<PAGE>
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] Quarterly report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
FOR THE QUARTERLY PERIOD ENDED DECEMBER 31, 1997
or
[_] Transition report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from _____ to _____
COMMISSION FILE NUMBER 0-12167
RATIONAL SOFTWARE CORPORATION
(Exact name of Registrant as specified in its charter)
DELAWARE 54-1217099
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
18880 HOMESTEAD ROAD, CUPERTINO, CA 95014
(Address of principal executive office) (Zip Code)
408-863-9900
(Registrant's telephone number including area code)
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes [X] No [_]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock as of the latest practicable date.
COMMON STOCK, PAR VALUE 88,424,339
$.01 PER SHARE
(Class) (Shares outstanding on January 30,
1998)
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CONTENTS PAGE
PART I -- FINANCIAL INFORMATION
Item 1 -- Condensed Consolidated Financial Statements:
<TABLE>
<CAPTION>
<S> <C>
Condensed Consolidated Balance Sheets................. 3
Condensed Consolidated Statements of Operations....... 5
Condensed Consolidated Statements of Cash Flows....... 6
Notes to Condensed Consolidated Financial Statements.. 7
Item 2 -- Management's Discussion and Analysis of Financial Condition
and Results of Operations ............................ 9
PART II OTHER INFORMATION
Item 1 -- Legal Proceedings ..................................... 23
Item 2 -- Changes in Securities and Use of Proceeds.............. 23
Item 6 -- Exhibits and Reports on Form 8-K ...................... 23
SIGNATURE ........................................................ 24
</TABLE>
2
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RATIONAL SOFTWARE CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)
<TABLE>
<CAPTION>
ASSETS
- ------
December 31, March 31,
1997 1997
----------- ----------
(Unaudited) (Note A)
<S> <C> <C>
Cash and cash equivalents $ 49,589 $244,856
Short-term investments 236,147 82,539
Accounts receivable, net 63,114 63,043
Prepaid expenses and other assets 19,431 15,975
----------- ----------
Total current assets 368,281 406,413
Property and equipment, at cost:
Computer, office and manufacturing equipment 61,006 46,663
Office furniture 7,905 7,256
Leasehold improvements 6,281 3,789
----------- ----------
75,192 57,708
Accumulated depreciation and amortization (40,526) (31,443)
----------- ----------
Property and equipment, net 34,666 26,265
Other assets, net 26,359 24,062
----------- ----------
Total assets $429,306 $456,740
=========== ==========
</TABLE>
Note A: The balance sheet at March 31, 1997 has been derived from the audited
financial statements at that date but does not include all of the
information and footnotes required by generally accepted accounting
principles for complete financial statements.
3
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RATIONAL SOFTWARE CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)
<TABLE>
<CAPTION>
LIABILITIES AND STOCKHOLDERS' EQUITY
- ------------------------------------
December 31, March 31,
1997 1997
------------ ----------
(Unaudited) (Note A)
<S> <C> <C>
Accounts payable $ 13,818 $ 13,783
Accrued employee benefits 26,683 21,256
Other accrued expenses 18,418 19,566
Accrued merger and restructuring expenses, current portion 36,279 24,607
Deferred revenue 51,641 42,217
Current portion of long-term debt and lease obligations 1,769 2,010
--------- ---------
Total current liabilities 148,608 123,439
Accrued rent 332 535
Accrued merger and restructuring expenses, long-term 5,892 916
Long-term debt 1,684 1,741
--------- ---------
Total liabilities 156,516 126,631
--------- ---------
Contingencies
Stockholders' equity:
Common stock 886 845
Additional paid-in capital 491,328 455,753
Treasury stock (1,340) (1,340)
Accumulated deficit (216,112) (123,828)
Cumulative translation adjustment (1,972) (1,321)
--------- ---------
Total stockholders' equity 272,790 330,109
--------- ---------
Total liabilities and stockholders' equity $ 429,306 $ 456,740
========= =========
</TABLE>
Note A: The balance sheet at March 31, 1997 has been derived from the audited
financial statements at that date but does not include all of the
information and footnotes required by generally accepted accounting
principles for complete financial statements.
4
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RATIONAL SOFTWARE CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts, unaudited)
<TABLE>
<CAPTION>
Three Months ended Nine Months ended
December 31, December 31,
---------------------- ---------------------
1997 1996 1997 1996
--------- --------- --------- ---------
<S> <C> <C> <C> <C>
Net product revenue $48,373 $ 49,542 $ 132,983 $ 134,109
Consulting and support revenue 33,933 23,607 90,439 65,689
------- --------- --------- ---------
Total revenue 82,306 73,149 223,422 199,798
Cost of product revenue 5,186 3,125 13,961 8,600
Cost of consulting and support revenue 11,508 9,947 31,932 26,699
------- --------- --------- ---------
Total cost of revenue 16,694 13,072 45,893 35,299
------- --------- --------- ---------
Gross margin 65,612 60,077 177,529 164,499
Product research and development expenses 14,869 11,769 45,848 33,291
Sales and marketing expenses 34,129 28,573 103,654 78,523
General and administrative expenses 6,794 8,865 21,915 19,844
Charges for acquired in-process R&D - 17,658 - 17,658
Merger and integration costs - 35,255 63,759 35,255
------- --------- --------- ---------
Total operating expenses 55,792 102,120 235,176 184,571
------- --------- --------- ---------
Operating income (loss) 9,820 (42,043) (57,647) (20,072)
Other income, net 4,004 3,763 13,305 7,401
------- --------- --------- ---------
Income (loss) before income taxes 13,824 (38,280) (44,342) (12,671)
Provision (benefit) for income taxes 3,456 (4,713) 4,781 1,443
------- --------- --------- ---------
Net income (loss) $10,368 $(33,567) $(49,123) $(14,114)
======= ========= ========= =========
Net income (loss) per common share - basic $ 0.12 $ (0.41) $ (0.56) $ (0.18)
Shares used in computing per share amounts - basic 88,008 81,751 87,267 78,252
Net income (loss) per common share - diluted $ 0.11 $ (0.41) $ (0.56) $ (0.18)
Shares used in computing per share amounts - diluted 90,632 81,751 87,267 78,252
</TABLE>
5
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RATIONAL SOFTWARE CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands, unaudited)
<TABLE>
<CAPTION>
Nine Months ended
December 31,
-----------------------
1997 1996
--------- ---------
<S> <C> <C>
Cash flows from operating activities:
Net loss $ (49,123) $ (14,114)
Adjustments to reconcile net loss to net
cash provided by (used in) operating activities:
Loss on disposal of capital eqiupment 134 -
Charges for acquired in-process R&D - 17,658
Depreciation and amortization 14,901 8,562
Noncash expense for stock options 109 1,649
Noncash merger and integration costs - 6,512
(Increase) decrease in assets:
Accounts receivable (71) (9,580)
Prepaids and other, net (3,456) (5,733)
Increase (decrease) in liabilities:
Accounts payable 35 1,935
Accrued employee benefits 5,427 2,754
Deferred revenue 9,424 3,117
Accrued expenses (1,351) 3,914
Accrued merger and restructuring expenses 16,648 16,898
--------- ---------
Net cash provided (used) by operating activities (7,323) 33,572
Cash flows from investing activities:
Purchase of investments (287,453) (9,413)
Sale of investments 133,845 9,133
Capital expenditures (22,904) (14,412)
Proceeds from sale of fixed assets 4,850 -
Net change in other assets (7,678) (241)
Purchase of Visual Test product - (23,000)
Net effect of merger with Pure Atria (15,949) -
--------- ---------
Net cash used in investing activities (195,289) (37,933)
Cash flows from financing activities:
Principal payments under debt and lease obligations (298) (977)
Proceeds from issuance of common stock 8,294 201,918
--------- ---------
Net cash provided by financing activities 7,996 200,941
--------- ---------
Effect of foreign currency exchange rate changes on cash (651) (422)
--------- ---------
Net increase (decrease) in cash and cash equivalents (195,267) 196,158
Cash and cash equivalents at beginning of period 244,856 104,672
--------- ---------
Cash and cash equivalents at end of period $ 49,589 $ 300,830
========= =========
</TABLE>
6
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RATIONAL SOFTWARE CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION -- The consolidated financial information included
herein has been prepared without audit in accordance with the Company's
accounting policies, as described in its latest annual report filed with
the Securities and Exchange Commission on Form 10-K. In the opinion of
management, all adjustments, which consist only of normal recurring
adjustments necessary for a fair presentation of the Company's financial
position, results of operations, and cash flows for the interim periods
presented have been made. As permitted by Form 10-Q, certain information
and footnote disclosures normally included in financial statements
prepared in accordance with generally accepted accounting principles
have been condensed or omitted. Operating results for the periods ended
December 31, 1997 are not necessarily indicative of the results that may
be expected for the fiscal year ending March 31, 1998.
On February 26, 1997 the Company merged with SQA, Inc. ("SQA") and on
July 30, 1997 the Company merged with Pure Atria Corporation ("Pure
Atria"). Both mergers were accounted for as pooling-of-interests and
the historical consolidated financial statements of the Company for
prior periods have been restated to include the financial position,
results of operations and cash flows of both SQA and Pure Atria. See
Note 3 and Note 13 in the Notes to Consolidated Financial Statements in
the Company's Annual Report to Stockholders (Form 10-K) for the year
ended March 31, 1997.
2. MERGER WITH PURE ATRIA CORPORATION
On July 30, 1997, the Company completed the acquisition of Pure Atria
Corporation ("Pure Atria"). Under the terms of the acquisition, which
was accounted for as a pooling of interests, the Company exchanged
approximately thirty nine million (39,082,337) shares of common stock
for all of Pure Atria's outstanding shares and assumed approximately
eight million (7,988,701) options to purchase its common stock, at a
common exchange ratio of 0.9 of a share of the Company's common stock
for each share of Pure Atria's common stock. Pure Atria, based in
Cupertino, California, was a leading provider of software products that
enable the production of reliable, high-quality software and improve the
software development process. Components of the consolidated results of
operations of Rational and Pure Atria for periods prior to the
acquisition are as follows:
<TABLE>
<CAPTION>
Rational Pure
Software Atria
Corporation Corp. Combined
----------- ----- --------
<S> <C> <C> <C>
Three months ended December 31, 1996
Revenue $ 39,057 $ 34,092 $ 73,149
Net loss $(11,836) $(21,731) $(33,567)
Nine months ended December 31, 1996
Revenue $105,084 $ 94,714 $199,798
Net loss $ (870) $(13,244) $(14,114)
</TABLE>
During the second fiscal quarter ended September 30, 1997, the Company
recorded a $63.8 million charge to operating expenses related to merger
and integration costs. Pure Atria merger costs consist principally of
transaction fees for investment bankers, attorneys, accountants,
financial printing, and other related charges of $15.7 million. Pure
Atria integration costs include severance and other employee related
charges, elimination of redundant facilities, write-off of excess
property and equipment and certain intangible assets, and other
professional fees of
7
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approximately $48.1 million. As of December 31, 1997 the Company has
paid out or charged $14.7 million and $25 million, respectively, against
the related transaction and integration merger accruals.
3. ACCOUNTS RECEIVABLE -- Accounts receivable are presented net of an
allowance for doubtful accounts of $2,933,000 at December 31, 1997 and
$4,064,000 at March 31, 1997, respectively.
4. NET INCOME PER COMMON SHARE -- In 1997, the Financial Accounting
Standards Board issued Statement of Financial Accounting Standards No.
128, Earnings per Share. Statement 128 replaced the previously reported
primary and fully diluted earnings per share with basic and diluted
earnings per share. Unlike primary earnings per share, basic earnings
per share excludes any dilutive effects of options, warrants, and
convertible securities. Diluted earnings per share is very similar to
the previously reported fully diluted earnings per share. All earnings
per share amounts for all periods have been presented, and where
necessary, restated to conform to the Statement 128 requirements.
5. CONTINGENCIES -- 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 its position.
The following actions have been filed against the Company, two of its
officers, and Cowen & Company: Randall v. Rational Software
Corporation, et al., No. C 97-03740 (N.D. Cal.); Sachs v. Rational
Software Corporation, et al., No. C-97-3845 (N.D. Cal.); Kalapa v.
Rational Software Corporation, et al., No. C-97-4028 (N.D. Cal);
Weiner, et al v. Rational Software Corporation et al., No. C-97-21086
(N.D. Cal.); Seiger v. Rational Software Corporation, et al., No. 97-
CV-7011 (E.D.N.Y.); Dolnick v. Rational Software Corporation, et al.,
No. 98-CV-0268 (E.D.N.Y.); Lynch v. Rational Software Corporation, et
al., No. CA-97-2081-A (E.D. Va.). The actions are putative shareholder
class action lawsuits, and the complaints are virtually identical. The
complaints allege that defendants violated Sections 10(b) and 20A of
the Securities Exchange Act of 1934 through the selective disclosure
of material inside information regarding the Company's prospects, and
seek damages on behalf of a class of shareholders who purchased the
Company's common stock on October 8, 1997. Defendants have filed
motions to transfer all pending cases to the Northern District of
California. Those motions have not been decided. The cases are in
preliminary stages. The Company believes that the lawsuits are without
merit and intends to defend the cases vigorously.
8
<PAGE>
ITEM 2 -- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
OVERVIEW
The statements contained in Management's Discussion and Analysis of Financial
Condition and Results of Operations include "forward looking" information within
the meaning of Sections 27A of the Securities Act of 1993 and 21E of the
Securities and Exchange Act of 1934, as amended, and are subject to the safe
harbor created by those sections. The actual future results of the Company
could differ materially from those projected in the forward looking information.
For a discussion of certain factors that could cause actual results to differ
materially from those projected by the forward looking information see "Factors
That May Affect Future Results", at the end of this Item 2.
The Company's revenue is derived from product license fees and charges for
services, including technical consulting, training, and customer support. In
accordance with generally accepted accounting principles, the Company recognizes
software license revenue upon shipment and recognizes customer-support revenue
over the term of the maintenance agreement. Revenue from consulting and
training is recognized when earned. The Company's license agreements generally
do not provide a right of return, and reserves are maintained for potential
credit losses, of which historically there have been only immaterial amounts.
On February 26, 1997 the Company merged with SQA, Inc. ("SQA") and on July 30,
1997 the Company merged with Pure Atria Corporation ("Pure Atria"). Both
mergers were accounted for as pooling-of-interests and the historical
consolidated financial statements of the Company for prior periods have been
restated to include the financial position, results of operations and cash flows
of both SQA and Pure Atria. See Note 3 and Note 13 in the Notes to Consolidated
Financial Statements in the Company's Annual Report to Stockholders (Form 10-K)
for the year ended March 31, 1997.
COMPARATIVE ANALYSIS OF OPERATING RESULTS FOR THE THREE AND NINE MONTHS ENDED
DECEMBER 31, 1997
Total revenue increased 13% and 12%, respectively, for the three- and nine-month
periods ended December 31, 1997 from the comparable prior year periods. Net
product revenue remained relatively flat for the three- and nine-month
periods ended December 31, 1997 from the comparable prior year periods.
Consulting and support revenue increased 44% and 38%, respectively, for the
three- and nine-month periods ended December 31, 1997 from the comparable
prior year periods. This increase reflects higher demand for the Company's
consulting expertise in component based development and advanced software
development practices, and increased training and customer support revenues.
International revenues from product sales and consulting and customer support
accounted for 34% of total revenues for both the three- and nine-month periods
ended December 31, 1997, as well as 34% for both of the comparable prior year
periods. The Company's international sales are principally priced in foreign
currencies and are generally exported out of the U.S. From time to time the
Company enters into short-term forward exchange contracts to hedge against the
impact of foreign currency fluctuations on the 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
9
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offset by gains and losses on the underlying receivables being hedged. At
December 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 $7,370,000. Two major U.S.
multinational banks are counterparty to all these contracts. The associated
gains and losses were not material to the Company's results of operations in any
period presented. There were no forward exchange contracts outstanding at
December 31, 1996.
Cost of product revenue consists principally of materials, packaging and
freight, amortization of developed technology and royalties. Cost of product
revenue increased 66% and 62%, respectively, for the three- and nine-month
periods ended December 31, 1997 from the comparable prior year periods. These
costs represented 11% and 10% respectively, of total product revenue for the
three- and nine-month periods ended December 31, 1997, as compared to 6% for
both of the comparable prior year periods. The increase in product cost as a
percentage of product revenue was due mainly to amortization of developed
technology associated with recent mergers and acquisitions.
Cost of consulting and support revenue consists principally of personnel costs
for training, consulting and customer support. Cost of consulting and support
increased 16% and 20% respectively, for the three- and nine-month periods ended
December 31, 1997 from the comparable prior year periods. These costs
represented 34% and 35%, respectively, of total consulting and support revenue
for the three- and nine-month periods ended December 31, 1997 as compared to 42%
and 41% for the comparable prior year periods. The decrease in cost as a
percentage of related revenue is primarily due to changes to the Company's
customer support business model as a result of merging the Pure Atria and
Rational service organizations, combined with the impact of an underlying
relatively fixed support cost base being spread over increased revenues.
Total expenditures for research and development increased 26% and 38%
respectively, for the three- and nine-month periods ended December 31, 1997 from
the comparable prior year periods. These costs represented 18% and 21%,
respectively, of total revenue for the three- and nine-month periods ended
December 31, 1997 as compared to 16% and 17% respectively, for the comparable
prior year periods. The increase in expenditures for research and development
is due primarily to the cost of additional personnel and related costs incurred
in maintaining existing products and developing new product releases and
increased operating expenses resulting from the recently completed merger with
Pure Atria.
Sales and marketing expenses increased 19% and 32% respectively, for the three-
and nine-month periods ended December 31, 1997 from the comparable prior year
periods. These costs represented 41% and 46%, respectively, of total revenue
for the three- and nine-month periods ended December 31, 1997 as compared to 39%
for both of the comparable prior year periods. The comparative increase in sales
and marketing expenses reflect the additional personnel, commissions and
related costs required in sales and marketing departments in an effort to expand
Rational's sales channels, to penetrate new markets, and to increase its market
share in core markets. In the nine months ended December 31, 1997, the Company
also incurred additional marketing and field training costs associated with the
recently completed merger with Pure Atria.
General and administrative expense consists of personnel costs for
administration, finance, information systems, human resources and general
management, as well as legal and accounting expenses. General and administrative
expense decreased 23% and increased 10% respectively, for the three- and nine-
month periods ended December 31, 1997 from the comparable prior year periods.
These costs represented 8% and 10% respectively, of total revenue for the three-
and nine-month periods ended December 31, 1997 as compared to 12% and 10%,
respectively, for the comparable prior year periods. The increased expense for
the nine-month period resulted from employee related expenses associated with
the staffing requirements needed to support the Company's expanding business,
and from an increase in amortization of purchased intangibles related to the
Company's recent mergers and acquisitions. The year to year decrease in
expense for the third quarter of fiscal 1998 results primarily from
non-recurring expenses in the third quarter of fiscal 1997 which were
associated with reimbursement of approximately $1,200,000 in expenses of
certain of its stockholders. These expenses were related to the underwriting
discount applicable to the shares of common stock sold by them, as well as
certain fees and expenses of such stockholders' legal counsel incurred in
connection with the Company's October 1996 public stock offering.
10
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In the second fiscal quarter ended September 30, 1997 the Company recorded a
charge of $63.8 million related to the combination of Rational and Pure Atria.
There can be no assurance that Rational will not incur additional charges
associated with the merger or that management will be successful in its efforts
to integrate the operations of the two companies. As of December 31, 1997 the
Company has charged $39.7 million against the related merger accruals.
Other income, net consists of interest income, interest expense, gains and
losses on foreign currency transactions and miscellaneous items of income and
expense. Other income has fluctuated as a result of the amount of cash available
for investment in interest-bearing accounts and from foreign currency
transactions. Other income, net increased $241,000 and $5,904,000, respectively,
for the three- and nine-month periods ended December 31, 1997 from the
corresponding prior year periods. The increases result primarily from the
investment earnings on the additional cash generated by the Company's
public offering in October 1996.
The provision for income taxes for the three- and nine-month periods ended
December 31, 1997 is based on the estimated annual effective tax rate applied to
the profit before income taxes (excluding one-time charges for acquired in-
process research and development) and includes current federal, state and
foreign income taxes. The provision for income taxes for the three- and nine-
month periods ending December 31, 1997 consists primarily of foreign income
taxes as well as federal and state minimum taxes. The effective tax rates for
fiscal 1998 and 1997 differ from the federal statutory rate, primarily, as a
result of the utilization of net operating loss carryforwards, the non-
deductibility of certain merger related costs, and by certain foreign and state
taxes.
LIQUIDITY AND CAPITAL RESOURCES AT DECEMBER 31, 1997
As of December 31, 1997, the Company had cash, cash equivalents and short-term
investments of $285,736,000 and working capital of $219,673,000. Net cash used
in operating activities for the period ending December 31, 1997 was composed
primarily of the operating loss, offset by an increase in accrued merger costs,
deferred revenue, and accrued employee benefits. Net cash used in investing
activities is primarily a result of increased short-term cash investments and
capital expenditures. Net cash provided by financing activities is primarily
the result of issuance of common stock under the Employee Stock Purchase Plan
and exercise of employee stock options.
The Company believes that expected cash flow from operations combined with
existing cash and cash equivalents and short-term investments will be sufficient
to meet its cash requirements for the foreseeable future.
11
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FACTORS THAT MAY AFFECT FUTURE RESULTS
Risks related to the Recent Acquisition of Pure Atria Corporation.
- -----------------------------------------------------------------
Rational acquired Pure Atria Corporation ("Pure Atria") on July 30, 1997 with
the expectation that the acquisition would result in long-term strategic
benefits. The realization of these anticipated benefits will continue to depend
in part on whether the companies' operations can be integrated in an efficient
and effective manner. There can be no assurance that this will occur. The
successful integration of Pure Atria's operations into Rational continues to
require, among other things, integration of the companies' respective product
offerings and coordination of the companies' sales and marketing efforts and
research and development efforts. Successful integration of the companies'
respective sales forces will continue to require sales personnel to become
familiar with the sales cycles and sales approaches required for products
recently added to their portfolios, and any failure to do so may result in sales
delays and decreased revenues for the Company. It is possible that the continued
integration of the companies' respective products, and the creation of
integrated bundles and suites, may not be accomplished in a timely manner or may
prove to be technologically infeasible. The difficulties of integrating the two
companies' respective operations is compounded by the fact that each company
had significant operations on both the East Coast and the West Coast of the
United States and in a number of foreign countries. The acquisition of Pure
Atria may cause resellers and present and potential customers of either
company to delay or cancel orders as a result of concerns and uncertainty over
evolution, integration and support of products. If affiliates of Rational or
Pure Atria sold their Rational Common Stock despite their contractual
obligations not to do so until Rational publicly announced financial results
covering at least 30 days of combined operations, the acquisition of Pure
Atria may not qualify for accounting as a pooling of interests. The failure of
such acquisition to qualify for accounting as a pooling of interests for any
reason would materially and adversely affect Rational's reported earnings and,
potentially, its stock price.
Fluctuations In Operating Results.
- ---------------------------------
Revenue in any quarter is substantially dependent on orders booked and shipped
in that quarter. Because staffing and operating expenses are based on
anticipated revenue levels, and a high percentage of the costs are fixed, small
variations in the timing of the recognition of specific revenues could cause
significant variations in operating results from quarter to quarter.
Historically, the Company has earned a substantial portion of its revenues in
the last weeks of the quarter. To the extent these trends continue, the failure
to achieve such revenues in the last weeks of any given quarter will have a
material adverse effect on the Company's financial results for that quarter. The
Company's revenue is difficult to forecast due to the fact that Rational's
sales cycles, from initial evaluation to purchase, vary substantially from
customer to customer and from product to product, and because the markets for
Rational's products are rapidly evolving. In addition, the Company's results
will be affected by the number, timing and significance of new product
announcements by it and its competitors, its ability to develop, introduce and
market new and enhanced and integrated versions of its products on a timely
basis, the level of product and price competition, changes in operating
expenses, changes in average selling prices and product mix, any changes in its
sales incentive strategy, the experience level of and any changes in sales
personnel, any changes in sales cycles, the mix of direct and indirect sales,
product returns and general economic factors, among others. The Company's sales
will also be sensitive to existing and prospective customers' budgeting
practices, to global economic conditions and to potential cutbacks in U.S.
defense spending, which has historically been a significant factor for Rational.
12
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The Company incurred direct transaction costs associated with the
acquisition of Pure Atria of approximately $16 million, which resulted in a non-
recurring charge to operations upon consummation of the acquisition. The Company
incurred non-recurring charges to operations of approximately $64 million in the
quarter ending September 30, 1997, the quarter in which the transaction was
consummated, to reflect costs associated with integrating the two companies.
Unanticipated expenses associated with the integration of the two companies may
arise, or the Company may incur additional material charges in subsequent
quarters to reflect additional costs associated with the integration of the two
companies. Total costs associated with such transactions are anticipated to
result in an operating loss and a net loss for the Company's fiscal year ending
March 31, 1998, and could negatively impact financial results in future periods
for the reasons discussed above.
Although Rational has experienced growth in revenues in recent years, there
can be no assurance that, in the future, Rational will sustain revenue growth or
be profitable on a quarterly or annual basis. Further, the revenues and
operating income (exclusive of nonrecurring operating, restructuring and merger-
related expenses) experienced by Rational in recent quarters are not necessarily
indicative of future results, and period-to-period comparisons of Rational's
financial results should not be relied upon as an indication of future
performance. Fluctuations in operating results may also result in volatility in
the prices of Rational's Common Stock.
Due to all of the foregoing factors, it is possible that in some future
quarter Rational's operating results will be below the expectations of public
market analysts and investors. In such event, the price of Rational's Common
Stock would likely be materially adversely affected, and significant declines in
stock prices frequently result in costly and lengthy securities litigation, with
its attendant costs, distraction and liability exposure.
Volatility Of Stock Price.
- -------------------------
The market price of the Company's Common Stock has been, and is likely to
continue to be, volatile. Factors such as new product announcements or changes
in product pricing policies by the Company or its competitors, quarterly
fluctuations in the Company's operating results, announcements of technical
innovations, announcements relating to strategic relationships or acquisitions,
changes in earnings estimates by analysts and general conditions in the
software development market, among other factors, may have a significant
impact on the market price of the Company's Common Stock. Should the Company
fail to introduce products on the schedule expected, the Company's stock price
could be adversely affected.
Any shortfall in anticipated operating results could have an immediate and
significant adverse effect on the market price of the Company's Common Stock.
Potential business synergies, if achieved, of Rational and Pure Atria may not
offset any such dilution. Further, the Company incurred substantial merger-
related charges in the quarter ending September 30, 1997. Rational expects the
merger to be accretive in the long-term. However, this forward-looking
statement may not prove to be an accurate prediction due to unforseen changes,
inaccurate or incomplete assumptions regarding the current business or future
prospects of either or both of the companies, or other reasons. Rational expects
that the Pure Atria merger will be dilutive in the initial periods following its
effective time, and there can be no assurance as to when the merger will become
accretive, if ever. Any failure of the Pure Atria merger to meet expectations
as to potential business synergies or any failure of the Pure Atria merger to be
accretive in any quarter could have an immediate and significant adverse effect
on the market price of the Company's Common Stock.
Statements or changes in opinions, ratings, or earnings estimates made by
brokerage firms or industry analysts relating to the market for software and
high technology company stocks or relating to Rational specifically have
resulted, and could in the future result, in an immediate and adverse effect
13
<PAGE>
on the market price of Rational's Common Stock. Statements by financial or
industry analysts regarding the extent of the dilution in Rational's net income
per share resulting from operating results, the Pure Atria merger or other
developments and the extent to which such analysts expect potential business
synergies to offset such dilution can be expected to contribute to volatility in
the market price of Rational's Common Stock. In addition, in recent years the
stock market in general, and the shares of technology companies in particular,
have experienced extreme price fluctuations. This volatility has had a
substantial effect on the market prices of securities issued by many companies,
including Rational, in certain cases for reasons unrelated to the operating
performance of the specific companies. These broad market fluctuations may
adversely affect the market price of the Rational Common Stock.
Risks Associated With Recent And Future Acquisitions.
- ----------------------------------------------------
During approximately the past three years, and the past year in particular,
Rational has made a number of strategic acquisitions, including Pure Atria on
July 30, 1997, SQA, Inc., Performance Awareness Corporation, Requisite, Inc.,
Softlab AB, and Software 9000 in the quarter ended March 31, 1997; the Visual
Test product from Microsoft in October 1996; and other acquisitions in earlier
periods. Rational acquired 19.9% of the outstanding capital stock of
ObjecTime, Ltd. in October, 1997 with an option to acquire the rest of the
company at a later date. Acquisitions result in the diversion of management's
attention from day-to-day operations and include numerous other risks,
including difficulties in the integration of operations, products and
personnel. To the extent that acquisitions have in the past resulted, or may
in the future result, in a diversion of resources or that efforts to integrate
recent and future acquisitions fail, there could be a material adverse effect
on Rational's business, results of operations and financial condition.
Acquisitions have the potential to result in dilutive issuances of equity
securities, the incurrence of debt, and amortization expenses related to
goodwill and other intangible assets. Rational management has historically
evaluated on an ongoing basis the strategic opportunities available to the
Company. Rational may in the near- or long-term future pursue acquisitions of
complementary products, technologies or businesses.
Dependence Upon Market Growth And Development Of Industry Standards.
- -------------------------------------------------------------------
Rational's future growth and financial performance will depend in part upon
continued growth in the need for and sales of tools for automating software
application development and management. Sales of these products may not continue
to grow or the Company may be unable to respond effectively to evolving customer
requirements. The number of software developers using Rational's products is
relatively small compared to the number of developers using more traditional
technology and products. The adoption of the Company's products by software
programmers who have traditionally used other technology requires re-orientation
to significantly different programming methods. The acceptance of the Company's
products, therefore, may not expand beyond sophisticated programmers who are
early adopters of the technology. Furthermore, potential customers may be
unwilling to make the investment required to retrain programmers to build
software using the Company's products rather than traditional programming
techniques. Many of Rational's customers have purchased only small quantities
of the Company's products, and these or new customers may decide not to broadly
implement or purchase additional units of such products.
Rational's future growth and financial performance may depend upon the
development of industry standards that facilitate the adoption of component-
based development, as well as Rational's ability to play a leading role in the
establishment of those standards. The Company has developed the Unified Modeling
Language ("UML") for visual modeling which has been adopted by the Object
Management Group ("OMG"), an industry consortium, for inclusion of the UML in
their Object Analysis and Design Facility specification. The official sanction
in the future of a competing standard by the OMG
14
<PAGE>
could have a material adverse effect on Rational's marketing and sales efforts
and, in turn, on Rational's business, operating results and financial condition.
Expansion Of Product Lines; Dependence Upon New Product Introductions.
- ----------------------------------------------------------------------
The Company believes that its continued success will depend in part upon its
ability to provide a tightly integrated line of software application development
tools, as well as integrated product suites and bundles, that support software
development for a number of implementation languages. This will require the
Company to modify and enhance its current products and to continue to develop,
introduce and integrate new products. The Company also believes its continued
success will become increasingly dependent on its ability to support the
Microsoft platform, including Windows 95, Windows 98, and Windows NT operating
systems. The Company believes that it will be particularly important to
successfully develop and market a broader line of products for C++, Visual
Basic, Java and other implementation languages in order to be successful in
its efforts to broaden its customer base and to further increase its share
within its existing market segments. The Company also believes that, over
time, its products must be extended to fully support off-the-shelf products
from companies such as SAP, Baan Company, and PeopleSoft. The Company may be
unable to successfully develop and market such a broad line of products, or
may encounter unexpected difficulties and delays in integrating new products
with existing product lines.
Rational has plans to introduce new products and enhanced versions of current
products during the next few fiscal quarters. Delay in the start of shipment of
new, enhanced or integrated products, suites and bundles would have an adverse
effect on the Company's revenues, gross profit and operating income. As a result
of Rational's business alliance with Microsoft, certain of Rational's new
product releases are expected to be tightly integrated with new releases of
certain Microsoft products. To the extent that scheduled Microsoft product
releases are delayed, there could be a material adverse effect on Rational's
revenues from new products.
Rational attempts to make adequate allowances in its product release schedules
for both internal and beta-site testing of product performance. Because of the
complexity of the Company's products, however, the release of new products may
be postponed should test results indicate the need for redesign and retesting,
or should the Company elect to add product enhancements in response to beta
customer feedback.
Competition
- ----------
The industry for tools for automating software application development and
management is extremely competitive and rapidly changing. Rational expects to
continue to experience significant and increasing levels of competition in the
future. Bases of competition include corporate and product reputation,
innovation with frequent product enhancement, breadth of integrated product
line, the availability of integrated suites and bundles, product architecture,
functionality and features, product quality, performance, ease-of-use, support,
availability of technical consulting services and price. Rational faces intense
competition for each product within its product lines, generally from both
Windows/NT and UNIX vendors. Because individual product sales are often the
first step in a broader customer relationship, Rational's success will depend in
part upon its ability to successfully compete with numerous competitors at each
point within its product line.
Rational faces competition from software development tools and processes
developed internally by customers, including ad hoc integrations of numerous
stand-alone development tools. Customers may be reluctant to purchase products
offered by independent vendors such as the Company. As a result, the Company
must educate prospective customers as to the advantages of the Company's
products versus internally developed software quality systems.
15
<PAGE>
Rational faces competition from, among others, Intersolv, Inc., Platinum
Technology, Inc., Select Software Tools plc, Cayenne, Oracle, IBM, Sun
Microsystems, and Sybase Inc. as well as numerous privately held tool suppliers
offering traditional CASE tools that compete with the Rational Rose approach to
visual modeling and component-based development. Oracle's recent announcement of
its intent to add visual modeling capability to its development products would
result in an increased level of competition to the Company's Rose products.
Rational's RequisitePro requirements management product faces competition from
companies such as GEC-Marconi. Rational's software testing tools--SQA Suite,
Rational Visual Test, Quantify, Purify, PureCoverage and preVue--face
competition from Compuware, (including its recently announced acquisition of
NuMega), Mercury Interactive Corporation, Segue Software, Inc., Intersolv,
Inc., Computer Associates, Platinum Technologies, Terodyne, Cyrano, SQL Bench
International, Inc., and several private companies offering testing automation
tools. Microsoft, Compuware, Oracle, Sybase and several of the major UNIX
platform vendors, including Sun Microsystems, Hewlett Packard, Digital
Equipment Corporation, Silicon Graphics Inc., and IBM, also compete with
Rational with respect to software quality products and testing tools, with
testing products customized to certain of their other software products.
Rational Apex for C/C++ faces competition from, among others, major UNIX
platform vendors such as Sun Microsystems, Hewlett-Packard and Digital
Equipment Corporation, which have C/C++ compilers and debuggers and in some
cases programming environments for their platforms. In addition, numerous
privately held companies offer compilers, debuggers and programming
environments which compete with Rational Apex. Rational's Apex Ada and VADS
product lines face competition from Aonix, Green Hills Software, Inc. and a
large number of other suppliers offering Ada products for native and embedded
systems.
The Company also experiences competition with respect to a number of its
products, both from utilities commonly bundled with versions of operating
systems and from stand-alone product offerings. For example, versions of UNIX
are commonly bundled with utilities (such as SCCS and RCS) that provide version
control, which is part of the functionality provided by ClearCase. Some system
vendors, such as Sun, already have products, such as Workshop, that provide
features similar to those in Purify or other of the Company's products and would
compete directly with such products if offered on a stand-alone basis. The
Companies recently announced ClearQuest defect tracking product is expected to
compete with products from LBMS, Inc., which was recently acquired by Platinum
Technology, Inc. There can be no assurance that Sun, which has a license to
some of the Company's patents, will not introduce stand-alone products that
compete with the Company's products. Companies offering products competitive
with Rational Summit and ClearCase in the UNIX marketplace include Sun, which
offers TeamWare, IBM, which offers Configuration Management/Version Control
("CMVC"), Computer Associates ("CA") through its acquisition of LEGENT
Corporation, which offers the Endeavor WSX product, and Platinum through its
acquisition of Softool Corp., which markets CCC Harvest. In addition, there
are several smaller, privately-held companies that market competitive
products, including Continuous Software Corporation, which markets
Continuus/CM. Other companies have offered version control or configuration
management products outside the UNIX market. Companies in this category
include CA, Intersolv and Microsoft. CA has a large installed base of its
configuration management product on IBM mainframes. Intersolv has a large
installed base of DOS and Windows software developers. In 1994, Microsoft
acquired OneTree Software, which offers a version control product. The Company
expects additional competition from other established and emerging companies.
Digital Equipment Corporation has spun-off an independently operated
subsidiary, TracePoint Technology, Inc., which has stated that it intends to
produce development and testing tools and compete against the Company.
Rational believes that the increased level of competition it observed in
fiscal 1997 and to date in fiscal 1998 will continue to increase. Certain of
Rational's competitors are more experienced than Rational in the development
of software-engineering tools, databases or software-development products.
Some of Rational's competitors have, and new competitors may have, larger
technical staffs, more established distribution channels and greater financial
resources than Rational. There can be no assurance that either existing or new
competitors will not develop products that are superior to Rational's products
or that achieve greater market acceptance. Rational's future success will
depend in large part upon its ability to increase its share of its target
markets and to license additional products and product enhancements to
16
<PAGE>
existing customers. Future competition may result in price reductions, reduced
margins or loss of sales which in turn would have a material adverse effect on
the Company's business, results of operations and financial condition.
Dependence Upon Sales Force And Other Channels Of Distribution.
- ------------------------------------------------------------
Rational currently distributes its products primarily through field sales
personnel teamed with highly trained technical support personnel. Rational
believes that a high level of technical consulting, training and customer
support is essential to maintaining its competitive position, and has found that
the ability to deliver a high level of technical consulting, training and
customer support is an important selling point with respect to its products.
While complementary to Rational's products, the services provided by these
personnel have historically yielded lower margins for Rational than the
Company's product business. If these services constitute a higher proportion of
total revenues in the future, the Company's margins will be adversely affected.
Rational markets and sells its products and services directly through its
major accounts field operations, its telesales organizations, and use of its
website, and indirectly through channels such as VARs and distributors. There
can be no assurance that such channels will be successful in increasing sales
of the Company's products or in reducing its sales costs on a percentage
basis.
Dependence on Key Personnel.
- ---------------------------
Rational believes that the hiring and retaining of qualified individuals at
all levels in the Company will be essential to the Company's ability to manage
growth successfully, and there can be no assurance that the Company will be
successful in attracting and retaining the necessary personnel. The Company
will be particularly dependent upon the efforts and abilities of its senior
management personnel. The departure of any of the senior management members or
other key personnel of the Company could have a material adverse effect on the
Company's business, financial condition, or results of operations depending upon
the timing of the departure, changes in the Company's business prior to such
time, the availability of qualified personnel to replace them, and whether such
personnel depart singly contemporaneously, or as a group, among other factors.
Merger activities, such as the acquisition of Pure Atria, can be accompanied or
followed by the departure of key personnel, which can compound the difficulty of
integrating the operations of the parties to the business combination.
The ability of the Company to attract and retain the highly trained technical
personnel that are integral to its direct sales and product development teams
may limit the rate at which the Company can develop products and generate sales.
Competition for qualified personnel in the software industry is intense, and
there can be no assurance that the Company will be successful in attracting and
retaining such personnel. Merger activities, such as the acquisition of Pure
Atria, may have a destabilizing effect on employee retention at all levels
within the Company. Departures of existing personnel, particularly in key
technical, sales, marketing or management positions, can be disruptive and can
result in departures of other existing personnel, which in turn could have a
material adverse effect upon the Company's business, operating results and
financial condition.
A traditional means of retaining employees following declines in a
corporation's stock price, such as those experienced recently by Rational, is to
re-price "underwater" stock options, both to offer an equity incentive to
existing employees and to avoid inequities relative to new employees offered
lower-priced options. On November 4, 1997 the Company's board of directors
approved a program enabling the Company to re-price stock options for most
employees. The re-priced options are subject
17
<PAGE>
to additional lock-up and repurchase restrictions. Certain members of the
company's senior management team were not eligible to participate in the
repricing program. To the extent that options held by members of senior
management remain underwater, these options may not serve as an incentive to
retain these individuals. The departure of one or more members of the senior
management team could have a material adverse effect on the Company's business,
results of operations and financial condition.
Rapid Technological Change.
- --------------------------
The industry for tools for automating software application development and
management is characterized by rapid technological advances, changes in customer
requirements and frequent new product introductions and enhancements. The
introduction of products embodying new technologies and the emergence of new
industry standards and practices can render existing products obsolete and
unmarketable. The Company must respond rapidly to developments related to
Internet and intranet applications, hardware platforms, operating systems and
applicable programming languages. Such developments will require the Company to
make substantial product development investments. Any failure by the Company to
anticipate or respond adequately to technology developments and customer
requirements, or any significant delays in product development, introduction or
integration could result in a loss of competitiveness or revenue. To the extent
the Company does not respond to technological change or evolving customer
requirements with new products or product enhancements, such new products or
product enhancements may fail to achieve market acceptance.
In addition, rapid growth of interest in and use of Internet and intranet
environments is a recent and emerging phenomenon. The Company's success may
depend, in part, on the compatibility of its products with Internet and intranet
applications. The Company may fail to effectively adapt its products for use in
Internet or intranet environments or to produce competitive Internet and
intranet applications.
Rational believes that factors affecting the ability of its products to
achieve broad consumer acceptance include product performance, price, ease of
adoption, displacement of existing approaches and adaptation to rapid
technological change and competitive product offerings. The Company may be
unable to respond promptly and effectively to the challenges of technological
change and its competitors' innovations, and it is possible that the Company
will be unable to achieve the necessary market acceptance, or compete
effectively, in new markets.
Dependence On Strategic Relationships.
- -------------------------------------
Rational's development, marketing and distribution strategies rely
increasingly on its ability to form long-term strategic relationships with major
software and hardware vendors, many of whom are substantially larger than
Rational. These business relationships often consist of cooperative marketing
programs, joint customer seminars, lead referrals or joint development projects.
Although certain aspects of some of these relationships are contractual in
nature, many important aspects of these relationships depend upon the continued
cooperation of each party with Rational. Merger activity, such as the
acquisition of Pure Atria, may disrupt these relationships or activities, and
certain partners may reassess the value of their relationship with Rational as a
result of such merger activity. Divergence in strategy between Rational and any
given partner, a change in focus by any given partner, or competitive product
offerings introduced by any given partner, may interfere with Rational's ability
to develop, market, sell or support its products, which in turn would have a
material adverse effect on Rational's business, results of operations and
financial condition. See "- Business Alliance with Microsoft."
18
<PAGE>
Business Alliance With Microsoft.
- --------------------------------
On October 2, 1996, Rational and Microsoft announced the formation of a
business alliance which consists of Rational's acquisition of Microsoft's Visual
Test product, technology cross-licensing, joint development projects and joint
marketing programs. While Rational believes that Microsoft's current strategy in
relation to the enterprise information systems market is based on component-
based development, there can be no assurance that this strategy will continue or
that, if it does continue, Microsoft's emphasis or priorities will not change in
the future, resulting in less attention and fewer resources being devoted to
Microsoft's relationship with Rational. Although certain aspects of the business
alliance are contractual in nature, many important aspects of the relationship
depend on the continued cooperation of the two companies, and there can be no
assurance that Rational and Microsoft will be able to work together successfully
over an extended period of time. In addition, there can be no assurance that
Microsoft will not use the information it gains in its relationship with
Rational to develop or market competing products.
Acquisition Of The Visual Test Product.
- --------------------------------------
The Company acquired the Visual Test product from Microsoft on October 2,
1996. There can be no assurance that Rational will be able to successfully
incorporate Visual Test into its integrated family of products, or that it will
be able to achieve significant sales of the Visual Test product. Many potential
customers for Visual Test differ from the Company's historical customer base in
terms of component-based software development expertise, purchasing processes,
financial resources and expectations regarding software-engineering tools.
There can be no assurance that the Company will not encounter unanticipated
concerns of Visual Test customers that are different from the concerns of the
Company's traditional customers, or that the Company will have the
infrastructure and experience necessary to adequately respond to the volume and
type of such concerns.
Rational has granted Microsoft a non-exclusive, perpetual license to the
Visual Test product source code for the purpose of creating derivative works and
for the purpose of distributing portions of the Visual Test product and
derivative works as part of Microsoft products that do not directly compete with
the Visual Test product in the software testing tools area. There can be no
assurance that Microsoft will not use such rights to create and distribute
products that compete with other Rational products. Rational has also granted
Microsoft a five-year option to obtain a license to incorporate certain elements
of Visual Test technology into Microsoft development tool products, including
Visual Basic, Visual C++ and Visual J++. Should Microsoft exercise such right,
sales of the Visual Test product by Rational could be materially and adversely
impacted. See "--Fluctuations in Operating Results."
Licensing Of Rose Technology To Microsoft.
- -----------------------------------------
In October 1996, Microsoft and Rational entered into a two-year agreement
providing for the inclusion of a subset of the Rational Rose visual modeling
technology in future versions of Microsoft's enterprise-oriented visual tools.
The Company's objective in entering into this arrangement is to expose the
Company's technology to a broader customer base, and is not to generate direct
product revenue from Microsoft. The Company expects that changes in the
Company's pricing models and combinations of features within product lines will
be required to appeal to this customer base, and there can be no assurance that
such changes will achieve customer acceptance. Rational does not
19
<PAGE>
expect the licensing of its Rose technology to Microsoft to directly result in a
material increase in product revenue. In addition, there can be no assurance
that developers introduced to the Rose technology incorporated into Microsoft
products will become purchasers of Rational products in the future. Rational has
granted Microsoft the option to obtain a perpetual, non-exclusive right to
source code for certain aspects of Rational's Rose technology after the
expiration of the agreement. While Rational believes that Microsoft's and
Rational's strategies currently are complementary, there can be no assurance
that Microsoft will not use this right to develop and market competing products
in the future.
Dependence Upon Major Operating Systems.
- ---------------------------------------
Many of Rational's major products have historically been licensed for use
principally on certain versions of the UNIX platform. These products constitute
a substantial portion of Rational's product and service revenues. Any factors
adversely affecting the demand for, or use of, the UNIX operating system that
would require changes to Rational's products would have a material adverse
effect upon the business, operating results and financial condition of Rational.
Likewise, other of Rational's major products have historically been licensed for
use purely on the Windows operating system. These products also constitute a
substantial portion of Rational's product and service revenues. Any factors
adversely affecting the demand for, or use of, the Windows operating system that
would require changes to Rational's products would have a material adverse
effect upon the business, operating results and financial condition of Rational.
In addition, any changes to the underlying components of or interfaces to the
UNIX or Windows operating systems that would require changes to Rational's
products for those platforms would materially adversely affect Rational if it
were not able to successfully develop or implement such changes in a timely
fashion.
Adverse Impact Of Promotional Product Versions On Actual Product Sales.
- ----------------------------------------------------------------------
The Company's marketing strategy relies in part on making elements of its
technology available for no charge or at a very low price, either directly or by
incorporating such elements into products offered by the Company's partners,
such as Microsoft. This strategy is designed to expose the Company's products to
a broader customer base than its historical customer base, and to encourage
potential customers to purchase an upgrade or other higher-priced product from
the Company. There can be no assurance that the Company will be able to
introduce enhancements to its full-price products or versions of its products
with intermediate functionality at a rate necessary to adequately differentiate
them from the promotional versions, particularly in cases where the Company's
partners are distributing versions of the Company's products with other
desirable features.
Management Of Growth.
- --------------------
Rational has experienced rapid growth, particularly as a result of its
acquisitions, and the Company is experiencing a period of aggressive product
introductions that have placed, and may continue to place, a significant strain
on its financial, operational, management, marketing and sales systems and
resources, including its personnel. Projects such as the expansion of or
enhancements to product lines, efforts to address broader markets and to expand
distribution channels, numerous acquisitions as described in "Risks Related to
the Recent Acquisition of Pure Atria Corporation" and "Risks Associated with
Recent and Future Acquisitions'' and business alliances such as the recent
arrangement between Rational and Microsoft, when added to the day-to day
activities of Rational, have placed and will continue to place further strain on
management resources and personnel. If Rational's management
20
<PAGE>
is unable to effectively manage growth, its business, competitive position,
results of operations and financial condition will be materially and adversely
affected.
To achieve and manage continued growth, the Company must continue to expand
and upgrade its information technology infrastructure and its scalability,
including improvements to various operations, financial and management
information systems. In addition, the Company believes that to remain
competitive it must significantly expand its capabilities for electronic
commerce. Improving management systems and infrastructure and building
electronic commerce capabilities will require that the Company recruit and
retain highly qualified technical personnel, and such personnel resources are
extremely scarce in the areas where the Company operates. Failure to improve
management infrastructure and build electronic commerce capabilities for future
growth would materially and adversely affect the Company's business, competitive
position, and results of operations and financial condition. See"--Dependence on
Key Personnel".
Risk of Software Defects
- ------------------------
Software products as complex as those sold by the Company often contain
undetected errors, or "bugs," or performance problems. Such defects are most
frequently found during the period immediately following the introduction of new
products or enhancements to existing products. Despite extensive product testing
prior to introduction, the Company's products have in the past contained
software errors that were discovered after commercial introduction. Errors or
performance problems may also be discovered in the future. Any future software
defects discovered after shipment of the Company's products could result in loss
of revenues or delays in market acceptance, which could have a material adverse
effect on the Company's business, operating results or financial condition.
Further, because the Company relies on its own products in connection with the
development of its software, any such errors could make it more difficult to
sell such products in the future. Rational attempts to make adequate allowance
in its new product release schedule for both internal and beta-site testing of
product performance. Because of the complexity of the Company's products,
however, the release of new products by the Company may be postponed should test
results indicate the need for redesign and retesting, or should the Company
elect to add product enhancements in response to beta customer feedback.
Risks Associated with International Operations.
- ----------------------------------------------
International sales accounted for approximately 28%, 32%, and 31% of
Rational's revenues in fiscal 1995, 1996 and 1997, respectively, and represented
34% for the nine months ended December 31, 1997. Rational expects that
international sales will continue to account for a significant portion of the
Company's revenues in future periods. International sales are subject to
inherent risks, including unexpected changes in regulatory requirements and
tariffs, unexpected changes in global economic conditions, difficulties in
staffing and managing foreign operations, longer payment cycles, greater
difficulty in accounts receivable collection, potentially adverse tax
consequences, price controls or other restrictions on foreign currency,
difficulties in obtaining export and import licenses, costs of localizing
products for foreign markets, lack of acceptance of localized products in
foreign markets, and the efforts of high local wage scales and other expenses.
Any material adverse effect on the Company's international business would be
likely to materially and adversely affect the Company's business, operating
results and financial condition as a whole. Rational's international sales are
generally denominated in foreign currencies. Rational has engaged in only
limited hedging activities. Gains and losses on the conversion of foreign
payments into U.S. dollars may contribute to fluctuations in the Company's
results of operations. Although the Company has not experienced a material
adverse impact to date from fluctuations in foreign currencies, there can be
no assurance that the Company will not experience a material adverse impact on
its financial condition and results of operations from fluctuations in foreign
currencies in the future.
Limited Protection of Intellectual Property and Proprietary Rights.
- ------------------------------------------------------------------
Rational relies on a combination of copyright, trademark and trade secret
laws, employee and third-party nondisclosure agreements and other methods to
protect its proprietary rights. Despite these precautions, it may be possible
for unauthorized third parties to copy certain portions of the Company's
products or reverse engineer or obtain and use information that Rational regards
as
21
<PAGE>
proprietary. Rational generally licenses its software products to end-users
on a "right to use" basis pursuant to a perpetual license. Rational licenses its
products primarily under "shrink-wrap" licenses (i.e., licenses included as part
of the product packaging). Shrink-wrap licenses are not negotiated with or
signed by individual licensees, and purport to take effect upon the opening of
the product package. Certain license provisions protecting against unauthorized
use, copying, transfer and disclosure of the licensed program may be
unenforceable under the laws of certain jurisdictions and foreign countries. In
addition, the laws of some foreign countries do not protect proprietary rights
to the same extent as do the laws of the United States. There can be no
assurance that these protections will be adequate. To the extent that the
Company increases its international activities, its exposure to unauthorized
copying and use of its products and proprietary information will increase.
The scope of United States patent protection in the software industry is not
well defined and will evolve as the United States Patent and Trademark Office
grants additional patents. Because patent applications in the United States are
not publicly disclosed until the patent is issued, applications may have been
filed which would relate to Rational's products.
Rational also relies on certain software that it licenses from third parties,
including software that is integrated with internally developed software and
used in its products to perform key functions. There can be no assurance that
these third-party software licenses will continue to be available to the Company
on commercially reasonable terms, or that the software will be appropriately
supported, maintained or enhanced by the licensors. The loss of licenses to, or
inability to support, maintain and enhance any of such software could result in
increased costs, or in delays or deductions in product shipments until
equivalent software could be developed, identified, licensed and integrated,
which would materially adversely affect the Company's business, operating
results and financial condition. In addition, Rational licenses certain of its
technology to its development partners. There can be no assurance that such
partners' use of the technology will be complementary to Rational's strategies
or that such partners will not use such technology to develop and market
competing products in the future.
Risks of Litigation.
- -------------------
Competitors and potential competitors may resort to litigation as a means of
competition. Such litigation or other legal disputes may be costly and expose
the Company to new claims that it may not have anticipated. In the past,
Rational has instituted litigation against several companies. Although patent
and intellectual property disputes in the software area have often been settled
through licensing, cross-licensing or similar arrangements, costs associated
with such arrangements may be substantial. Any litigation involving the Company,
whether as plaintiff or defendant, regardless of the outcome, may result in
substantial costs and expenses to the Company and significant diversion of
effort by the Company's technical and management personnel. In addition, there
can be no assurance that litigation, either instituted by or against the
Company, will not be necessary to resolve issues that may arise from time to
time in the future. Any such litigation could have a material adverse effect
upon the Company's business, operating results and financial condition.
Rational expects that software product developers will be increasingly subject
to infringement claims as the number of products and competitors grows and the
functionality of products in different industry segments overlaps. There can be
no assurance that third parties will not assert infringement claims against the
Company in the future or that such claims will not be successful. The Company
could incur substantial costs in defending itself and its customers against any
such claims. Parties making such claims may be able to obtain injunctive or
other equitable relief that could effectively block the Company's ability to
sell its products in the United States and abroad, and could result in an award
of substantial damages. In the event of a claim of infringement, the Company and
its customers may be required to obtain one or more licenses from third parties.
There can be no assurance that the Company or its customers could obtain
necessary licenses from third parties at a reasonable cost or at all. Defense
of any lawsuit or failure to obtain any such required license would have a
material adverse effect on the Company's business, results of operations and
financial condition.
22
<PAGE>
PART II -- OTHER INFORMATION
ITEM 1 - Legal Proceedings
The following actions have been filed against the Company, two of its
officers, and Cowen & Company; Randall v. Rational Software Corporation, et
al., No. C 97-03740 (N.D. Cal.); Sachs v. Rational Software Corporation, et
al., No. C-97-3845 (N.D. Cal.); Kalapa v. Rational Software Corporation, et
al., No. C-97-4028 (N.D. Cal); Weiner, et al v. Rational Software Corporation
et al., No. C-97-21086 (N.D. Cal.); Seiger v. Rational Software Corporation,
et al., No. 97-CV-7011 (E.D.N.Y.); Dolnick v. Rational Software Corporation,
et al., No. 98-CV-0268 (E.D.N.Y.); Lynch v. Rational Software Corporation, et
al., No. CA-97-2081-A (E.D. Va.). The actions are putative shareholder class
action lawsuits, and the complaints are virtually identical. The complaints
allege that defendants violated Sections 10(b) and 20A of the Securities
Exchange Act of 1934 through the selective disclosure of material inside
information regarding the Company's prospects, and seek damages on behalf of a
class of shareholders who purchased the Company's common stock on October 8,
1997. Defendants have filed motions to transfer all pending cases to the
Northern District of California. Those motions have not been decided. The
cases are in preliminary stages. The Company believes that the lawsuits are
without merit and intends to defend the cases vigorously.
ITEM 2 - Changes in Securities and Use of Proceeds
(a) Effective November 17, 1997 and pursuant to a repricing plan announced on
November 4, 1997, the Company entered into agreements with certain of its
employees (the "Repricing Agreements") to reprice (at the closing price for
the Company's Common Stock on November 14, 1997) such employees' stock options
with exercise prices higher than the closing price for the Company's Common
Stock on November 14, 1997. The closing price for the Company's Common Stock
on November 14, 1997 was $10.00. Options to purchase a total of 6,808,183
shares were repriced pursuant to the Repricing Agreements. All of the
Company's employees were entitled to participate in the repricing, except Paul
D. Levy, Michael T. Devlin, Robert T. Bond, David Bernstein, John R. Lovitt and
Robert Dickerson. In addition, members of the Company's Board of Directors and
consultants of the Company were not allowed to participate in the repricing.
Pursuant to the Repricing Agreements, each employee participating in the
repricing agreed to certain limitations on the disposition of, and granted the
Company certain rights of repurchase with respect to, shares subject to
repriced options. The foregoing discussion is qualified in its entirety by
reference to the form of Repricing Agreement filed with this Report as Exhibit
4.1, which is incorporated herein by reference.
ITEM 6 - Exhibits and Reports on Form 8-K
(a) Exhibit 4.1: Repricing Agreement
Exhibit 11.1: Statement of Computation of Net Income per Common Share
Exhibit 27: Financial Data Schedule
23
<PAGE>
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
RATIONAL SOFTWARE CORPORATION
by: /s/ Timothy A. Brennan
--------------------------------------------
Timothy A. Brennan
Senior Vice President
Chief Financial Officer and Secretary
February 10, 1998
24
<PAGE>
EXHIBIT 4.1
-----------
Repricing of Stock Options
--------------------------
The undersigned optionee hereby elects to reprice each of the
following stock options pursuant to the terms set forth in the letter dated
November 5, 1997 from the Company:
<TABLE>
<CAPTION>
Option #1 Option #2 Option #3 Option #4
--------- --------- --------- ---------
<S> <C> <C> <C> <C>
Option Grant Date:
--------- --------- --------- ---------
Plan Under Which Option
Was Granted
--------- --------- --------- ---------
Number of Shares
Remaining Unexercised:
--------- --------- --------- ---------
Exercise Price:
--------- --------- --------- ---------
ISO or NSO:
--------- --------- --------- ---------
</TABLE>
Instructions
------------
Please set forth above the information required with respect to each
outstanding stock option which you wish to reprice.
The undersigned acknowledges receipt of the Company's letter dated
November 5, 1997 and the enclosures referenced therein and contained therewith.
The undersigned hereby agrees to be bound by all of the terms and conditions of
the repricing program as described in said letter, which shall be deemed to
modify and amend the terms of the agreements pursuant to which such options were
granted to the undersigned (the "Agreements"). Without limiting the foregoing,
the undersigned understands that the Agreement(s) shall be deemed to be amended
to provide that the Repriced Option(s) shall be subject to the following
restrictions on disposition: None of the shares purchased pursuant to Repriced
Options may be sold or otherwise disposed of until November 17, 1998. On or
after November 17, 1998, up to fifty percent (50%) of the then-vested shares
subject to Repriced Options may be sold or otherwise disposed of without regard
to this limitation on distribution. On or after November 17, 1999, all of the
shares subject to Repriced Options may be sold or otherwise disposed of without
regard to this limit on disposition. However, these restrictions will not
prevent transfers not involving a change in beneficial ownership or pursuant to
a bona fide gift and will not prevent a bona fide pledge of the shares to secure
the purchase price thereof, although such shares shall remain subject to the
limitations on disposition and the buy back right stated herein. The undersigned
further agrees that the Agreement(s) shall be deemed to be amended to provide
that any shares subject to Repriced Options, which are still subject to any part
of the two year "lock-up" period discussed above, held by any optionee who
terminates employment with the Company, either voluntarily or involuntarily,
during the two year term of the "lock-up" are subject to a discretionary right
of repurchase, at their purchase price, by
<PAGE>
the Company. The Company intends to exercise this right if the fair market
value of the shares purchased pursuant to Repriced Options at the time the buy
back right is to be exercised is greater than their purchase price. As a
condition precedent to participating in this repricing and as a condition to
any exercise of any Repriced Options, all optionees participating in this
repricing program must agree that, upon exercise of any Repriced Option, the
optionee shall execute such agreements and/or instruments as the Company may
reasonably request to ensure enforceability of this buy back right including,
without limitation, a stock power executed in blank, an escrow agreement and a
restricted stock purchase agreement. Such right shall not apply in the event
that the optionee's employment is terminated due to death or disability or in
the event of an involuntary termination of the optionee following a change in
control of the Company (defined as a transaction or series of related
transactions following which securities possessing more than fifty percent
(50%) of the total combined voting power of the Company's outstanding
securities are transferred to a person or persons acting together as a group
different from the persons holding those securities immediately prior to such
transaction, through offerings to "the public" shall not constitute such a
change in control).
The undersigned further acknowledges and agrees that participation in
the repricing program shall not be construed as an express or implied
agreement of employment with the Company other than on an at-will basis.
(Print name of Optionee)
Signature of Optionee
Date:
PLEASE MAINTAIN A COPY OF THIS DOCUMENT AS EXECUTED FOR YOUR RECORDS,
---------------------------------------------------------------------
AS IT SHALL CONSTITUTE AN AMENDMENT TO THE AGREEMENT(S) PURSUANT TO WHICH YOU
- -----------------------------------------------------------------------------
WERE GRANTED THE OPTION(S) THAT YOU ENUMERATED ABOVE.
- -----------------------------------------------------------------------------
<PAGE>
Exhibit 11.1
Statement of Computation of Net Income (Loss) Per Common Share
<TABLE>
<CAPTION>
(In thousands, except per share amounts)
Three Months Ended Nine Months Ended
December 31, December 31,
1997 1996 1997 1996
---------------------------------------------------------------------
Basic:
<S> <C> <C> <C> <C>
Weighted average
shares outstanding 88,008 81,751 87,267 78,252
======= ======== ======== ========
Diluted:
Weighted average
shares outstanding 88,008 81,751 87,267 78,252
Dilutive stock options 2,624 - - -
------- -------- -------- --------
Total 90,632 81,751 87,267 78,252
======= ======== ======== ========
Net income (loss) $10,368 $(33,567) $(49,123) $(14,114)
Income (loss) per common share
Basic: $ 0.12 $ (0.41) $ (0.56) $ (0.18)
Diluted: $ 0.11 $ (0.41) $ (0.56) $ (0.18)
</TABLE>
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> MAR-31-1998
<PERIOD-START> APR-01-1997
<PERIOD-END> DEC-31-1997
<CASH> 49,589
<SECURITIES> 236,147
<RECEIVABLES> 66,047
<ALLOWANCES> 2,933
<INVENTORY> 0
<CURRENT-ASSETS> 368,281
<PP&E> 75,192
<DEPRECIATION> 40,526
<TOTAL-ASSETS> 429,306
<CURRENT-LIABILITIES> 148,608
<BONDS> 3,453
0
0
<COMMON> 886
<OTHER-SE> 272,790
<TOTAL-LIABILITY-AND-EQUITY> 429,306
<SALES> 132,983
<TOTAL-REVENUES> 223,422
<CGS> 13,961
<TOTAL-COSTS> 45,893
<OTHER-EXPENSES> 235,176
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> (13,305)
<INCOME-PRETAX> (44,342)
<INCOME-TAX> 4,781
<INCOME-CONTINUING> (49,123)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (49,123)
<EPS-PRIMARY> (0.56)
<EPS-DILUTED> (0.56)
</TABLE>
