28
<PAGE>
SQA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
The approximate income tax effect of each type of temporary difference and
carryforward is as follows:
<TABLE>
<CAPTION>
DECEMBER 31,
----------------
1994 1995
------- -------
(IN THOUSANDS)
<S> <C> <C> <C>
Net operating loss carryforwards.................... $ 2,055 $ 1,624
Research and development credit carryforwards....... 130 361
Nondeductible reserves and accruals................. 84 310
Other temporary differences......................... (17) (9)
------- -------
$ 2,252 $ 2,286
Valuation allowance................................. (2,252) (2,016)
------- -------
Net deferred tax asset.............................. $ -- $ 270
======= =======
</TABLE>
The Company cannot recognize a deferred tax asset for the future benefit of
its net operating loss and tax credit carryforwards unless it concludes that
it is "more likely than not" that the deferred tax assets will be realized.
As of December 31, 1995, the Company had established a full valuation
allowance against its deferred tax asset due to the Company's belief that at
that time it was more likely than not that the Company would not earn
sufficient taxable income in future periods to recognize the benefit of its
deferred tax asset. However, during 1996, the Company recognized a portion of
its deferred tax asset based on the Company's expected 1996 taxable income
level. SQA will continue to evaluate its operations to determine the extent to
which its deferred tax asset should be recognized.
(9) COMMITMENTS AND CONTINGENCIES
The Company leases office facilities and equipment under operating leases
expiring at various dates through 2000.
At September 30, 1996, minimum future rental payments due under these leases
are as follows:
<TABLE>
<CAPTION>
YEAR-ENDED AMOUNT
---------- --------------
(IN THOUSANDS)
<S> <C>
1996............................. $ 134
1997............................. 899
1998............................. 810
1999............................. 809
2000............................. 471
------
$3,123
======
</TABLE>
Aggregate rental expense under operating leases was approximately $58,000,
$220,000, $451,000 and $646,000 during the years ended December 31, 1993,
1994, and 1995 and the nine months ended September 30, respectively.
F-29
<PAGE>
SQA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
(10) GEOGRAPHIC INFORMATION
The percentage of total revenue is as follows:
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
------------------------
1994 1995
------------ ------------
<S> <C> <C>
United States.................................. 76.7% 77.6%
Europe......................................... 15.2% 12.4%
Other.......................................... 8.1% 10.0%
------------ ------------
100% 100%
============ ============
</TABLE>
(11) ACCRUED EXPENSES
Accrued expenses consist of the following:
<TABLE>
<CAPTION>
DECEMBER 31,
-------------
1994 1995
-------------
(IN
THOUSANDS)
<S> <C> <C>
Accrued sales returns....................................... $ 130 $ 131
Accrued commissions......................................... 183 216
Accrued bonuses............................................. 123 267
Other accruals.............................................. 484 1,032
----- -------
$ 920 $ 1,646
===== =======
</TABLE>
(12) ALLOWANCE FOR DOUBTFUL ACCOUNTS
A summary of the allowance for doubtful accounts activity is as follows:
<TABLE>
<CAPTION>
NINE MONTHS
YEARS ENDED DECEMBER 31, ENDED
-------------------------- SEPTEMBER 30,
1994 1995 1996
------------ ------------ -------------
(IN THOUSANDS)
<S> <C> <C> <C>
Balance, beginning of period... $21 $ 92 $244
Amounts, charged to expense.... 72 181 50
Amounts written off............ (1) (29) (62)
----------- ------------ ----
Balance, end of period......... $92 $244 $252
=========== ============ ====
</TABLE>
(13) SUBSEQUENT EVENT
On November 12, 1996, the Company and Rational Software Corporation of Santa
Clara, California (Rational) announced a definitive merger agreement. Under the
terms of the merger agreement, all outstanding shares of the Company's common
stock will be exchanged for shares of Rational on the basis of 0.86 shares of
Rational for each share of the Company. The transaction is expected to be
accounted for as a pooling of interest and to qualify as a tax-free
reorganization. There can be no assurances that the merger will be completed as
scheduled, or at all, or that the Company and Rational will be able to
successfully integrate.
F-30
<PAGE>
ANNEX A
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
AGREEMENT AND PLAN OF
REORGANIZATION
BY AND AMONG
RATIONAL SOFTWARE CORPORATION,
SUNSHINE ACQUISITION CORPORATION
AND SQA, INC.
November 12, 1996
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
<PAGE>
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PAGE
----
<C> <S> <C>
ARTICLE I -- THE MERGER.............................................. A-5
1.1 The Merger................................................. A-5
1.2 Closing: Effective Time.................................... A-5
1.3 Effect of the Merger....................................... A-6
1.4 Certificate of Incorporation: Bylaws....................... A-6
1.5 Directors and Officers..................................... A-6
1.6 Effect on Capital Stock.................................... A-6
1.7 Dissenting Shares.......................................... A-7
1.8 Surrender of Certificates.................................. A-7
1.9 No Further Ownership Rights in Target Common Stock......... A-8
1.10 Lost, Stolen or Destroyed Certificates..................... A-8
1.11 Tax and Accounting Consequences............................ A-9
1.12 Taking of Necessary Action; Further Action................. A-9
ARTICLE II -- REPRESENTATIONS AND WARRANTIES OF TARGET................ A-9
2.1 Organization; Standing and Power........................... A-9
2.2 Capital Structure.......................................... A-10
2.3 Authority.................................................. A-11
2.4 SEC Documents: Financial Statements........................ A-11
2.5 Absence of Certain Changes................................. A-12
2.6 Absence of Undisclosed Liabilities......................... A-12
2.7 Litigation................................................. A-13
2.8 Restrictions on Business Activities........................ A-13
2.9 Compliance; Governmental Authorization..................... A-13
2.10 Title to Property.......................................... A-13
2.11 Intellectual Property...................................... A-13
2.12 Environmental Matters...................................... A-14
2.13 Taxes...................................................... A-15
2.14 Employee Benefit Plans..................................... A-16
2.15 Certain Agreements Affected by the Merger.................. A-17
2.16 Employee Matters........................................... A-17
2.17 Interested Party Transactions.............................. A-18
2.18 Insurance.................................................. A-18
2.19 Compliance With Laws....................................... A-18
2.20 Pooling of interests....................................... A-18
2.21 Brokers' and Finders' Fees................................. A-18
2.22 Registration Statement; Proxy Statement/Prospectus......... A-18
2.23 Opinion of Financial Advisor............................... A-19
2.24 Vote Required.............................................. A-19
2.25 Board Approval............................................. A-19
2.26 Section 203 of the DGCL Not Applicable..................... A-19
2.27 Minute Books............................................... A-19
2.28 Representations Complete................................... A-19
ARTICLE III -- REPRESENTATIONS AND WARRANTIES OF ACQUIROR AND MERGER
SUB........................................................ A-19
3.1 Organization, Standing and Power........................... A-19
3.2 Capital Structure.......................................... A-20
3.3 Authority.................................................. A-20
</TABLE>
A-2
<PAGE>
<TABLE>
<CAPTION>
PAGE
----
<C> <S> <C>
3.4 SEC Documents: Financial Statements......................... A-21
3.5 Absence of Certain Changes.................................. A-22
3.6 Absence of Undisclosed Liabilities.......................... A-22
3.7 Litigation.................................................. A-22
3.8 Restrictions on Business Activities......................... A-22
3.9 Governmental Authorization.................................. A-22
3.10 Compliance With Laws........................................ A-22
3.11 Pooling of Interests........................................ A-23
3.12 Broker's and Finders' Fees.................................. A-23
3.13 Registration Statement: Proxy Statement/Prospectus.......... A-23
3.14 Board Approval.............................................. A-23
3.15 Opinion of Financial Advisor................................ A-23
3.16 Intellectual Property....................................... A-23
3.17 Taxes....................................................... A-24
3.18 Representations Complete.................................... A-25
ARTICLE IV -- CONDUCT PRIOR TO THE EFFECTIVE TIME...................... A-25
4.1 Conduct of Business of Target and Acquiror.................. A-25
4.2 Conduct of Business of Target............................... A-26
4.3 Solicitation................................................ A-27
ARTICLE V -- ADDITIONAL AGREEMENTS.................................... A-28
5.1 Proxy Statement/Prospectus; Registration Statement.......... A-28
5.2 Meeting of Stockholders..................................... A-29
5.3 Access to Information....................................... A-29
5.4 Confidentiality............................................. A-30
5.5 Public Disclosure........................................... A-30
5.6 Consents; Cooperation....................................... A-30
5.7 Pooling Accounting.......................................... A-31
5.8 Affiliate Agreements........................................ A-31
5.9 Legal Requirements.......................................... A-31
5.10 Blue Sky Laws............................................... A-31
5.11 Employee Benefit Plans...................................... A-32
5.12 [Intentionally left blank].................................. A-32
5.13 Form S-8.................................................... A-32
5.14 Indemnification............................................. A-33
5.15 Option Agreement............................................ A-34
5.16 Listing of Additional Shares................................ A-34
5.17 Nasdaq Quotation............................................ A-34
5.18 Pooling Letters............................................. A-34
5.19 Participation Agreement..................................... A-34
5.20 Employment and Noncompetition Agreements.................... A-34
5.21 Amendment to Registration Rights............................ A-34
5.22 FIRPTA...................................................... A-34
5.23 Best Efforts and Further Assurances......................... A-34
ARTICLE VI -- CONDITIONS TO THE MERGER................................. A-35
Conditions to Obligations of Each Party to Effect the
6.1 Merger...................................................... A-35
6.2 Additional Conditions to Obligations of Target.............. A-36
Additional Conditions to the Obligations of Acquiror and
6.3 Merger Sub.................................................. A-36
</TABLE>
A-3
<PAGE>
<TABLE>
<CAPTION>
PAGE
----
<C> <S> <C>
ARTICLE VII -- TERMINATION, AMENDMENT AND WAIVER....................... A-37
7.1 Termination................................................ A-37
7.2 Effect of Termination...................................... A-38
7.3 Expenses and Termination Fees.............................. A-39
7.4 Amendment.................................................. A-40
7.5 Extension; Waiver.......................................... A-40
ARTICLE VIII -- GENERAL PROVISIONS...................................... A-40
8.1 Non-Survival at Effective Time............................. A-40
8.2 Notices.................................................... A-40
8.3 Interpretation............................................. A-41
8.4 Counterparts............................................... A-41
8.5 Entire Agreement; Nonassignability; Parties in Interest.... A-41
8.6 Severability............................................... A-41
8.7 Remedies Cumulative........................................ A-42
8.8 Governing Law.............................................. A-42
8.9 Rules of Construction...................................... A-42
Rational Disclosure Letter
Target Disclosure Letter
EXHIBIT A Form of Certificate of Merger
EXHIBIT B-1 Form of Target Affiliate Agreement
EXHIBIT B-2 Form of Rational Affiliate Agreement
EXHIBIT C Option Agreement
EXHIBIT D Participation Agreement
EXHIBIT E-1 Form of Employment and Noncompetition Agreement
EXHIBIT E-2 Form of Employment and Noncompetition Agreement
EXHIBIT F Form of Opinion of Wilson, Sonsini, Goodrich & Rosati
EXHIBIT G Form of Opinion of Testa, Hurwitz & Thibeault, LLP
</TABLE>
A-4
<PAGE>
AGREEMENT AND PLAN OF REORGANIZATION
This AGREEMENT AND PLAN OF REORGANIZATION (the "Agreement") is made and
entered into as of November 12, 1996, by and among Rational Software
Corporation, a Delaware corporation ("Acquiror"), Sunshine Acquisition
Corporation, a Delaware corporation ("Merger Sub") and wholly owned subsidiary
of Acquiror, and SQA, Inc., a Delaware corporation ("Target").
RECITALS
A. The Boards of Directors of Target, Acquiror and Merger Sub believe it is
in the best interests of their respective companies and the stockholders of
their respective companies that Target and Merger Sub combine into a single
company through the statutory merger of Merger Sub with and into Target (the
"Merger") and, in furtherance thereof, have approved the Merger.
B. Pursuant to the Merger, among other things, the outstanding shares of
Target Common Stock, $.01 par value ("Target Common Stock"), shall be
converted into shares of Acquiror Common Stock, no par value ("Acquiror Common
Stock"), at the rate set forth herein.
C. Target, Acquiror and Merger Sub desire to make certain representations
and warranties and other agreements in connection with the Merger.
D. The parties intend, by executing this Agreement, to adopt a plan of
reorganization within the meaning of Section 368 of the Internal Revenue Code
of 1986, as amended (the "Code"), and to cause the Merger to qualify as a
reorganization under the provisions of Sections 368(a)(1)(A) and 368(a)(2)(E)
of the Code.
E. The parties intend to cause the Merger to be accounted for as a pooling
of interests pursuant to APB Opinion No. 16.
F. Concurrent with the execution of this Agreement and as an inducement to
Acquiror and Merger Sub to enter into this Agreement, (a) Target and Acquiror
have entered into a stock option agreement dated the date hereof (the "Option
Agreement") providing for the purchase by Acquiror of newly-issued shares of
Target's Common Stock, and (b) certain of the affiliates of Target who are
stockholders, officers or directors have on the date hereof entered into an
agreement to vote the shares of Target's Common Stock owned by such person to
approve the Merger and against any competing proposals.
NOW, THEREFORE, in consideration of the covenants and representations set
forth herein, and for other good and valuable consideration, the parties agree
as follows:
ARTICLE I
THE MERGER
1.1 The Merger. At the Effective Time (as defined in Section 1.2) and
subject to and upon the terms and conditions of this Agreement, the
Certificate of Merger attached hereto as Exhibit A (the "Certificate of
Merger") and the applicable provisions of the Delaware General Corporation Law
("Delaware Law"), Merger Sub shall be merged with and into Target, the
separate corporate existence of Merger Sub shall cease and Target shall
continue as the surviving corporation. Target as the surviving corporation
after the Merger is hereinafter sometimes referred to as the "Surviving
Corporation."
1.2 Closing: Effective Time. The closing of the transactions contemplated
hereby (the "Closing") shall take place as soon as practicable after the
satisfaction or waiver of each of the conditions set forth in Article VI
hereof or at such other time as the parties hereto agree (the "Closing Date").
The Closing shall take place at the
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offices of Wilson Sonsini Goodrich & Rosati, P.C., 650 Page Mill Road, Palo
Alto, California, or at such other location as the parties hereto agree. In
connection with the Closing, the parties hereto shall cause the Merger to be
consummated by filing the Certificate of Merger with the Secretary of State of
the State of Delaware and with the Recorder of the County in which the
registered office of each of Target and Merger Sub is located, in accordance
with the relevant provisions of Delaware Law (the time of such filing being
the "Effective Time").
1.3 Effect of the Merger. At the Effective Time, the effect of the Merger
shall be as provided in this Agreement, the Certificate of Merger and the
applicable provisions of Delaware Law. Without limiting the generality of the
foregoing, and subject thereto, at the Effective Time, all the property,
rights, privileges, powers and franchises of Target and Merger Sub shall vest
in the Surviving Corporation, and all debts, liabilities and duties of Target
and Merger Sub shall become the debts, liabilities and duties of the Surviving
Corporation.
1.4 Certificate of Incorporation: Bylaws.
(a) At the Effective Time, the Certificate of Incorporation of Target, as
in effect immediately prior to the Effective Time, shall be the Certificate
of Incorporation of the Surviving Corporation until thereafter amended as
provided by Delaware Law and such Certificate of Incorporation; provided,
however, that Article I of the Certificate of Incorporation of the
Surviving Corporation shall be amended to read as follows: "The name of the
corporation is SQA Holdings, Inc.."
(b) The Bylaws of Target, as in effect immediately prior to the Effective
Time, shall be the Bylaws of the Surviving Corporation until thereafter
amended.
1.5 Directors and Officers. At the Effective Time, the directors and
officers of the Surviving Corporation shall be the directors and officers,
respectively, of Merger Sub, until their respective successors are duly
elected or appointed and qualified.
1.6 Effect on Capital Stock. By virtue of the Merger and without any action
on the part of Merger Sub, Target or the holders of any of the following
securities:
(a) Conversion of Target Common Stock. At the Effective Time, each share
of Target Common Stock issued and outstanding immediately prior to the
Effective Time (other than any shares of Target Common Stock to be canceled
pursuant to Section 1.6(b)) will be canceled and extinguished and be
converted automatically into the right to receive 0.86 shares of Acquiror
Common Stock (the "Exchange Ratio").
(b) Cancellation of Target Common Stock Owned by Acquiror or Target. At
the Effective Time, all shares of Target Common that are owned by Stock
Target as treasury stock and each share of Target Common Stock owned by
Acquiror or any direct or indirect wholly owned subsidiary of Acquiror or
of Target immediately prior to the Effective Time shall be canceled and
extinguished without any conversion thereof.
(c) Target Stock Option Plans. At the Effective Time, all options to
purchase Target Common Stock then outstanding under the Target 1990
Incentive and Nonqualified Stock Option Plan, the 1995 Stock Plan and the
1995 Non-Employee Director Stock Option Plan (collectively, the "Target
Stock Option Plans") shall be assumed by Acquiror in accordance with
Section 5.11. At the Effective Time, in accordance with the terms of
Target's 1995 Employee Stock Purchase Plan (the "Target ESPP"), all rights
to purchase shares of Target Common Stock under the Target ESPP shall be
converted into rights to purchase a number of shares of Acquiror Common
Stock as provided in the Target ESPP (based on the Exchange Ratio), all
such rights shall be assumed by Acquiror, and the offering period in effect
under the Target ESPP immediately prior to the Effective Time shall not be
terminated early. At the Effective Time, each warrant to purchase Target
Common Stock shall be converted into warrants to purchase a number of
shares of Acquiror Common Stock, based on the Exchange Ratio.
(d) Capital Stock of Merger Sub. At the Effective Time, each share of
Common Stock, $.001 par value, of Merger Sub ("Merger Sub Common Stock")
issued and outstanding immediately prior to the Effective Time shall be
converted into and exchanged for one validly issued, fully paid and
nonassessable
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share of Common Stock, $.001 par value, of the Surviving Corporation. Each
stock certificate of Merger Sub evidencing ownership of any such shares
shall continue to evidence ownership of such shares of capital stock of the
Surviving Corporation.
(e) Adjustments to Exchange Ratio. The Exchange Ratio shall be adjusted
to reflect fully the effect of any stock split, reverse split, stock
dividend (including any dividend or distribution of securities convertible
into Acquiror Common Stock or Target Common Stock), reorganization,
recapitalization or other like change with respect to Acquiror Common Stock
or Target Common Stock occurring after the date hereof and prior to the
Effective Time.
(f) Fractional Shares. No fraction of a share of Acquiror Common Stock
will be issued, but in lieu thereof each holder of shares of Target Common
Stock who would otherwise be entitled to a fraction of a share of Acquiror
Common Stock (after aggregating all fractional shares of Acquiror Common
Stock to be received by such holder) shall receive from Acquiror an amount
of cash (rounded to the nearest whole cent) equal to the product of (i)
such fraction, multiplied by (ii) the average of the closing prices of a
share of Acquiror Common Stock for the ten most recent days that Acquiror
Common Stock has traded ending on the trading day immediately prior to the
Effective Time, as reported on the Nasdaq National Market.
1.7 Dissenting Shares.
(a) The shares of any holder of Target Common Stock who has demanded and
perfected appraisal rights for such shares in accordance with Delaware Law
and who, as of the Effective Time, has not effectively withdrawn or lost
such appraisal rights ("Dissenting Shares"), shall not be converted into or
represent a right to receive Acquiror Common Stock pursuant to Section 1.6,
but the holder thereof shall only be entitled to such rights as are granted
by Delaware Law.
(b) Notwithstanding the foregoing, if any holder of shares of Target
Common Stock who demands appraisal of such shares under Delaware Law shall
effectively withdraw the rights to appraisal, then, as of the later of the
Effective Time and the occurrence of such event, such holder's shares shall
automatically be converted into and represent only the right to receive
Acquiror Common Stock, without interest thereon, upon surrender of the
certificate representing such shares.
(c) Target shall give Acquiror (i) prompt notice of any written demands
for appraisal of any shares of Target Common Stock, withdrawals of such
demands, and any other instruments served pursuant to Delaware Law and
received by Target which relate to any such demand for appraisal and (ii)
the opportunity to participate in all negotiations and proceedings which
take place prior to the Effective Time with respect to demands for
appraisal under Delaware Law. Target shall not, except with the prior
written consent of Acquiror or as may be required by applicable law,
voluntarily make any payment with respect to any demands for appraisal of
Acquiror Common Stock or offer to settle or settle any such demands.
(d) The above provisions of this Section 1.7 shall apply only to the
extent that appraisal rights are required pursuant to Delaware law, and
shall not be construed to diminish the parties' obligations under Section
5.17.
1.8 Surrender of Certificates.
(a) Exchange Agent. ChaseMellon Shareholder Services or such other party
as the Acquiror and Target may agree upon shall act as exchange agent (the
"Exchange Agent") in the Merger.
(b) Acquiror to Provide Common Stock and Cash. Promptly after the
Effective Time, Acquiror shall make available to the Exchange Agent for
exchange in accordance with this Article 1, through such reasonable
procedures as Acquiror may adopt, (i) the shares of Acquiror Common Stock
issuable pursuant to Section 1.6(a) in exchange for shares of Target Common
Stock outstanding immediately prior to the Effective Time and (ii) cash in
an amount sufficient to permit payment of cash in lieu of fractional shares
pursuant to Section 1.6(f).
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(c) Exchange Procedures. Promptly after the Effective Time, the Surviving
Corporation shall cause to be mailed to each holder of record of a
certificate or certificates (the "Certificates") which immediately prior to
the Effective Time represented outstanding shares of Target Common Stock,
whose shares were converted into the right to receive shares of Acquiror
Common Stock (and cash in lieu of fractional shares) pursuant to Section
1.6, (i) a letter of transmittal (which shall specify that delivery shall
be effected, and risk of loss and title to the Certificates shall pass,
only upon receipt of the Certificates by the Exchange Agent, and shall be
in such form and have such other provisions as Acquiror may reasonably
specify) and (ii) instructions for use in effecting the surrender of the
Certificates in exchange for certificates representing shares of Acquiror
Common Stock (and cash in lieu of fractional shares). Upon surrender of a
Certificate for cancellation to the Exchange Agent or to such other agent
or agents as may be appointed by Acquiror, together with such letter of
transmittal, duly completed and validly executed in accordance with the
instructions thereto, the holder of such Certificate shall be entitled to
receive in exchange therefor a certificate representing the number of whole
shares of Acquiror Common Stock and payment in lieu of fractional shares
which such holder has the right to receive pursuant to Section 1.6, and the
Certificate so surrendered shall forthwith be canceled. Until so
surrendered, each outstanding Certificate that, prior to the Effective
Time, represented shares of Target Common Stock will be deemed from and
after the Effective Time, for all corporate purposes, subject to Section
1.8(d) below as to the payment of dividends, to evidence the ownership of
the number of full shares of Acquiror Common Stock into which such shares
of Target Common Stock shall have been so converted and the right to
receive an amount in cash in lieu of the issuance of any fractional shares
in accordance with Section 1.6.
(d) Distributions With Respect to Unexchanged Shares. No dividends or
other distributions with respect to Acquiror Common Stock with a record
date after the Effective Time will be paid to the holder of any
unsurrendered Certificate with respect to the shares of Acquiror Common
Stock represented thereby until the holder of record of such Certificate
shall surrender such Certificate. Subject to applicable law, following
surrender of any such Certificate, there shall be paid to the record holder
of the certificates representing whole shares of Acquiror Common Stock
issued in exchange therefor, without interest, at the time of such
surrender, the amount of any such dividends or other distributions with a
record date after the Effective Time theretofore payable (but for the
provisions of this Section 1.8(d)) with respect to such shares of Acquiror
Common Stock.
(e) Transfers of Ownership. If any certificate for shares of Acquiror
Common Stock is to be issued in a name other than that in which the
Certificate surrendered in exchange therefor is registered, it will be a
condition of the issuance thereof that the Certificate so surrendered will
be properly endorsed and otherwise in proper form for transfer and that the
person requesting such exchange will have paid to Acquiror or any agent
designated by it any transfer or other taxes required by reason of the
issuance of a certificate for shares of Acquiror Common Stock in any name
other than that of the registered holder of the Certificate surrendered, or
established to the satisfaction of Acquiror or any agent designated by it
that such tax has been paid or is not payable.
(f) No Liability. Notwithstanding anything to the contrary in this
Section 1.8, none of the Exchange Agent, the Surviving Corporation or any
party hereto shall be liable to any person for any amount properly paid to
a public official pursuant to any applicable abandoned property, escheat or
similar law.
1.9 No Further Ownership Rights in Target Common Stock. All shares of
Acquiror Common Stock issued upon the surrender for exchange of shares of
Target Common Stock in accordance with the terms hereof (including any cash
paid in lieu of fractional shares) shall be deemed to have been issued in full
satisfaction of all rights pertaining to such shares of Target Common Stock,
and there shall be no further registration of transfers on the records of the
Surviving Corporation of shares of Target Common Stock which were outstanding
immediately prior to the Effective Time. If, after the Effective Time,
Certificates are presented to the Surviving Corporation for any reason, they
shall be canceled and exchanged as provided in this Article 1.
1.10 Lost, Stolen or Destroyed Certificates. In the event any Certificates
shall have been lost, stolen or destroyed, the Exchange Agent shall issue in
exchange for such lost, stolen or destroyed Certificates, upon the
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making of an affidavit of that fact by the holder thereof, such shares of
Acquiror Common Stock (and cash in lieu of fractional shares) as may be
required pursuant to Section 1.6; provided, however, that Acquiror may, in its
discretion and as a condition precedent to the issuance thereof, require the
owner of such lost, stolen or destroyed Certificates to deliver a bond in such
sum as it may reasonably direct as indemnity against any claim that may be
made against Acquiror, the Surviving Corporation or the Exchange Agent with
respect to the Certificates alleged to have been lost, stolen or destroyed.
1.11 Tax and Accounting Consequences. It is intended by the parties hereto
that the Merger shall (i) constitute a reorganization within the meaning of
Section 368(a) of the Code and (ii) qualify for accounting treatment as a
pooling of interests.
1.12 Taking of Necessary Action; Further Action. If, at any time after the
Effective Time, any further action is necessary or desirable to carry out the
purposes of this Agreement and to vest the Surviving Corporation with full
right, title and possession to all assets, property, rights, privileges,
powers and franchises of Target and Merger Sub, the officers and directors of
Target and Merger Sub are fully authorized in the name of their respective
corporations or otherwise to take, and will take, all such lawful and
necessary action, so long as such action is not inconsistent with this
Agreement.
ARTICLE II
REPRESENTATIONS AND WARRANTIES OF TARGET
In this Agreement, any reference to any event, change, condition or effect
being "material" with respect to any entity or group of entities means any
material event, change, condition or effect related to the financial
condition, assets (including intangible assets), business or results of
operations of such entity or group of entities. In this Agreement, any
reference to a "Material Adverse Effect" with respect to any entity or group
of entities means any event, change or effect that is materially adverse to
the financial condition, assets (including intangible assets), business or
results of operations of such entity and its subsidiaries, taken as a whole;
provided, however, that a "Material Adverse Effect" with respect to Target
shall not include any adverse effect on the revenues or gross margins of
Target (or the direct consequences thereof) following the date of this
Agreement which is attributable to a delay of, reduction in or cancellation or
change in the terms of product orders by customers of Target, where Target
sustains the burden of reasonably demonstrating that any such delay,
reduction, cancellation or change is directly attributable to the transactions
contemplated by this Agreement.
In this Agreement, any reference to a party's "knowledge" means such party's
actual knowledge after reasonable inquiry of officers and directors of such
party.
Except as disclosed in a document of even date herewith and delivered by
Target to Acquiror prior to the execution and delivery of this Agreement and
referring to the representations and warranties in this Agreement (the "Target
Disclosure Letter"), Target represents and warrants to Acquiror and Merger Sub
as follows:
2.1 Organization; Standing and Power. Each of Target and SQA (Europe)
Limited and SQA Securities Corporation, being Target's only two subsidiaries,
is a corporation duly organized, validly existing and in good standing under
the laws of its jurisdiction of organization. Each of Target and its
subsidiaries has the corporate power to own its properties and to carry on its
business as now being conducted and as proposed to be conducted and is duly
qualified to do business and is in good standing in each jurisdiction in which
the failure to be so qualified and in good standing would have a Material
Adverse Effect on Target. Target has delivered a true and correct copy of the
Amended and Restated Certificate of Incorporation, as amended (the
"Certificate of Incorporation"), and Bylaws, as amended, or other charter
documents, as applicable, of Target and each of its subsidiaries, each as
amended to-date, to legal counsel for Acquiror. Neither Target nor any of its
subsidiaries is in violation of any of the provisions of its Certificate of
Incorporation or Bylaws or equivalent organizational documents. Target is the
owner of all outstanding shares of capital stock of each of its two
subsidiaries and all such shares are duly authorized, validly issued, fully
paid and nonassessable. All of the outstanding shares of
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capital stock of each such subsidiary are owned by Target free and clear of
all liens, charges, claims or encumbrances or rights of others. There are no
outstanding subscriptions, options, warrants, puts, calls, rights,
exchangeable or convertible securities or other commit ments or agreements of
any character relating to the issued or unissued capital stock or other
securities of any such subsidiary, or otherwise obligating Target or any such
subsidiary to issue, transfer, sell, purchase, redeem or otherwise acquire any
such securities. Except as disclosed in the Target SEC Documents (as defined
in Section 2.4), Target does not directly or indirectly own any equity or
similar interest in, or any interest convertible or exchangeable or
exercisable for, any equity or similar interest in, any corporation,
partnership, joint venture or other business association or entity.
2.2 Capital Structure. The authorized capital stock of Target consists of
18,000,000 shares of Common Stock, $.01 par value, and 3,000,000 shares of
Preferred Stock, $.01 par value, of which there were issued and outstanding as
of the close of business on November 11, 1996, 8,088,644 shares of Common
Stock and no shares of Preferred Stock. Since the close of business on
November 11, 1996, no shares of Target capital stock have been issued except
pursuant to the exercise of options outstanding as of November 11, 1996 under
the Target Stock Option Plans. As of the close of business on November 12,
1996, there were no other outstanding commitments to issue any shares of
capital stock or voting securities of Target other than pursuant to the Option
Agreement, the exercise of options outstanding as of such date under the
Target Stock Option Plans, pursuant to the Target ESPP or pursuant to the
Warrants (as defined below). All outstanding shares of Target Common Stock are
duly authorized, validly issued, fully paid and non-assessable and are not
subject to preemptive rights or rights of first refusal created by statute,
the Certificate of Incorporation or Bylaws of Target or any agreement to which
Target is a party or by which it is bound. As of the close of business on
November 12, 1996, Target has reserved (i) 1,426,687 shares of Common Stock
for issuance to employees, consultants and directors pursuant to the Target
Stock Option Plans, net of exercises, under which, as of the close of business
on November 11, 1996, options were outstanding for an aggregate of 1,304,697
shares, and no shares were subject to outstanding stock purchase rights, (ii)
285,000 shares of Common Stock for issuance to employees pursuant to the
Target ESPP, of which, as of the close of business on November 11, 1996, 6,898
shares had been issued, and (iii) 27,852 shares of Common Stock for issuance
upon the exercise of warrants to purchase Target Common Stock (the "Warrants")
of which no shares have been issued. When issued in accordance with the terms
of the Target Stock Option Plans, the Target ESPP and the Warrants, the Target
Common Stock so issued will be duly authorized, validly issued, fully paid and
non-assessable and will not be subject to preemptive rights or right of first
refusal created by statute, the Certificate of Incorporation or Bylaws of
Target or any agreement to which Target is a party or by which it is bound.
Except as expressly permitted by the terms of this Agreement, since November
11, 1996, Target has not (i) issued or granted additional options under the
Target Stock Option Plans, or (ii) accepted contributions to or enrollments in
the Target ESPP. Except for the rights created pursuant to this Agreement, the
Option Agreement, the Target Stock Option Plans, the Target ESPP and the
Warrants, there are no other options, warrants, calls, rights, commitments or
agreements of any character to which Target is a party or by which it is bound
obligating Target to issue, deliver, sell, repurchase or redeem, or cause to
be issued, delivered, sold, repurchased or redeemed, any shares of capital
stock of Target or obligating Target to grant, extend, accelerate the vesting
of, change the price of, or otherwise amend or enter into any such option,
warrant, call, right, commitment or agreement. There are no contracts,
commitments or agreements relating to voting, purchase or sale of Target's
capital stock (i) between or among Target and any of its stockholders and (ii)
to Target's knowledge, between or among any of Target's stockholders, except
for the voting agreement described in Section 5.19. Except as set forth in the
Target Disclosure Letter, there are no registration rights with respect to any
equity security of any class of Target or with respect to any equity security
of any class of any of its subsidiaries. The terms of the Target Stock Option
Plans permit the assumption or substitution of options to purchase Acquiror
Common Stock as provided in this Agreement, without the consent or approval of
the holders of such securities, the Target stockholders, or otherwise and
without any acceleration of the exercise schedule or vesting provisions in
effect for those options, other than as disclosed in the Target Disclosure
Letter. The current "Purchase Period" (as defined in the Target ESPP)
commenced under the Target ESPP on July 1, 1996 and will end as provided in
Section 5.11(b) of this Agreement, and except for the purchase rights granted
on such commencement date to participants in the current Purchase Period,
there are no other purchase rights or options outstanding under the Target
ESPP. True and complete copies of all agreements and instruments relating to
or
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issued under the Target Stock Option Plans. Target ESPP have been made
available to legal counsel for Acquiror and such agreements and instruments
have not been amended, modified or supplemented, and there are no agreements
to amend, modify or supplement such agreements or instruments in any case from
the form made available to Acquiror. Schedule 2.2 of the Disclosure Letter
lists the name of each holder of stock options and warrants, the number of
shares of Common Stock subject to such options and warrants, and the exercise
price for such options and warrants. Each of the options listed on Schedule
2.2 of the Disclosure Letter has a term of ten years.
2.3 Authority.
(a) Target has all requisite corporate power and authority to enter into
this Agreement and the Option Agreement and to consummate the transactions
contemplated hereby and thereby. The execution and delivery of this
Agreement and the Option Agreement and the consummation of the transactions
contemplated hereby and thereby have been duly authorized by all necessary
corporate action on the part of Target, subject only to the approval of the
Merger by Target's stockholders as contemplated by Section 6.1(a) and the
filing and recordation of the Certificate of Merger pursuant to Delaware
Law. Each of this Agreement and the Option Agreement has been duly executed
and delivered by Target and constitutes the valid and binding obligation of
Target enforceable against Target in accordance with its terms, except as
enforceability may be limited by bankruptcy and other laws affecting the
rights and remedies of creditors generally and, general principles of
equity. The execution and delivery of this Agreement and the Option
Agreement by Target does not, and the consummation of the transactions
contemplated hereby and thereby will not (i) conflict with, or result in
any violation of any provision of the Certificate of Incorporation or
Bylaws of Target or any of its subsidiaries, as amended, or (ii) subject to
obtaining the approval of Target's stockholders of the Merger as
contemplated in Section 5.2 and compliance with the requirements set forth
in Section 2.3(b) below, result in any breach of or constitute a default
under (with or without notice or lapse of time, or both) or give rise to a
right of termination, cancellation or acceleration of any material
obligation or loss of any material benefit under any material mortgage,
indenture, lease, contract or other agreement or instrument, permit,
concession, franchise, license, judgment, order, decree, statute, law,
ordinance, rule or regulation applicable to Target or any of its
subsidiaries or any of their properties or assets, except where such
conflict, violation, default, termination, cancellation or acceleration
with respect to the foregoing provisions of (ii) would not have had and
would not reasonably be expected to have a Material Adverse Effect on
Target.
(b) No consent, approval, order or authorization of, or registration,
declaration or filing with, any court, administrative agency or commission
or other federal, state, local, foreign or other governmental authority or
instrumentality ("Governmental Entity") is required by or, to the knowledge
of Target, with respect to, Target or any of its subsidiaries in connection
with the execution and delivery of this Agreement, the Option Agreement, or
the consummation of the transactions contemplated hereby and thereby,
except for (i) the filing of the Certificate of Merger as provided in
Section 1.2, (ii) the filing with the Securities and Exchange Commission
(the "SEC") and the National Association of Securities Dealers, Inc. (the
"NASD") of the Proxy Statement (as defined in Section 2.22) (iii) the
filing of a Current Report on Form 8-K with the SEC, (iv) relating to the
Target Stockholders Meeting (as defined in Section 2.22), (iv) such
consents, approvals, orders, authorizations, registrations, declarations
and filings as may be required under applicable state securities laws and
the securities laws of any foreign country; (v) such filings as may be
required under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as
amended ("HSR") or the competition regulations of any other foreign
governmental authority; and (vi) such other consents, authorizations,
filings, approvals and registrations which, if not obtained or made, would
not have a Material Adverse Effect on Target and would not prevent, or
materially alter or delay any of the transactions contemplated by this
Agreement or the Option Agreement.
2.4 SEC Documents: Financial Statements. Target has filed all forms,
reports, documents and other items required to be filed with the SEC since
October 25, 1995, and has made available to Acquiror such forms, reports,
documents and items in the form filed with the SEC, and, prior to the
Effective Time, will have furnished
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to Acquiror copies of any additional forms, reports, documents and other items
filed with the SEC prior to the Effective Time. All such required forms,
reports, document and other items (including those that Target may file
subsequent to the date hereof) are referred to herein collectively as the
"Target SEC Documents." In addition, Target has made available to Acquiror all
exhibits to the Target SEC Documents filed prior to the date hereof, and will
promptly make available to Acquiror all exhibits to any additional Target SEC
Documents filed prior to the Effective Time. All documents required to be
filed as exhibits to the Target SEC Documents have been so filed, and all
material contracts so filed as exhibits are in full force and effect, except
those which have expired in accordance with their terms, and neither Target
nor any of its subsidiaries is in default thereunder, except where any such
default has not resulted in and is not reasonably expected to result in any
Material Adverse Effect on Target. As of their respective filing dates, the
Target SEC Documents complied in all material respects with the requirements
of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), and
the Securities Act of 1933, as amended (the "Securities Act"), and none of the
Target SEC Documents contained any untrue statement of a material fact or
omitted to state a material fact required to be stated therein or necessary to
make the statements made therein, in light of the circumstances under which
they were made, not misleading, except to the extent corrected by a
subsequently filed Target SEC Document. The financial statements of Target,
including the notes thereto, included in the Target SEC Documents (the "Target
Financial Statements") were complete and correct in all material respects as
of their respective dates, complied as to form in all material respects with
applicable accounting requirements and with the published rules and
regulations of the SEC with respect thereto as of their respective dates, and
have been prepared in accordance with generally accepted accounting principles
("GAAP") applied on a basis consistent throughout the periods indicated and
consistent with each other (except as may be indicated in the notes thereto
or, in the case of unaudited statements included in Quarterly Reports on Form
10-Q, as permitted by Form 10-Q of the SEC). The Target Financial Statements
fairly present the consolidated financial condition and operating results of
Target and its subsidiaries at the dates and during the periods indicated
therein (subject, in the case of unaudited statements, to normal, recurring
period-end adjustments) in all material respects. There has been no material
change in Target accounting policies except as described in the notes to the
Target Financial Statements.
2.5 Absence of Certain Changes. Since September 30, 1996 (the "Target
Balance Sheet Date"), Target has conducted its business in the ordinary course
consistent with past practice and there has not occurred: (i) any change,
event or condition (whether or not covered by insurance) that would result in
a Material Adverse Effect to Target; (ii) any acquisition, sale or transfer of
any material asset of Target or any of its subsidiaries other than in the
ordinary course of business and consistent with past practice; (iii) any
material change in accounting methods or practices (including any change in
depreciation or amortization policies or rates) by Target or any material
revaluation by Target of any of its or any of its subsidiaries' assets, except
as required by concurrent changes in GAAP; (iv) any declaration, setting
aside, or payment of a dividend or other distribution with respect to the
shares of Target, or any direct or indirect redemption, purchase or other
acquisition by Target of any of its shares of capital stock; (v) any material
contract entered into by Target or any of its subsidiaries, other than in the
ordinary course of business and as provided to Acquiror, or any material
amendment or termination of, or default under, any material contract to which
Target or any of its subsidiaries is a party or by which it is bound which
would result in a Material Adverse Effect on Target; or (vi) any negotiation
or agreement by Target or any of its subsidiaries to do any of the things
described in the preceding clauses (i) through (v) (other than negotiations
with Acquiror and its representatives regarding the transactions contemplated
by this Agreement).
2.6 Absence of Undisclosed Liabilities. Target has no material obligations
or liabilities of any nature (matured or unmatured, fixed or contingent) other
than (i) those set forth or adequately provided for in the unaudited balance
sheet for the quarter ended September 30, 1996, which has been provided to
Acquiror (the "Target Balance Sheet"), (ii) those not required to be set forth
in the Target Balance Sheet under GAAP, (iii) those incurred in the ordinary
course of business since the Target Balance Sheet Date and consistent with
past practice; and (iv) those incurred in connection with the execution of
this Agreement.
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2.7 Litigation. There is no private or governmental action, suit,
proceeding, claim, arbitration or investigation pending before any agency,
court or tribunal, foreign or domestic, or, to the knowledge of Target or any
of its subsidiaries, threatened against Target or any of its subsidiaries or
any of their respective properties
or any of their respective officers or directors (in their capacities as such)
that, individually or in the aggregate, would have a Material Adverse Effect
on Target. There is no judgment, decree or order against Target or any of its
subsidiaries, or, to the knowledge of Target and its subsidiaries, any of
their respective directors or officers (in their capacities as such), that
would prevent, enjoin, materially alter or materially delay any of the
transactions contemplated by this Agreement, or that would have a Material
Adverse Effect on Target.
2.8 Restrictions on Business Activities. There is no agreement (other than
any exclusive distribution agreements identified in Schedule 2.8 of the
Disclosure Letter), judgment, injunction, order or decree binding upon Target
or any of its subsidiaries which has the effect of prohibiting or materially
impairing any current or future business practice of Target or any of its
subsidiaries, any acquisition of property by Target or any of its subsidiaries
or the conduct of business by Target or any of its subsidiaries as currently
conducted by Target or any of its subsidiaries.
2.9 Compliance; Governmental Authorization.
(a) Neither Target nor any of its subsidiaries is in conflict with, or in
default or violation of any note, bond, mortgage, indenture, contract,
agreement, lease, license, permit, franchise or other instrument or
obligation to which Target or any of its subsidiaries is a party or by
which Target or any of its subsidiaries or its or any of their respective
properties is bound or affected, except for any conflicts, defaults or
violations which would have a Material Adverse Effect on Target. No
investigation or review by any governmental or regulatory body or authority
is pending or threatened against Target or its subsidiaries, nor has any
governmental or regulatory body or authority indicated an intention to
conduct the same, other than, in each such case, those the outcome of which
would not have a Material Adverse Effect on Target.
(b) Target and each of its subsidiaries have obtained each federal,
state, county, local or foreign governmental consent, license, permit,
grant, or other authorization of a Governmental Entity which are material
to the operations of the business of Target and its subsidiaries taken as a
whole (collectively called "Target Authorizations"), and all of such Target
Authorizations are in full force and effect, except where the failure to
obtain or have any of such Target Authorizations would not have a Material
Adverse Effect on Target.
2.10 Title to Property. Target and its subsidiaries have good and valid
title to, or in the case of leased properties and assets, valid leasehold
interests in, all of its material tangible properties and assets, real,
personal and mixed, used in its business, free and clear of all mortgages,
liens, pledges, charges or encumbrances of any kind or character, except (i)
for liens for taxes not yet due and payable, (ii) for such imperfections of
title, liens and easements as do not and will not materially detract from or
interfere with the use of the properties subject thereto or affected thereby,
or otherwise materially impair business operations involving such properties,
(iii) as reflected on the Target Balance Sheet or (iv) for those which would
not have a Material Adverse Effect on Target. To Target's knowledge, the
plants, property and equipment of Target and its subsidiaries that are used in
the operations of their businesses are in good operating condition and repair
in all material respects. All properties used in the operations of Target and
its subsidiaries are reflected in the Target Balance Sheet to the extent GAAP
requires the same to be reflected. Schedule 2.10 of the Disclosure Letter
identifies each material parcel of real property owned or leased by Target or
any of its subsidiaries.
2.11 Intellectual Property.
(a) Target and its subsidiaries own, or are licensed or otherwise possess
legally enforceable rights to use all patents, trademarks, trade names,
service marks, copyrights, and any applications therefor, technology, know-
how, trade secrets, inventory, ideas, algorithms, processes, computer
software programs or applications (in both source code and object code
form), and tangible or intangible proprietary information or material
("Intellectual Property") that are used in the business of Target and its
subsidiaries
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as currently conducted or as proposed to be conducted by Target and its
subsidiaries, except to the extent that the failure to have such rights
have not had and would not reasonably be expected to have a Material
Adverse Effect on Target.
(b) Schedule 2.11 of the Disclosure Letter lists (i) all patents and
patent applications and all registered and unregistered trademarks, trade
names and service marks, registered and unregistered copyrights, and
maskworks, which Target considers to be material to its business and
included in the Intellectual Property, including the jurisdictions in which
each such Intellectual Property right has been issued or registered or in
which any application for such issuance and registration has been filed,
(ii) all material licenses, sublicenses and other agreements as to which
Target is a party and pursuant to which any person is authorized to use any
Intellectual Property (excluding object-code end-user licenses granted to
end-users in the ordinary course of business), and (iii) all material
licenses, sublicenses and other agreements as to which Target is a party
and pursuant to which Target is authorized to use any third party patents,
trademarks or copyrights, including software ("Third Party Intellectual
Property Rights") which are incorporated in, are, or form a part of any
Target product that is material to its business.
(c) There is no unauthorized use, disclosure, infringement or
misappropriation of any Intellectual Property rights of Target or any of
its subsidiaries, any trade secret material to Target or any of its
subsidiaries, or any Intellectual Property right of any third party to the
extent licensed by or through Target or any of its subsidiaries, by any
third party, including any employee or former employee of Target or any of
its subsidiaries. Neither Target nor any of its subsidiaries has entered
into any agreement to indemnify any other person against any charge of
infringement of any Intellectual Property, other than indemnification
provisions contained in purchase orders or customer agreements arising in
the ordinary course of business.
(d) Target is not, nor will it be as a result of the execution and
delivery of this Agreement or the performance of its obligations under this
Agreement, in breach of any license, sublicense or other agreement relating
to the Intellectual Property or Third Party Intellectual Property Rights,
the breach of which would have a Material Adverse Effect on Target.
(e) All patents, registered trademarks, service marks and copyrights held
by Target are valid and subsisting. Target (i) is not a party to any suit,
action or proceeding which involves a claim of infringement of any patents,
trademarks, service marks, copyrights or violation of any trade secret or
other proprietary right of any third party and (ii) has not brought any
action, suit or proceeding for infringement of Intellectual Property or
breach of any license or agreement involving Intellectual Property against
any third party. The manufacture, marketing, licensing or sale of Target's
products does not infringe any patent, trademark, service mark, copyright,
trade secret or other proprietary right of any third party, except where
such infringement would not have a Material Adverse Effect on Target.
(f) Target has a policy, which it has consistently enforced, to secure
valid written assignments from all consultants and employees who contribute
or have contributed to the creation or development of Intellectual Property
of the rights to such contributions that Target does not already own by
operation of law.
(g) Target believes it has taken all reasonable and appropriate steps to
protect and preserve the confidentiality of all Intellectual Property not
otherwise protected by patents, or patent applications or copyright
("Confidential Information"). To Target's knowledge, all use, disclosure or
appropriation of Confidential Information owned by Target by or to a third
party has been pursuant to the terms of a written agreement between Target
and such third party. To Target's knowledge, all use, disclosure or
appropriation of Confidential Information not owned by Target has been
pursuant to the terms of a written agreement between Target and the owner
of such Confidential Information, or is otherwise lawful.
2.12 Environmental Matters. Except in all cases as, in the aggregate, have
not had and would not have a Material Adverse Effect on Target, Target and
each of its subsidiaries (i) have obtained all applicable permits, licenses
and other authorizations that are required under Federal, state or local laws
relating to pollution or protection of the environment, including laws
relating to emissions, discharges, releases or threatened releases of
pollutants, contaminants or hazardous or toxic materials or wastes into
ambient air, surface water, ground water
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or land or otherwise relating to the manufacture, processing, distribution,
use, treatment, storage, disposal, transport or handling of pollutants,
contaminants or hazardous or toxic materials or wastes by Target or its
subsidiaries (or their respective agents); (ii) are in compliance with all
material terms and conditions of such required permits, licenses and
authorizations, and also are in compliance with all other material
limitations, restrictions, conditions, standards, prohibitions, requirements,
obligations, schedules and timetables contained in such laws or contained in
any regulation, code, plan, order, decree, judgment, notice or demand letter
issued, entered, promulgated or approved thereunder; (iii) as of the date
hereof, are not aware of and have not received notice of any event, condition,
circumstance, activity, practice, incident, action or plan that is reasonably
likely to interfere with or prevent continued compliance or that would give
rise to any common law or statutory liability, or otherwise form the basis of
any claim, action, suit or proceeding, based on or resulting from Target's or
any of its subsidiaries (or any of their respective agents) manufacture,
processing, distribution, use, treatment, storage, disposal, transport, or
handling, or the emission, discharge or release into the environment of any
pollutant, contaminant or hazardous or toxic material or waste; (iv) has not
disposed of any pollutants, contaminants or hazardous or toxic materials or
wastes into the soil or groundwater at any properties owned or leased by
Target, either now or in the past, or at any other property that would result
in any assessment or remedial action; and (v) have taken all actions necessary
under applicable requirements of Federal, state or local laws, rules or
regulations to register any products or materials required to be registered by
Target or its subsidiaries (or any of their respective agents) thereunder.
2.13 Taxes. Except as disclosed on Schedule 2.13 of the Disclosure Letter
and except to the extent the failure to do so would not have a Material
Adverse Effect, Target and each of its subsidiaries, and any consolidated,
combined, unitary or aggregate group for Tax purposes of which Target or any
of its subsidiaries is or has been a member have timely filed all Tax Returns
required to be filed by it, have paid all Taxes shown thereon to be due (or
Target has paid on its behalf) and have provided adequate accruals in
accordance with GAAP in its financial statements for any unpaid Taxes that are
imposed on Target or its subsidiaries. Except as disclosed on Schedule 2.13 of
the Disclosure Letter, the most recent financial statements contained in the
Target SEC Documents reflect an adequate reserve, in accordance with GAAP, for
all Taxes payable by Target and its subsidiaries through the date of such
financial statements. Except as disclosed in the Target Disclosure Letter, (i)
no material claim for Taxes has become a lien against the property of Target
or any of its subsidiaries or is being asserted against Target or any of its
subsidiaries other than liens for Taxes not yet due and payable, (ii) no audit
of any Tax Return of Target or any of its subsidiaries is being conducted by a
Tax authority, (iii) no extension of the statute of limitations on the
assessment of any Taxes has been granted by Target or any of its subsidiaries
and is currently in effect, and (iv) there is no agreement, contract or
arrangement to which Target or any of its subsidiaries is a party that may
result in the payment of any amount that would not be deductible by reason of
Sections 280G or 404 of the Code. Target has not been and will not be required
to include any material adjustment in Taxable income for any Tax period (or
portion thereof) pursuant to Section 481 or 263A of the Code or any comparable
provision under state or foreign Tax laws as a result of transactions, events
or accounting methods employed prior to the Merger. Neither Target nor any of
its subsidiaries is a party to any tax sharing or tax allocation agreement nor
does Target or any of its subsidiaries owe any amount under any such
agreement. For purposes of this Agreement, the following terms have the
following meanings: "Tax" (and, with correlative meaning, "Taxes" and
"Taxable") means (i) any net income, alternative or add-on minimum tax, gross
income, gross receipts, sales, use, ad valorem, transfer, franchise, profits,
license, withholding, payroll, employment, excise, severance, stamp,
occupation, premium, property, environmental or windfall profit tax, custom,
duty or other tax, governmental fee or other like assessment or charge of any
kind whatsoever, together with any interest or any penalty, addition to tax or
additional amount imposed by any Governmental Entity (a "Tax authority")
responsible for the imposition of any such tax (domestic or foreign), (ii) any
liability for the payment of any amounts of the type described in (i) as a
result of being a member of an affiliated, consolidated, combined or unitary
group for any Taxable period and (iii) any liability for the payment of any
amounts of the type described in (i) or (ii) as a result of any obligation to
indemnify any other person. As used herein, "Tax Return" shall mean any
return, statement, report or form (including, without limitation,) estimated
Tax returns and reports, withholding Tax returns and reports and information
reports and returns required to be filed with
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respect to Taxes. To the knowledge of Target, neither Target nor any of its
subsidiaries is a party to any Tax-exemption or other Tax-sparing agreement or
order of any foreign government.
2.14 Employee Benefit Plans.
(a) Schedule 2.14 of the Disclosure Letter lists, with respect to Target,
any subsidiary of Target and any trade or business (whether or not
incorporated) which is treated as a single employer with Target (an "ERISA
Affiliate") within the meaning of Section 414(b), (c), (m) or (o) of the
Code, (i) all employee benefit plans (as defined in Section 3(3) of the
Employee Retirement Income Security Act of 1974, as amended ("ERISA"))
whether or not such plans are subject to ERISA, (ii) each loan to a non-
officer employee in excess of $50,000, loans to officers and directors and
any stock option, stock purchase, phantom stock, stock appreciation right,
(iii) all supplemental retirement, severance, sabbatical, medical, dental,
vision care, disability, employee relocation, cafeteria benefit (Code
Section 125) or dependent care (Code Section 129), life insurance or
accident insurance, bonus, pension, profit sharing, savings, deferred
compensation or incentive plans, programs or arrangements which are not
employee benefit plans as otherwise covered under clause (i) above, (iv)
other fringe or employee benefit plans, programs or arrangements that apply
to senior management or overseas employees of Target and that do not
generally apply to all employees, and (v) any current or former employment
or executive compensation or severance agreements (other than pursuant to
the Target Stock Option Plans), written or otherwise, as to which
unsatisfied or potential obligations of Target of greater than $100,000
exist for the benefit of, or relating to, any present or former employee,
consultant or director of Target (together, the "Target Employee Plans").
(b) Target has furnished to Acquiror a copy of each of the Target
Employee Plans and related plan documents (including trust documents,
insurance policies or contracts) and has, with respect to each Target
Employee Plan which is subject to ERISA reporting requirements, provided
copies of the Form 5500 reports filed for the last three plan years. Any
Target Employee Plan intended to be qualified under Section 401(a) of the
Code has either obtained from the Internal Revenue Service a favorable
determination letter as to its qualified status under the Code, including
all amendments to the Code effected by the Tax Reform Act of 1986 and
subsequent legislation, or has applied to the Internal Revenue Service for
such a determination letter prior to the expiration of the requisite period
under applicable Treasury Regulations or Internal Revenue Service
pronouncements in which to apply for such determination letter and to make
any amendments necessary to obtain a favorable determination. Target has
also furnished Acquiror with the most recent Internal Revenue Service
determination letter issued with respect to each such Target Employee Plan,
and nothing has occurred since the issuance of each such letter which could
reasonably be expected to cause the loss of the tax-qualified status of any
Target Employee Plan subject to Code Section 401(a).
(c) (i) Other than continued health care coverage required under the
Consolidated Omnibus Budget Reconciliation Act of 1985, as amended
("COBRA"), none of the Target Employee Plans promises or provides retiree
medical or other retiree welfare benefits to any person; (ii) there has
been no "prohibited transaction," as such term is defined in Section 406 of
ERISA and Section 4975 of the Code, with respect to any Target Employee
Plan, which could reasonably be expected to have, in the aggregate, a
Material Adverse Effect; (iii) each Target Employee Plan has been
administered in accordance with its terms and in compliance with the
requirements prescribed by any and all statutes, rules and regulations
(including ERISA and the Code), except as would not have, in the aggregate,
a Material Adverse Effect, and Target and each subsidiary or ERISA
Affiliate have performed all obligations required to be performed by them
under, are not in any respect in default under or violation of, and have no
knowledge of any default or violation by any other party to, any of the
Target Employee Plans, which default or violation could reasonably be
expected to have a Material Adverse Effect on Target; (iv) neither Target
nor any subsidiary or ERISA Affiliate is subject to any liability or
penalty under Sections 4976 through 4980 of the Code or Title I of ERISA
with respect to any of the Target Employee Plans and which individually or
in the aggregate could reasonably be expected to have a Material Adverse
Effect on Target; (v) all material contributions required to be made by
Target or any subsidiary or ERISA Affiliate to any Target Employee Plan
have been made on or before their due dates and a reasonable amount has
been accrued for contributions to each Target
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Employee Plan for the current plan years; (vi) with respect to each Target
Employee Plan, no "reportable event" within the meaning of Section 4043 of
ERISA (excluding any such event for which the thirty (30) day notice
requirement has been waived under the regulations to Section 4043 of ERISA)
nor any event described in Section 4062, 4063 or 4041 or ERISA has
occurred; and (vii) no Target Employee Plan is covered by, and neither
Target nor any subsidiary or ERISA Affiliate has incurred or expects to
incur any liability under Title IV of ERISA or Section 412 of the Code.
With respect to each Target Employee Plan subject to ERISA as either an
employee pension plan within the meaning of Section 3(2) of ERISA or an
employee welfare benefit plan within the meaning of Section 3(l) of ERISA,
Target has prepared in good faith and timely filed all requisite
governmental reports (which were true and correct as of the date filed)
and, to Target's knowledge, Target has properly and timely filed and
distributed or posted all notices and reports to employees required to be
filed, distributed or posted with respect to each such Target Employee
Plan, except in each case to the extent that such failure to perform such
action would not, in the aggregate, have a Material Adverse Effect on
Target. No suit, administrative proceeding, action or other litigation has
been brought, or to the best knowledge of Target is threatened, against or
with respect to any such Target Employee Plan, including any audit or
inquiry by the IRS or United States Department of Labor. Neither Target nor
any Target subsidiary or other ERISA Affiliate is a party to, or has made
any contribution to or otherwise incurred any obligation under, any
"multiemployer plan" as defined in Section 3(37) of ERISA.
(d) With respect to each Target Employee Plan, Target and each of its
United States subsidiaries have complied with (i) the applicable health
care continuation and notice provisions of COBRA and the proposed
regulations thereunder and (ii) the applicable requirements of the Family
Leave Act of 1993 and the regulations thereunder, except to the extent that
such failure to comply would not, in the aggregate, have a Material Adverse
Effect on Target.
(e) Except as disclosed in the Target Disclosure Letter the consummation
of the transactions contemplated by this Agreement will not (i) entitle any
current or former employee or other service provider of Target, any Target
subsidiary or any other ERISA Affiliate to severance benefits or any other
payment, except as expressly provided in this Agreement, or (ii) accelerate
the time of payment or vesting, or increase the amount of compensation due
any such employee or service provider.
(f) There has been no amendment to, written interpretation or
announcement (whether or not written) by Target, any Target subsidiary or
other ERISA Affiliate relating to, or change in participation or coverage
under, any Target Employee Plan which would materially increase the expense
of maintaining such Plan above the level of expense incurred with respect
to that Plan for the most recent fiscal year included in Target's financial
statements.
2.15 Certain Agreements Affected by the Merger. Except as set forth in
Schedule 2.15 or pursuant to this Agreement, neither the execution and
delivery of this Agreement nor the consummation of the transaction
contemplated hereby will (i) result in any payment (including, without
limitation, severance, unemployment compensation, golden parachute, bonus or
otherwise) becoming due to any director or employee of Target or any of its
subsidiaries, (ii) materially increase any benefits otherwise payable by
Target or (iii) result in the acceleration of the time of payment or vesting
of any such benefits.
2.16 Employee Matters. Target and each of its subsidiaries are in compliance
in all respects with all currently applicable laws and regulations respecting
employment, discrimination in employment, terms and conditions of employment,
wages, hours and occupational safety and health and employment practices, and
is not engaged in any unfair labor practice, except where the failure to be in
compliance or the engagement in such unfair labor practices would not have a
Material Adverse Effect on Target. There are no pending claims against Target
or any of its subsidiaries under any workers compensation plan or policy or
for long term disability which would have a Material Adverse Effect on Target.
Neither Target nor any of its subsidiaries has any obligations under COBRA
with respect to any former employees or qualifying beneficiaries thereunder,
except for obligations that would not have a Material Adverse Effect on
Target. There are no controversies pending or, to the knowledge of Target or
any of its subsidiaries, threatened, between Target or any of. its
subsidiaries and any of their respective employees, which controversies would
have a Material Adverse Effect on Target. Neither
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Target nor any of its subsidiaries is a party to any collective bargaining
agreement or other labor union contract nor does Target nor any of its
subsidiaries know of any activities or proceedings of any labor union to
organize any such employees.
2.17 Interested Party Transactions. Except as disclosed in the Target SEC
Documents, neither Target nor any of its subsidiaries is indebted to any
director, officer, employee or agent of Target or any of its subsidiaries
(except for amounts due as normal salaries and bonuses and in reimbursement of
ordinary expenses), and no such person is indebted to Target or any of its
subsidiaries, and there have been no other transactions of the type required
to be disclosed pursuant to Items 402 and 404 of Regulation S-K under the
Securities Act and the Exchange Act since June 30, 1996.
2.18 Insurance. Target and each of its subsidiaries have policies of
insurance and bonds of the type and in amounts customarily carried by persons
conducting businesses or owning assets similar to those of Target and its
subsidiaries. There is no material claim pending under any of such policies or
bonds as to which coverage has been questioned, denied or disputed by the
underwriters of such policies or bonds. All premiums due and payable under all
such policies and bonds have been paid and Target and its subsidiaries are
otherwise in compliance in all material respects with the terms of such
policies and bonds. Target has no knowledge of any threatened termination of,
or material premium increase with respect to, any of such policies.
2.19 Compliance With Laws. Each of Target and its subsidiaries has complied
with, is not in violation of, and has not received any notices of violation
with respect to, any federal, state, local or foreign statute, law or
regulation with respect to the conduct of its business, or the ownership or
operation of its business, except for such violations or failures to comply as
would not have a Material Adverse Effect on Target.
2.20 Pooling of interests. To the knowledge of Target, based on consultation
with its independent accountants, neither Target, nor any of its subsidiaries,
nor any of their respective directors, officers or stockholders has taken any
action that would prevent Acquiror from accounting for the Merger as a pooling
of interests.
2.21 Brokers' and Finders' Fees. Except for payment obligations to Robertson
Stephens & Company disclosed to Acquiror, Target has not incurred, nor will it
incur, directly or indirectly, any liability for brokerage or finders' fees or
agents' commissions or investment bankers' fees or any similar charges in
connection with this Agreement or any transaction contemplated hereby.
2.22 Registration Statement; Proxy Statement/Prospectus. The information
supplied by Target for inclusion in the registration statement on Form S-4 (or
such other or successor form as shall be appropriate) pursuant to which the
shares of Acquiror Common Stock to be issued in the Merger will be registered
with the SEC (the "Registration Statement") shall not at the time the
Registration Statement (including any amendments or supplements thereto) is
declared effective by the SEC contain any untrue statement of a material fact
or omit to state any material fact required to be stated therein or necessary
in order to make the statements therein, in light of the circumstances under
which they were made, not misleading. The information supplied by Target for
inclusion in the proxy statement/prospectus to be sent to the stockholders of
Target in connection with the meeting of Target's stockholders to consider the
Merger (the "Target Stockholders Meeting") and to the stockholders of Acquiror
in connection with the meeting of Acquiror's stockholders to consider the
Merger (the "Acquiror Stockholders Meeting") (such proxy statement/prospectus
as amended or supplemented is referred to herein as the "Proxy Statement")
shall not, on the date the Proxy Statement is first mailed to Target's
stockholders and Acquiror's stockholders, at the time of the Target
Stockholders Meeting, at the time of the Acquiror Stockholders Meeting and at
the Effective Time, contain any statement which, at such time, is false or
misleading with respect to any material fact, or omit to state any material
fact necessary in order to make the statements made therein, in light of the
circumstances under which they are made, not false or misleading; or omit to
state any material fact necessary to correct any statement in any earlier
communication with respect to the solicitation of proxies for the Target
Stockholders Meeting or the Acquiror Stockholder Meeting which has become
false or misleading. If at any time prior to the Effective Time any event or
information should be
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discovered by Target which should be set forth in an amendment to the
Registration Statement or a supplement to the Proxy Statement, Target shall
promptly inform Acquiror and Merger Sub. Notwithstanding the foregoing, Target
makes no representation, warranty or covenant with respect to any information
supplied by Acquiror or Merger Sub which is contained in any of the foregoing
documents.
2.23 Opinion of Financial Advisor. Target has been advised orally (to be
subsequently confirmed in writing) by its financial advisor, Robertson,
Stephens & Company, that in such advisor's opinion, as of the date hereof, the
consideration to be received by the stockholders of Target is fair, from a
financial point of view, to the stockholders of Target.
2.24 Vote Required. The affirmative vote of the holders of a majority of the
shares of Target Common Stock outstanding on the record date set for the
Target Stockholders Meeting is the only vote of the holders of any of Target's
capital stock necessary to approve this Agreement and the transactions
contemplated hereby.
2.25 Board Approval. The Board of Directors of Target has, prior to the date
hereof, unanimously (i) approved this Agreement and the Merger, (ii)
determined that the Merger is in the best interests of the stockholders of
Target and is on terms that are fair to such stockholders and (iii) determined
to recommend that the stockholders of Target approve this Agreement and
consummation of the Merger.
2.26 Section 203 of the DGCL Not Applicable. The Board of Directors of
Target has taken all actions so that the restrictions contained in Section 203
of the Delaware Law applicable to a "business combination" (as defined in
Section 203) will not apply to the execution, delivery or performance of this
Agreement or the Option Agreement or the consummation of the Merger or the
other transactions contemplated by this Agreement or by the Option Agreement.
2.27 Minute Books. The minute books of Target and its subsidiaries made
available to legal counsel for Acquiror contain a complete and accurate
summary of all meetings of directors and stockholders or actions by written
consent since the time of incorporation of Target and the respective
subsidiaries through the date of this Agreement, and reflect all transactions
referred to in such minutes accurately in all material respects.
2.28 Representations Complete. None of the representations or warranties
made by Target herein or in any Letter hereto, including the Target Disclosure
Letter, or certificate furnished by Target pursuant to this Agreement, or the
Target SEC Documents, when all such documents are read together in their
entirety, contains or will contain at the Effective Time any untrue statement
of a material fact, or omits or will omit at the Effective Time to state any
material fact necessary in order to make the statements contained herein or
therein, in the light of the circumstances under which made, not misleading.
ARTICLE III
REPRESENTATIONS AND WARRANTIES OF ACQUIROR AND MERGER SUB
Except as disclosed in a document of even date herewith and delivered by
Acquiror to Target prior to the execution and delivery of this Agreement and
referring to the representations and warranties in this Agreement (the
"Acquiror Disclosure Letter"), Acquiror and Merger Sub represent and warrant
to Target as follows:
3.1 Organization, Standing and Power. Each of Acquiror and its subsidiaries,
including Merger Sub, is a corporation duly organized, validly existing and in
good standing under the laws of its jurisdiction of organization. Each of
Acquiror and its subsidiaries has the corporate power to own its properties
and to carry on its business as now being conducted and as proposed to be
conducted and is duly qualified to do business and is in good standing in each
jurisdiction in which the failure to be so qualified and in good standing
would have a Material Adverse Effect on Acquiror. Acquiror has delivered a
true and correct copy of the Certificate of Incorporation and Bylaws or other
charter documents, as applicable, of Acquiror to legal counsel for Target.
Neither Acquiror nor any of its subsidiaries is in violation of any of the
provisions of its Certificate of
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Incorporation or Bylaws or equivalent organizational documents. Acquiror is
the owner of all outstanding shares of capital stock of each of its
subsidiaries and all such shares are duly authorized, validly issued, fully
paid and nonassessable. All of the outstanding shares of capital stock of each
such subsidiary are owned by Acquiror free and clear of all liens, charges,
claims or encumbrances or rights of others. There are no outstanding
subscriptions, options, warrants, puts, calls, rights, exchangeable or
convertible securities or other commitments or agreements of any character
relating to the issued or unissued capital stock or other securities of any
such subsidiary, or otherwise obligating Acquiror or any such subsidiary to
issue, transfer, sell, purchase, redeem or otherwise acquire any such
securities. Except as disclosed in the Acquiror SEC Documents (as defined in
Section 3.4), Acquiror does not directly or indirectly own any equity or
similar interest in, or any interest convertible or exchangeable or
exercisable for, any equity or similar interest in, any corporation,
partnership, joint venture or other business association or entity.
3.2 Capital Structure. The authorized capital stock of Acquiror consists of
75,000,000 shares of Common Stock, $.01 par value and no shares of Preferred
Stock of which there were issued and outstanding as of the close of business
on November 11, 1996, 40,159,798 shares of Common Stock and no shares of
Preferred Stock. Since the close of business on November 11, 1996, no shares
of Acquiror capital stock have been issued except pursuant to the exercise of
options outstanding as of November 11, 1996 under the Acquiror Stock Option
Plans (as defined below). As of the close of business on November 12, 1996,
there were no other outstanding commitments to issue any shares of capital
stock or voting securities of Acquiror other than pursuant to the exercise of
options outstanding as of that date under the 1983 Incentive Stock Option
Plans, the 1986 Stock Option Plan, the Stock Option Plan for Directors, the
1993 Incentive Stock Option Plan, and the 1994 Stock Option Plan, and pursuant
to the 1994 Employee Stock Purchase Plan (collectively, the "Acquiror Stock
Option Plans"). The authorized capital stock of Merger Sub consists of 1,000
shares of Common Stock, $.001 par value, all of which are issued and
outstanding and are held by Acquiror. All outstanding shares of Acquiror and
Merger Sub have been duly authorized, validly issued, fully paid and are
nonassessable and free of any liens or encumbrances other than any liens or
encumbrances created by or imposed upon the holders thereof. As of the close
of business on November 12, 1996, Acquiror has reserved 6,545,604 shares of
Common Stock for issuance to employees, directors and independent contractors
pursuant to the Acquiror Stock Option Plans, net of exercises, cancellations,
repurchases and expiration of options of which, as of the close of business on
November 11, 1996, 4,965,519 shares were subject to outstanding, unexercised
options and 1,580,085 shares remained available for future grant. Other than
pursuant to this Agreement and the Acquiror 1994 Employee Stock Purchase Plan,
there are no other options, warrants, calls, rights, commitments or agreements
of any character to which Acquiror or Merger Sub is a party or by which either
of them is bound obligating Acquiror or Merger Sub to issue, deliver, sell,
repurchase or redeem, or cause to be issued, delivered, sold, repurchased or
redeemed, any shares of the capital stock of Acquiror or Merger Sub or
obligating Acquiror or Merger Sub to grant, extend or enter into any such
option, warrant, call, right, commitment or agreement. The shares of Acquiror
Common Stock to be issued pursuant to the Merger will be duly authorized,
validly issued, fully paid, and non-assessable.
3.3 Authority.
(a) Acquiror and Merger Sub have all requisite corporate power and
authority to enter into this Agreement and to consummate the transactions
contemplated hereby. The execution and delivery of this Agreement and the
consummation of the transactions contemplated hereby have been duly
authorized by all necessary corporate action on the part of Acquiror and
Merger Sub, and the approval of the shareholders of Acquiror is not
required for Acquiror to enter into this Agreement and consummate the
Merger. This Agreement has been duly executed and delivered by Acquiror and
Merger Sub and constitutes the valid and binding obligations of Acquiror
and Merger Sub, enforceable against each in accordance with its terms,
except as enforceability may be limited by bankruptcy and other laws
affecting the rights and remedies of creditors generally, and general
principles of equity. The execution and delivery of this Agreement do not,
and the consummation of the trans actions contemplated hereby will not, (i)
conflict with, or result in any violation of any provision of the
Certificate of Incorporation or Bylaws of Acquiror or any of its
subsidiaries, as amended, or (ii) subject to obtaining the approval of
Acquiror's stockholders of the Merger
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as contemplated in Section 5.2 and compliance with the requirements set
forth in Section 3.3(b) below, result in any breach of or constitute a
default under (with or without notice or lapse of time, or both) or give
rise to a right of termination, cancellation or acceleration of any
material obligation or loss of any material benefit under any material
mortgage, indenture, lease, contract or other agreement or instrument,
permit, concession, franchise, license, judgment, order, decree, statute,
law, ordinance, rule or regulation applicable to Acquiror or any of its
subsidiaries or their properties or assets, except where such conflict,
violation, default, termination, cancellation or acceleration with respect
to the foregoing provisions of (ii) would not have had and would not
reasonably be expected to have a Material Adverse Effect on Acquiror.
(b) No consent, approval, order or authorization of, or registration,
declaration or filing with, any Governmental Entity, is required by or, to
the knowledge of Acquiror with respect to, Acquiror or any of its
subsidiaries in connection with the execution and delivery of this
Agreement by Acquiror and Merger Sub or the consummation by Acquiror and
Merger Sub of the transactions contemplated hereby, except for (i) the
filing of the Certificate of Merger as provided in Section 1.2, (ii) the
filing with the SEC and NASD of the Registration Statement, (iii) the
filing of a Form 8-K with the SEC and NASD within 15 days after the Closing
Date, (iv) any filings as may be required under applicable state securities
laws and the securities laws of any foreign country, (v) such filings as
may be required under HSR or the competition regulations of any other
foreign governmental authority, (vi) the filing with the Nasdaq National
Market of a Notification Form for Listing of Additional Shares with respect
to the shares of Acquiror Common Stock issuable upon conversion of the
Target Common Stock in the Merger and upon exercise of the options under
the Target Stock Option Plans assumed by Acquiror, and (vii) such other
consents, authorizations, filings, approvals and registrations which, if
not obtained or made, would not have a Material Adverse Effect on Acquiror
and would not prevent or materially alter or delay any of the transactions
contemplated by this Agreement.
3.4 SEC Documents: Financial Statements. Acquiror has made available to
Target a true and complete copy of each statement, report, registration
statement (with the prospectus in the form filed pursuant to Rule 424(b) of
the Securities Act), definitive proxy statement, and other filing filed with
the SEC by Acquiror since June 30, 1994, and, prior to the Effective Time,
Acquiror will have furnished Target with true and complete copies of any
additional documents filed with the SEC by Acquiror prior to the Effective
Time (collectively, the "Acquiror SEC Documents"). In addition, Acquiror has
made available to Target all exhibits to the Acquiror SEC Documents filed
prior to the-date hereof, and will promptly make available to Target all
exhibits to any additional Acquiror SEC Documents filed prior to the Effective
Time. All documents required to be filed as exhibits to the Target SEC
Documents have been so filed, and all material contracts so filed as exhibits
are in full force and effect, except those which have expired in accordance
with their terms, and neither Acquiror nor any of its subsidiaries is in
default thereunder, except where such default has not resulted in and is not
reasonably expected to result in any Material Adverse Effect on Acquiror. As
of their respective filing dates, the Acquiror SEC Documents complied in all
material respects with the requirements of the Exchange Act and the Securities
Act, and none of the Acquiror SEC Documents contained any untrue statement of
a material fact or omitted to state a material fact required to be stated
therein or necessary to make the statements made therein, in light of the
circumstances under which they were made, not misleading, except to the extent
corrected by a subsequently filed Acquiror SEC Document. The financial
statements of Acquiror, including the notes thereto, included in the Acquiror
SEC Documents (the "Acquiror Financial Statements") were complete and correct
in all material respects as of their respective dates, complied as to form in
all material respects with applicable accounting requirements and with the
published rules and regulations of the SEC with respect thereto as of their
respective dates, and have been prepared in accordance with GAAP applied on a
basis consistent throughout the periods indicated and consistent with each
other (except as may be indicated in the notes thereto or, in the case of
unaudited statements included in Quarterly Reports on Form 10-Q, as permitted
by Form 10-Q of the SEC). The Acquiror Financial Statements fairly present the
consolidated financial condition and operating results of Acquiror and its
subsidiaries at the dates and during the periods indicated therein (subject,
in the case of unaudited statements, to normal, recurring year-end
adjustments) in all material respects. There has been no
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material change in Acquiror accounting policies except as described in the
notes to the Acquiror Financial Statements.
3.5 Absence of Certain Changes. Since September 30, 1996 (the "Acquiror
Balance Sheet Date"), Acquiror has conducted its business in the ordinary
course consistent with past practice and there has not occurred: (i) any
change, event or condition (whether or not covered by insurance) that would
result in a Material Adverse Effect to Acquiror; (ii) any acquisition, sale or
transfer of any material asset of Acquiror or any of its subsidiaries other
than in the ordinary course of business and consistent with past practice;
(iii) any material change in accounting methods or practices (including any
change in depreciation or amortization policies or rates) by Acquiror or any
material revaluation by Acquiror of any of its or any of its subsidiaries'
assets; (iv) any declaration, setting aside, or payment of a dividend or other
distribution with respect to the shares of Acquiror, or any direct or indirect
redemption, purchase or other acquisition by Acquiror of any of its shares of
capital stock; (v) any material contract entered into by Acquiror, other than
in the ordinary course of business and as provided to Target, or any material
amendment or termination of, or default under, any material contract to which
Acquiror or any of its subsidiaries is a party or by which it is bound which
would result in a Material Adverse Effect on Acquiror; or (vi) any negotiation
or agreement by Acquiror or any of its subsidiaries to do any of the things
described in the preceding clauses (i) through (v) (other than negotiations
with Target and its representatives regarding the transactions contemplated by
this Agreement).
3.6 Absence of Undisclosed Liabilities. Acquiror has no material obligations
or liabilities of any nature (matured or unmatured, fixed or contingent) other
than (i) those set forth or adequately provided for in the unaudited balance
sheet for the quarter ended September 30, 1996, which has been provided to
Target (the "Acquiror Balance Sheet"), (ii) those not required to be set forth
in the Acquiror Balance Sheet under GAAP, and (iii) those incurred in the
ordinary course of business since the Acquiror Balance Sheet Date and
consistent with past practice.
3.7 Litigation. There is no private or governmental action, suit,
proceeding, claim, arbitration or investigation pending before any agency,
court or tribunal, foreign or domestic, or, to the knowledge of Acquiror or
any of its subsidiaries, threatened against Acquiror or any of its
subsidiaries or any of their respective properties or any of their respective
officers or directors (in their capacities as such) that, individually or in
the aggregate, would have a Material Adverse Effect on Acquiror. There is no
judgment, decree or order against Acquiror or any of its subsidiaries or, to
the knowledge of Acquiror or any of its subsidiaries, any of their respective
directors or officers (in their capacities as such) that would prevent,
enjoin, materially alter or materially delay any of the transactions
contemplated by this Agreement, or that would. have a Material Adverse Effect
on Acquiror.
3.8 Restrictions on Business Activities. There is no material agreement,
judgment, injunction, order or decree binding upon Acquiror or any of its
subsidiaries which has the effect of prohibiting or materially impairing any
current or future business practice of Acquiror or any of its subsidiaries,
any acquisition of property by Acquiror or any of its subsidiaries or the
conduct of business by Acquiror or any of its subsidiaries as currently
conducted or as proposed to be conducted by Acquiror or any of its
subsidiaries.
3.9 Governmental Authorization. Acquiror and each of its subsidiaries have
obtained each federal, state, county, local or foreign governmental consent,
license, permit, grant, or other authorization of a Governmental Entity which
are material (collectively called "Acquiror Authorizations"), and all of such
Acquiror Authorizations are in full force and effect, except where the failure
to obtain or have any of such Acquiror Authorizations would not have a
Material Adverse Effect on Acquiror.
3.10 Compliance With Laws. Each of Acquiror and its subsidiaries has
complied with, are not in violation of, and has not received any notices of
violation with respect to, any federal, state, local or foreign statute, law
or regulation with respect to the conduct of its business, or the ownership or
operation of its business, except for such violations or failures to comply as
would not have a Material Adverse Effect on Acquiror.
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3.11 Pooling of Interests. To the knowledge of Acquiror, based on
consultation with its independent accountants, neither Acquiror nor any of its
subsidiaries nor any of their respective directors, officers or stockholders
has taken any action that would prevent Acquiror from accounting for the
Merger as a pooling of interests.
3.12 Broker's and Finders' Fees. Except for payment obligations to Hambrecht
& Quist disclosed to Target, Acquiror has not incurred, nor will it incur,
directly or indirectly, any liability for brokerage or finders' fees or
agents' commissions or investment bankers' fees or any similar charges in
connection with this Agreement or any transaction contemplated hereby.
3.13 Registration Statement: Proxy Statement/Prospectus. The information
supplied by Acquiror and Merger Sub for inclusion in the Registration
Statement shall not, at the time the Registration Statement (including any
amendments or supplements thereto) is declared effective by the SEC, contain
any untrue statement of a material fact or omit to state any material fact
necessary in order to make the statements therein, in light of the
circumstances under which they were made, not misleading. The information
supplied by Acquiror for inclusion in the Proxy Statement shall not, on the
date the Proxy Statement is first mailed to Target's stockholders, to
Acquiror's stockholders at the time of the Target Stockholders Meeting, at the
time of the Acquiror Stockholders Meeting and at the Effective Time, contain
any statement which, at such time, is false or misleading with respect to any
material fact, or omit to state any material fact necessary in order to make
the statements therein, in light of the circumstances under which it is made,
not false or misleading; or omit to state any material fact necessary to
correct any statement in any earlier communication with respect to the
solicitation of proxies for the Target Stockholders Meeting or the Acquiror
Stockholders Meeting which has become false or misleading. If at any time
prior to the Effective Time any event or information should be discovered by
Acquiror or Merger Sub which should be set forth in an amendment to the
Registration Statement or a supplement to the Proxy Statement, Acquiror or
Merger Sub will promptly inform Target. Notwithstanding the foregoing,
Acquiror and Merger Sub make no representation, warranty or covenant with
respect to any information supplied by Target which is contained in any of the
foregoing documents.
3.14 Board Approval. The Boards of Directors of Acquiror and Merger Sub have
prior to the date hereof unanimously (i) approved this Agreement and the
Merger, (ii) determined that the Merger is in the best interests of their
respective stockholders and is on terms that are fair to such stockholders and
(iii) determined to recommend that the stockholders of Acquiror and of Merger
Sub approve this Agreement and the consummation of the Merger.
3.15 Opinion of Financial Advisor. Acquiror has been advised orally (to be
subsequently confirmed in writing) by its financial advisor, Hambrecht &
Quist, that in such advisor's opinion as of the date hereof, the consideration
to be paid by Acquiror is fair to Acquiror from a financial point of view.
3.16 Intellectual Property.
(a) Acquiror and its subsidiaries own, or are licensed or otherwise
possess legally enforceable rights to use all patents, trademarks, trade
names, service marks, copyrights, and any applications therefor,
technology, know-how, trade secrets, inventory, ideas, algorithms,
processes, computer software programs or applications (in both source code
and object code form), and tangible or intangible proprietary information
or material ("Intellectual Property") that are used in the business of
Acquiror and its subsidiaries as currently conducted or as proposed to be
conducted by Acquiror and its subsidiaries, except to the extent that the
failure to have such rights have not had and would not reasonably be
expected to have a Material Adverse Effect on Acquiror.
(b) There is no unauthorized use, disclosure, infringement or
misappropriation of any Intellectual Property rights of Acquiror or any of
its subsidiaries, any trade secret material to Acquiror or any of its
subsidiaries, or any Intellectual Property right of any third party to the
extent licensed by or through Acquiror or any of its subsidiaries, by any
third party, including any employee or former employee of Acquiror or any
of its subsidiaries. Neither Acquiror nor any of its subsidiaries has
entered into any
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agreement to indemnify any other person against any charge of infringement
of any Intellectual Property, other than indemnification provisions
contained in purchase orders or customer agreements arising in the ordinary
course of business.
(c) Acquiror is not, nor will it be as a result of the execution and
delivery of this Agreement or the performance of its obligations under this
Agreement, in breach of any license, sublicense or other agreement relating
to the Intellectual Property or Third Party Intellectual Property Rights,
the breach of which would have a Material Adverse Effect on Acquiror.
(d) All patents, registered trademarks, service marks and copyrights held
by Acquiror are valid and subsisting. Acquiror (i) is not a party to any
suit, action or proceeding which involves a claim of infringement of any
patents, trademarks, service marks, copyrights or violation of any trade
secret or other proprietary right of any third party and (ii) has not
brought any action, suit or proceeding for infringement of Intellectual
Property or breach of any license or agreement involving Intellectual
Property against any third party. The manufacture, marketing, licensing or
sale of Acquiror's products does not infringe any patent, trademark,
service mark, copyright, trade secret or other proprietary right of any
third party, except where such infringement would not have a Material
Adverse Effect on Acquiror.
(e) Acquiror has a policy, which it has consistently enforced, to secure
valid written assignments from all consultants and employees who contribute
or have contributed to the creation or development of Intellectual Property
of the rights to such contributions that Acquiror does not already own by
operation of law.
(f) Acquiror believes it has taken all reasonable and appropriate steps
to protect and preserve the confidentiality of all Intellectual Property
not otherwise protected by patents, or patent applications or copyright
("Confidential Information"). To Acquiror's knowledge, all use, disclosure
or appropriation of Confidential Information owned by Acquiror by or to a
third party has been pursuant to the terms of a written agreement between
Acquiror and such third party. To Acquiror's knowledge, all use, disclosure
or appropriation of Confidential Information not owned by Acquiror has been
pursuant to the terms of a written agreement between Acquiror and the owner
of such Confidential Information, or is otherwise lawful.
3.17 Taxes. Except as disclosed in the Acquiror Disclosure Letter and except
to the extent the failure to do so would not have a Material Adverse Effect,
Acquiror and each of its subsidiaries, and any consolidated, combined, unitary
or aggregate group for Tax purposes of which Acquiror or any of its
subsidiaries is or has been a member have timely filed all Tax Returns
required to be filed by it, have paid all Taxes shown thereon to be due (or
Acquiror has paid on its behalf) and have provided adequate accruals in
accordance with GAAP in its financial statements for any unpaid Taxes that are
imposed on Acquiror or its subsidiaries. The most recent financial statements
contained in the Acquiror SEC Documents reflect an adequate accrual, in
accordance with GAAP, for all Taxes payable by Acquiror and its subsidiaries
through the date of such financial statements. Except as disclosed in the
Acquiror Disclosure Letter, (i) no material claim for Taxes has become a lien
against the property of Acquiror or any of its subsidiaries or is being
asserted against Acquiror or any of its subsidiaries other than liens for
Taxes not yet due and payable, (ii) no audit of any Tax Return of Acquiror or
any of its subsidiaries is being conducted by a Tax authority, (iii) no
extension of the statute of limitations on the assessment of any Taxes has
been granted by Acquiror or any of its subsidiaries and is currently in
effect, and (iv) there is no agreement, contract or arrangement to which
Acquiror or any of its subsidiaries is a party that may result in the payment
of any amount that would not be deductible by reason of Sections 280G or 404
of the Code. Acquiror has not been and will not be required to include any
material adjustment in Taxable income for any Tax period (or portion thereof)
pursuant to Section 481 or 263A of the Code or any comparable provision under
state or foreign Tax laws as a result of transactions, events or accounting
methods employed prior to the Merger. Neither Acquiror nor any of its
subsidiaries is a party to any tax sharing or tax allocation agreement nor
does Acquiror or any of its subsidiaries owe any amount under any such
agreement. For purposes of this Agreement, the following terms have the
following meanings: "Tax" (and, with correlative meaning, "Taxes" and
"Taxable") means (i) any net income, alternative or add-on minimum tax, gross
income, gross receipts, sales, use, ad valorem, transfer, franchise, profits,
license, withholding, payroll, employment, excise, severance, stamp,
occupation, premium, property, environmental or windfall profit tax, custom,
duty or other tax,
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governmental fee or other like assessment or charge of any kind whatsoever,
together with any interest or any penalty, addition to tax or additional
amount imposed by any Governmental Entity (a "Tax authority") responsible for
the imposition of any such tax (domestic or foreign), (ii) any liability for
the payment of any amounts of the type described in (i) as a result of being a
member of an affiliated, consolidated, combined or unitary group for any
Taxable period and (iii) any liability for the payment of any amounts of the
type described in (i) or (ii) as a result of any obligation to indemnify any
other person. As used herein, "Tax Return" shall mean any return, statement,
report or form (including, without limitation,) estimated Tax returns and
reports, withholding Tax returns and reports and information reports and
returns required to be filed with respect to Taxes. To the knowledge of
Acquiror, neither Acquiror nor any of its subsidiaries is a party to any Tax-
exemption or other Tax-sparing agreement or order of any foreign government.
3.18 Representations Complete. None of the representations or warranties
made by Acquiror or Merger Sub herein or in any Letter hereto, including the
Acquiror Disclosure Letter, or certificate furnished by Acquiror or Merger Sub
pursuant to this Agreement, or the Acquiror SEC Documents, when all such
documents are read together in their entirety, contains or will contain at the
Effective Time any untrue statement of a material fact, or omits or will omit
at the Effective Time to state any material fact necessary in order to make
the statements contained herein or therein in the light of the circumstances
under which made, not misleading.
ARTICLE IV
CONDUCT PRIOR TO THE EFFECTIVE TIME
4.1 Conduct of Business of Target and Acquiror. During the period from the
date of this Agreement and continuing until the earlier of the termination of
this Agreement or the Effective Time, each of Target and Acquiror agrees
(except to the extent expressly contemplated by this Agreement or as consented
to in writing by the other), to carry on its and its subsidiaries' business in
the usual, regular and ordinary course in substantially the same manner as
heretofore conducted, to pay and to cause its subsidiaries to pay debts and
Taxes when due subject to good faith disputes over such debts or taxes, to pay
or perform other obligations when due, and to use all reasonable efforts
consistent with past practice and policies to preserve intact its and its
subsidiaries' present business organizations, use its commercially reasonable
efforts consistent with past practice to keep available the services of its
and its subsidiaries' present officers and key employees and to preserve its
and its subsidiaries' relationships with customers, suppliers, distributors,
licensors, licensees, and others having business dealings with it or its
subsidiaries, it being the parties' intent that Target's and its subsidiaries'
goodwill and ongoing businesses shall be unimpaired at the Effective Time.
Each of Target and Acquiror agrees to use its best efforts to promptly notify
the other of any event or occurrence not in the ordinary course of its or its
subsidiaries' business, and of any event which would have a Material Adverse
Effect. Without limiting the foregoing, except as expressly contemplated by
this Agreement, neither Target nor Acquiror shall do, cause or permit any of
the following, or allow, cause or permit any of its subsidiaries to do, cause
or permit any of the following, without the prior written consent of the
other:
(a) Charter Documents. Cause or permit any amendments to its Certificate
of Incorporation or Bylaws;
(b) Dividends; Changes in Capital Stock. Except as set forth in the
Acquiror Disclosure Letter, declare or pay any dividends on or make any
other distributions (whether in cash, stock or property) in respect of any
of its capital stock, or split, combine or reclassify any of its capital
stock or issue or authorize the issuance of any other securities in respect
of, in lieu of or in substitution for shares of its capital stock, or
repurchase or otherwise acquire, directly or indirectly, any shares of its
capital stock except from former employees, directors and consultants in
accordance with agreements providing for the repurchase of shares in
connection with any termination of service to it or its subsidiaries;
(c) Stock Option Plans, Etc. Except as set forth in the Target Disclosure
Letter, accelerate, amend or change the period of exercisability or vesting
of options or other rights granted under its employee stock
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plans or director stock plans or authorize cash payments in exchange for
any options or other rights granted under any of such plans;
(d) Pooling. Take any action, which, to the knowledge of such party would
prevent Acquiror from accounting for the Merger as a pooling of interests;
or
(e) Other. Intentionally take, or agree in writing or otherwise to take,
any of the actions described in Sections 4.1(a) through (d) above, or any
action which would make any of its representations or warranties contained
in this Agreement untrue or incorrect or prevent it from performing or
cause it not to perform its covenants hereunder.
4.2 Conduct of Business of Target. During the period from the date of this
Agreement and continuing until the earlier of the termination of this
Agreement or the Effective Time, except as expressly contemplated by this
Agreement or consented to in writing by Acquiror, Target shall not do, cause
or permit any of the following, or allow, cause or permit any of its
subsidiaries to do, cause or permit any of the following, without the prior
written consent of Acquiror, which consent shall not be unreasonably withheld:
(a) Material Contracts. Enter into any partnership arrangements, joint
development agreements, strategic alliances, or other material contracts
other than in the ordinary course of business consistent with past
practice, or violate, amend or otherwise modify or waive any material
contract which violation, amendment, modification or waiver would have a
Material Adverse Effect;
(b) Issuance of Securities. Issue, deliver or sell or authorize or
propose the issuance, delivery or sale of, or purchase or propose the
purchase of, any shares of its capital stock or securities convertible
into, or subscriptions, rights, warrants or options to acquire, or other
agreements or commitments of any character obligating it to issue any such
shares or other convertible securities, other than the issuance of shares
of its Common Stock pursuant to the exercise of stock options, warrants or
other rights therefor outstanding as of November 11, 1996; provided,
however, that Target may, in the ordinary course of business consistent
with past practice, grant options for the purchase of Target Common Stock
under the Target Option Plans (not to exceed an aggregate of 50,000 options
to purchase shares of Target Common Stock granted after November 11, 1996);
(c) Intellectual Property. Transfer to any person or entity any rights to
its Intellectual Property other than in the ordinary course of business
consistent with past practice;
(d) Exclusive Rights. Enter into or amend any agreements pursuant to
which any other party is granted exclusive marketing or distribution rights
with respect to any of its products or technology;
(e) Dispositions. Sell, lease, license or otherwise dispose of or
encumber any of its properties or assets which are material, individually
or in the aggregate, to its and its subsidiaries' business, taken as a
whole, except in the ordinary course of business consistent with past
practice;
(f) Indebtedness. Incur any indebtedness for borrowed money or guarantee
any such indebtedness or issue or sell any debt securities or guarantee any
debt securities of others, except in the ordinary course of business
consistent with past practice;
(g) Leases. Enter into any operating lease, except in the ordinary course
of business consistent with past practice;
(h) Payment of Obligations. Pay, discharge or satisfy any material claim,
liability or obligation (absolute, accrued, asserted or unasserted,
contingent or otherwise) arising other than in the ordinary course of
business, other than the payment, discharge or satisfaction of liabilities
reflected or reserved against in the Target Financial Statements;
(i) Capital Expenditures. Make any material capital expenditures, capital
additions or capital improvements except in the ordinary course of business
and consistent with past practice;
(j) Insurance. Materially reduce the amount of any material insurance
coverage provided by existing insurance policies;
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(k) Employee Benefit Plans; New Hires; Pay Increases. Adopt or amend any
material employee benefit or stock purchase or option plan, or hire any new
officer or director level employee, pay any special bonus or special
remuneration to any employee or director, or increase the salaries or wage
rates of its employees, except in the ordinary course of business
consistent with past practice;
(l) Severance Arrangements. Grant any severance or termination pay to any
director or officer or to any other employee except (A) payments made
pursuant to standard written agreements outstanding on the date hereof or
(B) grants which are made in the ordinary course of business in accordance
with its standard past practice;
(m) Lawsuits. Commence a lawsuit other than (i) for the routine
collection of bills, (ii) in such cases where it in good faith determines
that failure to commence suit would result in the material impairment of a
valuable aspect of its business, provided that it consults with Acquiror
prior to the filing of such a suit, or (iii) for a breach of this
Agreement;
(n) Acquisitions. Acquire or agree to acquire by merging or consolidating
with, or by purchasing a substantial portion of the assets of, or by any
other manner, any business or any corporation, partnership, association or
other business organization or division thereof, or otherwise acquire or
agree to acquire any assets which are material, individually or in the
aggregate, to its and its subsidiaries' business, taken as a whole, or
acquire or agree to acquire any equity securities of any corporation,
partnership, association or business organization;
(o) Taxes. Other than in the ordinary course of business, make or change
any material election in respect of Taxes, adopt or change any accounting
method in respect of Taxes to the extent material to Target or its
subsidiaries, enter into any material closing agreement, settle any
material claim or assessment in respect of Taxes, or consent to any
extension or waiver of the limitation period applicable to any material
claim or assessment in respect of Taxes;
(p) Notices. Target shall give all notices and other information required
to be given to the employees of Target, any collective bargaining unit
representing any group of employees of Target, and any applicable
government authority under the WARN Act, the National Labor Relations Act,
the Code, COBRA, and other applicable law in connection with the
transactions provided for in this Agreement;
(q) Revaluation. Revalue any of its assets, including without limitation
writing down the value of inventory or writing off notes or accounts
receivable other than in the ordinary course of business; or
(r) Other. Intentionally take or agree in writing or otherwise to take,
any of the actions described in Sections 4.2(a) through (q) above, or any
action which would make any of its representations or warranties contained
in this Agreement untrue or incorrect or prevent it from performing or
cause it not to perform its covenants hereunder.
4.3 Solicitation. From the date of this Agreement until the earlier of the
Effective Time or the termination of this Agreement pursuant to Article VII,
Target and its subsidiaries will not, directly or indirectly through their
officers, directors, employees, agents or otherwise, (i) solicit, initiate or
encourage any Takeover Proposal (defined below) or (ii) engage in negotiations
with, or disclose any nonpublic information relating to Target or any of it
subsidiaries to, or afford access to the properties, books or records of
Target or any of its subsidiaries to, any person that has indicated to Target
that it may be considering making, or that has made, a Takeover Proposal;
provided, nothing herein shall prohibit Target's Board of Directors from
taking and disclosing to Target's stockholders a position with respect to a
tender offer pursuant to Rules 14d-9 and 14e-2 promulgated under the Exchange
Act. Notwithstanding the immediately preceding sentence, if an unsolicited
Takeover Proposal, or an unsolicited written expression of interest that
Target reasonably expects to lead to a Takeover Proposal, shall be received by
the Board of Directors of Target, then, to the extent the Board of Directors
of Target believes in good faith (after consultation with its financial
advisor) (i) that such Takeover Proposal would, if consummated, result in a
transaction that appears to be more favorable to Target's stockholders from a
financial point of view than the transaction contemplated by the Agreement and
(ii) after reasonable inquiry by Target, that the third party making such
Takeover Proposal is financially capable of consummating such Takeover
Proposal (any Takeover Proposal meeting such conditions being referred to in
this
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Agreement as a "Superior Proposal") and the Board of Directors of Target
determines in good faith after consultation with outside legal counsel that it
is necessary for the Board of Directors of Target to comply with its fiduciary
duties to stockholders under applicable law, Target and its officers,
directors, employees, investment bankers, financial advisors, attorneys,
accountants and other representatives retained by it may furnish in connection
therewith information and take such other actions as are consistent with the
fiduciary obligations of Target's Board of Directors, and such actions shall
not be considered a breach of this Section 4.3 or any other provisions of this
Agreement, provided that (A) upon each such determination Target notifies
Acquiror of such determination by the Target Board of Directors and provides
Acquiror with a true and complete copy of the Superior Proposal received from
such third party, if the Superior Proposal is in writing, or a written summary
of all material terms and conditions thereof, if it is not in writing, (B)
Target provides Acquiror (no later than the time that such documents are
provided to such third party) with all documents containing or referring to
non-public information of Target that are supplied to such third party, to the
extent not previously supplied by Target to Acquiror and (C) Target provides
such non-public information to any such third party pursuant to a non-
disclosure agreement at least as restrictive as to confidential information as
the Confidentiality Agreement (as defined in Section 5.4). Target shall not,
and shall not permit any of its officers, directors, employees (acting on
behalf of Target) or other representatives to agree to or endorse any Takeover
Proposal unless Target shall have terminated this Agreement pursuant to
Section 7.1(e) and paid Acquiror all amounts payable to Acquiror pursuant to
Section 7.3(b). Notwithstanding anything in this Agreement to the contrary,
Target shall not accept or recommend to its stockholders, or enter into any
agreement concerning, a Superior Proposal for a period of not less than 48
hours after Acquiror's receipt of a true and complete copy of such Superior
Proposal, if the Superior Proposal is in writing, or a written summary of all
material terms and conditions thereof, if it is not in writing. Target will
promptly notify Acquiror after receipt of any Takeover Proposal or any notice
that any person is considering making a Takeover Proposal or any request for
non-public information relating to Target or any of its subsidiaries or for
access to the properties, books or records of Target or any of its
subsidiaries by any person that has indicated to Target that it may be
considering making, or that has made, a Takeover Proposal and will keep
Acquiror fully informed of the status and details of any such Takeover
Proposal notice, request or any correspondence or communications related
thereto and shall provide Acquiror with a true and complete copy of such
Takeover Proposal notice or request or correspondence or communications
related thereto, if it is in writing, or a complete written summary thereof,
if it is not in writing. For purposes of this Agreement, "Takeover Proposal"
means any offer or proposal for, or any indication of interest in, a merger or
other business combination involving Target or the acquisition of 20% or more
of the outstanding shares of capital stock of Target, or the sale or transfer
of any material assets (excluding the sale or disposition of assets in the
ordinary course of business) of Target, other than, (i) the transactions
contemplated by this Agreement and (ii) transactions by persons disclosing
their beneficial ownership of shares of Target's Common Stock on Schedule 13G
under the Exchange Act.
ARTICLE V
ADDITIONAL AGREEMENTS
5.1 Proxy Statement/Prospectus; Registration Statement. As promptly as
practicable after the execution of this Agreement, Target and Acquiror shall
prepare, and file with the SEC, preliminary proxy materials relating to the
approval of the Merger and the transactions contemplated hereby by the
stockholders of Target and the stockholders of Acquiror and, as promptly as
practicable following receipt of SEC comments thereon, Acquiror shall file
with the SEC a Registration Statement on Form S-4 (or such other or successor
form as shall be appropriate), which complies in form with applicable SEC
requirements and shall use all reasonable efforts to cause the Registration
Statement to become effective as soon thereafter as practicable; provided,
however, that Acquiror shall have no obligation to agree to account for the
Merger as a "purchase" in order to cause the Registration Statement to become
effective. Each of Acquiror and Target will notify the other promptly of the
receipt of any comments from the SEC or its staff and of any request by the
SEC or its staff or any other government officials for amendments or
supplements to the Registration Statement or any other filing or for
additional information and will supply the other with copies of all
correspondence between such company or
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any of its representatives, on the one hand, and the SEC, or its staff or any
other government officials, on the other hand, with respect to the
Registration Statement or other filing. The Registration Statement and the
other filings shall comply in all material respects with all applicable
requirements of law. Whenever any event occurs which is required to be set
forth in an amendment or supplement to the Registration Statement or any other
filing, Acquiror or Target, as the case may be, shall promptly inform the
other of such occurrence and cooperate in filing with the SEC or its staff or
any other government officials, and/or mailing to stockholders of Acquiror,
such amendment or supplement. Subject to the provisions of Section 4.3, the
Proxy Statement shall include the recommendation of the Board of Directors of
Target in favor of the Merger; provided that such recommendation may not be
included or may be withdrawn if previously included if Target's Board of
Directors believes in good faith that a Superior Proposal has been made or,
upon written advice of its outside legal counsel, shall determine that to
include such recommendation or not withdraw such recommendation if previously
included would constitute a breach of the Board's fiduciary duty under
applicable law. The Proxy Statement shall include the recommendation of the
Board of Directors of Acquiror in favor of the Merger; provided that such
recommendation may not be included or may be withdrawn if previously included
if Acquiror's Board of Directors determines in good faith, upon written advice
of its outside legal counsel, that such Board's fiduciary duties under
applicable law require it to do so.
5.2 Meeting of Stockholders. Promptly after the date hereof, Target and
Acquiror shall each take all action necessary in accordance with Delaware Law
and their respective Certificates of Incorporation and Bylaws to convene the
Target Shareholders Meeting and the Acquiror Stock holders Meeting,
respectively, to be held as promptly as practicable, and in any event within
45 days after the declaration of effectiveness of the Registration Statement,
for the purpose of voting upon this Agreement. Target and Acquiror shall
consult with each other and use their commercially reasonable efforts to hold
their respective stockholders meetings on the same day. Promptly after the
date hereof, Target and Acquiror shall each use its commercially reasonable
efforts to solicit from its stockholders proxies in favor of the approval of
this Agreement and the approval of the issuance of shares of Acquiror Common
Stock pursuant to the terms of the Merger, as the case may be, and will take
all other action necessary or advisable to secure the vote or consent of their
respective stock holders required by the rules of the National Association of
Securities Dealers, Inc, or the Delaware General Corporation Law, except to
the extent that the Board of Directors of such party determines that doing so
would cause the Board of Directors to breach its fiduciary duties under
applicable law.
5.3 Access to Information.
(a) Target shall afford Acquiror and its accountants, counsel and other
representatives, reasonable access during normal business hours during the
period prior to the earlier of the Effective Time or the termination of
this Agreement under Article VII to (i) all of Target's and its
subsidiaries' properties, books, contracts, commitments and records, and
(ii) all other information concerning the business, properties and
personnel of Target and its subsidiaries as Acquiror may reasonably
request. Target agrees to provide to Acquiror and its accountants, counsel
and other representatives copies of internal financial statements promptly
upon request. Acquiror shall afford Target and its accountants, counsel and
other representatives, reasonable access during normal business hours
during the period prior to the earlier of the Effective Time or the
termination of this Agreement under Article VII to (i) all of Acquiror's
and its subsidiaries' properties, books, contracts, commitments and
records, and (ii) all other information concerning the business, properties
and personnel of Acquiror and its subsidiaries as Target may reasonably
request. Acquiror agrees to provide to Target and its accountants, counsel
and other representatives copies of internal financial statements promptly
upon request.
(b) Subject to compliance with applicable law, from the date hereof until
the earlier of the Effective Time or the termination of this Agreement
under Article VII, each of Acquiror and Target shall confer on a regular
and frequent basis with one or more representatives of the other party to
report matters of materiality and the general status of ongoing operations.
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(c) No information or knowledge obtained in any investigation pursuant to
this Section 5.3 shall affect or be deemed to modify any representation or
warranty contained herein or the conditions to the obligations of the
parties to consummate the Merger.
5.4 Confidentiality. The parties acknowledge that each of Acquiror and
Target have previously executed a Mutual Confidentiality and Standstill
Agreement, dated November 6, 1996 (the "Confidentiality Agreement"), which
Confidentiality Agreement shall continue in full force and effect in
accordance with its terms, except as is necessary to comply with the terms of
this Agreement.
5.5 Public Disclosure. Unless otherwise permitted by this Agreement,
Acquiror and Target shall consult with each other before issuing any press
release or otherwise making any public statement (whether or not in response
to an inquiry) regarding the terms of this Agreement and the transactions
contemplated hereby, and neither shall issue any such press release or make
any such statement without the prior approval of the other (which approval
shall not be unreasonably withheld), except as may be required by law, or in
exercise of the fiduciary duties of the Board of Directors, or by obligations
pursuant to any listing agreement with any national securities exchange or
with the NASD.
5.6 Consents; Cooperation.
(a) Each of Acquiror and Target shall promptly apply for or otherwise
seek, and use its best efforts to obtain, all consents and approvals
required to be obtained by it for the consummation of the Merger, including
those required under HSR, and shall use its reasonable efforts to obtain
all necessary consents, waivers and approvals under any of its material
contracts in connection with the Merger for the assignment thereof or
otherwise, except where the failure to obtain such consents under material
contracts would not have a Material Adverse Effect on Target. The parties
hereto will consult and cooperate with one another, and consider in good
faith the views of one another, in connection with any analyses,
appearances, presentations, memoranda, briefs, arguments, opinions and
proposals made or submitted by or on behalf of any party hereto in
connection with proceedings under or relating to HSR or any other federal,
state or foreign antitrust or fair trade law.
(b) Each of Acquiror and Target shall use all reasonable efforts to
resolve such objections, if any, as may be asserted by any Governmental
Entity with respect to the transactions contemplated by this Agreement
under HSR, the Sherman Act, as amended, the Clayton Act, as amended, the
Federal Trade Commission Act, as amended, and any other Federal, state or
foreign statutes, rules, regulations, orders or decrees that are designed
to prohibit, restrict or regulate actions having the purpose or effect of
monopolization or restraint of trade (collectively, "Antitrust Laws"). In
connection therewith, if any administrative or judicial action or
proceeding is instituted (or threatened to be instituted) challenging any
transaction contemplated by this Agreement as violative of any Antitrust
Law, each of Acquiror and Target shall cooperate and use all best efforts
vigorously to contest and resist any such action or proceeding and to have
vacated, lifted, reversed, or over turned any decree, judgment, injunction
or other order, whether temporary, preliminary or permanent (each an
"Order"), that is in effect and that prohibits, prevents, or restricts
consummation of the Merger or any such other transactions, unless by mutual
agreement Acquiror and Target decide that litigation is not in their
respective best interests. Notwithstanding the provisions of the
immediately preceding sentence, it is expressly understood and agreed that
Acquiror shall have no obligation to litigate or contest any administrative
or judicial action or proceeding or any Order beyond the earlier of (i)
April 15, 1997, or (ii) the date of a ruling preliminarily enjoining the
Merger issued by a court of competent jurisdiction. Each of Acquiror and
Target shall use all reasonable efforts to take such action as may be
required to cause the expiration of the notice periods under the HSR or
other Antitrust Laws with respect to such transactions as promptly as
possible after the execution of this Agreement.
(c) Notwithstanding anything to the contrary in Section 5.6(a) or (b),
(i) neither Acquiror nor any of it subsidiaries shall be required to divest
any of their respective businesses, product lines or assets, or to take or
agree to take any other action or agree to any limitation, that could
reasonably be expected to have a Material Adverse Effect on Acquiror or of
Acquiror combined with the Surviving Corporation after the
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Effective Time or (ii) neither Target nor its subsidiaries shall be
required to divest any of their respective businesses, product lines or
assets, or to take or agree to take any other action or agree to any
limitation, that could reasonably be expected to have a Material Adverse
Effect on Target.
5.7 Pooling Accounting. Acquiror and Target shall each use its best efforts
to cause the business combination to be effected by the Merger to be accounted
for as a pooling of interests. Each of Acquiror and Target shall use its best
efforts to cause its "Affiliates" (as defined in Section 5.8) not to take any
action that would prevent Acquiror from accounting for the business
combination to be effected by the merger as a pooling of interest.
5.8 Affiliate Agreements.
(a) Schedule 5.8(a) of the Disclosure Letter sets forth those persons who
may be deemed "Affiliates" of Target within the meaning of Rule 145
promulgated under the Securities Act ("Rule 145"). Target shall provide
Acquiror such information and documents as Acquiror shall reasonably
request for purposes of reviewing such list. Target shall use its best
efforts to deliver or cause to be delivered to Acquiror, promptly after the
execution of this Agreement (and in each case at least thirty (30) days
prior to the Effective Time) from each of the Affiliates of Target, an
executed Affiliate Agreement in the form attached hereto as Exhibit B-1.
Acquiror and Merger Sub shall be entitled to place appropriate legends on
the certificates evidencing any Acquiror Common Stock to be received by
such Affiliates of Target pursuant to the terms of this Agreement, and to
issue appropriate stop transfer instructions to the transfer agent for
Acquiror Common Stock, consistent with the terms of such Affiliates
Agreements.
(b) Schedule 5.8(b) of the Disclosure Letter sets forth those persons who
may be deemed "Affiliates" of Acquiror within the meaning of Rule 145.
Acquiror shall provide Target such information and documents as Target
shall reasonably request for purposes of reviewing such list. Acquiror
shall use its best efforts to deliver or cause to be delivered to Target,
concurrently with the execution of this Agreement (and in each case at
least thirty (30) days prior to the Effective Time) from each of the
Affiliates of Acquiror, an executed Affiliate Agreement in the form
attached hereto as Exhibit B-2.
5.9 Legal Requirements. Each of Acquiror, Merger Sub and Target will, and
will cause their respective subsidiaries to, take all reasonable actions
necessary to comply promptly with all legal requirements which may be imposed
on them with respect to the consummation of the transactions contemplated by
this Agreement and will promptly cooperate with and furnish information to any
party hereto necessary in connection with any such requirements imposed upon
such other party in connection with the consummation of the transactions
contemplated by this Agreement and will take all reasonable actions necessary
to obtain (and will cooperate with the other parties hereto in obtaining) any
consent, approval, order or authorization of, or any registration, declaration
or filing with, any Governmental Entity or other person, required to be
obtained or made in connection with the taking of any action contemplated by
this Agreement. Each of Acquiror and Target further agrees to notify the other
promptly of the receipt of any comments from any government officials for
amendments or supplements to any filing or for additional information and will
supply the other with copies of all correspondence between such company or any
of its representatives, on the one hand, and the government officials, on the
other hand, with respect to such filing. All filings shall comply in all
material respects with all applicable requirements of law. Whenever any event
occurs which is required to be set forth in an amendment or supplement to any
such filing, Acquiror or Target, as the case may be, shall promptly inform the
other of such occurrence and cooperate in filing with the government
officials.
5.10 Blue Sky Laws. Acquiror shall take such steps as may be necessary to
comply with the securities and blue sky laws of all jurisdictions which are
applicable to the issuance of the Acquiror Common Stock in connection with the
Merger. Target shall use its best efforts to assist Acquiror as may be
necessary to comply with the securities and blue sky laws of all jurisdictions
which are applicable in connection with the issuance of Acquiror Common Stock
in connection with the Merger.
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5.11 Employee Benefit Plans.
(a) At the Effective Time, each outstanding option to purchase shares of
Target Common Stock under the Target Stock Option Plans, whether vested or
unvested, will be assumed by Acquiror. Schedule 5.11 of the Disclosure
Letter hereto sets forth a true and complete list as of the date hereof of
all holders of outstanding options under the Target Stock Option Plans,
including the number of shares of Target capital stock subject to each such
option, the exercise or vesting schedule, the exercise price per share and
the term of each such option. On the Closing Date, Target shall deliver to
Acquiror an updated Schedule 5.11 of the Disclosure Letter hereto current
as of such date. Each such option so assumed by Acquiror under this
Agreement shall continue to have, and be subject to, the same terms and
conditions set forth in the Target Stock Option Plans and the documents
governing the outstanding options under those Plans, immediately prior to
the Effective Time, except that (i) such option will be exercisable for
that number of whole shares of Acquiror Common Stock equal to the product
of the number of shares of Target Common Stock that were issuable upon
exercise of such option immediately prior to the Effective Time multiplied
by the Exchange Ratio and rounded down to the nearest whole number of
shares of Acquiror Common Stock, and (ii) the per share exercise price for
the shares of Acquiror Common Stock issuable upon exercise of such assumed
option will be equal to the quotient determined by dividing the exercise
price per share of Target Common Stock at which such option was exercisable
immediately prior to the Effective Time by the Exchange Ratio, rounded up
to the nearest whole cent. Consistent with the terms of the Target Stock
Option Plans and the documents governing the outstanding options under
those Plans and except as set forth in the Target Disclosure Letter, the
Merger will not terminate any of the outstanding options under such Plans
or accelerate the exercisability or vesting of such options or the shares
of Acquiror Common Stock which will be subject to those options upon the
Acquiror's assumption of the options in the Merger. It is the intention of
the parties that the options so assumed by Acquiror qualify following the
Effective Time as incentive stock options as defined in Section 422 of the
Code to the extent such options qualified as incentive stock options as of
the Effective Time. As soon as reasonably practical but in no event more
than 30 days after the Effective Time, Acquiror will issue to each person
who, immediately prior to the Effective Time was a holder of an outstanding
option under the Target Stock Option Plans a document in form and substance
satisfactory to Target evidencing the foregoing assumption of such option
by Acquiror.
(b) Outstanding purchase rights under the Target ESPP shall be assumed by
Acquiror at the Effective Time. Schedule 5.11(b) of the Disclosure Letter
hereto sets forth a true and complete list as of the date hereof of all
holders of outstanding purchase rights under the Target ESPP, including
payroll deduction amounts elected by each holder and the price per share of
Target Stock at the beginning of the current offering period. On the
Closing Date, Target shall deliver to Acquiror an updated Schedule 5.11(b)
of the Disclosure Letter current as of such date. Each such purchase right
so assumed by Acquiror under this Agreement shall continue to have, and be
subject to, the same terms and conditions set forth in the Target ESPP and
the documents governing the outstanding purchase rights under the Target
ESPP, immediately prior to the Effective Time, except that the purchase
price of shares of Acquiror Common Stock and the number of shares of
Acquiror Common Stock to be issued upon the exercise of such purchase right
shall be adjusted in accordance with the Exchange Ratio. The assumed
outstanding purchase rights under the Target ESPP shall be exercised
immediately prior to the start date of the first offering period under the
Acquiror Employee Stock Purchase Plan occurring after the Effective Time,
and each participant in the Target ESPP shall accordingly be issued shares
of Acquiror Common Stock at that time. The Target ESPP, and all outstanding
purchase rights thereunder, shall terminate with such exercise date, and no
purchase rights shall be subsequently granted or exercised under the Target
ESPP. Target employees who meet the eligibility requirements for
participation in the Acquiror Employee Stock Purchase Plan shall be
eligible to begin payroll deductions under that plan as of the start date
of the first offering period thereunder after the Effective Time.
5.12 [Intentionally left blank.]
5.13 Form S-8. Acquiror agrees to file, no later than five (5) business days
after the Closing Date, a registration statement on Form S-8 covering the
shares of Acquiror Common Stock issuable pursuant to
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outstanding options and purchase rights under the Target Stock Option Plans
and Target ESPP assumed by Acquiror. Target shall cooperate with and assist
Acquiror in the prepara tion of such registration statement.
5.14 Indemnification.
(a) After the Effective Time, Acquiror will, and will cause the Surviving
Corporation to, indemnify and hold harmless the present and former
officers, directors, employees and agents of Target (the "Indemnified
Parties") in respect of acts or omissions occurring on or prior to the
Effective Time to the extent permitted by law and to the extent provided
under Target's Certificate of Incorporation and Bylaws or any
indemnification agreement with Target officers and directors to which
Target is a party, in each case in effect on the date hereof; provided that
such indemnification shall be subject to any limitation imposed from time
to time under applicable law. Without limitation of the foregoing, in the
event any such Indemnified Party is or becomes involved in any capacity in
any action, proceeding or investigation in connection with any matter
relating to this Agreement or the transactions contemplated hereby
occurring on or prior to the Effective Time, Acquiror shall, or shall cause
the Surviving Corporation to, pay as incurred such Indemnified Party's
reasonable legal and other expenses (including the cost of any
investigation and preparation) incurred in connection therewith.
(b) For six years after the Effective Time, Acquiror will either (i) at
all times maintain at least $5,000,000 in cash, marketable securities and
unrestricted lines of credit to be available to indemnify the Indemnified
Parties in accordance with Section 5.14(a) above (but such amount shall not
be construed as a limitation of any such indemnification), or (ii) cause
the Surviving Corporation to use its best efforts to provide officers' and
directors' liability insurance in respect of acts or omissions occurring on
or prior to the Effective Time covering each such person currently covered
by Target's officers' and directors' liability insurance policy on terms
substantially similar to those of such policy in effect on the date hereof,
provided that in satisfying its obligation under this Section, Acquiror
shall not be obligated to cause the Surviving Corporation to pay premiums
in excess of 150% of the amount per annum Target paid in its last full
fiscal year, which amount has been disclosed to Acquiror and if the
Surviving Corporation is unable to obtain the insurance required by this
Section 5.14, it shall obtain as much comparable insurance as possible for
an annual premium equal to such maximum amount.
(c) To the extent there is any claim, action, suit, proceeding or
investigation (whether arising before or after the Effective Time) against
an Indemnified Party that arises out of or pertains to any action or
omission in his or her capacity as a director, officer, employee, fiduciary
or agent of Target occurring prior to the Effective Time, or arises out of
or pertains to the transactions contemplated by this Agreement for a period
of six years after the Effective Time (whether arising before or after the
Effective Time), such Indemnified Party shall be entitled to be represented
by counsel and following the Effective Time (i) any counsel retained by the
Indemnified Parties shall be reasonably satisfactory to the Surviving
Corporation and Acquiror, (ii) the Surviving Corporation and Acquiror shall
pay the reasonable fees and expenses of such counsel, promptly after
statements therefor are received and (iii) the Surviving Corporation and
Acquiror will cooperate in the defense of any such matter; provided,
however, that neither the Surviving Corporation nor Acquiror shall be
liable for any settlement effected without its written consent (which
consent shall not be unreasonably withheld); and provided further, that, in
the event that any claim or claims for indemnification are asserted or made
within such six-year period, all rights to indemnification in respect of
any such claim or claims shall continue until the disposition of any and
all such claims. The Indemnified Parties as a group shall be entitled to
reimbursement for only one law firm (in addition to local counsel) to
represent them with respect to any single action unless there is, under
applicable standards of professional conduct, a conflict on any significant
issue between the positions of any two or more Indemnified Parties.
(d) The provisions of this Section 5.14 are intended to be for the
benefit of, and shall be enforceable by, each Indemnified Party, his or her
heirs and representatives.
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5.15 Option Agreement. Concurrently with the execution of this Agreement,
Target shall deliver to Acquiror an executed Option Agreement in the form of
Exhibit C attached hereto. Target agrees to fully perform its obligations
under the Option Agreement.
5.16 Listing of Additional Shares. Prior to the Effective Time, Acquiror shall
file with the Nasdaq National Market a Notification Form for Listing of
Additional Shares with respect to the shares referred to in Section 6.1(f).
5.17 Nasdaq Quotation. Target and Acquiror agree to continue the quotation of
Target Common Stock and Acquiror Common Stock, respectively, on the Nasdaq
National Market during the term of the Agreement so that, to the extent
necessary, appraisal rights will not be available to stockholders of Target
under Section 262 of the Delaware Law.
5.18 Pooling Letters.
(a) Target shall use all reasonable efforts to cause to be delivered to
Acquiror a letter of Target's independent auditors, dated on or prior to
the date of this Agreement and confirmed in writing two business days
before the date of the Proxy Statement to the effect that Target qualifies
as an entity that may be a party to a business combination for which the
pooling-of-interest method of accounting would be available and in a form
reasonably satisfactory to Acquiror and customary in scope and substance
for letters delivered by independent public accountants in connection with
transactions of this type.
(b) Acquiror shall use all reasonable efforts to cause to be delivered to
Target a letter of Acquiror's independent auditors, dated on or prior to
the date of this Agreement and confirmed in writing two business days
before the date of the Proxy Statement regarding concurrence with
Acquiror's management's conclusion regarding appropriateness of pooling-of-
interest accounting treatment for the Merger under APB Opinion No. 16 if
consummated in accordance with this Agreement and in a form reasonably
satisfactory to Target and customary in scope and substance for letters
delivered by independent public accountants in connection with transactions
of this type.
5.19 Participation Agreement. Target shall use its best efforts, on behalf of
Acquiror and pursuant to the request of Acquiror, to cause each Target
stockholder named in Schedule 5.19 of the Disclosure Letter to execute and
deliver to Acquiror a Participation Agreement in substantially the form of
Exhibit D attached hereto concurrently with the execution of this Agreement
(and in each case no later than the date prior to the time that the
preliminary proxy materials are filed with the SEC pursuant to Section 5.1).
Target shall use its commercially reasonable efforts to provide to Acquiror,
as promptly as practicable following the date hereof, a letter correctly
stating on Schedule 5.19 of the Disclosure Letter the number of shares of
Target Common Stock beneficially owned by each person listed.
5.20 Employment and Noncompetition Agreements. Prior to the Effective Time,
Acquiror shall enter into an Employment and Noncompetition Agreement (i) in
the form of Exhibit E-1 attached hereto with each of the individuals named on
Schedule 5.20(a) of the Disclosure Letter and (ii) in the form of Exhibit E-2
attached hereto with each of the individuals named on Schedule 5.20(b) of the
Disclosure Letter; provided, however, that this covenant shall not be deemed
to have been breached as a result of any individual named on Schedule 5.20(a)
or Schedule 5.20(b) of the Disclosure Letter failing to enter into any such
agreement.
5.21 Amendment to Registration Rights. Target shall use its commercially
reasonably efforts to obtain such amendments to registration rights agreements
to which it is a party as may be requested by Acquiror.
5.22 FIRPTA. Acquiror and Target shall use commercially reasonable efforts to
timely comply with the notice requirements of Income Tax Regulations, Section
1.897-2(h).
5.23 Best Efforts and Further Assurances. Each of the parties to this
Agreement shall use its best efforts to effectuate the transactions
contemplated hereby and to fulfill and cause to be fulfilled the conditions to
closing
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under this Agreement. Each party hereto, at the reasonable request of another
party hereto, shall execute and deliver such other instruments and do and
perform such other acts and things as may be necessary or desirable for
effecting completely the consummation of this Agreement and the transactions
contemplated hereby.
ARTICLE VI
CONDITIONS TO THE MERGER
6.1 Conditions to Obligations of Each Party to Effect the Merger. The
respective obligations of each party to this Agreement to consummate and
effect the Merger shall be subject to the satisfaction at or prior to the
Effective Time of each of the following conditions, any of which may be
waived, in writing, by agreement of all the parties hereto:
(a) Stockholder Approval. This Agreement and the Merger shall have been
approved and adopted by the requisite vote of the stockholders of Target
and the stockholders of Acquiror (as described in Section 2.24) under
Delaware Law and under NASD Rule 4460(i).
(b) Registration Statement Effective. The SEC shall have declared the
Registration Statement effective. No stop order suspending the
effectiveness of the Registration Statement or any part thereof shall have
been issued and no proceeding for that purpose, and no similar proceeding
respect of the Proxy Statement, shall have been initiated or threatened to
either party by the SEC.
(c) No Injunctions or Restraints: Illegality. No temporary restraining
order, preliminary or permanent injunction or other order issued by any
court of competent jurisdiction or other legal or regulatory restraint or
prohibition preventing the consummation of the Merger shall be in effect,
nor shall any proceeding brought by an administrative agency or commission
or other governmental authority or instrumentality, domestic or foreign,
seeking any of the foregoing be pending; nor shall there be any action
taken, or any statute, rule, regulation or order enacted, entered, enforced
or deemed applicable to the Merger, which makes the consummation of the
Merger illegal or prevents or prohibits the Merger. In the event an
injunction or other order shall have been issued, each party agrees to use
its reasonable diligent efforts to have such injunction or other order
lifted.
(d) Governmental Approval. All material authorizations, consents, orders
or approvals of, or declarations or filings with, or expiration of waiting
periods imposed by, any Governmental Entity necessary for the consummation
of the transactions contemplated by this Agreement and the Certificate of
Merger shall have been filed, expired or been obtained, other than those
that, individually or in the aggregate, the failure to be filed, expired or
obtained would not, in the reasonable opinion of Acquiror after
consultation with Target, have a Material Adverse Effect on Target or
Acquiror.
(e) Tax Opinion. Acquiror and Target shall have received substantially
identical written opinions of Wilson Sonsini Goodrich & Rosati, P.C., legal
counsel to Acquiror, and Testa, Hurwitz & Thibeault, LLP, legal counsel to
Target, respectively, in form and substance reasonably satisfactory to
them, and shall be to the effect that the Merger will constitute a
reorganization within the meaning of Section 368(a) of the Code, and such
opinions shall not have been withdrawn. In rendering such opinions, counsel
shall be entitled to rely upon, among other things, reasonable assumptions
as well as representations of Acquiror, Merger Sub and Target and certain
stockholders of Target.
(f) Listing of Additional Shares. The filing with the Nasdaq National
Market of a Notification Form for listing of Additional Shares with respect
to the shares of Acquiror Common Stock issuable upon conversion of the
Target Common Stock in the Merger and upon exercise of the options under
the Target Stock Option Plans assumed by Acquiror shall have been made.
(g) Letter from Accountants. Prior to the Effective Time, each of
Acquiror and Target shall have received a confirming letter from each of
Ernst & Young LLP, independent auditors, and Arthur Andersen LLP,
independent auditors, as described in Section 5.18.
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6.2 Additional Conditions to Obligations of Target. The obligations of Target
to consummate and effect the Merger shall be subject to the satisfaction at or
prior to the Effective Time of each of the following conditions, any of which
may be waived, in writing, by Target:
(a) Representations and Warranties. The representations and warranties of
Acquiror and Merger Sub contained in this Agreement shall be true and
correct as of the Effective Time, with the same force and effect as if made
on and as of the Effective Time, except for such inaccuracies as
individually or in the aggregate that would not have a Material Adverse
Effect on Acquiror, and Target shall have received a certificate to such
effect signed on behalf of Acquiror by the President and Chief Financial
Officer of Acquiror.
(b) Agreements and Covenants. Acquiror and Merger Sub shall have
performed or complied in all material respects with all covenants,
obligations, conditions and agreements required by this Agreement to be
performed or complied with by them on or prior to the Effective Time; and,
Target shall have received a certificate to such effect signed by the
President and Chief Financial Officer of Acquiror.
(c) Legal Opinion. Target shall have received a legal opinion from
Wilson, Sonsini, Goodrich & Rosati, P.C., counsel to Acquiror,
substantially in the form of Exhibit F hereto.
(d) No Material Adverse Effect. There shall not have occurred any
Material Adverse Effect with respect to Acquiror.
(e) Third Party Consents. Target shall have been furnished with evidence
satisfactory to it of the consent or approval of those persons whose
consent or approval shall be required in connection with the Merger under
any material contract of Acquiror or any of its subsidiaries or otherwise,
except where the failure to obtain such consent or approval would not have
a Material Adverse Effect on Acquiror.
(f) Injunctions or Restraints on Conduct of Business. No temporary
restraining order, preliminary or permanent injunction or other order
issued by any court of competent jurisdiction or other legal or regulatory
restraint provision limiting or restricting Acquiror's business following
the Merger shall be in effect, nor shall any proceeding brought by an
administrative agency or commission or other Governmental Entity, domestic
or foreign, seeking the foregoing be pending except where the existence of
any of the foregoing items would not have a Material Adverse Effect on
Acquiror.
(g) Appointment to Board of Acquiror. Ronald Nordin shall have been
appointed to the Board of Directors of Acquiror, contingent upon the
consummation of the Merger.
6.3 Additional Conditions to the Obligations of Acquiror and Merger Sub. The
obligations of Acquiror and Merger Sub to consummate and effect the Merger
shall be subject to the satisfaction at or prior to the Effective Time of each
of the following conditions, any of which may be waived, in writing, by
Acquiror:
(a) Representations and Warranties. The representations and warranties of
Target contained in this Agreement shall be true and correct as of the
Effective Time, with the same force and effect as if made on and as of the
Effective Time, except, for such inaccuracies as individually or in the
aggregate that would not have a Material Adverse Effect on Target; and,
Acquiror and Merger Sub shall have received a certificate to such effect
signed on behalf of Target by the President and Chief Financial Officer of
Target.
(b) Agreements and Covenants. Target shall have performed or complied in
all material respects with all agreements, covenants, obligations and
conditions required by this Agreement to be performed or complied with by
it on or prior to the Effective Time, and the Acquiror and Merger Sub shall
have received a certificate to such effect signed by the President and
Chief Financial Officer of Target.
(c) Legal Opinion. Acquiror shall have received a legal opinion from
Testa, Hurwitz & Thibeault, LLP, legal counsel to Target, in substantially
the form of Exhibit G.
(d) Third Party Consents. Acquiror shall have been furnished with
evidence satisfactory to it of the consent or approval of those persons
whose consent or approval shall be required in connection with the Merger
under any material contract of Target or any of its subsidiaries or
otherwise, except where the failure to obtain such consent or approval
would not have a Material Adverse Effect on Target.
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(e) Injunctions or Restraints on Conduct of Business. No temporary
restraining order, preliminary or permanent injunction or other order
issued by any court of competent jurisdiction or other legal or regulatory
restraint provision limiting or restricting Acquiror's conduct or operation
of the business of Target and its subsidiaries, following the Merger shall
be in effect, nor shall any proceeding brought by an administrative agency
or commission or other Governmental Entity, domestic or foreign, seeking
the foregoing be pending, except where the existence of any of the
foregoing items would not have a Material Adverse Effect on Target.
(f) No Material Adverse Effect. There shall not have occurred any
Material Adverse Effect with respect to Target.
(g) Affiliate Agreements. Acquiror shall have received from each of the
Affiliates of Target an executed Affiliate Agreement in substantially the
form attached hereto as Exhibit B-1.
ARTICLE VII
TERMINATION, AMENDMENT AND WAIVER
7.1 Termination. At any time prior to the Effective Time, whether before or
after approval of the matters presented in connection with the Merger by the
stockholders of Target and by the stockholders of Acquiror, this Agreement may
be terminated:
(a) by mutual written consent duly authorized by the Board of Directors
of Acquiror and Target;
(b) by either Acquiror or Target, if, without fault of the terminating
party, the Closing shall not have occurred on or before April 15, 1997
(provided, a later date may be agreed upon in writing by the parties
hereto, and provided further that the right to terminate this Agreement
under this Section 7.1(b) shall not be available to any party whose action
or failure to act has been the cause of or resulted in the failure of the
Merger to occur on or before such date and such action or failure to act
constitutes a breach of this Agreement);
(c) by Acquiror, (i) upon a breach of any representation, warranty,
covenant or agreement on the part of Target set forth in this Agreement, or
if any representation or warranty of Target shall have become untrue, in
either case such that the conditions set forth in Section 6.3(a) or Section
6.3(b) would not be satisfied as of the time of such breach or as of the
time such representation or warranty shall have become untrue, provided
that if such inaccuracy in Target's representations and warranties or
breach by Target is curable by Target through the exercise of its
commercially reasonable efforts within ten business days of receipt by
Target of written notice thereof, Acquiror may not terminate this Agreement
under this Section 7.1(c)(i) during such ten business day period, so long
as Target continues to exercise such commercially reasonable efforts, and
provided further that the right to terminate this Agreement by Acquiror
under this Section 7.1(c)(i) shall not be available to Acquiror where
Acquiror is at that time in willful breach of this Agreement; (ii) if the
Board of Directors of Target shall have withdrawn or modified its
recommendation of this Agreement or the Merger in a manner adverse to
Acquiror or shall have resolved to do any of the foregoing, provided that
the right to terminate this Agreement by Acquiror under this Section
7.1(c)(ii) shall not be available to Acquiror where Acquiror is at that
time in willful breach of this Agreement, or (iii) for any reason Target
fails to call and hold the Target Stockholders Meeting by April 15, 1997
and Target is at that time in willful breach of this Agreement, provided
that the right to terminate this Agreement by Acquiror under this Section
7.1(c)(iii) shall not be available to Acquiror where Acquiror is at that
time in willful breach of this Agreement;
(d) by Target (i) upon a breach of any representation, warranty, covenant
or agreement on the part of Acquiror set forth in this Agreement, or if any
representation or warranty of Acquiror shall have become untrue, in either
case such that the conditions set forth in Section 6.2(a) or Section 6.2(b)
would not be satisfied as of the time of such breach or as of the time such
representation or warranty shall have become untrue, provided that if such
inaccuracy in Acquiror's representations and warranties or breach by
Acquiror
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is curable by Acquiror through the exercise of its commercially reasonable
efforts within ten business days of receipt by Acquiror of written notice
thereof, Target may not terminate this Agreement under this Section
7.1(d)(i) during such ten business day period, so long as Acquiror
continues to exercise such commercially reasonable efforts, and provided
further that the right to terminate this Agreement by Target under this
Section 7.1(d)(i) shall not be available to Target where Target is at that
time in willful breach of this Agreement; (ii) if the Board of Directors of
Acquiror shall have withdrawn or modified its recommendation of this
Agreement or the Merger in a manner adverse to Target or shall have
resolved to do any of the foregoing, provided that the right to terminate
this Agreement by Target under this Section 7.1(d)(ii) shall not be
available to Target where Target is at that time in willful breach of this
Agreement, or (iii) for any reason Acquiror fails to call and hold the
Acquiror Stockholders Meeting by April 15, 1997 and Acquiror is at that
time in willful breach of this Agreement, provided that the right to
terminate this Agreement by Target under this Section 7.1(d)(iii) shall not
be available to Target where Target is at that time in willful breach of
this Agreement;
(e) by Target if a Trigger Event (as defined in Section 7.3(f)) or
Takeover Proposal (as defined in Section 7.3(g)) shall have occurred and
the Board of Directors of Target in connection therewith, after
consultation with its legal counsel, withdraws or modifies its approval and
recommendation of this Agreement and the transactions contemplated hereby
after, in the case of the termination by Target, determining that to cause
Target to proceed with the transactions contemplated hereby would not be
consistent with the Board of Directors' fiduciary duty to the stockholders
of Target;
(f) by Acquiror, if following a Trigger Event or Takeover Proposal, the
Board of Directors of Target shall withdraw or modify its recommendation of
this Agreement and the transactions contemplated hereby;
(g) by either Acquiror or Target, if there shall have occurred any
Material Adverse Effect with respect to the other party since the date of
this Agreement;
(h) by either Acquiror or Target if (i) any permanent injunction or other
order of a court or other competent authority preventing the consummation
of the Merger shall have become final and nonappealable or (ii) any
required approval of the stockholders of Target or the stockholders of
Acquiror shall not have been obtained by reason of the failure to obtain
the required vote upon a vote held at a duly held meeting of stockholders
or at any adjournment thereof; or
(i) by Target, in the event (i) of the acquisition, by any person or
group of persons (other than persons or groups of persons who (A) acquired
shares of Acquiror Common Stock pursuant to any merger of Acquiror in which
Acquiror was the surviving corporation and stock holders of Acquiror
represent less than 70% of the outstanding shares of the surviving
corporation following such transaction or any acquisition by Acquiror of
all or substantially all of the capital stock or assets of another person
or (B) disclose their beneficial ownership of shares of Acquiror Common
Stock on Schedule 13G under the Exchange Act), of beneficial ownership of
30% or more of the outstanding shares of Acquiror Common Stock (the terms
"person," "group" and "beneficial ownership" having the meanings ascribed
thereto in Section 13(d) of the Exchange Act and the regulations
promulgated thereunder), (ii) the Board of Directors of Acquiror accepts or
publicly recommends acceptance of an offer from a third party to acquire
50% or more of the outstanding shares of Acquiror Common Stock or of
Acquiror's consolidated assets; or (iii) Acquiror acquires or agrees to
acquire by merging or consolidating with, or by purchasing a substantial
portion of the assets of, or by any other manner, any business or any
corporation, partnership, association or other business organization or
division thereof and such acquisition requires the approval of the stock
holders of Acquiror in accordance with Delaware Law or NASD Rule 4460(i).
7.2 Effect of Termination. In the event of termination of this Agreement as
provided in Section 7.1, this Agreement shall forthwith become void and there
shall be no liability or obligation on the part of Acquiror, Merger Sub or
Target or their respective officers, directors, stockholders or affiliates,
except to the extent that such termination results from the willful breach by
a party hereto of any of its representations, warranties or covenants set
forth in this Agreement; provided that, the provisions of Section 5.4
(Confidentiality), Section 7.3
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(Expenses and Termination Fees) and this Section 7.2 shall remain in full
force and effect and survive any termination of this Agreement.
7.3 Expenses and Termination Fees.
(a) Subject to Sections 7.3(b), 7.3(c), 7.3(d) and 7.3(e), whether or not
the Merger is consummated, all costs and expenses incurred in connection
with this Agreement and the transactions contemplated hereby (including,
without limitation, the fees and expenses of its advisers, accountants and
legal counsel) shall be paid by the party incurring such expense, except
that expenses incurred in connection with printing the Proxy Materials and
the Registration Statement, registration and filing fees incurred in
connection with the Registration Statement, the Proxy Materials and the
listing of additional shares pursuant to Section 6.1(f) and fees, costs and
expenses associated with compliance with applicable state securities laws
in connection with the Merger shall be shared equally by Target and
Acquiror.
(b) In the event that (i) Target shall terminate this Agreement pursuant
to Section 7.1(e), (ii) either Acquiror or Target shall terminate this
Agreement pursuant to Section 7.1(h)(ii) following a failure of the
stockholders of Target to approve this Agreement and, prior to the time of
the meeting of Target's stockholders, there shall have been (A) a Trigger
Event or (B) a Takeover Proposal, (iii) Acquiror shall terminate this
Agreement pursuant to Section 7.1(c)(iii) and, prior thereto, there shall
have been (A) a Trigger Event or (B) a Takeover Proposal, or (iv) Acquiror
shall terminate this Agreement pursuant to Section 7.1(f), then Target
shall immediately reimburse Acquiror for up to $1,000,000 of out-of-pocket
costs and expenses incurred by Acquiror in connection with this Agreement
and the transactions contemplated hereby (including, without limitation,
the fees and expenses of its advisors, accountants and legal counsel), and,
in addition Target shall promptly pay to Acquiror the sum of $6,000,000.
(c) In the event that Target shall terminate this Agreement pursuant to
Section 7.1(d)(ii), 7.1(d)(iii) or, following a failure of the stockholders
of Acquiror to approve this Agreement, pursuant to 7.1(h)(ii), then
Acquiror shall immediately reimburse Target for up to $1,000,000 of out-of-
pocket costs and expenses incurred by Target in connection with this
Agreement and the transactions contemplated hereby (including, without
limitation, the fees and expenses of its advisors, accountants and legal
counsel), and, in addition Acquiror shall promptly pay to Target the sum of
$20,000,000.
(d) In the event that Acquiror shall terminate this Agreement pursuant to
Section 7.1(c) or, following a failure of the stockholders of Target to
approve this Agreement, pursuant to 7.1(h)(ii), Target shall promptly
reimburse Acquiror for up to $1,000,000 of out-of-pocket costs and expenses
incurred by Acquiror in connection with this Agreement and the transactions
contemplated hereby (including, without limitation, the fees and expenses
of its advisors, accountants and legal counsel).
(e) In the event that Target shall terminate this Agreement pursuant to
Section 7.1(d)(i), Acquiror shall promptly reimburse Target for up to
$1,000,000 of out-of-pocket costs and expenses incurred by Acquiror in
connection with this Agreement and the transactions contemplated hereby
(including, without limitation, the fees and expenses of its advisors,
accountants and legal counsel).
(f) As used herein, a "Trigger Event" shall occur if any Person (other
than a person disclosing its beneficial ownership of shares of Target's
Common Stock on Schedule 13G under the Exchange Act) acquires securities
representing 20% or more, or commences a tender or exchange offer following
the successful consummation of which the offeror and its affiliate would
beneficially own securities representing 20% or more, of the voting power
of Target.
(g) As used in Section 7.3(b), "Takeover Proposal" shall occur if there
is an offer or proposal for, or any indication of interest in (where such
indication of interest has been disclosed publicly), a merger or other
business combination involving Target or the acquisition of 20% or more of
the outstanding shares of capital stock of Target or the sale or transfer
of any material assets (excluding the sale or disposition of assets in the
ordinary course of business) of Target, or any of its subsidiaries, other
than transactions contemplated by this Agreement and transactions by
persons disclosing their beneficial ownership of shares of Target's Common
Stock on Schedule 13G under the Exchange Act.
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(h) Payment of any of the amounts described in Section 7.3(b), 7.3(c),
7.3(d) or 7.3(e) shall not be in lieu of damages in the event of breach of
this Agreement.
7.4 Amendment. The boards of directors of the parties hereto may cause this
Agreement to be amended at any time by execution of an instrument in writing
signed on behalf of each of the parties hereto; provided that an amendment
made subsequent to adoption of the Agreement by the stockholders of Target or
Merger Sub shall not (i) alter or change the amount or kind of consideration
to be received on conversion of the Target Common Stock, (ii) alter or change
any term of the Certificate of Incorporation of the Surviving Corporation to
be effected by the Merger, or (iii) alter or change any of the terms and
conditions of the Agreement if such alteration or change would adversely
affect the holders of Target Common Stock or Merger Sub Common Stock.
7.5 Extension; Waiver. At any time prior to the Effective Time any party
hereto may, to the extent legally allowed, (i) extend the time for the
performance of any of the obligations or other acts of the other parties
hereto, (ii) waive any inaccuracies in the representations and warranties made
to such party contained herein or in any document delivered pursuant hereto
and (iii) waive compliance with any of the agreements or conditions for the
benefit of such party contained herein. Any agreement on the part of a party
hereto to any such extension or waiver shall be valid only if set forth in an
instrument in writing signed on behalf of such party.
ARTICLE VIII
GENERAL PROVISIONS
8.1 Non-Survival at Effective Time. The representations, warranties and
agreements set forth in this Agreement shall terminate at the Effective Time,
except that the agreements set forth in Article 1, Section 5.4
(Confidentiality) 5.7 (Pooling Accounting), 5.8 (Affiliates), 5.12 (Employee
Benefit Plans), 5.14 (Form S-8), 5.15 (Indemnification), 5.21 (Best Efforts
and Further Assurances), 7.3 (Expenses and Termination Fees), 7.4 (Amendment),
and this Article VIII shall survive the Effective Time.
8.2 Notices. All notices and other communications hereunder shall be in
writing and shall be deemed given if delivered personally or by commercial
delivery service, or mailed by registered or certified mail (return receipt
requested) or sent via facsimile (with confirmation of receipt) to the parties
at the following address (or at such other address for a party as shall be
specified by like notice):
(a) if to Acquiror or Merger Sub, to:
Rational Software Corporation
2800 San Tomas Expressway
Santa Clara, California 95051
Attention: President
Facsimile No.: (408) 970-0715
Telephone No.: (408) 496-3600
with a copy to:
Wilson, Sonsini, Goodrich & Rosati 650 Page Mill
Road Palo Alto, California 94304-1050
Attention: Frank Currie, Esq.
Facsimile No.: (415) 493-6811
Telephone No.: (415) 493-9300
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(b) if to Target, to:
SQA, Inc.
One Burlington Woods
Burlington, Massachusetts 01803
Attention: President
Facsimile No.: (617) 229-3783
Telephone No.: (617) 229-3500
with a copy to:
Testa, Hurwitz & Thibeault, LLP
High Street Tower
125 High Street
Boston, MA 02110
Attention: William J. Schnoor, Jr., Esq.
Facsimile No.: (617) 248-7100
Telephone No.: (617) 248-7000
8.3 Interpretation. When a reference is made in this Agreement to Exhibits or
Schedules, such reference shall be to an Exhibit or Schedule to this Agreement
unless otherwise indicated. The words "include," "includes" and "including,"
when used herein shall be deemed in each case to be followed by the words
"without limitation." The phrase "made available" in this Agreement shall mean
that the information referred to has been made available if requested by the
party to whom such information is to be made available. The phrases "the date
of this Agreement", "the date hereof", and terms of similar import, unless the
context otherwise requires, shall be deemed to refer to November 12, 1996. The
table of contents and headings contained in this Agreement are for reference
purposes only and shall not affect in any way the meaning or interpretation of
this Agreement.
8.4 Counterparts. This Agreement may be executed in one or more counterparts,
all of which shall be considered one and the same agreement and shall become
effective when one or more counterparts have been signed by each of the
parties and delivered to the other parties, it being understood that all
parties need not sign the same counterpart.
8.5 Entire Agreement; Nonassignability; Parties in Interest. This Agreement
and the documents and instruments and other agreements specifically referred
to herein or delivered pursuant hereto, including the Exhibits, the Schedules,
including the Target Disclosure Letter and the Acquiror Disclosure Letter (a)
constitute the entire agreement among the parties with respect to the subject
matter hereof and supersede all prior agreements and understandings, both
written and oral, among the parties with respect to the subject matter hereof,
except for the Confidentiality Agreement, which shall continue in full force
and effect, and shall survive any termination of this Agreement or the
Closing, in accordance with its terms; (b) are not intended to confer upon any
other person any rights or remedies hereunder, except as set forth in Sections
1.6(a)-(c) and (f), 1.8-1.10, 5.11, 5.13 and 5.14; and (c) shall not be
assigned by operation of law or otherwise except as otherwise specifically
provided.
8.6 Severability. In the event that any provision of this Agreement, or the
application thereof, becomes or is declared by a court of competent
jurisdiction to be illegal, void or unenforceable, the remainder of this
Agreement will continue in full force and effect and the application of such
provision to other persons or circumstances will be interpreted so as
reasonably to effect the intent of the parties hereto. The parties further
agree to replace such void or unenforceable provision of this Agreement with a
valid and enforceable provision that will achieve, to the extent possible, the
economic, business and other purposes of such void or unenforceable provision.
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<PAGE>
8.7 Remedies Cumulative. Except as otherwise provided herein, any and all
remedies herein expressly conferred upon a party will be deemed cumulative
with and not exclusive of any other remedy conferred hereby, or by law or
equity upon such party, and the exercise by a party of any one remedy will not
preclude the exercise of any other remedy.
8.8 Governing Law. This Agreement shall be governed by and construed in
accordance with the laws of the State of Delaware, regardless of the laws that
might otherwise govern under applicable principles of conflicts of law. Each
of the parties hereto irrevocably consents to the exclusive jurisdiction of
the state or federal courts located in the State of Delaware in connection
with any matter based upon or arising out of this Agreement or the matters
contemplated herein, agrees that process may be served upon them in any manner
authorized by the laws of the State of California for such persons and waives
and covenants not to assert or plead any objection which they might otherwise
have to such jurisdiction and such process.
8.9 Rules of Construction. The parties hereto agree that they have been
represented by counsel during the negotiation, preparation and execution of
this Agreement and, therefore, waive the application of any law, regulation,
holding or rule of construction providing that ambiguities in an agreement or
other document will be construed against the party drafting such agreement or
document.
A-42
<PAGE>
IN WITNESS WHEREOF, Target, Acquiror and Merger Sub have caused this
Agreement to be executed and delivered by their respective officers thereunto
duly authorized, all as of the date first written above.
Rational Software Corporation
/s/ Paul D. Levy
By___________________________________
Chairman and Chief Executive
Officer
Sunshine Acquisition
/s/ Paul D. Levy
By___________________________________
President
SQA, Inc.
/s/ Ronald H. Nordin
By___________________________________
President and Chief Executive
Officer
A-43
<PAGE>
EXHIBIT A
CERTIFICATE OF MERGER
MERGING
SUNSHINE ACQUISITION CORPORATION
WITH AND INTO TARGET
----------------
Pursuant to Section 251 of the General Corporation Law of the State of
Delaware
----------------
Sunshine Acquisition Corporation, a Delaware corporation ("Merger Sub"), and
SQA, Inc., a Delaware corporation ("Target"), DO HEREBY CERTIFY AS FOLLOWS:
FIRST: That Merger Sub was incorporated on November 8, 1996, pursuant to the
Delaware General Corporation Law (the "Delaware Law"), and that Target was
incorporated on , , pursuant to the Delaware Law.
SECOND: That an Agreement and Plan of Reorganization (the "Reorganization
Agreement"), dated as of November , 1996, as amended, among Acquiror, a
California corporation, Merger Sub and Target, setting forth the terms and
conditions of the merger of Merger Sub with and into Target (the "Merger"),
has been approved, adopted, certified, executed and acknowledged by each of
the constituent corporations in accordance with Section 251 of the Delaware
Law.
THIRD: That the name of the surviving corporation (the "Surviving
Corporation") shall be .
FOURTH: That pursuant to the Reorganization Agreement, the Restated
Certificate of Incorporation of the Surviving Corporation is amended to read
in its entirety as set forth in Exhibit A hereto.
FIFTH: That an executed copy of the Reorganization Agreement is on file at
the principal place of business of the Surviving Corporation at the following
address:
Rational Software Corporation 2800 San Tomas Expressway Santa Clara, CA
95051
SIXTH: That a copy of the Reorganization Agreement will be furnished by the
Surviving Corporation, on request and without cost, to any stockholder of any
constituent corporation.
SEVENTH: That the Merger shall become effective upon the filing of this
Certificate of Merger with the Secretary of State of the State of Delaware.
IN WITNESS WHEREOF, each of Merger Sub and Target has caused this
Certificate of Merger to be executed in its corporate name this day of
, 199 .
Sunshine Acquisition Corporation
By___________________________________
President and Chief Executive
Officer
Attest:
, Secretary
SQA, Inc.
By___________________________________
President and Chief Executive
Officer
Attest:
, Secretary
A-44
<PAGE>
ANNEX B
STOCK OPTION AGREEMENT
THIS STOCK OPTION AGREEMENT dated as of November 12, 1996 (the "Agreement")
is entered into by and between Rational Software Corporation, a Delaware
corporation ("Acquiror"), and SQA, Inc., a Delaware corporation ("Target").
RECITALS
WHEREAS, concurrently with the execution and delivery of this Agreement,
Acquiror, Target and Sunshine Acquisition Corporation, a Delaware corporation
and a wholly owned subsidiary of Acquiror ("Sub"), are entering into an
Agreement and Plan of Reorganization (the "Merger Agreement"), which provides
that, among other things, upon the terms and subject to the conditions
thereof, Sub will be merged with and into Target (the "Merger") with Target
continuing as the surviving corporation and as a wholly owned subsidiary of
Acquiror; and
WHEREAS, as a condition to Acquiror's and Sub's willingness to enter into
the Merger Agreement, Acquiror has requested that Target agree, and Target has
so agreed, to grant to Acquiror an option to acquire shares of Target's Common
Stock upon the terms and subject to the conditions set forth herein;
AGREEMENT
NOW, THEREFORE, in consideration of the foregoing and of the mutual
covenants and agreements set forth herein and in the Merger Agreement and for
other good and valuable consideration, the receipt and adequacy of which are
hereby acknowledged, the parties hereto agree as follows:
1. GRANT OF OPTION
Target hereby grants to Acquiror an irrevocable option (the "Option") to
acquire 1,213,296 shares (the "Option Shares") of the Common Stock, par value
$.01 per share, of Target ("Target Shares") in the manner set forth below by
paying cash a price of $35.26 per share (the "Exercise Price"). Capitalized
terms used in this Agreement but not defined herein shall have the meanings
ascribed thereto in the Merger Agreement.
2. EXERCISE OF OPTION
The Option may be exercised by Acquiror, in full (but not in part), at any
time, (i) upon the termination of the Merger Agreement upon the occurrence of
any of the events described in Section 7.3(b)of the Merger Agreement, or (ii)
upon the termination of the Merger Agreement upon the occurrence of any of the
events described in Section 7.1(c)(ii) of the Merger Agreement if, in the case
of this clause (ii), (x) prior to such event, there shall have been a Trigger
Event or Takeover Proposal or (y) within 180 days after such event, there
shall be a Trigger Event or a Takeover Proposal (any of such events described
in clause (i) or (ii) being referred to herein as an "Exercise Event"). In the
event Acquiror wishes to exercise the Option, Acquiror shall deliver to Target
a written notice (an "Exercise Notice") specifying Acquiror's intention to
exercise the Option. The closing of a purchase of Option Shares (the
"Closing") shall occur on a date and at a time designated by Acquiror in an
Exercise Notice delivered at least five business days prior to the date of
such Closing, which Closing shall be held at the offices of counsel to Target.
The Option shall terminate upon the earliest of (i) the Effective Time, (ii)
180 days following the termination of the Merger Agreement pursuant to Article
VII thereof, if an Exercise Event shall have occurred on or prior to the date
of such termination (or, if later, ten days following the event described in
clause (ii)(y) above), and (iii) the date on which the Merger Agreement is
terminated pursuant to Article VII thereof if an Exercise Event shall not have
occurred on or prior to such date; provided, however, with respect to the
preceding clause (ii) of this sentence, that if, at the expiration of the
period specified
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<PAGE>
therein, the Option cannot be exercised by reason of any applicable judgment,
decree, order, laws or regulation, or because the waiting period related to
the issuance of the Option Shares under the Hart-Scott-Rodino Antitrust
Improvements Act of 1976, as amended (the "HSR Act"), if applicable, shall not
have expired or been terminated, then the Option shall not terminate until the
tenth business day after such impediment to exercise shall have been removed
or shall have become final and not subject to appeal. Notwithstanding the
foregoing, the Option may not be exercised if Acquiror is in breach in any
material respect of any of its covenants or agreements contained in the Merger
Agreement, or more than one year after the Exercise Event.
3. CONDITIONS TO CLOSING
The obligation of Target to issue Option Shares to Acquiror hereunder is
subject to the conditions that (a) any waiting period under the HSR Act
applicable to the issuance of the Option Shares hereunder shall have expired
or been terminated; (b) all consents, approvals, orders or authorizations of,
or registrations, declarations or filings with, any Federal, state, local or
foreign administrative agency or commission or other Federal, state, local or
foreign governmental authority or instrumentality, if any, required in
connection with the issuance of the Option Shares hereunder shall have been
obtained or made, as the case may be; and (c) no preliminary or permanent
injunction or other order by any court of competent jurisdiction prohibiting
or otherwise restraining such issuance shall be in effect.
4. CLOSING
At any Closing, (a) Target shall deliver to Acquiror a single certificate in
definitive form representing the number of Target Shares designated by
Acquiror in its Exercise Notice, such certificate to be registered in the name
of Acquiror and to bear the legend set forth in Section 9 hereof, and (b)
Acquiror shall pay to Target the aggregate purchase price for the Target
Shares so designated and being purchased by delivery of a certified check or
bank check.
5. REPRESENTATIONS AND WARRANTIES OF TARGET
Target represents and warrants to Acquiror that (a) Target is a corporation
duly organized, validly existing and in good standing under the laws of the
State of Delaware and has the corporate power and authority to enter into this
Agreement and to carry out its obligations hereunder; (b) the execution and
delivery of this Agreement by Target and consummation by Target of the
transactions contemplated hereby have been duly authorized by all necessary
corporate action on the part of Target and no other corporate proceedings on
the part of Target are necessary to authorize this Agreement or any of the
transactions contemplated hereby; (c) this Agreement has been duly executed
and delivered by Target and constitutes a legal, valid and binding obligation
of Target and, assuming this Agreement constitutes a legal, valid and binding
obligation of Acquiror, is enforceable against Target in accordance with its
terms, except as enforceability may be limited by bankruptcy and other laws
affecting the rights and remedies of creditors generally and general
principles of equity; (d) except for any filings as may be required under the
HSR Act or filings required for companies quoted on the NASDAQ National
Market, Target has taken all necessary corporate and other action to authorize
and reserve for issuance and to permit it to issue upon exercise of the
Option, and at all times from the date hereof until the termination of the
Option will have reserved for issuance, a sufficient number of unissued Target
Shares for Acquiror to exercise the Option in full and will take all necessary
corporate or other action to authorize and reserve for issuance all additional
Target Shares or other securities which may be issuable pursuant to Section 8
upon exercise of the Option, all of which, upon their issuance and delivery in
accordance with the terms of this Agreement, will be validly issued, fully
paid and nonassessable; (e) upon delivery of the Target Shares and any other
securities to Acquiror upon exercise of the Option, Acquiror will acquire such
Target Shares or other securities free and clear of all material claims,
liens, charges, encumbrances and security interests of any kind or nature
whatsoever, excluding those imposed by Acquiror; (f) the execution and
delivery of this Agreement by Target do not, and the performance of this
Agreement by Target will not, (i) violate the Certificate of Incorporation or
Bylaws of Target, (ii) conflict with or violate any order applicable to Target
or any of its subsidiaries or by which they or
B-2
<PAGE>
any of their property is bound or affected or (iii) result in any breach of or
constitute a default (or an event which with notice or lapse of time or both
would become a default) under, or give rise to any right of termination,
amendment, acceleration or cancellation of, or result in the creation of a
lien or encumbrance on any of the property or assets of Target or any of its
subsidiaries pursuant to, any contract or agreement to which Target or any of
its subsidiaries is a party or by which Target or any of its subsidiaries or
any of their property is bound or affected, except, in the case of clauses
(ii) and (iii) above, for violations, conflicts, breaches, defaults, rights of
termination, amendment, acceleration or cancellation, liens or encumbrances
which would not, individually or in the aggregate, have a Material Adverse
Effect on Target; and (g) the execution and delivery of this Agreement by
Target do not, and the performance of this Agreement by Target will not,
require any consent, approval, authorization or permit of, or filing with, or
notification to, any Governmental Entity except pursuant to the HSR Act or for
companies quoted on the NASDAQ National Market, if applicable.
6. REPRESENTATIONS AND WARRANTIES OF ACQUIROR
Acquiror represents and warrants to Target that (a) Acquiror is a
corporation duly incorporated, validly existing and in good standing under the
laws of the State of Delaware and has the corporate power and authority to
enter into this Agreement and to carry out its obligations hereunder; (b) the
execution and delivery of this Agreement by Acquiror and the consummation by
Acquiror of the transactions contemplated hereby have been duly authorized by
all necessary corporate action on the part of Acquiror and no other corporate
proceedings on the part of Acquiror are necessary to authorize this Agreement
or any of the transactions contemplated hereby; (c) this Agreement has been
duly executed and delivered by Acquiror and constitutes a legal, valid and
binding obligation of Acquiror and, assuming this Agreement constitutes a
legal, valid and binding obligation of Target, is enforceable against Acquiror
in accordance with its terms, except as enforceability may be limited by
bankruptcy and other laws affecting the rights and remedies of creditors
generally and general principles of equity; (d) the execution and delivery of
this Agreement by Acquiror do not, and the performance of this Agreement by
Acquiror will not, (i) violate the Certificate of Incorporation or Bylaws of
Acquiror, (ii) conflict with or violate any order applicable to Acquiror or
any of its subsidiaries or by which they or any of their property is bound or
affected or (iii) result in any breach of or constitute a default (or an event
which with notice or lapse of time or both would become a default) under, or
give rise to any right of termination, amendment, acceleration or cancellation
of, or result in the creation of a lien or encumbrance on any of the property
or assets of Acquiror or any of its subsidiaries pursuant to, any contract or
agreement to which Acquiror or any of its subsidiaries is a party or by which
Acquiror or any of its subsidiaries or any of their property is bound or
affected, except, in the case of clauses (ii) and (iii) above, for violations,
conflicts, breaches, defaults, rights of termination, amendment, acceleration
or cancellation, liens or encumbrances which would not, individually or in the
aggregate, have a Material Adverse Effect on Acquiror; (e) the execution and
delivery of this Agreement by Acquiror does not, and the performance of this
Agreement by Acquiror will not, require any consent, approval, authorization
or permit of, or filing with or notification to, any Governmental Entity
except pursuant to the HSR Act, if applicable; and (f) any Target Shares
acquired upon exercise of the Option will not be acquired by Acquiror with a
view to the public distribution thereof and Acquiror will not sell or
otherwise dispose of such shares in violation of applicable law or this
Agreement.
7. [INTENTIONALLY LEFT BLANK]
8. ADJUSTMENT UPON CHANGES IN CAPITALIZATION
In the event of any change in the Target Shares by reason of stock
dividends, split-ups, mergers (other than the Merger), recapitalizations,
combinations, exchanges of shares and the like, the type and number of shares
or securities subject to the Option and the Exercise Price shall be adjusted
appropriately, and proper provision shall be made in the agreements governing
such transaction so that Acquiror shall receive, upon exercise of the Option,
the number and class of shares or other securities or property that Acquiror
would have received in respect of the Target Shares if the Option had been
exercised immediately prior to such event or the record date therefor, as
applicable.
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<PAGE>
9. RESTRICTIVE LEGENDS
Each certificate representing Option Shares issued to Acquiror hereunder,
shall include a legend in substantially the following form:
THE SECURITIES REPRESENTED BY THIS CERTIFICATE HAVE NOT BEEN REGISTERED
UNDER THE SECURITIES ACT OF 1933, AS AMENDED, AND MAY BE REOFFERED OR SOLD
ONLY IF SO REGISTERED OR IF AN EXEMPTION FROM SUCH REGISTRATION IS AVAILABLE.
SUCH SECURITIES ARE ALSO SUBJECT TO ADDITIONAL RESTRICTIONS ON TRANSFER AS SET
FORTH IN THE STOCK OPTION AGREEMENT DATED AS OF NOVEMBER 12, 1996, A COPY OF
WHICH MAY BE OBTAINED FROM SQA, INC.
10. NASDAQ NATIONAL MARKET LISTING AND HSR FILING
Target, upon the request of Acquiror, shall promptly file an application to
list the Target Shares to be acquired upon exercise of the Option for
quotation on the Nasdaq National Market and shall use its best efforts to
obtain approval of such listing as soon as practicable. Promptly after the
date hereof, each of the parties hereto shall promptly file with the Federal
Trade Commission and the Antitrust Division of the United States Department of
Justice all required premerger notification and report forms and other
documents and exhibits required to be filed under the HSR Act, if any, to
permit the acquisition of the Target Shares subject to the Option at the
earliest possible date.
11. BINDING EFFECT
This Agreement shall be binding upon and inure to the benefit of the parties
hereto and their respective successors and permitted assigns. Nothing
contained in this Agreement, express or implied, is intended to confer upon
any person other than the parties hereto and their respective successors and
permitted assigns any rights or remedies of any nature whatsoever by reason of
this Agreement. Any shares sold by a party in compliance with the provisions
of Section 7 shall, upon consummation of such sale, be free of the
restrictions imposed with respect to such shares by this Agreement and any
transferee of such shares shall not be entitled to the rights of such party.
Certificates representing shares sold in a registered public offering pursuant
to Section 7 shall not be required to bear the legend set forth in Section 9.
12. SPECIFIC PERFORMANCE
The parties recognize and agree that if for any reason any of the provisions
of this Agreement are not performed in accordance with their specific terms or
are otherwise breached, immediate and irreparable harm or injury would be
caused for which money damages would not be an adequate remedy. Accordingly,
each party agrees that in addition to other remedies the other party shall be
entitled to an injunction restraining any violation or threatened violation of
the provisions of this Agreement. In the event that any action shall be
brought in equity to enforce the provisions of the Agreement, neither party
will allege, and each party hereby waives the defense, that there is an
adequate remedy at law.
13. ENTIRE AGREEMENT
This Agreement and the Merger Agreement (including the Exhibits and
Schedules thereto) constitute the entire agreement between the parties with
respect to the subject matter hereof and supersede all other prior agreements
and understandings, both written and oral, between the parties with respect to
the subject matter hereof.
14. FURTHER ASSURANCES
Each party will execute and deliver all such further documents and
instruments and take all such further action as may be necessary in order to
consummate the transactions contemplated hereby.
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<PAGE>
15. VALIDITY
The invalidity or unenforceability of any provision of this Agreement shall
not affect the validity or enforceability of the other provisions of this
Agreement, which shall remain in full force and effect. In the event any
Governmental Entity of competent jurisdiction holds any provision of this
Agreement to be null, void or unenforceable, the parties hereto shall
negotiate in good faith and shall execute and deliver an amendment to this
Agreement in order, as nearly as possible, to effectuate, to the extent
permitted by law, the intent of the parties hereto with respect to such
provision.
16. NOTICES
All notices and other communications hereunder shall be in writing and shall
be deemed given if delivered personally or by commercial delivery service, or
sent via telecopy (receipt confirmed) to the parties at the following
addresses or telecopy numbers (or at such other address or telecopy numbers
for a party as shall be specified by like notice):
(1) if to Acquiror, to:
Rational Software Corporation
2800 San Tomas
Expressway
Santa Clara, CA 95051
Attention: President
Telephone No.: (408) 496-3600
Telecopy No.: (408) 970-0715
with a copy to:
Wilson Sonsini Goodrich & Rosati, P.C.
650 Page Mill Road
Palo Alto, California 94304-1050
Attention: Frank Currie, Esq.
Telephone No.: (415) 493-9300
Telecopy No.: (415) 493-6811
(2) if to Target, to:
SQA, Inc.
One Burlington Woods
Burlington, Massachusetts 01803
Attention: President
Telephone No.: (617) 229-3500
Telecopy No.: (617) 229-3783
with a copy to:
Testa, Hurwitz & Thibeault, LLP
High Street Tower, 125 High Street
Boston, Massachusetts 02110
Attention: William J. Schnoor, Jr. Esq.
Telephone No.: (617) 248-7000
Telecopy No.: (617) 248-7100
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<PAGE>
17. GOVERNING LAW
This Agreement shall be governed by and construed in accordance with the
laws of the State of Delaware applicable to agreements made and to be
performed entirely within such State.
18. COUNTERPARTS
This Agreement may be executed in two counterparts, each of which shall be
deemed to be an original, but both of which, taken together, shall constitute
one and the same instrument.
19. EXPENSES
Except as otherwise expressly provided herein or in the Merger Agreement,
all costs and expenses incurred in connection with the transactions
contemplated by this Agreement shall be paid by the party incurring such
expenses.
20. AMENDMENTS; WAIVER
This Agreement may be amended by the parties hereto and the terms and
conditions hereof may be waived only by an instrument in writing signed on
behalf of each of the parties hereto, or, in the case of a waiver, by an
instrument signed on behalf of the party waiving compliance.
21. ASSIGNMENT
Neither of the parties hereto may sell, transfer, assign or otherwise
dispose of any of its rights or obligations under this Agreement or the Option
created hereunder to any other person, without the express written consent of
the other party, except that Acquiror may assign its rights and obligations
hereunder to Sub.
[Remainder of Page Intentionally Blank]
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<PAGE>
IN WITNESS WHEREOF, THE PARTIES HERETO HAVE CAUSED THIS AGREEMENT TO BE
EXECUTED BY THEIR RESPECTIVE DULY AUTHORIZED OFFICERS AS OF THE DATE FIRST
ABOVE WRITTEN.
Rational Software Corporation
By___________________________________
Name:
Title
SQA, Inc.
By___________________________________
Name
Title
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<PAGE>
ANNEX C
HAMBRECHT & QUIST LLC
One Bush Street
San Francisco, CA
94104
(415) 576-3300
Confidential
November 12, 1996
The Board of Directors
Rational Software Corporation
2800 San Tomas Expressway
Santa Clara, CA 95051-0951
Gentlemen:
You have requested our opinion as to the fairness from a financial point of
view to Rational Software Corporation ("Rational" or the "Company") of the
consideration to be paid by the Company in connection with the proposed merger
of a wholly-owned subsidiary of Rational with and into SQA, Inc. ("SQA") (the
"Proposed Transaction") under the terms of the Agreement and Plan of
Reorganization, dated as of November 12, 1996, among SQA and Rational and the
related Exhibits and Schedules thereto (the "Agreement"). The Agreement
provides, among other things, that Rational will issue to the stockholders of
SQA, upon consummation of the Proposed Transaction, 0.86 shares of Rational
common stock for each share of SQA common stock.
Hambrecht & Quist LLC ("Hambrecht & Quist"), as part of its investment
banking services, is regularly engaged in the valuation of businesses and
their securities in connection with mergers and acquisitions, strategic
transactions, corporate restructurings, negotiated underwritings, secondary
distributions of listed and unlisted securities, private placements and
valuations for corporate and other purposes. We have acted as a financial
advisor to the Board of Directors of Rational in connection with the Proposed
Transaction, and we will receive a fee for our services, which includes the
rendering of this opinion.
In the past, we have provided investment banking and other financial
advisory services to Rational and have received fees for rendering these
services. In the ordinary course of business, Hambrecht & Quist acts as a
market maker and broker in the publicly traded securities of Rational and
receives customary compensation in connection therewith, and also provides
research coverage for Rational. In the ordinary course of business, Hambrecht
& Quist actively trades in the equity and derivative securities of Rational
for its own account and for the accounts of its customers and, accordingly,
may at any time hold a long or short position in such securities. Hambrecht &
Quist may in the future provide additional investment banking or other
financial advisory services to Rational. In addition, the President and Chief
Executive Officer of Hambrecht & Quist, Daniel H. Case III, is a Director of
Rational.
In connection with our review of the Proposed Transaction, and in arriving
at our opinion, we have, among other things:
(i) reviewed the publicly available financial statements of Rational for
recent years and interim periods to date and certain other relevant
financial and operating data of Rational made available to us from
published sources;
(ii) discussed the business, financial condition and prospects of
Rational with certain of its officers;
(iii) reviewed the publicly available financial statements of SQA for
recent years and interim periods to date and certain other relevant
financial and operating data of SQA made available to us from published
sources;
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<PAGE>
(iv) discussed the business, financial condition and prospects of SQA
with certain of its officers;
(v) analyzed the pro forma impact of the Proposed Transaction on earnings
per share, consolidated capital and other financial ratios of Rational and
SQA;
(vi) reviewed and discussed with management of Rational and SQA, the
strategic rationale for the Proposed Transaction;
(vii) reviewed the recent reported prices and trading activity for the
common stocks of Rational and SQA and compared such information and certain
financial information for Rational and SQA with similar information for
certain other companies engaged in businesses we consider comparable;
(viii) reviewed the financial terms, to the extent publicly available, of
certain comparable merger and acquisition transactions;
(ix) reviewed the Agreement;
(x) discussed the tax and accounting treatment of the Proposed
Transaction with Rational and Rational lawyers and accountants; and
(xi) performed such other analyses and examinations and considered such
other information, financial studies, analyses and investigations and
financial, economic and market data as we deemed relevant.
In rendering our opinion, we have assumed and relied upon the accuracy and
completeness of all of the information concerning Rational or SQA considered
in connection with our review of the Proposed Transaction, and we have not
assumed any responsibility for independent verification of such information or
any independent valuation or appraisal of any of the assets or liabilities of
Rational or SQA nor have we conducted a physical inspection of the properties
and facilities of either company. For purposes of this Opinion, we have
assumed that neither Rational nor SQA is a party to any pending transactions,
including external financings, recapitalizations or material merger
discussions, other than the Proposed Transaction and those activities
undertaken in the ordinary course of conducting their respective businesses.
Our opinion is necessarily based upon market, economic, financial and other
conditions as they exist and can be evaluated as of the date of this letter
and any change in such conditions would require a reevaluation of this
opinion.
We express no opinion as to the price at which the shares of Rational will
trade after the announcement or consummation of the Proposed Transaction.
It is understood that this letter is for the information of the Board of
Directors and may not be summarized or publicly referred to without our prior
written consent; provided, however, that this letter may be reproduced in any
filing made by Rational with respect to the transaction contemplated by the
Agreement. This letter does not constitute a recommendation to any stockholder
as to how such stockholder should vote on the Proposed Transaction.
Based upon and subject to the foregoing and after considering such other
matters as we deem relevant, we are of the opinion that as of the date hereof
the consideration to be paid by Rational in the Proposed Transaction is fair
to the Company from a financial point of view.
Very truly yours,
Hambrecht & Quist llc
/s/ P.B. Cleveland
By___________________________________
Paul B. Cleveland
Managing Director
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<PAGE>
ANNEX D
[ROBERTSON STEPHENS & COMPANY LETTERHEAD]
November 12, 1996
CONFIDENTIAL
Board of Directors
SQA, Inc.
One Burlington Woods Drive
Burlington, MA 01803
Members of the Board:
You have asked our opinion with respect to the fairness to the shareholders
of SQA, Inc., ("SQA" or the "Company"), from a financial point of view and as
of the date hereof, of the Purchase Price Value (as defined below) to the
shareholders of SQA, in connection with the proposed merger of SQA with a
wholly-owned subsidiary of Rational Software Corporation ("Rational"),
pursuant to the draft Agreement and Plan of Reorganization, dated as of
November 12, 1996 (the "Agreement"). Under the terms of the Agreement, the
outstanding shares of SQA common stock will be converted into shares of
Rational common stock in connection with the statutory merger of the Rational
subsidiary with and into SQA (the "Merger"). As a result of the Agreement,
each share or equivalent of SQA common stock will be converted into the right
to receive 0.86 (the "Exchange Ratio") shares or equivalents of Rational
common stock. Based on the number of common and common equivalent shares
outstanding as of October 28, 1996 and the closing stock price for Rational as
of November 11, 1996, the implied value of the purchase price is $318 million
(the "Purchase Price Value"). We have been advised that the Merger is intended
qualify as a tax-free reorganization for federal income tax purposes. The
terms and conditions of the Merger are set out more fully in the Agreement.
For purposes of this opinion we have (i) reviewed financial information on
SQA furnished to us by SQA, including certain internal financial analyses and
forecasts prepared by the management of SQA; (ii) reviewed publicly available
information; (iii) held discussions with the management of SQA and Rational
concerning the businesses, past and current business operations, financial
condition and future prospects of SQA and Rational; (iv) reviewed the
Agreement; (v) reviewed the stock price and trading history of SQA and
Rational; (vi) reviewed the valuations of publicly traded companies which we
deemed comparable to SQA and Rational; (vii) compared the financial terms of
the Merger with other transactions which we deemed relevant; (viii) prepared a
discounted cash flow analysis of SQA; (ix) analyzed the proforma earnings per
share of the combined company; and (x) made such other studies and inquiries,
and reviewed such other data, as we deemed relevant.
In connection with our opinion, we have not independently verified any of
the foregoing information and have relied on all such information being
complete and accurate in all material respects. Furthermore, we did not obtain
any independent appraisal of the properties or assets and liabilities of SQA
or of Rational. With respect to the financial and operating forecasts (and the
assumptions and bases therefor) of SQA which we have reviewed, we have assumed
that such forecasts have been reasonably prepared in good faith on the basis
of reasonable assumptions, reflect the best available estimates and judgments
of the management of SQA and that such projections and forecasts will be
realized in the amounts and in the time periods currently estimated by the
management of SQA. In addition, we have relied on estimates and judgments of
the managements of SQA and Rational as to the future financial performance of
both companies. Further, we have assumed that the historical financial
statements of SQA and Rational that we have reviewed have been prepared and
presented in accordance with generally accepted accounting principles. While
we believe that our review, as described within, is an adequate basis for the
opinion that we express, this opinion is necessarily based on market,
economic, and other conditions that exist and can be evaluated as of the date
of this letter, and on information available to us as of the date hereof.
D-1
<PAGE>
Our opinion is limited to the fairness of the Purchase Price Value to the
shareholders of SQA. We do not express any opinion regarding the current or
future value of the shares of Rational common stock to be issued in the
Merger, nor do we express any opinion regarding the fairness of the Merger to
Rational or to its shareholders.
Robertson, Stephens & Company may, from time to time, trade in the shares of
the common stock of SQA. Furthermore, Robertson, Stephens & Company will
receive a fee in connection with the rendering of this opinion.
This opinion is for the Board of Directors of the Company and is not
intended to be and does not constitute a recommendation to any stockholder of
the Company as to how such stockholder should vote on the proposed Merger.
This opinion may be referred to and/or included in the Registration Statement
and/or Proxy Statement which may be prepared, filed and/or distributed in
connection with the proposed Merger. This opinion is not to be used, quoted or
referred to otherwise without Robertson, Stephens & Company's consent.
Based on and subject to the foregoing considerations, it is our opinion, as
investment bankers, that, as of the date hereof, the Purchase Price Value is
fair to SQA from a financial point of view.
Very truly yours,
Robertson, Stephens & Company LLC
By: Robertson, Stephens & Company
Group, L.L.C.
/s/ Edwin David Hetz
_____________________________________
Authorized Signatory
D-2
<PAGE>
PART II
INFORMATION NOT REQUIRED IN PROSPECTUS
ITEM 20. LNDEMNIFICATION OF DIRECTORS AND OFFICERS
Section 145 of the Delaware General Corporation Law authorizes a court to
award, or a corporation's Board of Directors to grant, indemnification to
directors and officers in terms sufficiently broad to permit such
indemnification under certain circumstances for liabilities (including
reimbursement for expenses incurred) arising under the Securities Act. Article
7 of the Registrant's Certificate (Exhibit 3.1 hereto) and Article VI of the
Registrants' Bylaws (Exhibit 3.2 hereto) provide for indemnification of its
directors, officers, employees and other agents to the maximum extent permitted
by the Delaware Law. In addition, the Registrant has entered into
Indemnification Agreements (Exhibit 10.1 hereto) with its officers and
directors.
The Agreement provides that commencing with the effectiveness of the Merger,
the Registrant will indemnify the current officers and directors of Atria for
any action or inaction by such person prior to the Merger.
ITEM 21. EXHIBITS AND FINANCIAL SCHEDULES
(a) EXHIBITS
<TABLE>
<C> <S>
2.01 Reorganization Agreement among Verdix Corporation, Rational Acquisition
Corporation, and Rational, dated December 15, 1993, is incorporated
herein by reference to Appendix A filed with the Registrant's
Registration Statement on Form S-4, dated February 25, 1994
(Registration No. 33-75724).
2.02 Share Purchase Agreement between Telefonaktiebolaget LM Ericsson
(publ.) and Rational Software Corporation, dated September 26, 1995, is
incorporated herein by reference to Exhibit 2 filed with the
Registrant's Form 8-K Current Report dated October 9, 1995 (File No. 0-
12167) ("October 1995 8-K").
2.03 Share Option Agreement between Usecase Engineering S.A. and Rational
Software Corporation, dated October 9, 1995, is incorporated herein by
reference to Exhibit 3 filed with the Registrant's October 1995 8-K.
3.01 Restatement of the Certificate of Incorporation of the Registrant,
dated August 30, 1996 is incorporated herein by reference to Exhibit
4.01 filed with the Company's Form S-3 Registration Statement on
October 3, 1996 (Registration No. 333-13313).
3.02 Bylaws of the Registrant as most recently amended are incorporated
herein by reference to Exhibit 3.9 filed with the 1996 10-K.
4.01 Reference is made to Exhibits 3.01 and 3.02.
4.02 Specimen of Common Stock Certificate is incorporated herein by
reference to Exhibit 4.06 filed with the Registrant's Amendment No. 1
to Form S-3 Registration Statement on May 31, 1995 (File No. 33-91740).
4.03 Rational 1983 Incentive Stock Option Plan, as amended, dated March 24,
1992, is incorporated herein by reference to Exhibit 4.7 filed with the
Registrant's Form S-8 Registration Statement on April 6, 1994
(Registration No. 33-77382).
4.04 Form of Stock Option Agreements for the Rational 1983 Incentive Stock
Option Plan is incorporated herein by reference to Exhibit 4.8 filed
with the Registrant's Form S-8 Registration Statement on April 6, 1994
(Registration No. 33-77382).
4.05 1983 Incentive Stock Option Plan, as amended, is incorporated herein by
reference to Exhibit 4.3 filed with Verdix's Form 10-K Annual Report
for the fiscal year ended March 31, 1989 (File No. 0-12167).
4.06 Form of Incentive Stock Option Agreement for the 1983 Incentive Stock
Option Plan, as amended, is incorporated herein by reference to Exhibit
4.4 filed with Verdix's Form 10-K Annual Report for the fiscal year
ended March 31, 1989 (File No. 0-12167).
</TABLE>
II-1
<PAGE>
<TABLE>
<C> <S>
4.07 1986 Stock Option Plan, as amended, is incorporated herein by reference
to Exhibit 4.6 filed with Verdix's Registration Statement on Form S-8
(Registration No. 33-20029).
4.08 Form of Stock Option Agreement for the 1986 Stock Option Plan, as
amended November 15, 1991, is incorporated herein by reference to
Exhibit 4.13 filed with Verdix's Post Effective Amendment No. 1 to the
Registration Statement on Form S-3 (Registration No. 33-12469).
4.09 Rational Software Corporation Stock Option Plan for Directors is
incorporated herein by reference to Exhibit 1 filed with the
Registrant's Form 8-K Current Report dated October 2, 1996.
4.10 Form of Stock Option Agreements for the Rational Software Corporation
Stock Option Plan for Directors is incorporated herein by reference to
Exhibit 4.6 filed with the Registrant's Form S-8 Registration Statement
on September 18, 1995 (Registration No. 33-97042).
4.11 Rational 1993 Incentive Stock Option Plan is incorporated herein by
reference to Exhibit 4.9 filed with the Registrant's Form S-8
Registration Statement on April 6, 1994 (Registration No. 33-77382).
4.12 Form of Stock Option Agreements for the Rational 1993 Stock Option Plan
is incorporated herein by reference to Exhibit 4.10 filed with the
Registrant's Form S-8 Registration Statement on April 6, 1994
(Registration No. 33-77328).
4.13 Rational Software Corporation 1994 Stock Option Plan is incorporated
herein by reference to Exhibit 3 filed with the Registrant's Form 8-K
Current Report dated October 2, 1996.
4.14 Form of Stock Option Agreements for the Rational Software Corporation
1994 Stock Option Plan is incorporated herein by reference to Exhibit
4.6 filed with the Registrant's Form S-8 Registration Statement on
September 18, 1995 (Registration No. 33-97044).
4.15 Rational Software Corporation 1994 Employee Stock Purchase Plan is
incorporated herein by reference to Exhibit 2 filed with the
Registrant's Form 8-K Current Report dated October 2, 1996.
4.16 Rational Software Corporation 1994 Employee Stock Purchase Plan
Subscription Agreement is incorporated herein by reference to Exhibit
4.8 filed with the Registrant's Form S-8 Registration Statement on
October 31, 1994 (Registration No. 33-85906) and amended September 18,
1995.
4.17 Rational Software Corporation 1997 Stock Option Plan.
4.18 Agreement among the Registrant, Rational, and International Business
Machines Corporation ("IBM"), dated December 15, 1993, is incorporated
by reference to Exhibit 4.17 filed with the Registrant's Registration
Statement on Form S-4, dated February 25, 1994 (Registration No. 33-
75724).
4.19 Preferred Stock Purchase Agreement between Rational and IBM, dated as
of November 29, 1989, is incorporated by reference to Exhibit 4.18
filed with the Registrant's Registration Statement on
Form S-4, dated February 25, 1994 (Registration No. 33-75724).
4.20 Agreement among the Registrant, Rational, Martin Marietta Investments,
Inc., and Martin Marietta Technologies, Inc., dated December 15, 1993,
is incorporated herein by reference to Exhibit 10.33 filed with the
Registrant's Registration Statement on Form S-4, dated February 25,
1994 (Registration No. 33-75724).
4.21 Stock Purchase Agreement between the Registrant and Martin Marietta
Corporation, dated March 8, 1985, is incorporated herein by reference
to Exhibit 4.1 filed with the Registrant's Form 8-K Current Report
dated March 8, 1985 (File No. 0-12167).
4.22 Letter Agreement among the Registrant, Martin Marietta Corporation, and
Martin Marietta Investments, Inc., dated June 2, 1987, is incorporated
herein by reference to Exhibit 4.1 filed with the Registrant's Form 8-K
Current Report dated June 2, 1987 (File No. 0-12167).
5.01 Opinion of Wilson Sonsini Goodrich & Rosati, P.C., regarding the
legality of securities being registered.
5.02 Tax Opinion of Wilson Sonsini Goodrich & Rosati, P.C., dated January
, 1997.
5.03 Tax Opinion of Testa, Hurwitz & Thibeault, LLP, dated January , 1997.
</TABLE>
II-2
<PAGE>
<TABLE>
<C> <S>
10.01 *Agreement for Purchase and Sale of Assets between the Registrant and
Microsoft Corporation, dated October 2, 1996, is incorporated herein by
reference to Exhibit 1 filed with the Registrant's Form 8-K Current
Report dated October 2, 1996 as amended by Exhibit 1 filed with the
Registrant's Form 8-K/A Current Report dated October 16, 1996.
10.02 *Development and License Agreement between the Registrant and Microsoft
Corporation, dated September 24, 1996, is incorporated herein by
reference to Exhibit 2 filed with the Registrant's
Form 8-K Current Report dated October 2, 1996 as amended by Exhibit 2
filed with the Registrant's Form 8-K/A Current Report dated October 16,
1996.
11.01 Statement of computation of the Registrant's per share earnings is
incorporated by reference to the Registrant's Form 10-K for the fiscal
year ended March 31, 1996.
21.01 Subsidiaries of the Registrant, incorporated by reference to the
Registrant's Form 10-K for the fiscal year ended March 31, 1996.
23.01 Consent of Ernst & Young LLP.
23.02 Consent of Arthur Andersen LLP.
23.03 Consents of Wilson Sonsini Goodrich & Rosati, P.C. (see Exhibits 5.01
and 5.02, above).
23.04 Consent of Testa, Hurwitz & Thibeault, LLP (see Exhibit 5.03 above).
24.01 Power of Attorney is contained on the signature pages of this
Registration Statement.
99.1 Rational Stockholder Letter, dated January , 1997.
99.2 SQA Stockholder Letter, dated January , 1997.
99.3 Rational Notice of Special Meeting of Stockholders, dated January ,
1997.
99.4 SQA Notice of Special Meeting of Stockholders, Dated January , 1997.
99.5 Rational Form of Proxy.
99.6 SQA Form of Proxy.
</TABLE>
- --------
* Confidential Treatment Requested.
(b) FINANCIAL STATEMENT SCHEDULES
Rational
SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS
<TABLE>
<CAPTION>
BALANCE AT BALANCE AT
BEGINNING ENDING OF
OF PERIOD ADDITIONS DEDUCTIONS PERIOD
---------- --------- ---------- ----------
<S> <C> <C> <C> <C>
March 31, 1996
Allowance for doubtful accounts..... $477,600 $643,648 $ (79,233) $1,042,015
March 31, 1995
Allowance for doubtful accounts..... $618,088 $200,000 $(340,488) $ 477,600
March 31, 1994
Allowance for doubtful accounts..... 940,427 100,000 (422,339) 618,088
</TABLE>
Schedules not listed above have been omitted because the information required
to be set forth therein is not applicable or is shown in the financial
statements, management's discussion and analysis or notes thereto.
ITEM 22. UNDERTAKINGS
(1) The undersigned Registrant hereby undertakes as follows: that prior to
any public reoffering of the securities registered hereunder through use of a
prospectus which is a part of this Registration Statement, by any person or
party who is deemed to be an underwriter within the meaning of Rule 145(c), the
undersigned Registrant undertakes that such reoffering prospectus will contain
the information called for by the applicable registration form with respect to
reofferings by persons who may be deemed underwriters, in addition to the
information called for by the other Items of the applicable form.
II-3
<PAGE>
(2) The Registrant undertakes that every prospectus (i) that is filed
pursuant to paragraph (1) immediately preceding, or (ii) that purports to meet
the requirements of Section 10(a)(3) of the Act and is used in connection with
an offering of securities subject to Rule 415, will be filed as a part of an
amendment to the Registration Statement and will not be used until such
amendment is effective, and that, for purposes of determining any liability
under the Securities Act of 1933, each such post-effective amendment shall be
deemed to be a new Registration Statement relating to the securities offered
therein, and the offering of such securities at that time shall be deemed to
be the initial bona fide offering thereof.
(3) Insofar as the indemnification for liabilities arising under the
Securities Act of 1933 may be permitted to directors, officers and controlling
persons of the Registrant pursuant to the foregoing provisions, or otherwise,
the Registrant has been advised that in the opinion of the Securities and
Exchange Commission such indemnification is against public policy as expressed
in the Act and is, therefore, unenforceable. In the event that a claim for
indemnification against such liabilities (other than the payment by the
Registrant of expenses incurred or paid by a director, officer or controlling
person of the Registrant in the successful defense of any action, suit or
proceeding) is asserted by such director, officer or controlling person in
connection with the securities being registered, the Registrant will, unless
in the opinion of its counsel the matter has been settled by controlling
precedent, submit to a court of appropriate jurisdiction the question whether
such indemnification by it is against public policy as expressed in the Act
and will be governed by the final adjudication of such issue.
(4) The undersigned Registrant hereby undertakes to respond to requests for
information that is incorporated by reference into the Prospectus pursuant to
Items 4, 10(b), 11 or 13 of this Form, within one business day of receipt of
such request, and to send the incorporated documents by first class mail or
other equally prompt means. This includes information contained in documents
filed subsequent to the effective date of the Registration Statement through
the date of responding to the request.
(5) The undersigned Registrant hereby undertakes to supply by means of a
post-effective amendment all information concerning a transaction, and the
company being acquired involved therein, that was not the subject of and
included in the Registration Statement when it became effective.
II-4
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Act of 1933, as amended, the
Registrant has duly caused this Registration Statement to be signed on its
behalf by the undersigned, thereunto duly authorized, in the City of Santa
Clara, State of California on the 13th day of January 1997.
RATIONAL SOFTWARE CORPORATION
By: /s/ ROBERT T. BOND
_____________________________________
Robert T. Bond
Senior Vice President, Chief
Operating Officer, Chief Financial
Officer and Secretary
POWER OF ATTORNEY
KNOW ALL THESE PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints Paul D. Levy and Robert T. Bond and
each of them, jointly and severally, as his attorneys-in-fact, each with full
power of substitution for him in any and all capacities, to sign any and all
amendments to this Registration Statement, and to file the same, with exhibits
thereto and other documents in connection therewith, with the Securities and
Exchange Commission, hereby ratifying and confirming all that each said
attorneys-in-fact or his substitute or substitutes, may do or cause to be done
by virtue hereof.
PURSUANT TO THE REQUIREMENTS OF THE SECURITIES ACT OF 1933, AS AMENDED, THIS
REGISTRATION STATEMENT HAS BEEN SIGNED BY THE FOLLOWING PERSONS IN THE
CAPACITIES AND ON THE DATES INDICATED:
<TABLE>
<CAPTION>
SIGNATURES TITLE DATE
---------- ----- ----
<S> <C> <C>
/s/ Paul D. Levy Chief Executive Officer and January 13, 1997
____________________________________ Chairman of the Board
Paul D. Levy (Principal Executive
Officer)
/s/ Robert T. Bond Senior Vice President, Chief January 13, 1997
____________________________________ Operating Officer, Chief
Robert T. Bond Financial Officer and
Secretary (Principal
Financial Officer)
/s/ Timothy A. Brennan Vice President, Finance and January 13, 1997
____________________________________ Administration (Principal
Timothy A. Brennan Accounting Officer)
/s/ Michael T. Devlin President and Director January 13, 1997
____________________________________
Michael T. Devlin
/s/ James S. Campbell Director January 13, 1997
____________________________________
James S. Campbell
/s/ Daniel H. Case III Director January 13, 1997
____________________________________
Daniel H. Case III
/s/ Leslie G. Denend Director January 13, 1997
____________________________________
Leslie G. Denend
</TABLE>
II-5
<PAGE>
<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
--------- ----- ----
<S> <C> <C>
/s/ John E. Montague Director January 13, 1997
____________________________________
John E. Montague
/s/ Allison R. Schleicher Director January 13, 1997
____________________________________
Allison R. Schleicher
</TABLE>
II-6
<PAGE>
EXHIBIT INDEX
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DOCUMENT DESCRIPTION
------- --------------------
<C> <S>
2.01 Reorganization Agreement among Verdix Corporation, Rational
Acquisition Corporation, and Rational, dated December 15, 1993, is
incorporated herein by reference to Appendix A filed with the
Registrant's Registration Statement on Form S-4, dated February 25,
1994 (Registration No. 33-75724).
2.02 Share Purchase Agreement between Telefonaktiebolaget LM Ericsson
(publ.) and Rational Software Corporation, dated September 26, 1995,
is incorporated herein by reference to Exhibit 2 filed with the
Registrant's Form 8-K Current Report dated October 9, 1995 (File No.
0-12167) ("October 1995 8-K").
2.03 Share Option Agreement between Usecase Engineering S.A. and Rational
Software Corporation, dated October 9, 1995, is incorporated herein by
reference to Exhibit 3 filed with the Registrant's October 1995 8-K.
3.01 Restatement of the Certificate of Incorporation of the Registrant,
dated August 30, 1996 is incorporated herein by reference to Exhibit
4.01 filed with the Company's Form S-3 Registration Statement on
October 3, 1996 (Registration No. 333-13313).
3.02 Bylaws of the Registrant as most recently amended are incorporated
herein by reference to Exhibit 3.9 filed with the 1996 10-K.
4.01 Reference is made to Exhibits 3.01 and 3.02.
4.02 Specimen of Common Stock Certificate is incorporated herein by
reference to Exhibit 4.06 filed with the Registrant's Amendment No. 1
to Form S-3 Registration Statement on May 31, 1995 (File No. 33-
91740).
4.03 Rational 1983 Incentive Stock Option Plan, as amended, dated March 24,
1992, is incorporated herein by reference to Exhibit 4.7 filed with
the Registrant's Form S-8 Registration Statement on April 6, 1994
(Registration No. 33-77382).
4.04 Form of Stock Option Agreements for the Rational 1983 Incentive Stock
Option Plan is incorporated herein by reference to Exhibit 4.8 filed
with the Registrant's Form S-8 Registration Statement on April 6, 1994
(Registration No. 33-77382).
4.05 1983 Incentive Stock Option Plan, as amended, is incorporated herein
by reference to Exhibit 4.3 filed with Verdix's Form 10-K Annual
Report for the fiscal year ended March 31, 1989 (File No. 0-12167).
4.06 Form of Incentive Stock Option Agreement for the 1983 Incentive Stock
Option Plan, as amended, is incorporated herein by reference to
Exhibit 4.4 filed with Verdix's Form 10-K Annual Report for the fiscal
year ended March 31, 1989 (File No. 0-12167).
4.07 1986 Stock Option Plan, as amended, is incorporated herein by
reference to Exhibit 4.6 filed with Verdix's Registration Statement on
Form S-8 (Registration No. 33-20029).
4.08 Form of Stock Option Agreement for the 1986 Stock Option Plan, as
amended November 15, 1991, is incorporated herein by reference to
Exhibit 4.13 filed with Verdix's Post Effective Amendment No. 1 to the
Registration Statement on Form S-3 (Registration No. 33-12469).
4.09 Rational Software Corporation Stock Option Plan for Directors is
incorporated herein by reference to Exhibit 1 filed with the
Registrant's Form 8-K Current Report dated October 2, 1996.
4.10 Form of Stock Option Agreements for the Rational Software Corporation
Stock Option Plan for Directors is incorporated herein by reference to
Exhibit 4.6 filed with the Registrant's Form S-8 Registration
Statement on September 18, 1995 (Registration No. 33-97042).
4.11 Rational 1993 Incentive Stock Option Plan is incorporated herein by
reference to Exhibit 4.9 filed with the Registrant's Form S-8
Registration Statement on April 6, 1994 (Registration No. 33-77382).
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DOCUMENT DESCRIPTION
------- --------------------
<C> <S>
4.12 Form of Stock Option Agreements for the Rational 1993 Stock Option
Plan is incorporated herein by reference to Exhibit 4.10 filed with
the Registrant's Form S-8 Registration Statement on April 6, 1994
(Registration No. 33-77328).
4.13 Rational Software Corporation 1994 Stock Option Plan is incorporated
herein by reference to Exhibit 3 filed with the Registrant's Form 8-K
Current Report dated October 2, 1996.
4.14 Form of Stock Option Agreements for the Rational Software Corporation
1994 Stock Option Plan is incorporated herein by reference to Exhibit
4.6 filed with the Registrant's Form S-8 Registration Statement on
September 18, 1995 (Registration No. 33-97044).
4.15 Rational Software Corporation 1994 Employee Stock Purchase Plan is
incorporated herein by reference to Exhibit 2 filed with the
Registrant's Form 8-K Current Report dated October 2, 1996.
4.16 Rational Software Corporation 1994 Employee Stock Purchase Plan
Subscription Agreement is incorporated herein by reference to Exhibit
4.8 filed with the Registrant's Form S-8 Registration Statement on
October 31, 1994 (Registration No. 33-85906) and amended September 18,
1995.
4.17 Rational Software Corporation 1997 Stock Option Plan.
4.18 Agreement among the Registrant, Rational, and International Business
Machines Corporation ("IBM"), dated December 15, 1993, is incorporated
by reference to Exhibit 4.17 filed with the Registrant's Registration
Statement on Form S-4, dated February 25, 1994 (Registration No. 33-
75724).
4.19 Preferred Stock Purchase Agreement between Rational and IBM, dated as
of November 29, 1989, is incorporated by reference to Exhibit 4.18
filed with the Registrant's Registration Statement on
Form S-4, dated February 25, 1994 (Registration No. 33-75724).
4.20 Agreement among the Registrant, Rational, Martin Marietta Investments,
Inc., and Martin Marietta Technologies, Inc., dated December 15, 1993,
is incorporated herein by reference to Exhibit 10.33 filed with the
Registrant's Registration Statement on Form S-4, dated February 25,
1994 (Registration No. 33-75724).
4.21 Stock Purchase Agreement between the Registrant and Martin Marietta
Corporation, dated March 8, 1985, is incorporated herein by reference
to Exhibit 4.1 filed with the Registrant's Form 8-K Current Report
dated March 8, 1985 (File No. 0-12167).
4.22 Letter Agreement among the Registrant, Martin Marietta Corporation,
and Martin Marietta Investments, Inc., dated June 2, 1987, is
incorporated herein by reference to Exhibit 4.1 filed with the
Registrant's Form 8-K Current Report dated June 2, 1987 (File No. 0-
12167).
5.01 Opinion of Wilson Sonsini Goodrich & Rosati, P.C., regarding the
legality of securities being registered.
5.02 Tax Opinion of Wilson Sonsini Goodrich & Rosati, P.C., dated January
, 1997.
5.03 Tax Opinion of Testa, Hurwitz & Thibeault, LLP, dated January ,
1997.
10.01 *Agreement for Purchase and Sale of Assets between the Registrant and
Microsoft Corporation, dated October 2, 1996, is incorporated herein
by reference to Exhibit 1 filed with the Registrant's Form 8-K Current
Report dated October 2, 1996 as amended by Exhibit 1 filed with the
Registrant's Form 8-K/A Current Report dated October 16, 1996.
10.02 *Development and License Agreement between the Registrant and
Microsoft Corporation, dated September 24, 1996, is incorporated
herein by reference to Exhibit 2 filed with the Registrant's
Form 8-K Current Report dated October 2, 1996 as amended by Exhibit 2
filed with the Registrant's Form 8-K/A Current Report dated October
16, 1996.
11.01 Statement of computation of the Registrant's per share earnings is
incorporated by reference to the Registrant's Form 10-K for the fiscal
year ended March 31, 1996.
21.01 Subsidiaries of the Registrant, incorporated by reference to the
Registrant's Form 10-K for the fiscal year ended March 31, 1996.
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DOCUMENT DESCRIPTION
------- --------------------
<C> <S>
23.01 Consent of Ernst & Young LLP.
23.02 Consent of Arthur Andersen LLP.
23.03 Consents of Wilson Sonsini Goodrich & Rosati, P.C. (see Exhibits 5.01
and 5.02, above).
23.04 Consent of Testa, Hurwitz & Thibeault, LLP (see Exhibit 5.03 above).
24.01 Power of Attorney is contained on the signature pages of this
Registration Statement.
99.1 Rational Stockholder Letter, dated January , 1997.
99.2 SQA Stockholder Letter, dated January , 1997.
99.3 Rational Notice of Special Meeting of Stockholders, dated January ,
1997.
99.4 SQA Notice of Special Meeting of Stockholders, Dated January , 1997.
99.5 Rational Form of Proxy.
99.6 SQA Form of Proxy.
</TABLE>
- --------
* Confidential Treatment Requested.
<PAGE>
EXHIBIT 4.17
RATIONAL SOFTWARE CORPORATION
1997 STOCK OPTION PLAN
1. Purposes of the Plan. The purposes of this Stock Plan are:
--------------------
. to attract and retain the best available personnel for positions
of substantial responsibility,
. to provide additional incentive to Employees, Directors and
Consultants, and
. to promote the success of the Company's business.
Options granted under the Plan may be Incentive Stock Options or
Nonstatutory Stock Options, as determined by the Administrator at the time of
grant. Stock Purchase Rights may also be granted under the Plan.
2. Definitions. As used herein, the following definitions shall apply:
-----------
(a) "Administrator" means the Board or any of its Committees as
-------------
shall be administering the Plan, in accordance with Section 4 of the Plan.
(b) "Applicable Laws" means the requirements relating to the
---------------
administration of stock option plans under U. S. state corporate laws, U.S.
federal and state securities laws, the Code, any stock exchange or quotation
system on which the Common Stock is listed or quoted and the applicable laws of
any foreign country or jurisdiction where Options or Stock Purchase Rights are,
or will be, granted under the Plan.
(c) "Board" means the Board of Directors of the Company.
-----
(d) "Code" means the Internal Revenue Code of 1986, as amended.
----
(e) "Committee" means a committee of Directors appointed by the Board
---------
in accordance with Section 4 of the Plan.
(f) "Common Stock" means the common stock of the Company.
------------
(g) "Company" means Rational Software Corporation, a Delaware
-------
corporation.
(h) "Consultant" means any person, including an advisor, engaged by
----------
the Company or a Parent or Subsidiary to render services to such entity.
(i) "Director" means a member of the Board.
--------
<PAGE>
(j) "Disability" means total and permanent disability as defined in
----------
Section 22(e)(3) of the Code.
(k) "Employee" means any person, including Officers and Directors,
--------
employed by the Company or any Parent or Subsidiary of the Company. A Service
Provider shall not cease to be an Employee in the case of (i) any leave of
absence approved by the Company or (ii) transfers between locations of the
Company or between the Company, its Parent, any Subsidiary, or any successor.
For purposes of Incentive Stock Options, no such leave may exceed ninety days,
unless reemployment upon expiration of such leave is guaranteed by statute or
contract. If reemployment upon expiration of a leave of absence approved by the
Company is not so guaranteed, on the 181st day of such leave any Incentive Stock
Option held by the Optionee shall cease to be treated as an Incentive Stock
Option and shall be treated for tax purposes as a Nonstatutory Stock Option.
Neither service as a Director nor payment of a director's fee by the Company
shall be sufficient to constitute "employment" by the Company.
(l) "Exchange Act" means the Securities Exchange Act of 1934, as
------------
amended.
(m) "Fair Market Value" means, as of any date, the value of Common
-----------------
Stock determined as follows:
(i) If the Common Stock is listed on any established stock
exchange or a national market system, including without limitation the Nasdaq
National Market or The Nasdaq SmallCap Market of The Nasdaq Stock Market, its
Fair Market Value shall be the closing sales price for such stock (or the
closing bid, if no sales were reported) as quoted on such exchange or system
for the last market trading day prior to the time of determination, as
reported in The Wall Street Journal or such other source as the Administrator
deems reliable;
(ii) If the Common Stock is regularly quoted by a recognized
securities dealer but selling prices are not reported, the Fair Market Value
of a Share of Common Stock shall be the mean between the high bid and low
asked prices for the Common Stock on the last market trading day prior to the
day of determination, as reported in The Wall Street Journal or such other
source as the Administrator deems reliable; or
(iii) In the absence of an established market for the Common
Stock, the Fair Market Value shall be determined in good faith by the
Administrator.
(n) "Incentive Stock Option" means an Option intended to qualify as an
----------------------
incentive stock option within the meaning of Section 422 of the Code and the
regulations promulgated thereunder.
(o) "Nonstatutory Stock Option" means an Option not intended to
-------------------------
qualify as an Incentive Stock Option.
-2-
<PAGE>
(p) "Notice of Grant" means a written or electronic notice evidencing
---------------
certain terms and conditions of an individual Option or Stock Purchase Right
grant. The Notice of Grant is part of the Option Agreement.
(q) "Officer" means a person who is an officer of the Company within
------
the meaning of Section 16 of the Exchange Act and the rules and regulations
promulgated thereunder.
(r) "Option" means a stock option granted pursuant to the Plan.
------
(s) "Option Agreement" means an agreement between the Company and an
----------------
Optionee evidencing the terms and conditions of an individual Option grant. The
Option Agreement is subject to the terms and conditions of the Plan.
(t) "Option Exchange Program" means a program whereby outstanding
-----------------------
Options are surrendered in exchange for Options with a lower exercise price.
(u) "Optioned Stock" means the Common Stock subject to an Option or
--------------
Stock Purchase Right.
(v) "Optionee" means the holder of an outstanding Option or Stock
--------
Purchase Right granted under the Plan.
(w) "Parent" means a "parent corporation," whether now or hereafter
------
existing, as defined in Section 424(e) of the Code.
(x) "Plan" means this 1997 Stock Option Plan.
----
(y) "Restricted Stock" means shares of Common Stock acquired
----------------
pursuant to a grant of Stock Purchase Rights under Section 11 of the Plan.
(z) "Restricted Stock Purchase Agreement" means a written agreement
-----------------------------------
between the Company and the Optionee evidencing the terms and restrictions
applying to stock purchased under a Stock Purchase Right. The Restricted Stock
Purchase Agreement is subject to the terms and conditions of the Plan and the
Notice of Grant.
(aa) "Rule 16b-3" means Rule 16b-3 of the Exchange Act or any
----------
successor to Rule 16b-3, as in effect when discretion is being exercised with
respect to the Plan.
(bb) "Section 16(b)" means Section 16(b) of the Exchange Act.
-------------
(cc) "Service Provider" means an Employee, Director or Consultant.
----------------
-3-
<PAGE>
(dd) "Share" means a share of the Common Stock, as adjusted in
-----
accordance with Section 13 of the Plan.
(ee) "Stock Purchase Right" means the right to purchase Common Stock
--------------------
pursuant to Section 11 of the Plan, as evidenced by a Notice of Grant.
(ff) "Subsidiary" means a "subsidiary corporation", whether now or
----------
hereafter existing, as defined in Section 424(f) of the Code.
3. Stock Subject to the Plan. Subject to the provisions of Section 13 of
-------------------------
the Plan, the maximum aggregate number of Shares which may be optioned and sold
under the Plan is 1,000,000 Shares, plus any shares under stock options plans
(exclusive of the Stock Option Plan for Directors) adopted prior to the date
of stockholder approval hereof for which no options to purchase were
outstanding. The Shares may be authorized, but unissued, or reacquired Common
Stock.
If an Option or Stock Purchase Right expires or becomes unexercisable
without having been exercised in full, or is surrendered pursuant to an Option
Exchange Program, the unpurchased Shares which were subject thereto shall become
available for future grant or sale under the Plan (unless the Plan has
terminated); provided, however, that Shares that have actually been issued under
--------
the Plan, whether upon exercise of an Option or Right, shall not be returned to
the Plan and shall not become available for future distribution under the Plan,
except that if Shares of Restricted Stock are repurchased by the Company at
their original purchase price, such Shares shall become available for future
grant under the Plan.
4. Administration of the Plan.
--------------------------
(a) Procedure.
---------
(i) Multiple Administrative Bodies. The Plan may be
------------------------------
administered by different Committees with respect to different groups of
Service Providers.
(ii) Section 162(m). To the extent that the Administrator
--------------
determines it to be desirable to qualify Options granted hereunder as
"performance-based compensation" within the meaning of Section 162(m) of the
Code, the Plan shall be administered by a Committee of two or more "outside
directors" within the meaning of Section 162(m) of the Code.
(iii) Rule 16b-3. To the extent desirable to qualify
----------
transactions hereunder as exempt under Rule 16b-3, the transactions
contemplated hereunder shall be structured to satisfy the requirements for
exemption under Rule 16b-3.
(iv) Other Administration. Other than as provided above, the
--------------------
Plan shall be administered by (A) the Board or (B) a Committee, which
committee shall be constituted to satisfy Applicable Laws.
-4-
<PAGE>
(b) Powers of the Administrator. Subject to the provisions of the
---------------------------
Plan, and in the case of a Committee, subject to the specific duties delegated
by the Board to such Committee, the Administrator shall have the authority, in
its discretion:
(i) to determine the Fair Market Value;
(ii) to select the Service Providers to whom Options and Stock
Purchase Rights may be granted hereunder;
(iii) to determine the number of shares of Common Stock to be
covered by each Option and Stock Purchase Right granted hereunder;
(iv) to approve forms of agreement for use under the Plan;
(v) to determine the terms and conditions, not inconsistent
with the terms of the Plan, of any Option or Stock Purchase Right granted
hereunder. Such terms and conditions include, but are not limited to, the
exercise price, the time or times when Options or Stock Purchase Rights may be
exercised (which may be based on performance criteria), any vesting
acceleration or waiver of forfeiture restrictions, and any restriction or
limitation regarding any Option or Stock Purchase Right of the shares of
Common Stock relating thereto, based in each case on such factors as the
Administrator, in its sole discretion, shall determine;
(vi) to reduce the exercise price of any Option or Stock
Purchase Right to the then current Fair Market Value if the Fair Market Value
of the Common Stock covered by such Option or Stock Purchase Right shall have
declined since the date the Option or Stock Purchase Right was granted;
(vii) to institute an Option Exchange Program;
(viii) to construe and interpret the terms of the Plan and awards
granted pursuant to the Plan;
(ix) to prescribe, amend and rescind rules and regulations
relating to the Plan, including rules and regulations relating to sub-plans
established for the purpose of qualifying for preferred tax treatment under
foreign tax laws;
(x) to modify or amend each Option or Stock Purchase Right
(subject to Section 15(c) of the Plan), including the discretionary authority
to extend the post-termination exercisability period of Options longer than is
otherwise provided for in the Plan;
(xi) to allow Optionees to satisfy withholding tax obligations
by electing to have the Company withhold from the Shares to be issued upon
exercise of an Option or Stock Purchase Right that number of Shares having a
Fair Market Value equal to the amount required to be
-5-
<PAGE>
withheld. The Fair Market Value of the Shares to be withheld shall be
determined on the date that the amount of tax to be withheld is to be
determined. All elections by an Optionee to have Shares withheld for this
purpose shall be made in such form and under such conditions as the
Administrator may deem necessary or advisable;
(xii) to authorize any person to execute on behalf of the
Company any instrument required to effect the grant of an Option or Stock
Purchase Right previously granted by the Administrator;
(xiii) to make all other determinations deemed necessary or
advisable for administering the Plan.
(c) Effect of Administrator's Decision. The Administrator's
----------------------------------
decisions, determinations and interpretations shall be final and binding on
all Optionees and any other holders of Options or Stock Purchase Rights.
5. Eligibility. Nonstatutory Stock Options and Stock Purchase Rights may
-----------
be granted to Service Providers. Incentive Stock Options may be granted only to
Employees.
6. Limitations.
-----------
(a) Each Option shall be designated in the Option Agreement as
either an Incentive Stock Option or a Nonstatutory Stock Option. However,
notwithstanding such designation, to the extent that the aggregate Fair Market
Value of the Shares with respect to which Incentive Stock Options are
exercisable for the first time by the Optionee during any calendar year (under
all plans of the Company and any Parent or Subsidiary) exceeds $100,000, such
Options shall be treated as Nonstatutory Stock Options. For purposes of this
Section 6(a), Incentive Stock Options shall be taken into account in the order
in which they were granted. The Fair Market Value of the Shares shall be
determined as of the time the Option with respect to such Shares is granted.
(b) Neither the Plan nor any Option or Stock Purchase Right shall
confer upon an Optionee any right with respect to continuing the Optionee's
relationship as a Service Provider with the Company, nor shall they interfere
in any way with the Optionee's right or the Company's right to terminate such
relationship at any time, with or without cause.
(c) The following limitations shall apply to grants of Options:
(i) No Service Provider shall be granted, in any fiscal year
of the Company, Options to purchase more than 500,000 Shares (as appropriately
adjusted pursuant to Section 13(a) ("Changes in Capitalization") hereof.
(ii) In connection with his or her initial service, a Service
Provider may be granted Options to purchase up to an additional 500,000 Shares
which shall not count against the
-6-
<PAGE>
limit set forth in subsection (i) above (as appropriately adjusted pursuant to
Section 13(a) ("Changes in Capitalization") hereof.
(iii) The foregoing limitations shall be adjusted
proportionately in connection with any change in the Company's capitalization
as described in Section 13.
(iv) If an Option is cancelled in the same fiscal year of the
Company in which it was granted (other than in connection with a transaction
described in Section 13), the cancelled Option will be counted against the
limits set forth in subsections (i) and (ii) above. For this purpose, if the
exercise price of an Option is reduced, the transaction will be treated as a
cancellation of the Option and the grant of a new Option.
7. Term of Plan. Subject to Section 19 of the Plan, the Plan shall
------------
become effective upon its adoption by the Board. It shall continue in effect
for a term of ten (10) years unless terminated earlier under Section 15 of the
Plan.
8. Term of Option. The term of each Option shall be stated in the Option
--------------
Agreement. In the case of an Incentive Stock Option, the term shall be ten (10)
years from the date of grant or such shorter term as may be provided in the
Option Agreement. Moreover, in the case of an Incentive Stock Option granted to
an Optionee who, at the time the Incentive Stock Option is granted, owns stock
representing more than ten percent (10%) of the total combined voting power of
all classes of stock of the Company or any Parent or Subsidiary, the term of the
Incentive Stock Option shall be five (5) years from the date of grant or such
shorter term as may be provided in the Option Agreement.
9. Option Exercise Price and Consideration.
---------------------------------------
(a) Exercise Price. The per share exercise price for the Shares to be
--------------
issued pursuant to exercise of an Option shall be determined by the
Administrator, subject to the following:
(i) In the case of an Incentive Stock Option
(A) granted to an Employee who, at the time the Incentive
Stock Option is granted, owns stock representing more than ten percent (10%)
of the voting power of all classes of stock of the Company or any Parent or
Subsidiary, the per Share exercise price shall be no less than 110% of the
Fair Market Value per Share on the date of grant.
(B) granted to any Employee other than an Employee
described in paragraph (A) immediately above, the per Share exercise price
shall be no less than 100% of the Fair Market Value per Share on the date of
grant.
(ii) In the case of a Nonstatutory Stock Option, the per Share
exercise price shall be determined by the Administrator. In the case of a
Nonstatutory Stock Option intended to
-7-
<PAGE>
qualify as "performance-based compensation" within the meaning of Section 162(m)
of the Code, the per Share exercise price shall be no less than 100% of the Fair
Market Value per Share on the date of grant.
(iii) Notwithstanding the foregoing, Options may be granted with
a per Share exercise price of less than 100% of the Fair Market Value per
Share on the date of grant pursuant to a merger or other corporate
transaction.
(b) Waiting Period and Exercise Dates. At the time an Option is
---------------------------------
granted, the Administrator shall fix the period within which the Option may be
exercised and shall determine any conditions which must be satisfied before
the Option may be exercised.
(c) Form of Consideration. The Administrator shall determine the
---------------------
acceptable form of consideration for exercising an Option, including the method
of payment. In the case of an Incentive Stock Option, the Administrator shall
determine the acceptable form of consideration at the time of grant. Such
consideration may consist entirely of:
(i) cash;
(ii) check;
(iii) promissory note;
(iv) other Shares which (A) in the case of Shares acquired
upon exercise of an option, have been owned by the Optionee for more than six
months on the date of surrender, and (B) have a Fair Market Value on the date
of surrender equal to the aggregate exercise price of the Shares as to which
said Option shall be exercised;
(v) consideration received by the Company under a cashless
exercise program implemented by the Company in connection with the Plan;
(vi) a reduction in the amount of any Company liability to the
Optionee, including any liability attributable to the Optionee's participation
in any Company-sponsored deferred compensation program or arrangement;
(vii) any combination of the foregoing methods of payment; or
(viii) such other consideration and method of payment for the
issuance of Shares to the extent permitted by Applicable Laws.
10. Exercise of Option.
------------------
-8-
<PAGE>
(a) Procedure for Exercise; Rights as a Shareholder. Any Option
-----------------------------------------------
granted hereunder shall be exercisable according to the terms of the Plan and
at such times and under such conditions as determined by the Administrator and
set forth in the Option Agreement. Unless the Administrator provides
otherwise, vesting of Options granted hereunder shall be tolled during any
unpaid leave of absence. An Option may not be exercised for a fraction of a
Share.
An Option shall be deemed exercised when the Company receives:
(i) written or electronic notice of exercise (in accordance with the Option
Agreement) from the person entitled to exercise the Option, and (ii) full
payment for the Shares with respect to which the Option is exercised. Full
payment may consist of any consideration and method of payment authorized by
the Administrator and permitted by the Option Agreement and the Plan. Shares
issued upon exercise of an Option shall be issued in the name of the Optionee
or, if requested by the Optionee, in the name of the Optionee and his or her
spouse. Until the Shares are issued (as evidenced by the appropriate entry on
the books of the Company or of a duly authorized transfer agent of the
Company), no right to vote or receive dividends or any other rights as a
shareholder shall exist with respect to the Optioned Stock, notwithstanding
the exercise of the Option. The Company shall issue (or cause to be issued)
such Shares promptly after the Option is exercised. No adjustment will be made
for a dividend or other right for which the record date is prior to the date
the Shares are issued, except as provided in Section 13 of the Plan.
Exercising an Option in any manner shall decrease the number of
Shares thereafter available, both for purposes of the Plan and for sale under
the Option, by the number of Shares as to which the Option is exercised.
(b) Termination of Relationship as a Service Provider. If an
-------------------------------------------------
Optionee ceases to be a Service Provider, other than upon the Optionee's death
or Disability, the Optionee may exercise his or her Option within such period
of time as is specified in the Option Agreement to the extent that the Option
is vested on the date of termination (but in no event later than the
expiration of the term of such Option as set forth in the Option Agreement).
In the absence of a specified time in the Option Agreement, the Option shall
remain exercisable for three (3) months following the Optionee's termination.
If, on the date of termination, the Optionee is not vested as to his or her
entire Option, the Shares covered by the unvested portion of the Option shall
revert to the Plan. If, after termination, the Optionee does not exercise his
or her Option within the time specified by the Administrator, the Option shall
terminate, and the Shares covered by such Option shall revert to the Plan.
(c) Disability of Optionee. If an Optionee ceases to be a Service
----------------------
Provider as a result of the Optionee's Disability, the Optionee may exercise his
or her Option within such period of time as is specified in the Option Agreement
to the extent the Option is vested on the date of termination (but in no event
later than the expiration of the term of such Option as set forth in the Option
Agreement). In the absence of a specified time in the Option Agreement, the
Option shall remain exercisable for twelve (12) months following the Optionee's
termination. If, on the date of termination, the Optionee is not vested as to
his or her entire Option, the Shares covered by the
-9-
<PAGE>
unvested portion of the Option shall revert to the Plan. If, after termination,
the Optionee does not exercise his or her Option within the time specified
herein, the Option shall terminate, and the Shares covered by such Option shall
revert to the Plan.
(d) Death of Optionee. If an Optionee dies while a Service
-----------------
Provider, the Option may be exercised within such period of time as is
specified in the Option Agreement (but in no event later than the expiration
of the term of such Option as set forth in the Notice of Grant), by the
Optionee's estate or by a person who acquires the right to exercise the Option
by bequest or inheritance, but only to the extent that the Option is vested on
the date of death. In the absence of a specified time in the Option Agreement,
the Option shall remain exercisable for twelve (12) months following the
Optionee's termination. If, at the time of death, the Optionee is not vested
as to his or her entire Option, the Shares covered by the unvested portion of
the Option shall immediately revert to the Plan. The Option may be exercised
by the executor or administrator of the Optionee's estate or, if none, by the
person(s) entitled to exercise the Option under the Optionee's will or the
laws of descent or distribution. If the Option is not so exercised within the
time specified herein, the Option shall terminate, and the Shares covered by
such Option shall revert to the Plan.
(e) Buyout Provisions. The Administrator may at any time offer to
-----------------
buy out for a payment in cash or Shares an Option previously granted based on
such terms and conditions as the Administrator shall establish and communicate
to the Optionee at the time that such offer is made.
11. Stock Purchase Rights.
---------------------
(a) Rights to Purchase. Stock Purchase Rights may be issued either
------------------
alone, in addition to, or in tandem with other awards granted under the Plan
and/or cash awards made outside of the Plan. After the Administrator
determines that it will offer Stock Purchase Rights under the Plan, it shall
advise the offeree in writing or electronically, by means of a Notice of
Grant, of the terms, conditions and restrictions related to the offer,
including the number of Shares that the offeree shall be entitled to purchase,
the price to be paid, and the time within which the offeree must accept such
offer. The offer shall be accepted by execution of a Restricted Stock Purchase
Agreement in the form determined by the Administrator.
(b) Repurchase Option. Unless the Administrator determines
-----------------
otherwise, the Restricted Stock Purchase Agreement shall grant the Company a
repurchase option exercisable upon the voluntary or involuntary termination of
the purchaser's service with the Company for any reason (including death or
Disability). The purchase price for Shares repurchased pursuant to the
Restricted Stock Purchase Agreement shall be the original price paid by the
purchaser and may be paid by cancellation of any indebtedness of the purchaser
to the Company. The repurchase option shall lapse at a rate determined by the
Administrator.
(c) Other Provisions. The Restricted Stock Purchase Agreement shall
----------------
contain such other terms, provisions and conditions not inconsistent with the
Plan as may be determined by the Administrator in its sole discretion.
-10-
<PAGE>
(d) Rights as a Shareholder. Once the Stock Purchase Right is
-----------------------
exercised, the purchaser shall have the rights equivalent to those of a
shareholder, and shall be a shareholder when his or her purchase is entered
upon the records of the duly authorized transfer agent of the Company. No
adjustment will be made for a dividend or other right for which the record
date is prior to the date the Stock Purchase Right is exercised, except as
provided in Section 13 of the Plan.
12. Non-Transferability of Options and Stock Purchase Rights. Unless
--------------------------------------------------------
determined otherwise by the Administrator, an Option or Stock Purchase Right may
not be sold, pledged, assigned, hypothecated, transferred, or disposed of in any
manner other than by will or by the laws of descent or distribution and may be
exercised, during the lifetime of the Optionee, only by the Optionee. If the
Administrator makes an Option or Stock Purchase Right transferable, such Option
or Stock Purchase Right shall contain such additional terms and conditions as
the Administrator deems appropriate.
13. Adjustments Upon Changes in Capitalization, Dissolution, Merger or
------------------------------------------------------------------
Asset Sale.
----------
(a) Changes in Capitalization. Subject to any required action by the
-------------------------
shareholders of the Company, the number of shares of Common Stock covered by
each outstanding Option and Stock Purchase Right, and the number of shares of
Common Stock which have been authorized for issuance under the Plan but as to
which no Options or Stock Purchase Rights have yet been granted or which have
been returned to the Plan upon cancellation or expiration of an Option or Stock
Purchase Right, as well as the price per share of Common Stock covered by each
such outstanding Option or Stock Purchase Right and the limitations on issuance
as set forth in Sections 6(c)(i) and 6(c)(ii) hereof, shall be proportionately
adjusted for any increase or decrease in the number of issued shares of Common
Stock resulting from a stock split, reverse stock split, stock dividend,
combination or reclassification of the Common Stock, or any other increase or
decrease in the number of issued shares of Common Stock effected without receipt
of consideration by the Company; provided, however, that conversion of any
convertible securities of the Company shall not be deemed to have been "effected
without receipt of consideration." Such adjustment shall be made by the Board,
whose determination in that respect shall be final, binding and conclusive.
Except as expressly provided herein, no issuance by the Company of shares of
stock of any class, or securities convertible into shares of stock of any class,
shall affect, and no adjustment by reason thereof shall be made with respect to,
the number or price of shares of Common Stock subject to an Option or Stock
Purchase Right.
(b) Dissolution or Liquidation. In the event of the proposed
--------------------------
dissolution or liquidation of the Company, the Administrator shall notify each
Optionee as soon as practicable prior to the effective date of such proposed
transaction. The Administrator in its discretion may provide for an Optionee
to have the right to exercise his or her Option until ten (10) days prior to
such transaction as to all of the Optioned Stock covered thereby, including
Shares as to which the Option would not otherwise be exercisable. In addition,
the Administrator may provide that any Company repurchase option applicable to
any Shares purchased upon exercise of an Option or Stock Purchase Right shall
lapse as to all such Shares, provided the proposed dissolution or
-11-
<PAGE>
liquidation takes place at the time and in the manner contemplated. To the
extent it has not been previously exercised, an Option or Stock Purchase Right
will terminate immediately prior to the consummation of such proposed action.
(c) Merger or Asset Sale. In the event of a merger of the Company
--------------------
with or into another corporation, or the sale of substantially all of the
assets of the Company, each outstanding Option and Stock Purchase Right shall
be assumed or an equivalent option or right substituted by the successor
corporation or a Parent or Subsidiary of the successor corporation. In the
event that the successor corporation refuses to assume or substitute for the
Option or Stock Purchase Right, the Optionee shall fully vest in and have the
right to exercise the Option or Stock Purchase Right as to all of the Optioned
Stock, including Shares as to which it would not otherwise be vested or
exercisable. If an Option or Stock Purchase Right becomes fully vested and
exercisable in lieu of assumption or substitution in the event of a merger or
sale of assets, the Administrator shall notify the Optionee in writing or
electronically that the Option or Stock Purchase Right shall be fully vested
and exercisable for a period of fifteen (15) days from the date of such
notice, and the Option or Stock Purchase Right shall terminate upon the
expiration of such period. For the purposes of this paragraph, the Option or
Stock Purchase Right shall be considered assumed if, following the merger or
sale of assets, the option or right confers the right to purchase or receive,
for each Share of Optioned Stock subject to the Option or Stock Purchase Right
immediately prior to the merger or sale of assets, the consideration (whether
stock, cash, or other securities or property) received in the merger or sale
of assets by holders of Common Stock for each Share held on the effective date
of the transaction (and if holders were offered a choice of consideration, the
type of consideration chosen by the holders of a majority of the outstanding
Shares); provided, however, that if such consideration received in the merger
or sale of assets is not solely common stock of the successor corporation or
its Parent, the Administrator may, with the consent of the successor
corporation, provide for the consideration to be received upon the exercise of
the Option or Stock Purchase Right, for each Share of Optioned Stock subject
to the Option or Stock Purchase Right, to be solely common stock of the
successor corporation or its Parent equal in fair market value to the per
share consideration received by holders of Common Stock in the merger or sale
of assets.
14. Date of Grant. The date of grant of an Option or Stock Purchase Right
-------------
shall be, for all purposes, the date on which the Administrator makes the
determination granting such Option or Stock Purchase Right, or such other later
date as is determined by the Administrator. Notice of the determination shall
be provided to each Optionee within a reasonable time after the date of such
grant.
15. Amendment and Termination of the Plan.
-------------------------------------
(a) Amendment and Termination. The Board may at any time amend,
-------------------------
alter, suspend or terminate the Plan.
(b) Shareholder Approval. The Company shall obtain shareholder
--------------------
approval of any Plan amendment to the extent necessary and desirable to comply
with Applicable Laws.
-12-
<PAGE>
(c) Effect of Amendment or Termination. No amendment, alteration,
----------------------------------
suspension or termination of the Plan shall impair the rights of any Optionee,
unless mutually agreed otherwise between the Optionee and the Administrator,
which agreement must be in writing and signed by the Optionee and the Company.
Termination of the Plan shall not affect the Administrator's ability to exercise
the powers granted to it hereunder with respect to Options granted under the
Plan prior to the date of such termination.
16. Conditions Upon Issuance of Shares.
----------------------------------
(a) Legal Compliance. Shares shall not be issued pursuant to the
----------------
exercise of an Option or Stock Purchase Right unless the exercise of such
Option or Stock Purchase Right and the issuance and delivery of such Shares
shall comply with Applicable Laws and shall be further subject to the approval
of counsel for the Company with respect to such compliance.
(b) Investment Representations. As a condition to the exercise of an
--------------------------
Option or Stock Purchase Right, the Company may require the person exercising
such Option or Stock Purchase Right to represent and warrant at the time of any
such exercise that the Shares are being purchased only for investment and
without any present intention to sell or distribute such Shares if, in the
opinion of counsel for the Company, such a representation is required.
17. Inability to Obtain Authority. The inability of the Company to obtain
-----------------------------
authority from any regulatory body having jurisdiction, which authority is
deemed by the Company's counsel to be necessary to the lawful issuance and sale
of any Shares hereunder, shall relieve the Company of any liability in respect
of the failure to issue or sell such Shares as to which such requisite authority
shall not have been obtained.
18. Reservation of Shares. The Company, during the term of this Plan,
---------------------
will at all times reserve and keep available such number of Shares as shall be
sufficient to satisfy the requirements of the Plan.
19. Shareholder Approval. The Plan shall be subject to approval by the
--------------------
shareholders of the Company within twelve (12) months after the date the Plan is
adopted. Such shareholder approval shall be obtained in the manner and to the
degree required under Applicable Laws.
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<PAGE>
EXHIBIT 5.01
FORM OF OPINION OF WSGR
January 10, 1997
Rational Software Corporation
2800 San Tomas Expressway
Santa Clara, CA 95051
RE: REGISTRATION STATEMENT ON FORM S-4
----------------------------------
Gentlemen:
We have examined the Registration Statement on Form S-4 to be filed by
you with the Securities and Exchange Commission on or about this date (the
"Registration Statement"), in connection with the registration under the
Securities Act of 1933, as amended, of 7,273,000 shares of your Common Stock
(the "Shares"), all of which are authorized but heretofore unissued. The
shares are to be exchanged for exhisting shares of SQA, Inc. Common Stock as
described in the Registration Statement and pursuant to the Agreement and Plan
of Reorganization by and among Rational Software Corporation, Sunshine
Acquisition Corp. and SQA, Inc. (the "Agreement") filed as an exhibit thereto.
As your counsel, we have examined the proceedings proposed to be taken in
connection with said sale and issuance of the Shares.
It is our opinion that, upon completion of the proceedings being taken
or contemplated by us, as your counsel, to be taken prior to the issuance of
the Shares, and upon completion of the proceedings being taken in order to
permit such transactions to be carried out in accordance with the securities
laws of the various states, where required, the shares when issued and sold
in the manner referred to in the Registration Statement will be legally and
validly issued, fully paid and nonassessable.
We consent to the use of this opinion as an exhibit to the
Registration Statement, and further consent to the use of our name wherever
appearing in the Registration Statement, including the Prospectus constituting
a part thereof, and any amendment thereto.
Very truly yours,
WILSON, SONSINI, GOODRICH & ROSATI
Professional Corporation
/s/ Wilson Sonsini Goodrich & Rosati
<PAGE>
EXHIBIT 5.02
FORM OF WSGR TAX OPINION
January , 1997
Rational Software Corporation
2800 San Tomas Expressway
Santa Clara, CA 95051
Ladies and Gentlemen:
We have acted as counsel for Rational Software Corporation, a Delaware
corporation ("Rational") in connection with the preparation and execution of
the Agreement and Plan of Reorganization dated as of November 12, 1996 (the
"Reorganization Agreement") among Rational, Sunshine Acquisition Corporation,
a wholly-owned subsidiary of Rational incorporated in Delaware ("Merger Sub"),
and SQA, Inc., a Delaware corporation ("SQA"). Pursuant to the Reorganization
Agreement, Merger Sub will merge with and into SQA (the "Merger"), and SQA
will become a wholly-owned subsidiary of Rational. Unless otherwise defined,
capitalized terms referred to herein have the meanings set forth in the
Reorganization Agreement. All section references, unless otherwise indicated,
are to the Internal Revenue Code of 1986, as amended (the "Code").
You have requested our opinion regarding certain United States federal
income tax consequences of the Merger. In delivering this opinion, we have
reviewed and relied upon the facts, statements, descriptions and
representations set forth in the Registration Statement on Form S-4 filed by
Rational with the Securities and Exchange Commission (which contains a joint
proxy statement/prospectus) (the "Registration Statement"), the Reorganization
Agreement (including Exhibits) and such other documents pertaining to the
Merger as we have deemed necessary or appropriate. We have also relied upon
certificates of officers of Rational and SQA respectively (the "Officers'
Certificates").
In connection with rendering this opinion, we have also assumed (without any
independent investigation) that:
1. Original documents (including signatures) are authentic, documents
submitted to us as copies conform to the original documents, and there has
been (or will be by the Effective Time) due execution and delivery of all
documents where due execution and delivery are prerequisites to
effectiveness thereof;
2. Any statement made in any of the documents referred to herein, "to the
best of the knowledge" of any person or party is correct without such
qualification;
3. All statements, descriptions and representations contained in any of
the documents referred to herein or otherwise made to us are true and
correct in all material respects and no actions have been (or will be)
taken which are inconsistent with such representations;
4. The Merger will be reported by Rational and SQA on their respective
federal income tax returns in a manner consistent with the opinion set
forth below; and
5. The shareholders of SQA do not, and will not on or before the
Effective Time, have an existing plan or intent to dispose of an amount of
Rational Common Stock to be received in the Merger (or to dispose of SQA
capital stock in anticipation of the Merger) such that the shareholders of
SQA will not receive and retain a meaningful continuing equity ownership in
Rational that is sufficient to satisfy the continuity of interest
requirement as specificed in Treasury Regulation Section 1.368-1(b) and as
interpreted in certain Internal Revenue Service rulings and federal
judicial decisions.
<PAGE>
Rational Software Corporation
January , 1997
Page 2
Based on our examination of the foregoing items and subject to the
assumptions, exceptions, limitations and qualifications set forth herein, we
are of the opinion that, if the Merger is consummated in accordance with the
Reorganization Agreement (and without any waiver, breach or amendment of any
of the provisions thereof) and the statements set forth in the Officers'
Certificates are true and correct as of the date hereof, then:
(a) For federal income tax purposes, the Merger will qualify as a
"reorganization" as defined in Section 368(a) of the Code; and
(b) The discussion entitled "Certain Federal Income Tax Considerations"
in the Prospectus constituting a part of the Registration Statement insofar
as it relates to the statements of law or legal conclusions is correct in
all material respects.
This opinion represents and is based upon our best judgment regarding the
application of federal income tax laws arising under the Code, existing
judicial decisions, administrative regulations and published rules and
procedures. Our opinion is not binding upon the Internal Revenue Service or
the courts, and there is no assurance that the Internal Revenue Service will
not successfully assert a contrary position. Furthermore, no assurance can be
given that future legislative, judicial or administrative changes, on either a
prospective or retroactive basis, would not adversely affect the accuracy of
the conclusions stated herein. Nevertheless, we undertake no responsibility to
advise you of any new developments in the application or interpretation of the
federal income tax laws.
This opinion addressed only the matters set forth above, and does not
address any other federal, state, local or foreign tax consequences that may
result from the Merger or any other transaction (including any transaction
undertaken in connection with the Merger).
No opinion is expressed as to any transaction other than the Merger as
described in the Reorganization Agreement or to any transaction whatsoever,
including the Merger, if all the transactions described in the Reorganization
Agreement are not consummated in accordance with the terms of such
Reorganization Agreement and without waiver or breach of any material
provision thereof or if all of the representations, warranties, statements and
assumptions upon which we relied are not true and accurate at all relevant
times. In the event any one of the statements, representations, warranties or
assumptions upon which we have relied to issue this opinion is incorrect, our
opinion might be adversely affected and may not be relied upon.
This opinion has been delivered to you for the purposes of being included as
an exhibit to the Registration Statement and satisfying the requirements of
Section 6.1(e) of the Reorganization Agreement. We hereby consent to the
filing of this opinion as an exhibit to the Registration Statement and to the
use of our name under the heading "Certain Federal Income Tax Considerations"
in the Registration Statement.
Very truly yours,
WILSON SONSINI GOODRICH & ROSATI
Professional Corporation
<PAGE>
EXHIBIT 5.03
------------
TESTA, HURWITZ & THIBEAULT, LLP
FORM OF OPINION/DRAFT DATED: January 10, 1997
----------------
[DATE]
SQA, Inc.
One Burlington Woods Drive
Burlington, MA 01803
Dear Ladies and Gentlemen:
We have acted as counsel for SQA, Inc., a Delaware corporation ("SQA")
in connection with the preparation and execution of the Agreement and Plan of
Reorganization, dated as of November 12, 1996 (the "Reorganization Agreement"),
among SQA, Rational Software Corporation, a Delaware corporation ("Rational"),
and Sunshine Acquisition Corporation, a wholly-owned subsidiary of Rational
incorporated in Delaware ("Merger Sub"). Pursuant to the Reorganization
Agreement, Merger Sub will merge with and into SQA (the "Merger"), and SQA will
become a wholly-owned subsidiary of Rational. Unless otherwise defined,
capitalized terms referred to herein have the meanings set forth in the
Reorganization Agreement. All section references, unless otherwise indicated,
are to the Internal Revenue Code of 1986, as amended (the "Code").
You have requested our opinion regarding certain United States federal
income tax consequences of the Merger. In delivering this opinion, we have
reviewed and relied upon the facts, statements, descriptions and representations
set forth in the Registration Statement on Form S-4 filed by Rational with the
Securities and Exchange Commission (which contains a joint proxy
statement/prospectus) (the "Registration Statement"), the Reorganization
Agreement (including Exhibits) and such other documents pertaining to the Merger
as we have deemed necessary or appropriate. We have also relied upon
certificates of officers of SQA and Rational respectively (the "Officers'
Certificates").
In connection with rendering this opinion, we have also assumed (without
any independent investigation) that:
1. Original documents (including signatures) are authentic,
documents submitted to us as copies conform to the original documents, and there
has been (or will be by the Effective Time) due execution and delivery of all
documents where due execution and delivery are prerequisites to effectiveness
thereof;
2. Any statement made in any of the documents referred to herein,
"to the best of the knowledge" of any person or party is correct without such
qualification;
<PAGE>
SQA, Inc.
[Date]
Page 2
3. All statements, descriptions and representations contained in
any of the documents referred to herein or otherwise made to us are true and
correct in all material respects and no actions have been (or will be) taken
which are inconsistent with such representations;
4. The Merger will be reported by Rational and SQA on their
respective federal income tax returns in a manner consistent with the opinion
set forth below;
5. The shareholders of SQA do not, and will not on or before the
Effective Time, have an existing plan or intent to dispose of an amount of
Rational Common Stock to be received in the Merger (or to dispose of SQA capital
stock in anticipation of the Merger) such that the shareholders of SQA will not
receive and retain a meaningful continuing equity ownership in Rational that is
sufficient to satisfy the continuity of interest requirement as specified in
Treas. Reg. (S)1.368-1(b) and as interpreted in certain Internal Revenue Service
rulings and federal judicial decisions.
Based on our examination of the foregoing items and subject to the
assumptions, exceptions, limitations and qualifications set forth herein, we are
of the opinion that, if the Merger is consummated in accordance with the
Reorganization Agreement (and without any waiver, breach or amendment of any of
the provisions thereof) and the statements set forth in the Officers'
Certificates are true and correct as of the date hereof, then:
(a) For federal income tax purposes, the Merger will qualify
as a "reorganization" as defined in Section 368(a) of the Code; and
(b) The discussion entitled "Certain Federal Income Tax
Considerations" in the Prospectus constituting a part of the Registration
Statement insofar as it relates to the statements of law or legal conclusions
set forth therein is correct in all material respects.
This opinion represents and is based upon our best judgment regarding
the application of federal income tax laws arising under the Code, existing
judicial decisions, administrative regulations and published rulings and
procedures. Our opinion is not binding upon the Internal Revenue Service or the
courts, and there is no assurance that the Internal Revenue Service will not
successfully assert a contrary position. Furthermore, no assurance can be given
that future legislative, judicial or administrative changes, on either a
prospective or retroactive basis, would not adversely affect the accuracy of the
conclusions stated herein. Nevertheless, we undertake no responsibility to
advise you of any new developments in the application or interpretation of the
federal income tax laws.
This opinion addresses only the matters set forth above, and does not
address any other federal, state, local or foreign tax consequences that may
result from the Merger or any other transaction (including any transaction
undertaken in connection with he Merger).
No opinion is expressed as to any transaction other than the Merger as
described in the Reorganization Agreement or to any transaction whatsoever,
including the Merger, if all the transactions described in the Reorganization
Agreement are not consummated in accordance with the terms of the Reorganization
Agreement and without waiver or breach of any material
<PAGE>
SQA, Inc.
[Date]
Page 3
provision thereof or if all of the representation, warranties, statements and
assumptions upon which we relied are not true and accurate at all relevant
times. In the event any one of the statements, representations, warranties or
assumptions upon which we have relied to issue this opinion is incorrect, our
opinion might be adversely affected and may not be relied upon.
This opinion has been delivered to you for the purposes of being
included as an exhibit to the Registration Statement and satisfying the
requirements of Section 6.1(e) of the Reorganization Agreement. We hereby
consent to the filing of this opinion as an exhibit to the Registration
Statement and to the use of our name under the heading "Certain Federal Income
Tax Considerations" in the Registration Statement.
Very truly yours,
TESTA, HURWITZ & THIBEAULT, LLP
<PAGE>
EXHIBIT 23.01
CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
We consent to the reference to our firm under the caption"Experts" and to the
use of our report dated April 22, 1996, included in the Joint Proxy/Prospectus
of Rational Software Corporation that is made a part of the Registration
Statement (Form S-4) and Prospectus of Rational Software Corporation for the
registration of up to 7,273,000 shares of its common stock.
/s/ Ernst & Young LLP
San Jose, California
January 10, 1997
<PAGE>
EXHIBIT 23.02
CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS
As independent public accountants, we hereby consent to the use of our
reports and to all references to our Firm included in or made a part of this
registration statement.
/s/ ARTHUR ANDERSEN LLP
Arthur Andersen LLP
January 10, 1997
Boston, Massachusetts
<PAGE>
EXHIBIT 99.1
[RATIONAL LOGO]
January , 1997
Dear Stockholder:
As most of you are aware, Rational Software Corporation ("Rational") has
entered into an agreement providing for the merger of SQA, Inc. ("SQA") with
Rational in a strategic business combination (the "Merger"). At our Special
Meeting on February 26, 1997, you will be asked to consider and vote upon the
issuance of shares of the Common Stock, par value $0.01 per share, of Rational
(the "Rational Common Stock," and the "Combined Company Common Stock"
immediately following the Merger) to the stockholders of SQA pursuant to an
Agreement and Plan of Reorganization, dated November 12, 1996 (the
"Agreement"), among Rational, SQA and Sunshine Acquisition Corp., a wholly
owned subsidiary of Rational ("Merger Sub").
In the Merger, Merger Sub will be merged with and into SQA, which will be
the surviving corporation and will become a wholly owned subsidiary of
Rational. Pursuant to the Merger, each outstanding share of Common Stock, par
value $0.01 per share, of SQA (the "SQA Common Stock") will be converted into
the right to receive 0.86 (the "Exchange Ratio") shares of Rational Common
Stock, and each outstanding option or right to purchase SQA Common Stock under
the SQA stock option plans, the SQA stock purchase plan or outstanding
warrants will be assumed by Rational and will become an option or right to
purchase Combined Company Common Stock, with appropriate adjustments to be
made to the number of shares issuable thereunder and the exercise price
thereof based on the Exchange Ratio. The shares of Rational Common Stock held
by Rational stockholders immediately prior to the Merger will remain unchanged
by the Merger. It is expected that SQA stockholders will receive approximately
7.0 million shares of Rational Common Stock in the Merger, and another
approximately 2.0 million shares of Combined Company Common Stock will be
reserved for issuance pursuant to options, warrants and rights to purchase SQA
Common Stock outstanding immediately prior to the Merger. Upon the
consummation of the Merger, Ronald H. Nordin, currently the President and
Chief Executive Officer of SQA, will be employed by Rational and will join the
existing Rational Board of Directors. The proposal relating to the Merger is
described more fully in the accompanying Notice of Special Meeting of
Stockholders and Prospectus/Joint Proxy Statement.
After careful consideration, Rational's Board of Directors has approved the
Agreement and the transactions contemplated thereby by the unanimous vote of
all non-interested directors, and recommends that you vote FOR the proposal
relating to the Merger.
Rational has retained the investment banking firm of Hambrecht & Quist LLC
("Hambrecht & Quist") to advise it with respect to the consideration to be
paid by Rational in the Merger. Hambrecht & Quist has advised the Rational
Board that, in its opinion, the consideration to be paid is fair, from a
financial point of view, to Rational. A copy of the Hambrecht & Quist opinion
is attached to the Prospectus/Joint Proxy Statement as Annex C.
The Board of Directors of Rational believes the Merger offers Rational and
its stockholders a number of important benefits, including the strategic fit
between the two companies' product lines, technologies, development teams and
sales and marketing resources, as well as long-term administrative and
operational economies of scale.
All stockholders are invited to attend the meeting in person. The issuance
of the shares of Rational Common Stock in connection with the Merger requires
the affirmative vote of the majority of the total votes cast regarding such
proposal.
Stockholders are urged to review carefully the information contained in the
accompanying Prospectus/Joint Proxy Statement, including in particular the
information under the captions "Risk Factors," "Rational Software Corporation
Special Meeting--Recommendation of Rational Board of Directors," "Approval of
the Merger and Related Transactions--Joint Reasons for the Merger" and "--
Rational's Reasons for the Merger" prior to making any voting decision.
In addition to the proposal relating to the Merger, Rational's Board of
Directors has deemed it to be in the best interest of Rational that Rational
adopt a 1997 Stock Option Plan (the "Plan") which conforms to recent changes
in federal securities laws. Upon stockholder approval, there will be reserved
for issuance under the Plan 1,000,000 shares of Rational Common Stock, plus
all shares of Rational Common Stock available for issuance under existing
Rational option plans (exclusive of the Stock Option Plan for Directors) for
which there are no options to purchase outstanding at the time of the
approval. Once the Plan is approved by stockholders, no new options will be
issued under pre-existing option plans. After careful consideration,
Rational's Board of Directors unanimously approved the Plan, and recommends
that you vote FOR the proposal related to the Plan.
Whether or not you expect to attend the Special Meeting in person, please
complete, sign and promptly return the enclosed proxy card in the enclosed
postage-prepaid envelope to assure representation of your shares. You may
revoke your proxy at any time before it has been voted, and if you attend the
meeting you may vote in person even if you have previously returned your proxy
card. Your prompt cooperation will be greatly appreciated.
Sincerely,
/s/ Paul D. Levy
-------------------------------------
Paul D. Levy
Chief Executive Officer
Santa Clara, California
YOUR PROXY IS IMPORTANT--PLEASE VOTE PROMPTLY
<PAGE>
EXHIBIT 99.2
[SQA, INC. LOGO]
January , 1997
Dear Stockholder:
As most of you are aware, SQA, Inc. ("SQA") has entered into a definitive
merger agreement to combine with Rational Software Corporation ("Rational") in
a strategic business combination (the "Merger"). At our Special Meeting
onFebruary 26, 1997, you will be asked to consider and approve the Agreement
and Plan of Reorganization between Rational, its wholly owned subsidiary,
Sunshine Acquisition Corp., and SQA (the "Agreement") relating to the Merger.
In the Merger, Sunshine Acquisition Corp., a wholly-owned subsidiary of
Rational ("Merger Sub"), will be merged with and into SQA, which will be the
surviving corporation and will become a wholly owned subsidiary of Rational.
Pursuant to the Merger, each outstanding share of Common Stock, par value
$0.01 per share, of SQA (the "SQA Common Stock") will be converted into the
right to receive 0.86 (the "Exchange Ratio") shares of Common Stock, par value
$0.01 per share, of Rational (the "Rational Common Stock," and the "Combined
Company Common Stock" immediately following the Merger), and each outstanding
option or right to purchase SQA Common Stock under the SQA stock option plans,
the SQA stock purchase plan or outstanding warrants will be assumed by
Rational and will become an option or right to purchase Combined Company
Common Stock, with appropriate adjustments to be made to the number of shares
issuable thereunder and the exercise price thereof based on the Exchange
Ratio. The shares of Rational Common Stock held by Rational stockholders
immediately prior to the Merger will remain unchanged by the Merger. It is
expected that SQA stockholders will receive approximately 7.0 million shares
of Rational Common Stock in the Merger, and another approximately 2.0 million
shares of Combined Company Common Stock will be reserved for issuance pursuant
to options, warrants and rights to purchase SQA Common Stock outstanding
immediately prior to the Merger. Upon the consummation of the Merger, Ronald
H. Nordin, currently the President and Chief Executive Officer of SQA, will be
employed by Rational and will join the existing Rational Board of Directors.
The accompanying Prospectus/Joint Proxy Statement describes more fully the
proposal relating to the Merger.
After careful consideration, SQA's Board of Directors has approved the
Agreement by the unanimous vote of all non- interested directors, and
recommends that you vote FOR the approval and adoption of the Agreement.
SQA has retained the investment banking firm of Robertson Stephens & Company
LLC ("RS & Co.") to advise it with respect to the Purchase Price Value, as
defined in RS & Co.'s written opinion, to be paid by Rational in the Merger.
RS & Co. has advised the SQA Board that, in its opinion, the Purchase Price
Value to be paid is fair, from a financial point of view, to SQA. A copy of
the RS & Co. opinion is attached to the Prospectus/Joint Proxy Statement as
Annex D.
The Board of Directors of SQA believes the Merger offers SQA and its
stockholders a number of important benefits, including the strategic fit
between the two Companies' product lines, technologies, development teams and
sales and marketing resources, as well as long-term administrative and
operational economies of scale.
All stockholders are invited to attend the meeting in person. The
affirmative vote of holders of a majority of the shares of SQA Common Stock
outstanding as of the record date will be necessary for approval and adoption
of the Agreement and the transactions contemplated thereby.
Stockholders are urged to review carefully the information contained in the
accompanying Prospectus/Joint Proxy Statement, including in particular the
information under the captions "Risk Factors," "SQA, Inc. Special Meeting--
Recommendation of SQA, Inc. Board of Directors," "Approval of the Merger and
Related Transactions--Joint Reasons for the Merger" and "--SQA's Reasons for
the Merger" prior to making any voting decision in connection with their SQA
Common Stock.
Whether or not you expect to attend the Special Meeting in person, please
complete, sign and promptly return the enclosed proxy card in the enclosed
postage-prepaid envelope to assure representation of your shares. You may
revoke your proxy at any time before it has been voted, and if you attend the
meeting you may vote in person even if you have previously returned your proxy
card. Your prompt cooperation will be greatly appreciated.
Sincerely,
/s/ Ronald H. Nordin
-------------------------------------
Ronald H. Nordin
President and Chief Executive
Officer
Burlington, Massachusetts
YOUR PROXY IS IMPORTANT-PLEASE VOTE PROMPTLY
SQA STOCKHOLDERS SHOULD NOT SURRENDER OR OTHERWISE ATTEMPT TO EXCHANGE THEIR
SQA STOCK CERTIFICATES FOR RATIONAL STOCK CERTIFICATES UNLESS AND UNTIL THEY
HAVE RECEIVED APPROPRIATE NOTICE AND INSTRUCTIONS FOR EXCHANGE.
<PAGE>
EXHIBIT 99.3
RATIONAL SOFTWARE CORPORATION
2800 SAN TOMAS EXPRESSWAY
SANTA CLARA, CALIFORNIA 95051
NOTICE OF SPECIAL MEETING OF STOCKHOLDERS
TO BE HELD ON FEBRUARY 26, 1997
TO THE STOCKHOLDERS OF RATIONAL SOFTWARE CORPORATION:
NOTICE IS HEREBY GIVEN that a Special Meeting of Stockholders (the "Rational
Meeting") of Rational Software Corporation, a Delaware corporation
("Rational"), will be held on February 26, 1997 at 9:00 a.m., local time, at
2800 San Tomas Expressway, Santa Clara, California.
At the Rational Meeting you will be asked to consider and vote upon the
following matters:
(1) The reservation and issuance of shares of the Common Stock, par value
$0.01 per share, of Rational (the "Rational Common Stock" and the "Combined
Company Common Stock" following the Merger (as defined below)) to the
stockholders of SQA, Inc. ("SQA") pursuant to an Agreement and Plan of
Reorganization, dated November 12, 1996 (the "Agreement"), among Rational,
SQA and Sunshine Acquisition Corp., a wholly owned subsidiary of Rational
("Merger Sub"), providing, among other things, (i) for the merger of Merger
Sub with and into SQA, resulting in SQA becoming a wholly owned subsidiary
of Rational (the "Merger"), (ii) for the conversion of outstanding shares
of Common Stock, par value $0.01 per share, of SQA ("SQA Common Stock")
into the right to receive 0.86 (the "Exchange Ratio") shares of Rational
Common Stock, and (iii) that each outstanding option or right to purchase
SQA Common Stock under the SQA stock option plans, the SQA stock purchase
plan and outstanding warrants will be assumed by Rational and will become
an option or right to purchase Combined Company Common Stock, with
appropriate adjustments to be made to the number of shares issuable
thereunder and the exercise price thereof based on the Exchange Ratio.
(2) The adoption of the Rational 1997 Stock Option Plan, including the
reservation thereunder of 1,000,000 shares of Rational Common Stock plus
all shares of Rational Common Stock available for issuance under pre-
existing Rational option plans (exclusive of the Stock Option Plan for
Directors) for which there are no options to purchase outstanding at the
time of the approval.
(3) Such other matters as may properly come before the Rational Meeting
or any postponements or adjournments thereof.
The proposal relating to the Merger is described more fully in the
accompanying Prospectus/Joint Proxy Statement.
Stockholders of record at the close of business on January 10, 1997 are
entitled to notice of, and to vote at, the Rational Meeting and any
adjournments or postponements thereof. All stockholders are cordially invited
to attend the Rational Meeting in person.
By Order of the Board of Directors
Paul D. Levy
Chief Executive Officer
Santa Clara, California
January , 1997
WHETHER OR NOT YOU EXPECT TO ATTEND THE MEETING, PLEASE COMPLETE, DATE AND
SIGN THE ENCLOSED PROXY CARD AND MAIL IT PROMPTLY IN THE ENCLOSED ENVELOPE IN
ORDER TO ASSURE REPRESENTATION OF YOUR SHARES. NO POSTAGE NEED BE AFFIXED IF
THE PROXY CARD IS MAILED IN THE UNITED STATES.
<PAGE>
EXHIBIT 99.4
SQA, INC.
ONE BURLINGTON WOODS DRIVE
BURLINGTON, MASSACHUSETTS 01803
NOTICE OF SPECIAL MEETING OF STOCKHOLDERS
TO BE HELD ON FEBRUARY 26, 1997
TO THE STOCKHOLDERS OF SQA, INC.
NOTICE IS HEREBY GIVEN that a Special Meeting of Stockholders (the "SQA
Meeting") of SQA, Inc., a Delaware corporation ("SQA"), will be held at the
offices of Testa, Hurwitz & Thibeault, LLP, located at High Street Tower, 125
High Street, Boston, Massachusetts, 02110 on February 26, 1997, at 12:00 p.m.,
local time, to consider and vote upon the following matters:
1. Approval and adoption of the Agreement and Plan of Reorganization (the
"Agreement") dated November 12, 1996, among Rational Software Corporation,
a Delaware corporation ("Rational"), Sunshine Acquisition Corp., a Delaware
corporation and wholly owned subsidiary of Rational ("Merger Sub"), and
SQA, pursuant to which, among other matters (i) Merger Sub will be merged
with and into SQA (the "Merger"), (ii) each share of Common Stock, $0.01
per share of SQA ("SQA Common Stock"), will be converted into the right to
receive, and become exchangeable for, 0.86 (the "Exchange Ratio") shares of
Common Stock, $0.01 per share, of Rational ("Combined Company Common Stock"
immediately following the Merger) and (iii) each outstanding option or
right to purchase SQA Common Stock under the SQA stock options plans, the
SQA stock purchase plan or outstanding warrants will be assumed by Rational
and will become an option or right to purchase Combined Company Common
Stock, with appropriate adjustments to be made to the number of shares
issuable thereunder and the exercise price thereof based on the Exchange
Ratio.
2. Such other matters as may properly come before the SQA Meeting or any
postponements or adjournments of the SQA Meeting.
The proposal relating to the Merger is described more fully in the
accompanying Prospectus/Joint Proxy Statement. Stockholders of record as of
the close of business on January , 1997 will be entitled to notice of, and to
vote at, the SQA Meeting and any adjournments or postponements thereof.
All stockholders are cordially invited to attend the meeting in person.
By Order of the Board of Directors
William J. Schnoor, Jr.
Secretary
Burlington, Massachusetts
January , 1997
WHETHER OR NOT YOU EXPECT TO ATTEND THE MEETING, PLEASE COMPLETE, DATE AND
SIGN THE ENCLOSED PROXY CARD AND MAIL IT PROMPTLY IN THE ENCLOSED ENVELOPE IN
ORDER TO ASSURE REPRESENTATION OF YOUR SHARES. NO POSTAGE NEED BE AFFIXED IF
THE PROXY CARD IS MAILED IN THE UNITED STATES.
<PAGE>
Exhibit 99.5
- -------------------------------------------------------------------------------
PROXY
RATIONAL SOFTWARE CORPORATION
SPECIAL MEETING OF STOCKHOLDERS
, 1997
THIS PROXY IS SOLICITED ON BEHALF OF THE BOARD OF DIRECTORS
The undersigned stockholder of Rational Software Corporation, a Delaware
corporation, hereby acknowledges receipt of the Notice of Special Meeting of
Stockholders and Prospectus/Joint Proxy Statement, each dated , 1997, and
hereby appoints Paul D. Levy and Robert T. Bond, and each of them, with full
power of substitution, as Proxy or Proxies, to vote all shares of the Common
Stock of the undersigned at the Special Meeting of Stockholders of Rational
Software Corporation to be held on , 1997, and at any adjournments
thereof, upon the proposals set forth on this form of proxy and described in
the Prospectus/Joint Proxy Statement, and in their discretion with respect to
such other matters as may be brought before the meeting or any adjournments
thereof.
(Continued and to be signed on the other side)
- -------------------------------------------------------------------------------
[UP ARROW APPEARS HERE] FOLD AND DETACH HERE [UP ARROW APPEARS HERE]
<PAGE>
- -------------------------------------------------------------------------------
(1) Proposal to reserve and issue shares of the Common Stock, par value $0.01
per share, of Rational Software Corporation ("Rational") to the stockholders
of SQA, Inc. ("SQA") pursuant to an Agreement and Plan of Reorganization,
dated November 12, 1996 (the "Agreement"), among Rational, SQA and Sunshine
Acquisition Corp., a wholly owned subsidiary of Rational ("Merger Sub"),
providing, among other things, (i) for the merger of Merger Sub with and
into SQA, resulting in SQA becoming a wholly owned subsidiary of Rational
(the "Merger"), (ii) for the conversion of outstanding shares of Common
Stock, par value $0.01 per share, of SQA ("SQA Common Stock") into the right
to receive 0.86 (the "Exchange Ratio") shares of Rational Common Stock, and
(iii) that each outstanding option or right to purchase SQA Common Stock
under the SQA stock option plans, the SQA stock purchase plan and
outstanding warrants will be assumed by Rational and will become an option
or right to purchase Combined Company Common Stock, with appropriate
adjustments to be made to the number of shares issuable thereunder and the
exercise price thereof based on the Exchange Ratio.
(2) The adoption of the Rational 1997 Stock Option Plan, including the
reservation thereunder of 1,000,000 shares of Rational Common Stock, plus
all shares of Rational Common Stock reserved for issuance under pre-existing
Rational option plans (exclusive of the Stock Option Plan for Directors) for
which there are not options to purchase outstanding at the time of the vote
hereon.
Please mark
your votes as
indicated in
this example [X]
FOR AGAINST ABSTAIN
[_] [_] [_]
THIS PROXY WILL BE VOTED AS DIRECTOR OR, IF NO DIRECTION IS INDICATED, WILL BE
VOTED FOR EACH OF THE PROPOSALS LISTED ABOVE, AND AS SAID PROXIES DEEM
ADVISABLE ON SUCH OTHER MATTERS AS MAY COME BEFORE THE MEETING.
Either of such Proxies or substitutes shall have and may exercise all of the
powers of said Proxies hereunder.
Signature(s) _______________________________________________ Date __________
(This proxy should be marked, dated, signed by the stockholder or stockholders
exactly as the stockholder's or stockholders' names appear hereon, and
returned promptly in the enclosed envelope. Persons signing in a fiduciary or
representative capacity should so indicate. If shares are held by joint
tenants, as community property or otherwise by more than one person, all
should sign).
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[UP ARROW APPEARS HERE] FOLD AND DETACH HERE [UP ARROW APPEARS HERE]
<PAGE>
Exhibit 99.6
- -------------------------------------------------------------------------------
PROXY
SQA, INC.
ONE BURLINGTON WOODS DRIVE, BURLINGTON, MASSACHUSETTS 01803
(617) 229-3500
PROXY FOR SPECIAL MEETING OF STOCKHOLDERS
, 1997
The undersigned hereby appoints Ronald H. Nordin, Thomas F. Bogan and
William J. Schnoor, Jr., and each of them singly, proxies for the undersigned,
with full power of attorney and power of substitution to vote all shares of
Common Stock which the undersigned is entitled to vote at the Special Meeting
of Stockholders (the "Meeting") of SQA, Inc. (the "Company") to be held on
, 1997, at at , and at any adjournment
thereof, upon the matters set forth in the Notice of Special Meeting of
Stockholders and accompanying Prospectus/Joint Proxy Statement, each dated
, 1997, receipt of which is hereby acknowledged.
THIS PROXY IS SOLICITED ON BEHALF OF THE BOARD OF DIRECTORS. THIS PROXY WILL
BE VOTED AS SPECIFIED OR, WHERE NO DIRECTION IS GIVEN, WILL BE VOTED FOR THE
PROPOSAL IN ITEM 1. A VOTE TO TRANSACT SUCH OTHER BUSINESS AS MAY BE PROPERLY
TAKEN UNDER ITEM 2 WILL BE VOTED IN ACCORDANCE WITH THE JUDGMENT OF THE
PERSONS HEREINBEFORE NAMED AS ATTORNEYS.
STOCKHOLDERS WHO ATTEND THE SPECIAL MEETING OF STOCKHOLDERS MAY VOTE IN
PERSON EVEN THOUGH THEY HAVE PREVIOUSLY MAILED THIS PROXY. PLEASE DATE, SIGN
AND RETURN THIS PROXY PROMPTLY IN THE ENCLOSED PRE-PAID, PRE-ADDRESSED
ENVELOPE.
PLEASE VOTE AND SIGN ON OTHER SIDE AND RETURN PROMPTLY IN ENCLOSED ENVELOPE.
(Continued and to be signed on reverse side)
- -------------------------------------------------------------------------------
[UP ARROW APPEARS HERE] FOLD AND DETACH HERE [UP ARROW APPEARS HERE]
<PAGE>
- -------------------------------------------------------------------------------
(1) To approve and adopt the Agreement and Plan of Reorganization (the
"Agreement") dated as of November 12, 1996, among Rational Software
Corporation, a Delaware corporation ("Rational"), Sunshine Acquisition
Corp., a Delaware corporation and wholly owned subsidiary of Rational (the
"Merger Sub"), and SQA, pursuant to which, among other matters (i) Merger
Sub will be merged with and into SQA (the "Merger"), (ii) each share of
Common Stock, $.01 par value per share ("SQA Common Stock"), of SQA will be
converted into the right to receive, and become exchangeable for, 0.86
shares of Common Stock, $.01 par value per share, of Rational (the "Exchange
Ratio"), and (iii) each outstanding option or right to purchase SQA Common
Stock under the SQA stock option plans and SQA's stock purchase plan or
outstanding warrants will be assumed by Rational and will become an option
or right to purchase Combined Company Common Stock, with appropriate
adjustments to be made to the number of shares issuable thereunder and the
exercise price thereof based on the Exchange Ratio.
(2) To transact such other business as may properly come before the meeting or
any postponements or adjournments thereof.
Please mark
your votes as
indicated in
this example [X]
FOR AGAINST ABSTAIN
[_] [_] [_]
MARK HERE
FOR ADDRESS
CHANGE AND
NOTE AT LEFT [_]
IMPORTANT: Please date this Proxy and sign exactly as your name(s) appear(s)
hereon. If stock is held jointly, each owner should sign. If signing as
attorney, executor, administrator, trustee, guardian or other fiduciary please
give your full title as such.
Signature(s) __________________________ Date _______________________________
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[UP ARROW APPEARS HERE] FOLD AND DETACH HERE [UP ARROW APPEARS HERE]
