<PAGE>
===============================================================================
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 8-K/A
CURRENT REPORT
Pursuant to Section 13 or 15(d) of
the Securities Exchange Act of 1934
March 31, 1997
--------------------------------------------------
Date of Report (date of earliest event reported)
RATIONAL SOFTWARE CORPORATION
------------------------------------------------------------------------------
(Exact name of Registrant as specified in its charter)
DELAWARE 0-12167 54-121709
------------------------------------------------------------------------------
(State or other jurisdiction of (Commission File Number) (I.R.S. Employer
incorporation or organization) Identification No.)
2800 SAN TOMAS EXPRESSWAY
SANTA CLARA, CA 95051-0951
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(Address of principal executive offices)
Registrant's telephone number, including area code: (408) 496-3600
Not Applicable
--------------------------------------------------
(Former name or former address, if changed since last report)
===============================================================================
<PAGE>
The registrant hereby amends Item 7 of its current report on Form 8-K filed
April 9, 1997 in its entirety to read as follows:
ITEM 7. FINANCIAL STATEMENTS AND EXHIBITS.
The following financial statements and exhibits are filed as part of this
report, where indicated.
(a) Financial statements of business acquired, prepared pursuant
to rule 3.05 of Regulation S-X are included at Exhibit 3.1.
Consolidated Financial Statements of Rational Software
Corporation as of March 31, 1997 and 1996 and for the three
years ended March 31, 1997 are included at Exhibit 99.2
(b) Pro forma financial information required pursuant to Article 11
of Regulation S-X:
The following unaudited pro forma condensed combined financial statements
assume a business combination between Rational and PAC accounted for using the
purchase method. The unaudited pro forma condensed combined financial
statements are based on the historical financial statements of Rational and
PAC and should be read in conjunction with such historical statements and
notes thereto. The historical financial statements and notes thereto of
Rational are included in this Form 8-K/A, and the historical financial
statements and notes thereto of PAC, are also included in this Form 8-K/A. The
transaction is already reflected in the audited consolidated balance sheet of
Rational at March 31, 1997. The unaudited pro forma condensed combined
statements of operations combine Rational's historical consolidated statements
of operations for the year ended March 31, 1997 with the year ended December
31, 1996 of PAC, 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 business combination 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 PAC incorporated by reference and
included herein, respectively.
UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENT OF OPERATIONS
REFLECTING RATIONAL SOFTWARE CORPORATION
AFTER GIVING EFFECT TO THE BUSINESS COMBINATION
(IN THOUSANDS, EXCEPT FOR PER SHARE DATA)
<TABLE>
<CAPTION>
Performance
Rational Awareness Rational/
Year Ended Year Ended Performance
March 31, December 31, Pro Forma Awareness
1997 1996 Adjustments Combined Pro Forma
---------- ----------- ----------- ------------------
<S> <C> <C> <C> <C>
Net product revenue................. $ 91,696 $ 4,064 $ 95,760
Consulting and support revenue...... 53,677 1,614 55,291
-------- ------- ---------
Total revenue....................... 145,373 5,678 151,051
Cost of product revenue............. 9,134 69 2,500 11,703
Cost of consulting and support
revenue........................... 26,566 1,091 27,657
-------- ------- ------ ---------
Total cost of revenue............... 35,700 1,160 2,500 39,360
-------- ------- ------ ---------
Gross margin........................ 109,673 4,518 (2,500) 111,691
Research and development
expenses....................... 24,445 2,078 26,523
Sales and marketing expenses..... 50,646 4,005 54,651
General and administrative
expenses....................... 16,995 885 600 18,480
Charges for acquired in-process
research and development....... 56,798 - 56,798
Merger and restructuring costs... 7,201 - 7,201
-------- ------- ------ ---------
Total operating expenses............ 156,085 6,968 600 163,653
-------- ------- ------ ---------
Operating loss...................... (46,412) (2,450) (3,100) (51,962)
Other income, net................... 7,917 (45) 7,872
-------- ------- ------ ---------
Loss before income taxes............ (38,495) (2,495) (3,100) (44,090)
Provision for (benefit from) income
taxes............................ 4,459 (276) 4,183
-------- ------- ------ ---------
Net loss............................ $(42,954) $(2,219) (3,100) $(48,273)
======== ======= ====== ========
Net loss per share.................. $ (0.98) $ (1.10)
======== ========
Equivalent Shares used in computing
net loss per share............... 43,702 43,702
======== ========
</TABLE>
See accompanying notes to unaudited pro forma condensed combined balance
statements
NOTES TO UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENT OF OPERATIONS
1. The pro forma condensed combined statement of operations for the fiscal year
ended March 31, 1997 gives effect to the acquisition of Performance
Awareness Corporation ("PAC") which was completed by Rational on March 31,
1997 and accounted for using the purchase method. The aggregate purchase
price (including direct acquisition costs) was approximately $32.9 million
in cash as well as options assumed by Rational. The pro forma statement of
operations gives effect to the acquisition as if it had occurred on April 1,
1996, accordingly the Company would have recorded approximately $3.1 million
of amortization on purchased intangibles.
2. There were no material transactions between Rational and PAC during any
period presented. In addition, the impact of conforming accounting policies
is not material.
(c) Exhibits
+ 2.1 Stock Purchase Agreement by and among Rational Software
Corporation, a Delaware corporation, Performance
Awareness Corporation, a North Carolina corporation
("PAC"), and all of the Stockholders of PAC dated March
31, 1997.
3.1 Consolidated Financial Statements of Performance
Awareness Corporation as of December 31, 1996 and 1995
and for the three years ended December 31, 1996.
23.1 Consent of Coopers & Lybrand LLP, Independent
Accountants.
23.2 Consent of Ernst & Young LLP, Independent Auditors
+99.1 Press Release dated March 31, 1997.
99.2 Consolidated Financial Statements of Rational Software
Corporation as of March 31, 1997 and 1996 and for the
three years ended March 31, 1997
---------------
+Filed previously
-2-
<PAGE>
Pursuant to this requirement of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned hereunto duly authorized.
RATIONAL SOFTWARE CORPORATION
June 16, 1997 /s/ Robert T. Bond
------------------
Robert T. Bond
Senior Vice President, Chief Operating
Officer, Chief Financial Officer, and
Secretary
-3-
<PAGE>
EXHIBIT INDEX
-------------
ITEM DESCRIPTION
- ---- -----------
+ 2.1 Stock Purchase Agreement by and among Rational Software
Corporation, a Delaware corporation, Performance
Awareness Corporation, a North Carolina corporation
("PAC"), and all of the Stockholders of PAC dated March
31, 1997.
3.1 Consolidated Financial Statements of Performance
Awareness Corporation as of December 31, 1996 and 1995
and for the three years ended December 31, 1996.
23.1 Consent of Coopers & Lybrand LLP, Independent
Accountants.
23.2 Consent of Ernst & Young LLP, Independent Auditors
+99.1 Press Release dated March 31, 1997.
99.2 Consolidated Financial Statements of Rational Software
Corporation as of March 31, 1997 and 1996 and for the
three years ended March 31, 1997.
- ---------------
+Filed previously.
<PAGE>
Exhibit 3.1
Report of Independent Accountants
---------------------------------
The Board of Directors
Performance Awareness Corporation
We have audited the accompanying consolidated balance sheets of Performance
Awareness Corporation and subsidiaries (the Company) as of December 31, 1996 and
1995, and the related consolidated statements of operations, shareholders'
equity, and cash flows for each of the years in the three-year period ended
December 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 financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Performance
Awareness Corporation and subsidiaries as of December 31, 1996 and 1995, and the
consolidated results of their operations and their cash flows for each of the
years in the three-year period ended December 31, 1996, in conformity with
generally accepted accounting principles.
/s/ Coopers & Lybrand L.L.P.
March 24, 1997, except as to the
information presented in Note 11,
for which the date is April 2, 1997
McLean, Virginia USA
1
<PAGE>
PERFORMANCE AWARENESS CORPORATION AND SUBSIDIARIES
Consolidated Balance sheets
December 31, 1996 and 1995
(amounts in thousands, except share data)
<TABLE>
<CAPTION>
Assets 1996 1995
------ ---- ----
<S> <C> <C>
Current assets:
Cash and cash equivalents $ 343 $ 248
Accounts receivable, net 1,977 1,003
Prepaid income taxes 383 --
Other 91 118
------- ------
Total current assets 2,794 1,369
Equipment, furniture, and fixtures, net 496 323
Assets under capital lease, net 467 9
Capitalized software, net 191 160
Deferred income taxes -- 107
Deposits and other 140 106
------- ------
Total assets $ 4,088 $2,074
======= ======
Liabilities and Shareholders' Equity
------------------------------------
Current liabilities:
Current portion of capital lease obligations 182 5
Current portion of long term debt 99 31
Accounts payable 411 145
Borrowings under line of credit 5 30
Accrued compensation 361 73
Other accrued liabilities 302 275
Deferred revenue 609 377
------- ------
Total current liabilities: 1,969 936
Capital lease obligations, less current portion 269 5
Long term debt 120 219
Deferred rent 160 --
Not payable to shareholder 100 100
------- ------
Total liabilities 2,618 1,260
------- ------
Commitments and Contingencies
Series A convertible preferred stock, $0.01 par value;
4,000,000 shares authorized in 1996, none in 1995;
1,206,897 issued and outstanding in 1996, none in
1995, liquidation preference of $6,000 3,112 --
Shareholders' equity:
Common stock, $0.01 par value; 11,000,000 shares
authorized, 5,000,000 and 4,325,000 shares issued
and outstanding in 1996 and 1995, respectively 50 43
Additional paid-in capital 611 --
Cumulative translation adjustments (20) 55
Retained earnings (deficit) (1,585) 835
------- ------
(944) 933
Notes receivable from shareholders (698) (119)
------- ------
Total shareholders' equity (1,642) 814
------- ------
Total liabilities and shareholders' equity $ 4,088 $2,074
======= ======
</TABLE>
See accompanying notes to consolidated financial statements.
2
<PAGE>
PERFORMANCE AWARENESS CORPORATION AND SUBSIDIARIES
Consolidated Statements of Operations
Years ended December 31, 1996, 1995 and 1994
(amounts in thousands)
<TABLE>
<CAPTION>
1996 1995 1994
---- ---- ----
<S> <C> <C> <C>
Revenue:
Software $ 4,064 $2,499 $2,126
Services and other 1,614 2,542 2,045
------- ------ ------
Total revenue 5,678 5,041 4,171
------- ------ ------
Costs and expenses:
Costs of software 69 38 27
Costs of services and other 1,091 1,379 829
Selling and marketing 4,005 1,589 1,499
Research and development 2,078 1,785 1,238
General and administrative 885 432 350
------- ------ ------
Total operating expenses 8,128 5,223 3,943
------- ------ ------
Income (loss) from operations (2,450) (182) 228
Interest income 20 21 17
Interest expense (65) (15) (9)
------- ------ ------
Income (loss) before income taxes (2,495) (176) 236
Provision for (benefit from) income taxes (276) (32) 97
------- ------ ------
Net (loss) income $(2,219) $ (144) $ 139
======= ====== ======
</TABLE>
See accompanying notes to consolidated financial statements.
3
<PAGE>
PERFORMANCE AWARENESS CORPORATION AND SUBSIDIARIES
Consolidated Statements of Shareholders' Equity (Deficit)
Years ended December 31, 1996, 1995 and 1994
(amounts in thousands, except share amounts)
<TABLE>
<CAPTION>
Common Stock Additional Cumulative Retained Notes Receiv- Total
-------------- paid-in translation Earnings able from Shareholders'
Shares Amount capital adjustments (Deficit) Shareholders Equity (Deficit)
------ ------ ---------- ----------- -------- ------------ ----------------
<S> <C> <C> <C> <C> <C> <C> <C>
Balances as of
January 1,
1994 4,325,000 $43 $ -- $ 30 $ 840 -- $ 913
Cumulative
translation
adjustment -- -- -- 18 -- -- 18
Loan to shareholder -- -- -- -- -- (280) (280)
Net income for 1994 -- -- -- -- 139 -- 139
--------- --- ---- ---- ------ ----- -------
Balances as of
December 31,
1994 4,325,000 43 -- 48 979 (280) 790
Cumulative translation
adjustment -- -- -- 7 -- -- 7
Payments on loan to
shareholder -- -- -- -- -- 161 161
Net loss for 1995 -- -- -- -- (144) -- (144)
--------- --- ---- ---- ------ ----- -------
Balances as of
December 31,
1995 4,325,000 43 -- 55 835 (119) 814
Cumulative
translation
adjustment -- -- -- (75) -- -- (75)
Payments on loan to
shareholder -- -- -- -- -- 32 32
Issuance of common
stock 675,000 7 611 -- -- (611) 7
Accretion of
preferred
stock -- -- -- -- (201) -- --
Net loss for 1996 -- -- -- -- (2,219) -- (2,219)
--------- --- ---- ---- ------ ----- -------
Balances as of
December 31,
1996 5,000,000 $50 $611 $(20) $(1,585) $(698) $(1,642)
========= === ==== ==== ======= ===== =======
</TABLE>
See accompanying notes to consolidated financial statements.
4
<PAGE>
PERFORMANCE AWARENESS CORPORATION AND SUBSIDIARIES
Consolidated Statements of Cash Flows
Years ended December 31, 1996, 1995, and 1994
(amounts in thousands)
1996 1995 1994
------- ------ ------
Cash flows from operating activities:
Net income (loss) $(2,219) $(144) $ 139
Adjustments to reconcile net income
(loss) to net cash used by operating
activities:
Provisions for bad debts 215 8 -
Depreciation and amortization 310 145 110
Amortization of capitalized software
costs 69 38 19
Deferred income taxes 107 (59) (59)
Deferred rent 160 - -
Changes in operating assets and
liabilities:
Accounts receivable, net (1,189) (411) (57)
Prepaid income taxes (383) - -
Other current assets 27 (53) (10)
Accounts payable 266 44 (135)
Accrued compensation 288 18 14
Accrued income taxes - - (68)
Other accrued liabilities 27 172 (3)
Deposits and other assets (34) (10) (34)
Deferred revenue 232 125 72
------- ----- -----
Net cash used by operating
activities (2,124) (127) (12)
------- ----- -----
Cash flows from investing activities:
Purchases of equipment, furniture, and
fixtures (387) (276) (139)
Advances under note receivable -
shareholder - - (130)
Payments under note receivable -
shareholder 32 11 -
Capitalized software development costs (100) (165) -
------- ----- -----
Net cash used in investing
activities (455) (430) (269)
------- ----- -----
Cash flows from financing activities:
Principal payments under capital lease
obligations (113) - -
Proceeds from issuance of preferred
stock, net 2,911 - -
Proceeds from issuance of common stock 7 - -
Repayment of long term debt (31) - (44)
Borrowings under lines of credit 900 30 -
Repayments under lines of credit (925) - -
Borrowings under long term debt - 100 -
Borrowings under notes payable to
shareholder 200 100 -
Repayments of notes payable to shareholder (200) - -
------- ----- -----
Net cash provided by (used in)
financing activities 2,749 230 (44)
------- ----- -----
Effect of exchange rate changes on cash (75) 7 18
------- ----- -----
Net increase (decrease) in cash and cash
equivalents 95 (320) (307)
Cash and cash equivalents, beginning of year 248 568 875
------- ----- -----
Cash and cash equivalents, end of year $343 $ 248 $ 568
======= ===== =====
See accompanying notes to consolidated financial statements.
5
<PAGE>
PERFORMANCE AWARENESS CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 1996, 1995 and 1994
(1) NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of Business
------------------
Performance Awareness Corporation (the Company), develops, markets and
supports Automated Software Quality products and related services that
provide solutions for the global software testing market. Its primary
customers are financial and telecommunications companies in the United
States and Japan.
Principles of Presentation and Preparation
------------------------------------------
The accompanying consolidated financial statements include the accounts
of the Company and its wholly owned subsidiaries. All significant
intercompany accounts and transactions have been eliminated in
consolidation. All amounts are in the thousands, except share data.
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities
and disclosure of contingent assets and liabilities at the date of the
financial statements and reported amount of revenues and expenses during
the reporting period. Actual results could differ from those estimates.
Revenue Recognition
-------------------
Revenue consists primarily of fees for licenses of the Company's software
products, maintenance and customer support.
License
-------
Revenue from the sale of software licenses is recognized upon
shipment of the products, delivery of permanent authorization codes,
and fulfillment of acceptance terms, if any, provided that no
significant vendor and post-contract support obligations remain and
collection of the related receivable is probable. Revenue related to
post-contract support obligations is deferred at the time the license
revenue is recognized. In instances where there is a contingency
regarding the sale, revenue recognition is delayed until the
contingency has been resolved. When the Company receives advance
payment for software products, such payments are reported as deferred
revenue until all conditions for revenue recognition are met.
Services and Other Revenue
--------------------------
Maintenance revenue is deferred and recognized ratably over the term
of the maintenance agreement, which is typically twelve months.
Revenue from customer training, support, and other services is
recognized as the service is performed.
(Continued)
6
<PAGE>
PERFORMANCE AWARENESS CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 1996, 1995 and 1994
Cash and Cash Equivalents
For the purpose of the Consolidated Statements of Cash Flows, the Company
considers all highly liquid investments with an original maturity of three
months or less to be cash equivalents. At December 31, 1996, excess cash
balances were invested in overnight commercial paper.
Equipment, Furniture, and Fixtures
Equipment, furniture, and fixtures consist primarily of computer workstations
and file servers for employees and are stated at cost net of accumulated
depreciation of $819 and $631 as of December 31, 1996 and 1995, respectively.
Depreciation is provided on the straight-line method over the estimated useful
lives of the related assets (generally three to five years). The cost and
accumulated depreciation of property and equipment are removed from the
accounts upon retirement or other disposition and any resulting gain or loss
is reflected in operations.
Software Development Costs
Certain software development costs for new products and product enhancements
are capitalized upon the establishment of technological feasibility, which is
defined by the Company as the completion of a working model of the software.
Capitalization of computer software development costs ceases, and amortization
begins, when the product is available for general release to customers. The
ongoing assessment of the realizability of these costs requires considerable
judgment related to anticipated future product revenues, estimated economic
life, and changes in hardware and software technology. The amount of software
development costs capitalized for the years 1996, 1995, and 1994 was $100,
$165, and $0, respectively. Accumulated amortization of software development
costs was $190 and $121 as of December 31, 1996 and 1995, respectively.
Amortization of software development costs is provided on a product-by-product
basis. Annual amortization is the greater of the amount computed using the
ratio of current product revenue to the total of current and anticipated
future product revenue or the straight-line method over the remaining
estimated economic life of the product. All current products have estimated
economic lives of three years. Amortization of software development costs for
the years 1996, 1995, and 1994 was $69, $38, and $19, respectively.
Amortization of software development costs is included in costs of software in
the accompanying Consolidated Statements of Income. Costs incurred prior to
the establishment of technological feasibility are charged to research and
development expense as incurred.
(Continued)
7
<PAGE>
PERFORMANCE AWARENESS CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 1996, 1995 and 1994
Income Taxes
Income taxes are provided under the asset and liability method, whereby
deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases. Deferred tax assets and liabilities are measured using enacted tax
rates expected to apply to taxable income in the years in which those
temporary differences are expected to be recovered or settled. The effect on
deferred tax assets and liabilities of a change in tax rates is recognized in
income in the period that includes the enactment date. Valuation allowances
are established when necessary to reduce deferred tax assets to the amounts
expected to be realized. During 1996, the Company experienced net operating
losses and established a valuation allowance against its deferred tax assets
relating to the resulting net operating loss carryforwards for tax purposes
due to the uncertainty surrounding the realization of such assets.
Statement of Cash Flows
Interest of $45, $11, and $8 was paid in 1996, 1995, and 1994, respectively.
Income taxes of $0, $85 and $236 were paid during 1996, 1995, and 1994,
respectively. Acquisition of equipment under capital lease obligations was
$552, $11, and $0 during 1996, 1995, and 1994, respectively. During 1996, the
Company sold common stock to various employees and officers, and received
notes receivable from these individuals totaling $611. During 1996, the
liquidation preference and dividends of the preferred stock was accreted by
$201.
Translation of Foreign Currencies
The Company's Japanese subsidiary considers the Japanese yen as its functional
currency. The assets and liabilities of the foreign subsidiary are translated
to U.S. dollars at the current exchange rate as of the balance sheet date. The
resulting translation adjustment is recorded as a separate component of
stockholder's equity. Statement of operations items are translated at average
rates of exchange during each reporting period. Resulting foreign exchange
gains and losses, which have been insignificant, are included in the results
of operations. The Company's other subsidiary is located in the United
Kingdom. It's activities are insignificant to the consolidated financial
statements.
(Continued)
8
<PAGE>
PERFORMANCE AWARENESS CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 1996, 1995 and 1994
(2) DEBT
Long-Term Debt
Long-term debt consisted of the following at December 31:
1996 1995
---- ----
Note payable to individual, 10%, uncollateralized,
annual payments of $30 plus interest, due annually
beginning December, 1997 $150 $150
Note payable to bank, 8.2%, collateralized by
substantially all the assets of the Company,
monthly payments of principal and interest
of $3 due through 1998 69 100
---- ----
219 250
Less current portion 99 31
---- ----
$120 $219
==== ====
Line of Credit
The Company has a revolving credit facility with a commercial bank which is
subject to renewal annually each June. This facility provides for
borrowings of up to $300 for working capital purposes based on a percentage
of eligible receivables, as defined. Borrowings under the facility bore
interest at the bank's prime rate plus 1/2% (8.75% and 9.00% at December
31, 1996 and 1995, respectively), and are collateralized by the Company's
accounts receivable. Outstanding borrowings under this line of credit were
$5 and $30 at December 31, 1996 and 1995, respectively. The loan agreement
requires the Company to comply with certain financial covenants. Among
other things, the Company is required to maintain a ratio of total
liabilities to tangible net worth, as defined in the agreement, of not more
than .75 to 1. As of December 31, 1996, the Company failed to comply with
two covenants, for which the associated debt is included in current
liabilities.
During 1996, the Company entered into a $700 credit facility with a
commercial bank, which expired upon the closing of the preferred stock
investment discussed in note 4. This facility was collateralized by a deed
of trust on the principal shareholder's residence. Borrowings under the
facility bore interest at the bank's prime rate plus 1/2%.
(Continued)
9
<PAGE>
PERFORMANCE AWARENESS CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 1996, 1995 and 1994
Notes Payable To Shareholder
During 1996 and 1995, the Company borrowed $200 and $100, respectively from
a shareholder. These loans are uncollateralized and bear interest at 8.25%
and 8.75% in 1996 and 1995, respectively. The Company repaid the principal
and interest for $200 of the notes during fiscal year 1996. For the
remaining $100 note payable outstanding as of December 31, 1996, principal
and interest payments are due when the Company is fiscally capable and are
not expected to be repaid during 1997. Interest expense paid to the
shareholder was $8, $4 and $0 during 1996, 1995 and 1994, respectively.
(3) LEASES
Capital Leases
The Company has leased certain furniture and equipment under capital lease
arrangements. Accumulated amortization of assets under capital lease was
$96 and $2 at December 31, 1996 and 1995, respectively. Future minimum
lease payments under these capital lease arrangements are as follows:
Year ending
December 31,
-----------
1997 $214
1998 213
1999 72
----
499
Less amounts representing interest 48
----
451
Less current portion 182
----
$269
====
Operating Leases
The Company leases its Raleigh, North Carolina, headquarters, and sales
offices in Virginia, Texas, Illinois, California and New Jersey, under
operating lease agreements which expire over the next 7 years. The Company
also leases certain computer and other office equipment under operating
lease agreements. Rental expense incurred by the Company under operating
lease agreements totaled $432, $202 and $177 for the years 1996, 1995 and
1994, respectively.
(Continued)
10
<PAGE>
PERFORMANCE AWARENESS CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 1996, 1995 and 1994
Future annual minimum lease payments under operating leases as of December 31,
1996 are as follows:
1997 $ 628
1998 490
1999 457
2000 457
2001 457
Thereafter 609
------
$3,098
======
(4) Shareholders' Equity
During May, 1996, the Company's Articles of Incorporation were amended to
change the par value of the common stock from $1 to $0.01 per share and
the number of authorized shares from 100,000 to 11,000,000. A stock split
of 43,250 to 1 occurred in conjunction with this amendment. The effect of
this stock split has been reflected retroactively for all periods
presented. In addition, the Company was given authorization to issue
4,000,000 shares of preferred stock with a par value of $0.01 per share.
Preferred Stock
During September, 1996, the Company sold 1,206,897 shares of Series A
Convertible Preferred Stock resulting in net proceeds of $2,911, net of
expenses of $89. The holder of the Series A Convertible Preferred Stock
is entitled to cumulative dividends at an annual rate of 10% of their
initial investment of $3,000. These dividends are payable upon either,
(i) the closing of an initial public offering of the Company's stock,
(ii) a merger or consolidation of the Company (iii) repurchase of the
Series A Convertible Preferred Stock by the Company under the terms of
the Stock Purchase Agreement, or (iv) a liquidation of the Company as
defined in the Stock Purchase Agreement. In the event of any liquidation,
dissolution or winding up of the Company, the holder of the Series A
Convertible Preferred Stock is entitled to a liquidation preference equal
to $6,000. These shares are redeemable at the option of the holder upon
(i) the fifth anniversary of their issuance, (ii) the closing of an
initial public offering of the Company's stock, (iii) the sale of the
Company at a price of the greater of the fair market value of the shares
or the historical cost of the investment plus a 12% return per annum, as
defined, or (iv) violation of a material provision of the Stock Purchase
Agreement.
The Series A Convertible Preferred Stock is convertible on a one-for-one
basis into 1,206,897 shares of common stock at the option of the holder.
The Series A Convertible Preferred Stock will be automatically converted to
common stock upon the closing of an initial public offering of the
Company's stock as described in the Stock Purchase Agreement. The holders
of the Series A Convertible Preferred Stock are entitled to vote on all
matters with the holders of common stock on an as if converted basis.
(Continued)
11
<PAGE>
PERFORMANCE AWARENESS CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 1996, 1995 and 1994
Common Stock
During 1996, the Company sold common stock to various employees and
officers. These individuals paid an amount equal to the par value of the
stock, and the Company loaned the remaining balance to these individuals.
These notes are collateralized by the common stock, bear no interest and
are due in May, 2001. The balance of these notes are recorded as a
reduction of shareholders' equity in the accompanying balance sheet.
(5) INCOME TAXES
The provision for income taxes consisted of the following:
<TABLE>
<CAPTION>
1996 1995 1994
---- ---- ----
<S> <C> <C> <C>
Current:
Federal $(384) $ 17 $121
Foreign 1 1 1
State - 9 34
----- ---- ----
Total (383) 27 156
----- ---- ----
Deferred:
Federal 107 (50) (50)
Foreign - - -
State - (9) (9)
----- ---- ----
Total 107 (59) (59)
----- ---- ----
Total (benefit)
provision for
income taxes $(276) $(32) $ 97
===== ==== ====
</TABLE>
The Company's effective tax rate differs from the statutory federal income
tax rate as shown in the following schedule:
<TABLE>
<CAPTION>
1996 1995 1994
----- ---- ----
<S> <C> <C> <C>
Income tax (benefit) expense at
statutory rate $(848) $(60) $80
State income tax (benefit)
expense, net of federal benefit - - 17
Change in valuation allowance 657 37 -
Other (85) (9) -
----- ---- ---
Actual income tax (benefit)
expense $(276) $(32) $97
===== ==== ===
</TABLE>
(Continued)
12
<PAGE>
PERFORMANCE AWARENESS CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 1996, 1995 and 1994
The tax effects of the temporary differences that give rise to
significant portions of the deferred tax assets and liabilities as of
December 31, 1996 and 1995 are as follows:
1996 1995
------ ------
Deferred tax assets:
Accrued liabilities $102 $ 82
Allowance for doubtful accounts 89 3
Deferred rent 64 -
Deferred revenue 244 151
Net operating loss carryforward 271 -
---- ----
Total gross deferred tax assets 770 236
---- ----
Less valuation allowance 694 37
---- ----
Deferred tax assets, net of valuation
allowance 76 199
---- ----
Deferred tax liabilities:
Depreciation and amortization 76 20
Unearned royalties - 72
---- ----
Total gross deferred tax liabilities 76 92
---- ----
Net deferred tax asset $ - $107
==== ====
As of December 31, 1996, the Company had approximately $679 of net
operating loss carryforwards, expiring in the year 2011, available to
offset future federal income taxes. Due to the uncertainty related to the
realization of the benefits of certain deferred tax assets, the Company
has placed a valuation allowance against a portion of the otherwise
recognizable net deferred tax asset at December 31, 1996.
(6) EMPLOYEE BENEFIT PLANS
401(k) Plan
The Company has a 401(k) retirement savings plan covering substantially
all employees. The Company matches contributions in the plan at the
discretion of the Board of Directors. Effective August 1, 1993, the Board
of Directors authorized matching contributions up to 3% of participants'
salaries, amounting to $53, $33 and $27 for 1996, 1995 and 1994,
respectively.
(Continued)
13
<PAGE>
PERFORMANCE AWARENESS CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 1996, 1995 and 1994
(7) HIGH TEST TRANSACTION
In November, 1995, the Company purchased rights to High Test software from
Vermont Creative Software (VCS). The purchase price of $100 was considered
to be research and development costs and was charged to operations on the
acquisition date. In addition, royalty payments based on the number of
licenses sold by the Company are due to VCS. Minimum royalties of $150 must
be paid by December 31, 1997, and maximum royalties are approximately $350.
Minimum royalties of $150 were accrued and charged to research and
development expense during 1995. Payments under this agreement are
collateralized by the Company's accounts receivable. Payments under this
agreement are collateralized by the Company's accounts receivable. Payments
under this agreement were $9 and $0 during 1996 and 1995, respectively.
Under this agreement, VCS has a nonexclusive nontransferable right to sell
licenses of the software to end users, and must pay the Company a royalty.
(8) CONCENTRATIONS OF CREDIT RISK
The Company maintains excess cash balances in a money market account with a
federally insured financial institution and overnight commercial paper. At
times, the aggregate total of deposits may be in excess of FDIC insurance
limits. The Company has not experienced any losses in any of the
instruments it has used for excess cash balances.
To reduce credit risk, the Company performs ongoing credit evaluations of
its customers' financial condition. The Company maintains reserves for
potential credit losses, but historically has not experienced any
significant losses related to individual customers or groups of customers
in any geographic area. The Company's allowance for doubtful accounts was
$223 and $8 as of December 31, 1996 and 1995, respectively. As of December
31, 1996, one customer accounted for 29% of accounts receivable. As of
December 31, 1995, a different customer accounted for 12% of accounts
receivable.
(9) BUSINESS SEGMENT AND GEOGRAPHIC INFORMATION
The Company operates primarily in one business segment, comprising the
automated software quality testing industry.
The Company's foreign revenues are summarized as follows:
<TABLE>
<CAPTION>
1996 1995 1994
---- ---- ----
<S> <C> <C> <C>
Western Europe $ 341 $ 277 $ 118
Japan 1,123 1,566 899
------ ------ ------
$1,464 $1,843 $1,017
====== ====== ======
</TABLE>
In 1996, one key customer accounted for 13% of the Company's revenue. No
customer accounted for more than 10% of the Company's revenue in 1995 or
1994.
(Continued)
14
<PAGE>
PERFORMANCE AWARENESS CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 1996, 1995 and 1994
(10) Related Party Transactions
An officer and shareholder of the Company is the sole shareholder of a
separate business that provides security system services as well as sells
certain telecommunications equipment and provides telecommunications
maintenance to the Company. These services and equipment purchases amounted to
approximately $63, $5 and $10 for the years ended December 31, 1996, 1995 and
1994 respectively.
(11) Subsequent Acquisition of the Company
On March 31, 1997 the Company agreed to be acquired by Rational Software
Corporation in exchange for cash of $31,000 and the assumption of certain
stock options. In connection with this acquisition, the Series A Convertible
Preferred Stock has been reclassified to be in compliance with Regulation S-X.
15
<PAGE>
EXHIBIT 23.1
CONSENT OF INDEPENDENT ACCOUNTANTS
We consent to the inclusion in this Form 8-K/A of our report dated
March 24, 1997, except as to the information presented in Note 11, for which
the date is April 2, 1997, on our audits of the financial statements for
Performance Awareness Corporation as of December 31, 1996 and 1995 and for
each of the years in the three year period ended December 31, 1996.
/s/ COOPERS & LYBRAND L.L.P.
McLean, VA
June 16, 1997
<PAGE>
EXHIBIT 23.2
CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
We consent to the use of our report dated April 22, 1997 with respect
to the Consolidated Financial Statements of Rational Software Corporation as
of March 31,1997 and 1996 and for each of the three years in the period ended
March 31, 1997, included in this Form 8-K/A.
/s/ Ernst & Young LLP
Palo Alto, CA
June 16, 1997
<PAGE>
EXHIBIT 99.2
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 1997, and the related
consolidated statements of operations, redeemable convertible preferred stock
and stockholders' equity and cash flows for each of the three years in the
period ended March 31, 1997. These consolidated 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. In February
1997, the Company merged with SQA, Inc. in a transaction which was accounted
for as a pooling of interests. We did not audit the financial statements of
SQA, Inc. for the years prior to fiscal 1997, which statements reflect total
assets constituting 32% of the related 1996 consolidated financial statement
totals, and which statements reflect net income (loss) of approximately
($2,422,000) and $431,000 of related 1995 and 1996 consolidated financial
statement totals, respectively. Those statements were audited by other
auditors whose report has been furnished to us, and our opinion, insofar as it
relates to data included for SQA, Inc. is based solely on the report of the
other auditors.
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 and the report of other
auditors provide a reasonable basis for our opinion.
In our opinion, based on our audits and the report of the other auditors,
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 1997, and the consolidated results of its
operations and its cash flows for each of the three years in the period ended
March 31, 1997, in conformity with generally accepted accounting principles.
/s/ Ernst & Young LLP
San Jose, California
April 22, 1997
F-1
<PAGE>
RATIONAL SOFTWARE CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
FISCAL YEAR ENDED MARCH 31,
---------------------------
1995 1996 1997
------- ------- --------
<S> <C> <C> <C>
Net product revenue............................... $42,611 $64,743 $ 91,696
Consulting and support revenue.................... 34,738 39,209 53,677
------- ------- --------
Total revenue................................... 77,349 103,952 145,373
Cost of product revenue........................... 7,148 7,826 9,134
Cost of consulting and support revenue............ 18,875 20,823 26,566
------- ------- --------
Total cost of revenue........................... 26,023 28,649 35,700
------- ------- --------
Gross margin.................................... 51,326 75,303 109,673
Product research and development expenses......... 13,914 18,305 24,445
Sales and marketing expenses...................... 28,454 41,000 50,646
General and administrative expenses............... 7,892 11,690 16,995
Charges for acquired in-process research and
development...................................... -- 8,700 56,798
Merger and restructuring costs (credit)........... (1,100) -- 7,201
------- ------- --------
Total operating expenses........................ 49,160 79,695 156,085
------- ------- --------
Operating income (loss)......................... 2,166 (4,392) (46,412)
Other income, net................................. 496 1,830 7,917
------- ------- --------
Income (loss) before income taxes............... 2,662 (2,562) (38,495)
Provision for income taxes........................ 406 1,028 4,459
------- ------- --------
Net income (loss)................................. $ 2,256 ($3,590) ($42,954)
======= ======= ========
Net income (loss) per common share................ $0.08 ($0.10) ($0.98)
Shares used in computing per share amounts........ 29,745 35,938 43,702
</TABLE>
See Notes to Consolidated Financial Statements.
F-2
<PAGE>
RATIONAL SOFTWARE CORPORATION
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
MARCH 31,
-------------------
1996 1997
-------- ---------
ASSETS
------
<S> <C> <C>
Current assets:
Cash and cash equivalents............................... $ 80,378 $ 227,493
Short-term investments.................................. 8,711 2,525
Accounts receivable, net of allowance for doubtful
accounts of $1,286 in 1996 and $1,960 in 1997.......... 26,043 33,565
Prepaid expenses and other assets....................... 2,550 3,395
-------- ---------
Total current assets.................................. 117,682 266,978
Property and equipment, net............................... 6,247 13,291
Other assets, net......................................... 2,210 22,521
-------- ---------
Total assets.......................................... $126,139 $ 302,790
======== =========
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
Current liabilities:
Accounts payable........................................ $ 3,802 $ 9,981
Accrued employee benefits............................... 9,225 12,269
Other accrued expenses.................................. 5,182 8,255
Current portion of accrued merger and restructuring
expenses............................................... 575 9,236
Deferred revenue........................................ 17,885 17,936
Current portion of long-term debt and lease
obligations............................................ 654 2,010
-------- ---------
Total current liabilities............................. 37,323 59,687
Accrued rent.............................................. 880 535
Long-term accrued merger and restructuring expenses....... 1,309 916
Long-term debt............................................ -- 1,741
-------- ---------
Total liabilities..................................... 39,512 62,879
-------- ---------
Commitments and contingencies
Stockholders' equity:
Common stock, $.01 par value, 75,000 shares authorized,
issued and outstanding 40,211 shares in 1996 and 47,684
shares in 1997......................................... 402 477
Additional paid-in capital.............................. 155,336 356,270
Treasury stock.......................................... (1,340) (1,340)
Accumulated deficit..................................... (67,905) (115,006)
Cumulative translation adjustment....................... 134 (490)
-------- ---------
Total stockholders' equity............................ 86,627 239,911
-------- ---------
Total liabilities and stockholders' equity............ $126,139 $ 302,790
======== =========
</TABLE>
See Notes to Consolidated Financial Statements.
F-3
<PAGE>
RATIONAL SOFTWARE CORPORATION
CONSOLIDATED STATEMENT OF REDEEMABLE CONVERTIBLE PREFERRED
STOCK AND STOCKHOLDERS' EQUITY
(IN THOUSANDS)
<TABLE>
<CAPTION>
REDEEMABLE
CONVERTIBLE
PREFERRED STOCK
----------------
SHARES AMOUNT STOCKHOLDERS' EQUITY
------ -------- ------------------------------------------------------
COMMON STOCK ADDITIONAL CUMULATIVE TOTAL
------------- PAID-IN TREASURY ACCUMULATED TRANSLATION STOCKHOLDERS'
SHARES AMOUNT CAPITAL STOCK DEFICIT ADJUSTMENT EQUITY
------ ------ ---------- --------- ----------- ----------- -------------
<S> <C> <C>
BALANCE AT MARCH 31, 1994..... 4,060 $ 4,866
Issuance of Series C preferred
stock........................ 2,172 3,030
Exercise of stock options.....
Issuance of common stock...... -- --
Issuance of treasury stock.... -- --
Net income.................... -- --
------ --------
BALANCE AT MARCH 31, 1995..... 6,232 7,896
Issuance of Series D preferred
stock........................ 1,393 4,455
Conversion of redeemable
preferred stock to common
stock........................ (7,625) (12,351)
Issuance of common stock, net
of $808 in costs............. -- --
Issuance of common stock, net
of $852 in costs............. -- --
Issuance of common stock for
the acquisition of Objectory
AB........................... -- --
Exercise of common stock
options......................
Issuance of common stock under
Employee Stock Purchase
Plan......................... -- --
Cumulative translation
adjustment................... -- --
Net loss...................... -- --
------ --------
BALANCE AT MARCH 31, 1996..... -- --
Issuance of common stock, net
of expenses of $675..........
Exercise of common stock
options...................... -- --
Issuance of common stock......
Issuance of common stock under
Employee Stock Purchase
Plan......................... -- --
Stock options issued in
business combination......... -- --
Tax benefit from option
transactions................. -- --
Cumulative translation
adjustment................... -- --
Net loss...................... -- --
Net transactions of SQA from
January 1, 1997 to March 31,
1997......................... -- --
------ --------
BALANCE AT MARCH 31, 1997..... -- --
====== ========
BALANCE AT MARCH 31, 1994..... 24,874 $249 $ 70,601 $(1,394) $ (66,571) $ -- $ 2,885
Issuance of Series C preferred
stock........................ -- -- (22) -- -- -- (22)
Exercise of stock options..... 221 2 636 638
Issuance of common stock...... 66 1 226 -- -- -- 227
Issuance of treasury stock.... -- -- -- 54 -- -- 54
Net income.................... -- -- -- -- 2,256 -- 2,256
------ ------ -------- ------- --------- ------- --------
BALANCE AT MARCH 31, 1995..... 25,161 252 71,441 (1,340) (64,315) -- 6,038
Issuance of Series D preferred
stock........................ -- -- (20) -- -- -- (20)
Conversion of redeemable
preferred stock to common
stock........................ 4,575 46 12,305 -- -- -- 12,351
Issuance of common stock, net
of $808 in costs............. 1,720 17 28,935 -- -- -- 28,952
Issuance of common stock, net
of $852 in costs............. 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...................... 1,349 14 3,585 3,599
Issuance of common stock under
Employee Stock Purchase
Plan......................... 150 1 448 -- -- -- 449
Cumulative translation
adjustment................... -- -- -- -- -- 134 134
Net loss...................... -- -- -- -- (3,590) -- (3,590)
------ ------ -------- ------- --------- ------- --------
BALANCE AT MARCH 31, 1996..... 40,211 402 155,336 (1,340) (67,905) 134 86,627
Issuance of common stock, net
of expenses of $675.......... 5,188 52 186,304 -- -- -- 186,356
Exercise of common stock
options...................... 1,216 12 4,703 -- -- -- 4,715
Issuance of common stock...... 258 3 4,369 -- -- -- 4,372
Issuance of common stock under
Employee Stock Purchase
Plan......................... 787 8 2,927 -- -- -- 2,935
Stock options issued in
business combination......... -- -- 1,600 -- -- -- 1,600
Tax benefit from option
transactions................. -- 880 -- -- 880
Cumulative translation
adjustment................... -- -- -- -- -- (624) (624)
Net loss...................... -- -- -- -- (42,954) -- (42,954)
Net transactions of SQA from
January 1, 1997 to March 31,
1997......................... 24 -- 151 -- (4,147) -- (3,996)
------ ------ -------- ------- --------- ------- --------
BALANCE AT MARCH 31, 1997..... 47,684 $477 $356,270 $(1,340) $(115,006) $(490) $239,911
</TABLE>
See Notes to Consolidated Financial Statements.
F-4
<PAGE>
RATIONAL SOFTWARE CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
<TABLE>
<CAPTION>
1995 1996 1997
------- ------- --------
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)................................ $ 2,256 $(3,590) $(42,954)
Adjustments to reconcile net income to net cash
provided by operating activities:
Charges for acquired in-process research and
development................................... -- 8,700 56,798
Depreciation................................... 4,361 3,873 4,063
Amortization................................... 678 842 1,675
Compensation expense for stock option grants... -- 229 145
Changes in operating assets and liabilities
Accounts receivable.......................... (4,145) (4,550) (9,083)
Prepaids and other, net...................... 402 (947) 829
Accounts payable............................. 1,161 (1,336) 5,122
Accrued employee benefits and accrued
expenses.................................... (1,564) 2,296 (2,392)
Deferred revenue............................. 1,181 9,367 (23)
Accrued merger and restructuring expenses.... (4,062) (329) 8,268
------- ------- --------
Net cash provided by operating activities...... 268 14,555 22,448
------- ------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of short-term investments.............. (2,369) (11,124) (10,611)
Maturities and sales of short-term investments... 7,581 3,449 16,824
Purchase of property and equipment............... (3,361) (3,608) (9,143)
Additions to capitalized software costs.......... (154) -- --
Business combinations, net of cash acquired...... -- 279 (69,992)
------- ------- --------
Net cash provided by (used in) investing
activities.................................... 1,697 (11,004) (72,922)
CASH FLOWS FROM FINANCING ACTIVITIES:
Principal payments under long-term debt and
capital lease obligations....................... (2,463) (2,569) (644)
Net proceeds from issuance of common stock....... 865 62,715 198,233
Net proceeds from the sale of redeemable
convertible preferred stock, net of issuance
costs........................................... 3,008 4,435 --
Other............................................ 35 -- --
------- ------- --------
Net cash provided by financing activities...... 1,445 64,581 197,589
Net increase in cash and cash equivalents.......... 3,410 68,132 147,115
Cash and cash equivalents at beginning of year..... 8,836 12,246 80,378
------- ------- --------
Cash and cash equivalents at end of year........... $12,246 $80,378 $227,493
======= ======= ========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid:
Income taxes................................... 199 355 929
Interest paid.................................. 101 107 12
NON-CASH INVESTING AND FINANCING ACTIVITIES:
Conversion of redeemable preferred stock to
common stock.................................... -- 12,351 --
Options issued in business combination........... -- -- 1,600
Tax benefit from option transactions............. -- -- 880
Note payable issued for business combination..... -- -- 2,800
</TABLE>
See Notes to Consolidated Financial Statements.
F-5
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 1997
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 accompanying consolidated financial statements include the accounts of
the Company and its wholly-owned subsidiaries including SQA, Inc. (SQA), which
was merged with the Company effective February 26, 1997. The historical
consolidated financial statements of the Company for all periods prior to such
merger date have been restated to reflect the merger, which has been accounted
for as a pooling-of-interests. The consolidated financial statements for all
periods include results of the Company's operations and balance sheet data on
a March 31 fiscal year basis and SQA's results on a December 31, fiscal year
basis. All intercompany transactions and balances have been eliminated upon
consolidation.
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.
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 became effective for the Company on April 1,
1996. The adoption of FAS 121 did not have a material effect on the Company's
consolidated results of operations.
Revenue recognition. The Company recognizes revenue and related costs from
the sale of its software products and systems upon shipment to the customer if
collection is probable and remaining Company obligations are insignificant.
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 agreements. Contract revenue, which
generally represents 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.
There were no capitalized software development costs as of March 31, 1996
and 1997. For the years ended March 31, 1995, 1996 and 1997, software
amortization was $472,000, $329,000 and $0, respectively.
F-6
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
MARCH 31, 1997
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 its
Swedish subsidiary for which the functional currency is the local currency.
Gains and losses resulting from the remeasurement of the foreign currency
financial statements of the sales operations 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, 1997, other income consisted
primarily of interest earned on the Company's excess cash, cash equivalents
and short-term investments and interest expense. It also included gains and
losses on foreign currency transactions.
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 and
redeemable convertible preferred stock.
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 of greater than
three months are considered to be short-term investments.
All 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." Investments are carried at amortized cost which
approximates estimated fair value based on quoted market prices at March 31,
1996 and 1997.
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 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.
Property and equipment. The Company's property and equipment are recorded at
cost, which is generally depreciated over three- to five-year periods 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.
Stock-based compensation. The Company has elected to follow Accounting
Principles Board Opinion No. 25, "Accounting for Stock issued to Employees"
(APB 25) and related Interpretations in accounting for its employee stock
options because the alternative fair value accounting provided for under FASB
Statement No. 123, "Accounting for Stock-Based Compensation" ("FAS 123"),
requires use of option valuation models that were not developed for use in
valuing employee stock options. The Company generally grants stock options for
a fixed number of shares to employees with an exercise price equal to the fair
value of the shares at the date of grant, accordingly, no compensation expense
is recorded. The Company recognizes compensation expense for those options
granted with an exercise price less than fair value.
F-7
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
MARCH 31, 1997
Fair value of financial instruments. The carrying values reported in the
balance sheet for cash and cash equivalents, short-term investments and long-
term debt approximate fair value. The fair value of short-term investments is
based on quoted market prices.
Advertising costs. The Company expenses advertising costs as incurred.
Advertising costs totaled $1,362,000, $2,109,000 and $2,618,000 for the years
ended March 31, 1995, 1996 and 1997, respectively.
Reclassifications. Certain prior year amounts have been reclassified to
conform with current year presentation.
Recent pronouncements. In February 1997, the Financial Accounting Standards
Board issued Statement No. 128, Earnings per Share, which is required to be
adopted on March 31, 1998. At that time, the Company will be required to
change the method currently used to compute earnings per share and to restate
all prior periods. Under the new requirements for calculating primary earnings
per share, the dilutive effect of stock options will be excluded.
2. RISKS DUE TO CONCENTRATIONS
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 and 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 Company maintains
reserves for potential credit losses and such losses have been within
management's expectations.
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.
From time to time the Company enters into short-term forward exchange
contracts to hedge against the impact of foreign currency fluctuations on
accounts receivable denominated in foreign currencies. The total amount of
these contracts is offset by the underlying foreign currency denominated
accounts receivable. The gains or losses on the contracts are included in
income as the contracts expire and are offset by gains and losses on the
underlying receivables being hedged. At March 31, 1997, the Company had
outstanding forward exchange contracts, all having maturities of approximately
35 days, to exchange various European currencies for US. dollars in the
amounts of $7,397,000. Neither the carrying amount nor the fair value of these
foreign currency forward exchange contracts was material at March 31, 1997.
One major U.S. multinational bank is counterparty to all these contracts. The
associated gains and losses are not material to the Company's results of
operations. There were no forward exchange contracts outstanding at March 31,
1996.
F-8
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
MARCH 31, 1997
3. MERGER WITH SQA, INC.
On February 26, 1997, the Company acquired all the outstanding shares of
SQA, Inc.("SQA"), a company incorporated in Delaware, by issuing approximately
6,997,000 shares of common stock. In addition, each outstanding option or
right to purchase SQA common stock under various stock option and purchase
plans were assumed by the Company and became an option or right to purchase
the Company's common stock after giving affect to the 0.86 exchange ratio. SQA
is primarily involved in developing and marketing integrated software products
for the automated testing and quality management of Windows-based
client/server applications. The acquisition was accounted for a pooling-of-
interests, and accordingly, the Company's historical consolidated financial
statements have been restated to include the results for SQA for all periods
presented. The following information shows revenue and net income (loss) of
the separate companies for the periods preceding the combination. Information
relating to SQA is for the year ended December 31, 1996, 1995 and 1994
respectively (in thousands):
<TABLE>
<CAPTION>
RATIONAL MERGER
SOFTWARE SQA, RELATED
CORPORATION INC. EXPENSES COMBINED
----------- ------- -------- --------
<S> <C> <C> <C> <C>
Year ended March 31, 1997
Revenue............................... $121,264 $24,109 $ -- $145,373
Net income (loss)..................... (40,518) 4,765 (7,201) (42,954)
Year ended March 31, 1996
Revenue .............................. $ 91,107 $12,845 $ -- $103,952
Net income (loss)..................... (4,021) 31 -- (3,590)
Year ended March 31, 1995
Revenue .............................. $ 72,899 $ 4,450 $ -- $ 77,349
Net income (loss)..................... 4,678 (2,422) -- (2,256)
</TABLE>
Revenue and net loss of SQA for the three-month period ended March 31, 1997
the period which is excluded in the accompanying financial statements was
$2,351,000 and $4,147,000, respectively. Included in the accompanying
consolidated statement of operations for the year ended March 31, 1997 are
merger-related expenses totaling $7,201,000 consisting primarily of charges
for investment banking and professional fees of $3,100,000, severance costs of
$1,767,000 associated with employee terminations and charges of $2,334,000
incurred as a result of the closing of duplicate facilities, other merger-
related administrative costs and asset write-downs. As of March 31, 1997 the
Company has paid out or charged $3,842,000 against the related merger accrual.
4. PURCHASE OF VISUAL TEST PRODUCT AND BUSINESS COMBINATIONS
VISUAL TEST PRODUCT. During October 1996 the Company purchased the Visual
Test product from Microsoft Corporation. The aggregate purchase price
(including direct acquisition costs) was $23,146,000 in cash, which has been
allocated to the fair value of the assets acquired, including in-process
research and development. Acquired in-process research and development
represents the present value of the estimated cash flows expected to be
generated by Visual Test related technology, which at the acquisition date had
not yet reached the point of technological feasibility and does not have an
alternative future use. The value of the in-process research and development
was charged to operations on the acquisition date.
REQUISITE, INC. During February 1997 the Company acquired all of the
outstanding shares of common stock of Requisite, Inc. a Colorado-based
provider of software requirements-management tools and training. The aggregate
purchase price (including direct acquisition costs) was $8,631,000. The
Company also assumed the outstanding prequisite employee stock options in
exchange for stock options to purchase 6,450 shares of common stock of the
Company.
F-9
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
MARCH 31, 1997
SOFTLAB AB. During March 1997 the Company acquired all the outstanding
shares of common stock of Softlab AB, a developer of custom software-
engineering tools, integrated software-development environments, and software-
development processes based in Sweden. The aggregate purchase price (including
direct acquisition costs) was $6,732,000 in cash, plus notes payable totaling
approximately $2,800,000. The notes are due in two equal installments on the
first and second anniversary of the closing date.
PERFORMANCE AWARENESS CORPORATION. During March 1997 the Company acquired
all the outstanding shares of capital stock of Performance Awareness
Corporation for cash and assumed the outstanding Performance Awareness
employee stock options in exchange for options to purchase 250,000 shares of
the Company's Common Stock. Performance Awareness develops, markets and
supports automated software quality products and related services that provide
solutions for the software testing market. The aggregate purchase price
(including direct acquisition costs) was $32,929,000 in cash and fair value of
options which were assumed by the Company.
SOFTWARE 9000. Also during March 1997, the Company acquired all the
outstanding shares of common stock of Software 9000, a New Zealand software
distribution company. The aggregate purchase price was $425,000 (including
direct acquisition costs).
OBJECTORY AB. During 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 Company has accounted for the acquisitions of Requisite, Inc., Softlab
AB, Performance Awareness, Software 9000 and Objectory AB using the purchase
method, and accordingly, the operating results of the respective companies are
included in the consolidated results of the Company from the date of
acquisition. The consolidated balance sheets include the assets and
liabilities of these businesses at March 31, 1997. The total purchase price
paid for the Visual Test product and of each acquisition was allocated based
upon discounted cash flow valuation techniques and is summarized as of March
31, as follows (in thousands):
<TABLE>
<CAPTION>
1997 1996
------------------------------------------------ ---------
VISUAL PERFORMANCE
TEST REQUISITE, SOFTLAB AWARENESS SOFTWARE OBJECTORY
PRODUCT INC. AB CORPORATION 9000 AB
------- ---------- ------- ----------- -------- ---------
<S> <C> <C> <C> <C> <C> <C>
Property and equipment.. $ -- $ 132 $ 508 $ 894 $ 16 $ 188
Intangible assets....... 5,488 2,447 3,632 10,094 366 1,216
Severance and facility
accruals............... -- -- (163) (3,573) -- (312)
Net assets (liabilities)
acquired............... -- 341 (512) (1,848) 43 (1,022)
In-process research and
development............ 17,658 5,711 6,067 27,362 -- 8,700
------- ------ ------ ------- ---- -------
$23,146 $8,631 $9,532 $32,929 $425 $ 8,770
======= ====== ====== ======= ==== =======
</TABLE>
Intangible assets include developed technology, assembled workforce,
customer base, trade name and covenant not-to-compete. The estimated average
useful life of these assets is four years. Accumulated amortization of
intangible assets totaled $2,184,000 and $509,000 at March 31, 1997 and 1996,
respectively. In-process research and development represents the present value
of the estimated cash flows expected to be generated by the related technology
from the Visual Test product and from each acquisition, which at the date of
purchase 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 in which the purchase
took place.
F-10
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
MARCH 31, 1997
The following unaudited pro forma combined results of operations of the
Company for fiscal 1996 and 1997, had the business combinations occurred at
the beginning of each fiscal year presented, including non-recurring charges
for acquired in-process technology of $8,700,000 and $56,798,000 in 1996 and
1997, respectively, are as follows:
<TABLE>
<CAPTION>
1996 1997
-------- --------
(IN THOUSANDS,
EXCEPT PER SHARE
DATA)
<S> <C> <C>
Net revenue........................................... $118,880 $158,606
Net loss.............................................. $(10,419) $(50,059)
Net loss per share.................................... $ (0.28) $ (1.15)
</TABLE>
The unaudited pro forma information is presented for illustrative purposes
only and is not necessarily indicative of the operating results that would
have occurred had the transactions been completed at the beginning of the
periods indicated, nor is it necessarily indicative of future operating
results.
5. CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS
The Company's cash equivalents and short-term investments as of March 31,
1996 and 1997 are as follows (in thousands):
<TABLE>
<CAPTION>
1996 1997
------- --------
<S> <C> <C>
Cash and cash equivalents:
Cash................................................... $ 7,998 $ 10,518
Money market funds..................................... 35,470 169,305
Commercial paper....................................... 3,470 11,875
U.S. Government........................................ 33,440 35,795
------- --------
Total................................................ $80,378 $227,493
======= ========
Short-term investments:
U.S. government........................................ $ 4,745 $ --
Commercial paper....................................... 3,908 2,465
Certificates of deposit................................ 58 60
------- --------
Total................................................ $ 8,711 $ 2,525
======= ========
</TABLE>
Realized gains and losses on sales of available-for-sale securities were
immaterial for the years ended March 31, 1996 and 1997. There were no
significant unrealized holding gains or losses on such securities at March 31,
1996 and 1997.
F-11
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
MARCH 31, 1997
6. PROPERTY AND EQUIPMENT
Property and equipment at March 31, 1996 and 1997 is as follows (in
thousands):
<TABLE>
<CAPTION>
1996 1997
-------- --------
<S> <C> <C>
Computer, office and manufacturing equipment........... $ 23,816 $ 27,686
Office furniture....................................... 2,192 3,031
Leasehold improvements................................. 1,228 2,342
-------- --------
27,236 33,059
Accumulated depreciation and amortization.............. (20,989) (19,768)
-------- --------
Net property and equipment............................. $ 6,247 $ 13,291
======== ========
</TABLE>
7. LONG-TERM DEBT AND CAPITAL LEASE OBLIGATIONS
In November 1989, the Company entered into a product development and loan
agreement with International Business Machines (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 loans were fully repaid as of March 31, 1997.
The Company leases certain equipment and furniture under capitalized lease
obligations. The related obligations under capitalized leases represent the
present value of future minimum lease payments. Assets capitalized under
leases totaled $3,979,000 and $4,524,000 at March 31, 1996 and 1997,
respectively. Long-term debt and capitalized lease obligations consist of the
following at March 31 (in thousands):
<TABLE>
<CAPTION>
1996 1997
----- -------
<S> <C> <C>
Long-term debt payable to IBM............................ $ 488 $ --
Note payable to former Softlab AB shareholders........... -- 2,800
Present value of capital lease obligation................ 166 416
Other.................................................... -- 535
----- -------
654 3,751
Less current portion of capital lease obligations and
debt.................................................... (654) (2,010)
----- -------
Due after one year....................................... $ -- $ 1,741
===== =======
</TABLE>
F-12
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
MARCH 31, 1997
8. COMMITMENTS AND CONTINGENCIES
Commitments. The Company leases its primary office space under operating
-----------
leases. Rental expense for facilities was approximately $2,070,000, $2,750,000
and $3,520,000 for the years ended March 31, 1995, 1996 and 1997,
respectively. As a result of merger-related activity at March 31, 1997, the
Company has accrued $1,339,000 of estimated costs of future rent associated
with the excess office space. Estimated future rents from sublease agreements
are $501,000, $358,000, and $119,000 in fiscal 1998, 1999 and 2000,
respectively. Future minimum rental payments, net of sublease income, at March
31, 1997 are as follows for the fiscal years indicated (in thousands):
<TABLE>
<S> <C>
1998............................................................... $ 5,127
1999............................................................... 4,743
2000............................................................... 3,443
2001............................................................... 2,043
2002............................................................... 471
Thereafter......................................................... 495
-------
$16,322
=======
</TABLE>
Legal Matters. On December 1, 1995, a complaint was filed against the
-------------
Company relating to the Company's preliminary acquisition negotiations with
Interactive Development Environments, which were subsequently terminated. The
complaint was settled in March 1997, within amounts previously reserved for.
On December 16, 1996, the Company filed a lawsuit against Silicon Graphics,
Inc. ("SGI") arising from SGI's failure to pay certain royalties due to the
Company under a software license agreement entered into between the Company's
predecessor, VERDIX Corporation, and SGI. SGI has filed an answer denying the
Company's allegations, and also filed a cross-complaint against the Company for
unspecified damages for alleged wrongdoing arising out of the license agreement
with SGI. The Company denies the allegations and intends to vigorously defend
SGI's claims. The Company believes the resolution of this matter will not have
an adverse impact on its financial condition and results of operations.
9. STOCKHOLDERS' EQUITY
Common stock. In July 1996, the Company's Board of Directors and
stockholders approved a two-for-one stock split payable in the form of a stock
dividend to stockholders. All share and per share information have been
adjusted to reflect this change.
During October 1996, the Company sold 5,188,000 shares of common stock in a
public offering. Net proceeds from the sale were $186,356,000 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 which
historically have been provided under various stock option plans. The Company
now issues options from the Non-Employee Director Stock Option Plan and the
1997 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 options, or 100% of fair
market value in the case of incentive stock options, determined on the date
that the option is granted. Under these plans, the Company has reserved
8,468,200 shares for issuance at March 31, 1997. Options expire at various
dates ranging from 5 to 10 years from the date of grant.
In July, 1995, an amendment was approved during the annual meeting of the
Company's stockholders that established a new formula for determining the size
of directors grants and that lengthened the vesting period of directors
grants. The compensation expense recognized during fiscal 1996 and 1997 as a
result of this change was $229,000 and $145,000, respectively.
F-13
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
MARCH 31, 1997
Activity under all plans is summarized as follows:
<TABLE>
<CAPTION>
SHARES UNDER OUTSTANDING
OPTIONS
---------------------------
WEIGHTED-
SHARES AVAILABLE AVERAGE
FOR GRANT OPTIONS EXERCISE PRICE
---------------- ----------- --------------
<S> <C> <C> <C>
Balance at March 31, 1994......... 3,422,832 3,234,918 $ 2.64
Granted......................... (2,723,378) 2,723,378 2.61
Exercised....................... -- (221,003) 2.71
Canceled........................ 338,077 (338,077) 3.61
Expired......................... (448,620) -- --
----------- ----------- ------
Balance at March 31, 1995......... 588,911 5,399,216 2.56
Additional shares authorized...... 1,952,532 -- --
Granted......................... (1,679,429) 1,679,429 7.44
Exercised....................... -- (1,349,398) 2.50
Canceled........................ 244,975 (244,975) 2.50
Expired......................... (16,860) -- --
----------- ----------- ------
Balance at March 31, 1996......... 1,090,129 5,484,272 4.11
Additional shares authorized...... 3,250,000 -- --
Expiration of SQA option plans.... (123,036) -- --
Granted......................... (4,328,634) 4,328,634 24.48
Exercised....................... -- (1,215,624) 3.66
Canceled........................ 554,317 (554,317) 15.75
Expired......................... (13,226) -- --
Net transactions of SQA during the
period from January 1, 1997 to
March 31, 1997................... (94,385) 90,070 32.98
----------- ----------- ------
Balance at March 31, 1997......... 335,165 8,133,035 $14.54
=========== =========== ======
</TABLE>
F-14
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
MARCH 31, 1997
At March 31, 1996 options to purchase 1,585,514 shares of common stock were
exercisable at a weighted-average exercise price of $2.92. At March 31, 1997
the range of options outstanding and exercisable is as follows:
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
-------------------------------- --------------------
WEIGHTED
AVERAGE WEIGHTED WEIGHTED
REMAINING AVERAGE AVERAGE
RANGE OF NUMBER CONTRACTUAL EXERCISE NUMBER EXERCISE
EXERCISE PRICES OUTSTANDING LIFE PRICE EXERCISABLE PRICE
--------------- ----------- ----------- -------- ----------- --------
<S> <C> <C> <C> <C> <C>
$0.29-$0.29......... 359,537 4.68 $ 0.29 205,865 $ 0.29
$0.87-$3.47......... 2,441,461 5.46 2.65 1,365,270 2.77
$3.75-$7.06......... 713,296 7.67 6.16 240,035 5.57
$7.69-$12.31........ 437,338 8.63 9.37 74,596 9.06
$13.57-$19.75....... 1,729,381 9.77 17.50 54,187 14.21
$20.63-$29.14....... 1,672,345 8.23 26.28 31,193 24.89
$31.06-$39.56....... 779,677 8.72 37.21 9,331 37.33
--------- ---- ------ --------- ------
8,133,035 7.59 $14.54 1,980,477 $ 3.92
========= ==== ====== ========= ======
</TABLE>
Employee stock purchase plan. The Company has an employee stock purchase
plan ("ESPP") under which substantially all employees may purchase common
stock through payroll deductions at a price equal to 85% of the lower of fair
market values as of the beginning or end of the offering period. Stock
purchases under the plan are limited to the lessor of 10% of an employee's
compensation or $25,000 per year. At March 31, 1997, 931,000 shares had been
issued under the Plan and 269,000 shares were reserved for issuance.
Stock-based compensation. Pro forma information regarding net income (loss)
and earnings (loss) per share is required by FASB 123 for awards granted or
modified after December 31, 1994 as if the Company had accounted for its
stock-based awards to employees under the fair value method of FASB 123. The
fair value of the Company's stock-based awards to employees was estimated
using a Black-Scholes option pricing model. The Black-Scholes model requires
the input of highly subjective assumptions including the expected stock price
volatility. Because the Company's stock-based awards to employees have
characteristics significantly different from those of traded options, and
because changes in the subjective input assumptions can materially affect the
fair value estimate, in management's opinion, the existing models do not
necessarily provide a reliable single measure of the fair value of its stock-
based awards to employees. The fair value of the Company's stock-based awards
to employees was estimated assuming no expected dividends and the following
weighted-average assumptions:
<TABLE>
<CAPTION>
STOCK
OPTIONS ESPP
--------- ---------
1996 1997 1996 1997
---- ---- ---- ----
<S> <C> <C> <C> <C>
Expected life (years).................................. 3.47 3.52 0.5 0.5
Expected volatility.................................... 0.62 0.59 0.76 1.02
Risk-free interest rate................................ 5.79 6.52 5.64 5.38
</TABLE>
F-15
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
MARCH 31, 1997
For pro forma purposes, the estimated fair value of the Company's stock-
based awards to employees is amortized over the options' vesting period (for
options) and the six-month purchase period (for stock purchases under the
ESPP). The Company's pro forma information for the years ended March 31, is as
follows (in thousands, except for loss per share information):
<TABLE>
<CAPTION>
1996 1997
------- --------
<S> <C> <C>
Net loss:
As reported........................................... $(3,590) $(42,954)
Pro forma............................................. (5,367) (54,663)
Net loss per share:
As reported........................................... $ (0.10) $ (0.98)
Pro forma............................................. (0.15) (1.25)
</TABLE>
Because FASB 123 is applicable only to awards granted subsequent to December
31, 1994, its pro forma effect will not be fully reflected until approximately
1999 and is not expected to be indicative of the effects on net income (loss)
and net income (loss) per share in future years.
The weighted-average fair value of options granted at market value during
fiscal 1996 and 1997 was $3.81 and $11.74 per share, respectively. The
weighted-average fair value of employee stock purchase rights during fiscal
1996 and 1997 was $1.35 and $4.65 per share, respectively.
10. INCOME TAXES
Pretax income (loss) from continuing operations is as follows at March 31
(in thousands):
<TABLE>
<CAPTION>
1995 1996 1997
------ ------- --------
<S> <C> <C> <C>
Domestic......................................... $2,404 $(4,002) $(41,538)
Foreign.......................................... 258 1,440 3,043
------ ------- --------
Total........................................ $2,662 $(2,562) $(38,495)
====== ======= ========
</TABLE>
The provision for income taxes consists of the following at March 31 (in
thousands):
<TABLE>
<CAPTION>
1995 1996 1997
----- ------ ------
<S> <C> <C> <C>
Current
Federal.............................................. $ 100 $ 28 $2,029
State................................................ 70 52 730
Foreign.............................................. 236 948 1,700
----- ------ ------
Total.............................................. $ 406 $1,028 $4,459
===== ====== ======
</TABLE>
F-16
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
MARCH 31, 1997
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 for the years ended March 31 (in
thousands):
<TABLE>
<CAPTION>
1995 1996 1997
----- ------- --------
<S> <C> <C> <C>
Income tax (benefit) at the federal statutory
rate............................................ $ 932 $(897) $(13,473)
Net operating loss carryforwards utilized ....... (720) (1,616) (6,361)
Nondeductible charges for acquired in-process
research and development........................ -- 3,045 19,879
State income taxes............................... 46 52 474
Foreign taxes.................................... 148 444 1,700
Merger related costs............................. -- -- 1,103
Other............................................ -- -- 1,137
----- ------- --------
Total........................................ $ 406 $ 1,028 $ 4,459
===== ======= ========
</TABLE>
Significant components of the Company's deferred tax assets are as follows
at March 31 (in thousands):
<TABLE>
<CAPTION>
1996 1997
-------- --------
<S> <C> <C>
Net operating loss carryforwards........................ $ 18,324 $ 24,605
Tax credit carryforwards................................ 3,492 3,862
Acquired intangibles.................................... -- 4,357
Reserves and accruals not currently deductible.......... 3,301 2,815
Depreciation............................................ 1,323 660
Other................................................... 802 2,153
-------- --------
Total deferred tax assets............................... 27,242 38,452
Valuation allowance for deferred tax assets............. (27,242) (38,452)
-------- --------
$ -- $ --
======== ========
</TABLE>
The valuation allowance increased by $5,647,000 and $11,210,000 in 1996 and
1997, respectively. Approximately $14,119,000 of the valuation allowance is
attributable to stock options, the benefit of which will be credited to
additional paid-in capital when realized.
FASB Statement 109 provides for the recognition of deferred tax assets if
realization of such assets is more likely than not. Based upon the weight of
available evidence, which includes the Company's historical operating
performance and the reported cumulative net loss for the prior three years,
the Company has provided a full valuation allowance against its net deferred
tax assets. The Company will evaluate the realizability of the deferred tax
asset on a quarterly basis.
At March 31, 1997, the Company had net operating loss carryforwards for
federal income tax purposes of approximately $69,000,000 and tax credit
carryforwards of $3,900,000 that expire in 1997 through 2012. 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 $29,000,000 of the Company's net operating loss
carryforwards and $3,100,000 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.
11. 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 1995 and
sales
F-17
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
MARCH 31, 1997
to IBM amounted to 3% of the Company's revenue in 1995. Sales to Lockheed
Martin Corporation, which had a representative on the Board through September
1995, amounted to 2%, and 4% of the Company's revenue in 1995 and 1996,
respectively.
The Company also derives revenues from the sale of its products to customers
in international geographic areas. Total revenue from international sales and
related consulting and customer support in different geographic areas is as
follows at March 31, (in thousands):
<TABLE>
<CAPTION>
1995 1996 1997
------- ------- --------
<S> <C> <C> <C>
Net Sales to Customers:
Western Europe................................... $12,776 $25,066 $ 31,934
Other............................................ 13,086 10,873 13,924
------- ------- --------
Total.......................................... $25,862 $35,939 $ 45,858
======= ======= ========
</TABLE>
Other primarily consists of sales to Canada and the Asia/Pacific region.
12. QUARTERLY INFORMATION (UNAUDITED)
The following table presents unaudited quarterly operating results for each
of the Company's eight quarters in the two-year period ended March 31, 1997.
<TABLE>
<CAPTION>
QUARTER ENDED
-----------------------------------
JUNE 30 SEPT. 30 DEC. 31 MARCH 31
------- -------- -------- --------
<S> <C> <C> <C> <C>
1997
Total revenue........................... $32,002 $34,025 $ 39,057 $ 40,289
Gross margin............................ 24,054 25,754 29,697 30,168
Operating income(loss).................. 4,956 5,718 (13,743) (43,343)
Net income(loss)........................ 5,093 5,872 (11,836) (42,083)
Net income (loss) per share............. 0.11 0.13 (0.26) (0.89)
1996
Total revenue........................... $22,065 $24,579 $ 27,445 $ 29,863
Gross margin............................ 15,627 18,075 20,073 21,528
Operating income (loss)................. 662 1,840 (11,022) 4,128
Net income (loss)....................... 750 2,171 (10,874) 4,363
Net income (loss) per share............. 0.02 0.06 (0.29) 0.10
</TABLE>
13. SUBSEQUENT EVENTS
On April 6, 1997, the Company entered into an Agreement and Plan of
Reorganization (the "Merger Agreement") providing for the merger of Pure Atria
Corporation ("Pure Atria") with and into Wings Merger Corporation, a wholly
owned subsidiary of the Company. Pursuant to the Merger Agreement, all of the
outstanding shares of Pure Atria common stock and each outstanding option or
right to purchase shares of Pure Atria common stock will be exchanged at the
ratio of 0.90 shares and options and rights to purchase shares of Rational
common stock for each share and option or right to purchase common stock of
Pure Atria, respectively. The consummation of the merger requires approval by
the Company's stockholders of the reservation and issuance of the shares of
the Company's common stock to be issued in the merger. The Company expects to
account for the Merger as a pooling of interests and issue approximately
45,493,000 shares in exchange for all outstanding common stock and upon
exercise of outstanding options of Pure Atria.
The Board of Directors has also authorized an increase in the authorized
number of shares of common stock from 75,000,000 to 150,000,000, subject to
stockholder approval, to provide Rational a sufficient number of shares of
common stock to consummate the merger.
F-18
