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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
[X] ANNUAL REPORT
PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED MARCH 31, 1998
[_] 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)
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DELAWARE 54-1217099
(STATE OR OTHER JURISDICTION OF (I.R.S EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NUMBER)
18880 HOMESTEAD ROAD,
CUPERTINO, CA 95014-0721
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
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Securities registered pursuant to
Section 12(b) of the Act: None
Securities registered pursuant to
Section 12(g) of the Act: Common Stock, par value $0.01 per share
(Title of Class)
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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 periods as 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 by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [_]
At May 28, 1998, the aggregate market value of Registrant's voting stock
held by nonaffiliates was $1,292,084,000. For the purposes of the preceding
sentence only, "affiliates" is deemed to consist of executive officers and
directors. At May 28, there were 86,499,328 shares of the Registrant's $0.01
par value Common Stock outstanding. (This number does not include the
2,955,500 shares which were repurchased by the Company between April 29, 1998
and May 28, 1998).
Unless indicated otherwise, all Common Stock share numbers and prices have
been adjusted to reflect Rational Software Corporation's May 1995 3:1 reverse
stock split and July 1996 1:2 forward stock split, accomplished by means of a
stock dividend.
Unless indicated otherwise, all financial information has been restated to
reflect Rational Software Corporation's acquisitions of SQA, Inc., and Pure
Atria Corporation, accounted for as poolings of interests.
Certain sections of the Registrant's definitive Proxy Statement for the 1998
Annual Meeting of Stockholders to be held on July 16, 1998, are incorporated
by reference in Part III of this Form 10-K to the extent stated herein.
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AN INDEX TO EXHIBITS BEGINS ON PAGE 56.
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The statements contained in this 10-K include forward-looking information
within the meaning of Section 27A of the Securities Act of 1933, as amended,
and Section 21E of the Securities Exchange Act of 1934, as amended, and are
subject to the safe harbor created by those sections. Such forward-looking
statements include without limitation statements regarding product development
plans and schedules, relationships with strategic partners and other third
parties, and trends in overall revenue, revenue mix, expenses, and other
financial statement items. Rational's actual future results could differ
materially from those projected in the forward-looking information. Factors
that could cause actual results to differ materially include, without
limitation, those identified in "Factors That May Affect Future Results"
below.
PART I
ITEM 1--BUSINESS
Rational Software Corporation (Rational or the Company) is the author of the
Unified Modeling Language (UML) and an industry leader and standards-setter in
software development. Rational's mission is to ensure the success of customers
who depend on their ability to develop software. Rational unifies proven
principles of software development, tools, and services into what it believes
are best practices that unite developers, analysts, designers, quality
engineers, and project managers in improving software timeliness, reliability,
and return on investment. Rational's integrated family of tools supports
requirements management, visual modeling, testing, and configuration and
change management. Rational's extensive range of professional services
accelerates customers' ability to apply the principles and tools on their
projects.
INDUSTRY BACKGROUND
General
Software permeates products and processes encountered in almost every aspect
of daily life. Many companies base their businesses on enterprisewide
information systems that are increasingly built as distributed systems
exploiting a company-specific intranet or the Internet. Software is at the
core of business applications ranging from equity-trading systems to inventory
management. The telecommunications business is highly dependent on software in
areas as diverse as call routing, switching, rate setting, and billing.
Software is the central element of command-and-control systems in submarines
and military aircraft. Software governs the operation of machines from
ordinary office copiers and cellular phones to life-saving medical devices. As
organizations seek competitive advantage by exploiting the ongoing
improvements in microprocessor technology and the emergence of new computing
platforms, software is becoming more pervasive and more sophisticated. The
success of businesses around the world depends increasingly on their ability
to construct and modify software systems that match their changing business
needs.
Traditional software-development techniques have not kept pace with advances
in computer processor technology, with the development of new platforms such
as the Internet or company-specific intranets, or with the general demand for
distributed software systems such as multitiered client/server applications.
Software, therefore, has increasingly become the constraint on performance,
quality, and time-to-market for many organizations. The ability to quickly and
cost-effectively create complex software applications that perform as desired
and that are easy to maintain and reuse in related applications and products
can be a critical competitive differentiator. As the number and complexity of
software applications continue to expand, it is becoming increasingly
important for businesses to migrate to a more effective approach to software
development.
Component-based development is a way of constructing software systems by
combining and integrating preengineered and pretested software components.
Component-based development has emerged as a powerful technique to simplify
the construction of software systems and to improve their quality. Software
components can be designed, developed, and tested once, and then combined
multiple times by other users to create new software systems in a manner
analogous to combining hardware integrated circuits to create a new electronic
device. By increasing software reuse, this approach reduces the amount of
source code that must be created in
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connection with the development of a new software system, helping to reduce
risk, time-to-market, and cost, as well as to improve the quality of the
resulting software.
PRODUCTS AND SERVICES
Rational supports component-based development with an extensive family of
software products covering critical phases of the software-development
lifecycle, from initial analysis of requirements through detailed design,
coding, testing, debugging, and maintenance. Rational's products support
individual designers and developers, development teams, and project managers.
The major components of Rational's product line are RequisitePro for
requirements management; Rational Rose for visual modeling; Purify, Quantify,
PureCoverage, SQA Suite, Rational Visual Test, and preVue-C/S for various
aspects of automated testing; ClearCase, ClearCase MultiSite, ClearCase
Attache, ClearDDTS, and ClearQuest for configuration and change management;
and Rational Apex for managing development teams and the components they
generate. These tools work together to enable customers to employ proven
principles of effective software development throughout the project lifecycle.
RequisitePro: Requirements-Management Tool
RequisitePro is a family of products that help users define and manage the
formal requirements for their software systems. RequisitePro runs on Windows-
based PCs and makes use of Microsoft Word and Microsoft Access. RequisitePro
allows users to collect and organize textual descriptions of software
requirements in the form of structured documents, which can be queried later.
Rational Rose: Visual Modeling Tools
Rational Rose is a software-engineering tool that allows users to visually
model and document the structure and behavior of their software systems. The
Rational Rose product line supports major platforms, including UNIX, Windows
95, and Windows NT, and implementation languages, including C++, Visual Basic,
Java, Forte, PowerBuilder, and Ada, that are widely used today.
Automated Testing Tools
Rational's solution for automated testing focuses on helping users verify
the reliability of their software, the correct functionality of their
software, the performance of their software, and the performance of the
overall system (including databases and middleware) of which their software is
a part. Rational's automated testing solution helps users deliver software of
higher quality more quickly and at lower cost.
Purify (for UNIX), Purify for Windows NT, and PureCoverage help users verify
the reliability of their software. Purify and Purify for Windows NT employ
patented object-code insertion (OCI) technology on users' executable code and
automatically detect many common runtime errors. Users can fix the problems in
their source code, guided by the precise information provided by Purify and
Purify for Windows NT. PureCoverage also employs OCI technology to analyze
users' executable code and to report which parts of the code have not been
executed and tested. Using this information, users can develop more complete
test suites and deliver more reliable software.
SQA Suite verifies whether client/server software has the proper
functionality--in other words, that it does what was intended. SQA Suite
includes: SQA Robot, which allows users to create and run automated tests; SQA
Manager, which allows users to plan, manage, and measure the progress of
testing projects; SQA LoadTest, which allows users to test client/server
applications under different load, stress, and multiuser scenarios; and SQA
Process, which is a methodology for the automated testing of Windows
client/server applications.
Rational Visual Test, an automated, language-independent, software-testing
tool, is designed to test proper software functionality by rapidly creating
tests for applications of virtually any size and created in any implementation
language by capturing those tests for later reuse. These capabilities enhance
the ability of organizations to deploy applications for the Windows 95 and
Windows NT operating systems. Rational Visual
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Test is integrated with Microsoft Developer Studio, a desktop development
environment. Rational acquired Visual Test on October 2, 1996, from Microsoft.
Quantify (for UNIX) and Visual Quantify (for Windows NT) help verify
software performance by measuring where time is spent during software
execution and by providing users with accurate data on potential performance
bottlenecks. This data tells users what portions of the application need to be
tuned or revised to improve performance.
The preVue family of products helps to automate software load and stress
testing, which verifies that a software application will perform properly in
the face of a given load, as measured by the number of simultaneous users or
the level of computer network traffic. Thus preVue helps users verify that
their software will perform as desired once it is deployed. The preVue family
runs on UNIX-based workstations and is integrated with major commercial
database management systems such as Oracle.
Configuration and Change Management
Rational's configuration and change management products provide
comprehensive support for developers and development teams working in parallel
on a shared set of project artifacts, such as source code, binary files,
models, requirements documents, test cases, reports, and so on. ClearCase
provides secure and reliable access to all project artifacts, allowing teams
to share these artifacts and work in parallel, making changes simultaneously,
without interfering with one another's work. ClearCase maintains a full audit
trail of who changed what, when, where, and why, manages multiple versions of
software and software systems, and reliably performs builds of software
systems. ClearCase MultiSite supports geographic distribution of software-
development teams working on a shared set of artifacts. ClearCase Attache
allows access from a Windows client to ClearCase on UNIX or Windows NT.
ClearDDTS (for UNIX) and ClearQuest (for Windows NT) allow users to manage
requests for changes (such as error reports or requests for enhancement) and
to track their progress during the development process.
Rational Apex: Integrated Development Environment Tools
Rational Apex is a software-engineering environment for control of software
projects. It effectively controls large-scale development efforts, helping
customers improve time-to-market while reducing risk and cost. It also makes
large-scale software reuse possible by directly managing software
architecture, significantly improving the efficiency of the overall software-
development process. Rational Apex runs on UNIX platforms and is available in
versions that support the C/C++ and Ada programming languages for UNIX,
Windows NT, and embedded applications.
Technical Consulting and Customer-Support Services
Rational's services include consulting and training that enable customers to
adopt advanced software- development processes and to use component-based
development effectively. Consulting services range from helping customers
implement large-scale software reuse to working with customers to develop the
right architecture for their software systems to helping customers'
development teams work through the first few iterations of the controlled
iterative development process. Rational also offers several standard
consulting packages and training courses that assist customers in the
implementation of controlled iterative development and the use of component-
based development. Rational also offers a support program that entitles a
licensee to receive all enhancements and upgrades to the licensed product that
are published in the succeeding 12-month period, as well as certain other
support services.
RECENT ACQUISITIONS
For a listing of recent acquisitions by the Company, see "Management's
Discussion and Analysis of Financial Condition and Results of Operations:
Overview: Recent Acquisitions."
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BUSINESS ALLIANCE WITH MICROSOFT
On October 2, 1996, Rational and Microsoft announced the formation of a
business alliance that consisted of Rational's acquisition of Microsoft's
Visual Test product, technology cross-licensing, joint development projects,
and joint marketing programs.
In connection with this alliance, Rational acquired from Microsoft the
Visual Test product, a leading software-testing tool.
The cross-licensing element of the alliance includes a five-year license to
Rational to develop and distribute, as part of Rational's products,
Microsoft's Developer Studio, an integrated development environment for
Windows 95 and Windows NT.
Rational has entered into a two-year agreement to develop a visual modeling
product, including certain elements of Rational Rose, for distribution in
certain Microsoft development tools that run on Windows 95 and Windows NT.
Rational will be obligated to provide timely product updates to maintain
compatibility with changes in Microsoft operating systems. Following
expiration of the agreement, Microsoft will have the option to obtain a
perpetual, nonexclusive right to source code for the product, including
certain aspects of Rational Rose technology.
Rational's objective in acquiring the Visual Test product and partnering
with Microsoft is to extend Rational's product line and to increase the use of
component-based development by providing visual modeling capabilities to
developers using Microsoft's visual tools. In addition, Rational believes that
its arrangement with Microsoft has exposed Rational's technology to potential
customers outside of its historical customer base. Rational expects that
continued changes in its pricing models and combinations of features within
product lines will be required to encourage these potential customers to
purchase Rational products. Rational's objective in entering into the cross-
licensing arrangements with Microsoft was not to generate direct product
revenue from Microsoft, and Rational does not expect such arrangements to
directly result in a material increase in product revenue.
See "Factors That May Affect Future Results: Business Alliance with
Microsoft; Acquisition of Visual Test; Licensing of Rational Rose Technology
to Microsoft."
PRODUCT DEVELOPMENT
Rational believes that its success will depend largely on its ability to
enhance existing products and develop new products that meet the needs of a
rapidly evolving marketplace and increasingly sophisticated and demanding
customers. Rational intends to extend and strengthen its lifecycle support for
component-based development by expanding its product offerings, introducing
new products, and offering higher levels of integration between its products.
Rational uses its own software processes and tools extensively in its own
software-development activities. Although Rational has primarily developed
products internally, it may, based on timing and cost considerations, acquire
technologies or products from third parties.
Rational's research and development staff, including product development,
product support, and technical writing personnel, consists of 626 employees as
March 31, 1998. Rational's total research and development expenses were
approximately $61.6 million, $47.2 million, and $33.8 million in fiscal years
1998, 1997, and 1996, respectively. As a result of the Company's mergers with
Pure Atria and SQA, accounted for as poolings of interests, research and
development costs are presented on a combined basis for all periods shown.
CUSTOMERS AND APPLICATIONS
More than 265,000 licenses of Rational's software products, exclusive of
Rational Visual Test but inclusive of SQA Suite, have been sold to more than
21,000 customers worldwide. No single customer accounted for 10% or more of
revenues in fiscal 1998. Rational's comprehensive solution of software-
development tools and professional services is used by major organizations in
many industry segments to design, build, and maintain complex software
systems.
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SALES AND MARKETING
Rational markets and sells its products and services directly through
telesales field operations, sales organizations, and the World Wide Web and
indirectly through channels such as value-added resellers (VARs) and
distributors.
Rational's direct selling approach couples sales of its integrated software
tools with high-value technical consulting services. Rational has established
a major-account direct sales and technical consulting organization in the
United States, Canada, Europe, and the Asia/Pacific/Latin America region.
Rational's sales, marketing, and professional services organization consists
of 861 individuals, operating out of corporate headquarters in Cupertino,
California, and from field offices in other locations throughout North
America, the United Kingdom, France, Germany, Sweden, The Netherlands,
Belgium, Switzerland, Australia, Hong Kong, Taiwan, India, South Korea, New
Zealand, Japan, and Brazil. Rational's direct international operations are
staffed almost exclusively by local personnel. Rational also has distributors
and resellers in North America, Europe, and Asia Pacific.
In support of its sales efforts, Rational's marketing department conducts
comprehensive programs, which include maintenance of an extensive World Wide
Web site, an electronic subscription service for news announcements about
Rational, print advertising, direct mail, public relations, trade shows, and
ongoing customer communications programs. Rational also keeps its customers
informed of advances in the field through technical papers and other mailings.
The Company also has an extensive set of relationships with independent
software vendors (ISVs) including Microsoft, PeopleSoft, and Oracle. These
companies work closely with Rational on marketing and technology programs,
providing customers with a comprehensive, easy-to-use development and testing
solution. The marketing relationships often involve one or more of the
following programs: joint advertising campaigns, exchange of mailing lists,
reciprocal use of logos in marketing literature, and joint promotions,
seminars, or trade-show presentations.
International sales accounted for approximately 34%, 27%, and 27% of the
Company's revenues in fiscal 1998, 1997, and 1996, respectively, and the
Company expects that international sales will continue to account for a
significant portion of the Company's revenues in the future. International
sales are subject to inherent risks, including unexpected changes in
regulatory requirements and tariffs, difficulties in staffing and managing
foreign operations, longer payment cycles, greater difficulty in accounts
receivable collection, potentially adverse tax consequences, price controls or
other restrictions on foreign currency, and difficulties in obtaining export
and import licenses. Any material adverse effect on the Company's
international business would be likely to materially and adversely affect the
Company's business, operating results, and financial condition as a whole. The
Company's international sales are generally denominated in local currencies.
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 local currencies. Gains and losses on the
conversion of foreign payments into U.S. dollars may contribute to
fluctuations in the Company's results of operations. Although the Company has
not experienced any material adverse impact to date from fluctuations in
foreign currencies, there can be no assurance that the Company will not
experience a material adverse impact on its financial condition and results of
operations from fluctuations in foreign currencies in the future. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations: Overview: Revenue: International Sales."
PRODUCT PRICING
Rational's software licenses are normally perpetual, fully paid-up floating
or node-locked licenses. Floating licenses limit the number of simultaneous
users on a network instead of being associated with a specific user or
computer. Node-locked licenses limit a software license to a single computer.
Rational also offers other kinds of licenses, such as project licenses that
provide selected Rational tools to all the developers working on a specific
project.
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The bulk of Rational's net product revenue in fiscal 1998 was derived from
sales of its ClearCase, Rational Rose, testing, and Rational Apex product
families. A ClearCase license is $3,000 on UNIX or Windows NT. Elements of the
Rational Rose family range in price from $495 for a single-user PC version of
Rational Rose, to $3,600 for Rational Rose 98 Enterprise Edition on a PC, to
$8,400 for a floating license of Rational Rose/C++ on a UNIX workstation.
Rational's Purify, Quantify, and PureCoverage products range in price from
about $500 to $2,000, depending on platform and specific combination. Elements
of SQA Suite, available on Windows, range from $1,395 for SQA Manager to
$3,295 for SQA Suite Team Test Edition. The price of preVue ranges beyond
$100,000 for a high-capacity version. Elements of the Rational Apex family
range in price from $22,000 for a Rational Apex Ada license on UNIX to $35,000
and above for an embedded-systems version of Rational Apex. Rational's
products are often sold in multiple quantities to teams of software developers
working together in a client/server environment. Rational offers standard
discounts based on dollar volume in a single-purchase order.
Rational also offers a support program that entitles a licensee to receive
all enhancements and upgrades to the licensed product that are published in
the succeeding 12-month period, as well as certain other support services.
Annual fees for support generally range from 15% to 20% of the software
license fee.
Rational's packaged training courses are offered in the form of open-
enrollment public courses and in-house courses at customer facilities, which
range from $1,750 per person for a typical four-day course to between $3,000
and $12,500 for in-house courses, depending on the length of the course and
the maximum number of students in the class. Rational's packaged consulting
services range from approximately $50,000 to several hundred thousand dollars.
Custom consulting generally is priced on a time-and-materials basis.
See "Factors That May Affect Future Results: Adverse Impact of Promotional
Product Versions on Actual Product Sales."
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 in its product lines, generally
from both Windows and UNIX vendors. Because individual product sales are often
the first step in a broader customer relationship, Rational's success will
depend in part on its ability to successfully compete with numerous
competitors at each point in its product line.
Rational faces competition from software-development tools and processes
developed internally by customers, including ad hoc integrations of numerous
standalone 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 about the advantages of the Company's
products versus internally developed software-quality systems.
Rational faces competition from, among others, Intersolv, Inc., Platinum
Technology, Inc., Select Software Tools plc, Cayenne, Oracle, IBM Corporation
(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. Rational's
RequisitePro requirements-management product faces competition from companies
such as GEC-Marconi. Rational's software-testing tools--Purify, Quantify,
PureCoverage, SQA Suite, Rational Visual Test, and preVue--face competition
from Compuware, Mercury Interactive Corporation, Segue Software, Inc.,
Intersolv, Inc., Computer Associates, Platinum Technologies,
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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 that compete with Rational Apex. Rational's ClearCase, ClearDDTS,
and ClearQuest product line faces competition from various suppliers offering
products with configuration and change management functions, including
Continuous Software Corporation, StarBase Corporation, Hewlett Packard, True
Software, SQL Software, LTD., Intersolv, Inc., Sun Microsystems, and IBM. The
Rational Apex Ada product line faces 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 standalone 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 others of the Company's
products and would compete directly with such products if offered on a
standalone basis. The Company's 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
standalone 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.
Rational believes that the major competitive factors in its markets are
corporate and product reputation, breadth of coverage by an integrated product
line, product architecture, functionality and features, product quality,
performance, ease of use, quality of support, availability of technical
consulting services, and price. Rational believes that its combination of an
integrated family of products supporting component-based development
throughout the software-development lifecycle and its emphasis on controlled
iterative development, visual modeling, and an architecture-driven process,
coupled with its extensive major-account direct sales and technical consulting
organization and the supporting channels such as telesales, VARs,
distributors, and the World Wide Web helps it compete.
Rational believes that the increased level of competition it observed 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 on its ability to increase its share of its target markets and to
license additional products and product
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enhancements to 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.
INTELLECTUAL PROPERTY
Rational regards its software as proprietary and attempts to protect it
under a combination of copyright, trademark, and trade-secret laws, employee
and third-party nondisclosure agreements, and other methods of protection.
Despite these precautions, it may be possible for unauthorized third parties
to copy certain portions of Rational's products or to reverse engineer or
obtain and use information Rational regards as proprietary. Although
Rational's competitive position may be affected by its ability to protect its
proprietary information, Rational believes that trademark and copyright
protections are less significant to Rational's success than other factors,
such as trade-secret protection, the knowledge, ability, and experience of
Rational's personnel, name recognition, and ongoing product development and
support.
Rational's software products are generally licensed to end users on a right-
to-use basis pursuant to a perpetual license. Rational licenses its products
primarily under "shrink wrap" licenses (that is, licenses included as part of
the product packaging). Shrink-wrap licenses are not negotiated with or signed
by individual licensees and purport to take effect upon the opening of the
product package. Certain provisions of such licenses, including provisions
protecting against unauthorized use, copying, transfer, and disclosure of the
licensed program, may be unenforceable under the laws of certain
jurisdictions. In addition, the laws of some countries do not protect
Rational's proprietary rights to the same extent as the laws of the United
States.
As the number of software products in the industry increases and the
functionality of these products further overlaps, Rational believes that
software programs will increasingly become subject to infringement claims.
There can be no assurance that third parties will not assert infringement
claims against Rational in the future with respect to current or future
products. Any such assertion could require Rational to enter into royalty
arrangements or result in costly litigation.
EMPLOYEES
As of March 31, 1998, Rational employed 1,743 full-time personnel, including
626 in product development and support, 861 in sales, marketing, and technical
consulting, and 256 in finance and administration. Rational's employees are
not represented by any collective bargaining organization, and Rational has
never experienced a work stoppage. Rational believes its success will depend
in part on its continued ability to attract and retain highly qualified
personnel in a competitive market for experienced and talented software
engineers and sales and marketing personnel.
EXECUTIVE OFFICERS OF THE REGISTRANT
The executive officers of the Registrant are as follows:
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NAME POSITION
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<S> <C>
Paul D. Levy......................... Chairman and Chief Executive Officer
Michael T. Devlin.................... President
David H. Bernstein................... Senior Vice President and General Manager,
Products
Timothy A. Brennan................... Senior Vice President, Chief Financial
Officer, and Secretary
Robert H. Dickerson.................. Senior Vice President and General Manager,
Products
Kevin J. Haar........................ Vice President, North American Field
Operations
John R. Lovitt....................... Senior Vice President, Worldwide Field
Operations
Joseph N. Marasco.................... Senior Vice President, Operations
</TABLE>
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Paul D. Levy, age 42, cofounded Rational in 1981. He is currently Chairman
of the Board and Chief Executive Officer. Before September 1996, Mr. Levy
served as President and Chief Executive Officer of Rational. Mr. Levy is the
son-in-law of James S. Campbell, member of Rational's Board of Directors.
Michael T. Devlin, age 43, cofounded Rational in 1981. He is currently
President and a Director. Before September 1996, Mr. Devlin served as Chairman
of the Board of Rational.
David H. Bernstein, age 46, joined Rational in 1982 as Vice President,
Product Development. In 1991, Mr. Bernstein was named Vice President and
General Manager of the Ada business unit. Mr. Bernstein was named Vice
President and General Manager, Object Technology Products, and Senior Vice
President and General Manager, Object Technology Products, in 1994 and 1995,
respectively. In May 1996, Mr. Bernstein was named Senior Vice President and
General Manager, Products.
Timothy A. Brennan, age 42, joined Rational as Corporate Controller in 1994.
In 1995, he was promoted to Vice President, Finance and Administration. In
January 1998, Mr. Brennan was named Senior Vice President, Chief Financial
Officer, and Secretary. From 1987 to 1994, Mr. Brennan held various financial
management and controllership positions with the ASK Group, Inc.
Robert Dickerson, age 41, is Senior Vice President and General Manager,
Products. He joined Rational in 1994 as Vice President, Developer and
Performix Products Groups. Prior to that, Mr. Dickerson was Senior Vice
President, Client/Server Division of Borland International.
Kevin J. Haar, age 41, is Vice President, North American Field Operations.
He joined Rational in 1986 as an account representative in the field sales
force. Since then, he has held a number of positions, most recently Vice
President, Major Accounts, North American Field Operations.
John R. Lovitt, age 53, joined Rational as a regional manager responsible
for sales and marketing in 1986. In 1990, he was promoted to Vice President,
and subsequently to Senior Vice President, North American Field Operations. In
November 1996, Mr. Lovitt was promoted to Senior Vice President, Worldwide
Field Operations, where he is responsible for worldwide field sales and
marketing and technical services.
Joseph N. Marasco, age 52, is Senior Vice President, Operations. He joined
Rational in 1986 as a product manager. Since then he has held a number of
positions in Rational, most recently, Vice President and General Manager,
Programming Environments.
FACTORS THAT MAY AFFECT FUTURE RESULTS
Risks Associated with Recent and Future Acquisitions
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 other countries. The
acquisition of Pure Atria has been accounted for as a pooling of interests.
Accordingly, if such accounting treatment were to be nullified for any reason,
it would materially and adversely affect Rational's reported earnings and,
potentially, its stock price.
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In addition to the acquisition of Pure Atria, during approximately the past
three years, Rational has made a number of strategic acquisitions, including
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 has recently acquired 19.9% of the outstanding capital stock of
ObjecTime, Ltd. 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's management has historically
evaluated on an ongoing basis the strategic opportunities available to the
Company. Rational may in the near-term or long-term future pursue acquisitions
of complementary products, technologies, or businesses.
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 because 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, 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, global economic conditions, and potential cutbacks in U.S. defense
spending, which has historically been a significant factor for Rational.
Unanticipated expenses associated with the integration of Rational and Pure
Atria 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 resulted in an operating loss and a net loss for the Company's
fiscal year ended 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 on as an indication of
future performance. Fluctuations in operating results have previously and may
continue to result in volatility in the price 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.
11
<PAGE>
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 ended September 30, 1997. Although Rational
entered into the merger with the expectation that it would be accretive in the
long term, the merger has been 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
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 Rational's common
stock.
Dependence on Market Growth and Development of Industry Standards
Rational's future growth and financial performance will depend in part on
continued growth in the need for and sales of tools for automating software
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
reorientation 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 on 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 in their
object analysis and design facility specification. The official sanction in
the future of a competing standard by the OMG could have a material adverse
effect on Rational's marketing and sales efforts and, in turn, on Rational's
business, operating results, and financial condition.
12
<PAGE>
Expansion of Product Lines; Dependence on New Product Introductions
The Company believes that its continued success will depend in part on 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 the 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 in 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, The 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, 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 on its ability to successfully compete with
numerous competitors at each point in its product line.
Rational faces competition from software-development tools and processes
developed internally by customers, including ad hoc integrations of numerous
standalone 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 about the advantages of the Company's
products versus internally developed software-quality systems.
Rational faces competition from, among others, Intersolv, Inc., Platinum
Technology, Inc., Select Software Tools plc, Cayenne, Oracle, IBM Corporation
(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. Rational's
RequisitePro requirements-management product faces competition from companies
such as GEC-Marconi. Rational's software-testing tools--Purify, Quantify,
PureCoverage, SQA Suite, Rational Visual Test, and preVue--face competition
from Compuware, 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
13
<PAGE>
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 that compete with Rational Apex. Rational's ClearCase, ClearDDTS,
and ClearQuest product line faces competition from various suppliers offering
products with configuration and change management functions, including
Continuus Software Corporation, StarBase Corporation, Hewlett Packard, True
Software, SQL Software, LTD., Intersolv, Inc., Sun Microsystems, and IBM. The
Rational Apex Ada product line faces 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 standalone 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 others of the Company's
products and would compete directly with such products if offered on a
standalone basis. The Company's 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
standalone 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.
Rational believes that the major competitive factors in its markets are
corporate and product reputation, breadth of coverage by an integrated product
line, product architecture, functionality and features, product quality,
performance, ease of use, quality of support, availability of technical
consulting services, and price.
Rational believes that the increased level of competition it observed 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 on its ability to increase its share of its target markets and to
license additional products and product enhancements to 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.
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Dependence on 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. Although 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 its World Wide Web site, 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 on 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
on 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 on 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 reprice "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 reprice stock options for most
employees. The repriced options are subject to additional lock-up and
repurchase restrictions. Members of the Company's senior management team at
that time were not eligible to participate in that repricing program. In April
1998, the compensation committee of the board, after consulting with all of
the outside directors, approved repricing agreements with the members of the
senior management team who were not eligible to participate in the November
1997 repricing program. The senior officer repricing was completed on
substantially the same terms, including the disposition limitations and
repurchase provisions, offered to the rest of the employees in November 1997,
although at the higher fair market price existing at the time of the April
1998 repricing. There can be no assurance that such repricing will be
sufficient to retain employees or senior management or that at some future
date the outstanding stock options will not again be underwater. To the extent
that options held by employees, including members of senior management, again
become underwater, those 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.
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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 on 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."
Business Alliance with Microsoft
On October 2, 1996, Rational and Microsoft announced the formation of a
business alliance that consisted of Rational's acquisition of Microsoft's
Visual Test product, technology cross-licensing, joint development projects,
and joint marketing programs. Although 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.
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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 the Visual Test product 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 nonexclusive, 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 Rational 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 not to generate direct
product revenue from Microsoft. The Company expects that continued 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 expect the licensing of its Rational 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 Rational 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, nonexclusive right to source code for certain aspects of the
Rational 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 on 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 on the business, operating results, and financial condition of
Rational. Likewise, others 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 on 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.
17
<PAGE>
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
Associated with Recent and Future Acquisitions" and business alliances such as
the 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 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, 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 34%, 27%, and 27% of
Rational's revenues in fiscal 1998, 1997, and 1996, respectively. Rational
expects that international sales will continue to account for a significant
18
<PAGE>
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 international 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 local currencies. Rational
has engaged only in 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 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 (that is,
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 countries do not protect
proprietary rights to the same extent as 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 that 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 may
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
19
<PAGE>
disputes in the software area have often been settled through licensing,
cross-licensing, or similar arrangements, costs associated with such
arrangements may be substantial. The Company is also currently a party to
securities litigation. 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, instituted either 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 on 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. See also "Item 3:
Legal Proceedings" of Part I of the Form 10-K.
Year 2000 Compliance
Rational is aware of the problems associated with computer systems as the
year 2000 approaches. Year 2000 problems are the result of common computer
programming techniques that result in systems that do not function properly
when manipulating dates later than December 31, 1999. The problem may affect
transaction processing computer applications used by the Company for
accounting, distribution, and planning. The problem may also affect embedded
systems such as building security systems, machine controllers, and other
equipment.
Rational is in the process of assessing and upgrading systems which fail to
be year 2000 compliant and will continue to review internal system
requirements and correct further issues as they are identified. Based on
recent assessment, the Company does not anticipate incurring material costs to
be year 2000 compliant. However, there can be no assurance that actual costs
will not substantially exceed the Company's assessment due to internal year
2000 problems or year 2000 problems associated with the Company's products.
Further, there can be no guarantee that the systems of other companies on
which the Company's systems rely will be converted in a timely manner or that
a failure to convert by another company, including without limitation any of
the Company's vendors, customers, or partners, or a conversion that is
incompatible with the Company's systems would not have a material adverse
effect on the Company.
Deferred Tax Assets
Based on 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 valuation allowance against
certain deferred tax assets, for the "more likely than not" criteria for
recognition which has not been met.
20
<PAGE>
ITEM 2--PROPERTIES
Rational's headquarters are located in a leased facility, in Cupertino,
California, consisting of approximately 101,000 square feet of office space
occupied under a lease expiring in January 2007. Rational also leases:
approximately 95,000 square feet of office space in Santa Clara, California,
under a lease expiring in January 2001, with a renewal option for an
additional five years; 98,000 square feet of office space in Lexington,
Massachusetts, under a lease expiring in December 2001; 83,000 square feet of
office space in Burlington, Massachusetts, under a lease expiring in July
2000; approximately 24,000 square feet of office space in Raleigh, North
Carolina, under a lease expiring in June 2003; approximately 18,000 square
feet of office space in Aloha, Oregon, under a lease expiring in April 2001;
and approximately 23,000 square feet of office space in McLean, Virginia,
under a lease expiring in February 2001. In North America, Rational leases
additional facilities and offices including locations in Alabama, California,
Colorado, Illinois, Massachusetts, New Jersey, New York, Pennsylvania, Texas,
Virginia, Washington, Wisconsin, and Canada. Rational also leases facilities
and offices outside of North America, including locations in Bangalore,
Hoofddorp, London, Munich, Paris, Sao Paolo, Seoul, Stockholm, Sydney, Taipei,
Tokyo, and Wellington. Rational believes that its existing facilities and
offices, together with additional space available to it, are adequate to meet
its requirements for the foreseeable future.
ITEM 3--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
stockholder 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 stockholders who purchased the Company's common stock on
October 8, 1997. Defendants' motions to transfer the cases pending in New York
and Virginia have been granted, and all pending actions will be consolidated
in the Northern District of California. A consolidated amended complaint has
not yet been filed; the case is in its preliminary stages. The Company
believes that the action is without merit and intends to defend the case
vigorously.
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.
Any adverse outcome to these or future lawsuits against the Company may
result in a material adverse effect on the Company's financial condition.
ITEM 4--SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
21
<PAGE>
PART II
ITEM 5--MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
The Company's common stock is traded on the NASDAQ national market under the
symbol RATL. As of May 21, 1998, there were 1,876 stockholders of record of
the Company's common stock. The Company has not, since its formation, declared
or paid any cash dividends on its common stock. The Company intends to employ
all available funds for the development of its business and, accordingly, does
not intend to declare or pay any cash dividends in the foreseeable future.
The following table sets forth the range of high and low bids for the
Company's common stock as quoted on the NASDAQ national market for Rational
Common Stock for the periods indicated:
<TABLE>
<CAPTION>
HIGH LOW
------ ------
<S> <C> <C>
FISCAL YEAR ENDED MARCH 31, 1998:
Fourth Quarter.............................................. $13.81 $10.75
Third Quarter............................................... 15.50 8.06
Second Quarter.............................................. 22.50 14.00
First Quarter............................................... 23.38 10.94
FISCAL YEAR ENDED MARCH 31, 1997:
Fourth Quarter.............................................. $40.88 $17.00
Third Quarter............................................... 44.25 29.75
Second Quarter.............................................. 36.00 17.50
First Quarter............................................... 33.13 19.00
</TABLE>
The foregoing reflects interdealer prices without retail markup, markdown, or
commissions and may not necessarily reflect actual transactions.
22
<PAGE>
ITEM 6--SELECTED FINANCIAL DATA
<TABLE>
<CAPTION>
FISCAL YEAR ENDED MARCH 31,
------------------------------------------------
1998 1997 1996 1995 1994
-------- -------- -------- -------- --------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C>
CONSOLIDATED STATEMENTS OF
OPERATIONS DATA:
Net product revenue.......... $184,953 $185,133 $126,876 $ 74,688 $ 59,929
Consulting and support
revenue..................... 125,717 92,735 61,261 45,419 33,256
-------- -------- -------- -------- --------
Total revenue............... 310,670 277,868 188,137 120,107 93,185
Cost of product revenue...... 19,709 11,777 9,735 7,989 12,567
Cost of consulting and
support revenue............. 43,356 38,305 26,779 22,016 15,047
-------- -------- -------- -------- --------
Total cost of revenue....... 63,065 50,082 36,514 30,005 27,614
-------- -------- -------- -------- --------
Gross margin................. 247,605 227,786 151,623 90,102 65,571
Operating expenses:
Research and development.... 61,560 47,239 33,773 23,379 26,072
Sales and marketing......... 138,709 108,403 80,063 47,388 33,247
General and administrative.. 29,092 27,267 19,481 12,342 10,127
Charges for acquired in-
process research and
development................ -- 56,798 20,300 -- --
Merger and integration
costs...................... 63,759 42,456 2,961 (1,100) 9,922
-------- -------- -------- -------- --------
Total operating expenses.... 293,120 282,163 156,578 82,009 79,368
-------- -------- -------- -------- --------
Operating income (loss)...... (45,515) (54,377) (4,955) 8,093 (13,797)
Other income, net............ 16,689 11,586 4,234 1,331 437
-------- -------- -------- -------- --------
Income (loss) from continuing
operations before income
taxes....................... (28,826) (42,791) (721) 9,424 (13,360)
Provision for income taxes... 9,447 6,820 7,115 2,036 487
-------- -------- -------- -------- --------
Net income (loss) from con-
tinuing operations.......... (38,273) (49,611) (7,836) 7,388 (13,847)
Discontinued operations--loss
on disposal................. -- -- -- -- (175)
-------- -------- -------- -------- --------
Net income (loss)........... $(38,273) $(49,611) $ (7,836) $ 7,388 $(14,022)
======== ======== ======== ======== ========
Income (loss) from continuing
operations per common
share--basic and diluted.... $ (.44) $ (.62) $ (.11) $ .12
Net income (loss) per common
share (pro forma for fiscal
1996 and 1995):
Basic....................... $ (.44) $ (.62) $ (.11) $ .12
Diluted..................... $ (.44) $ (.62) $ (.11) $ .12
Shares used in computing per
share amounts:
Basic....................... 87,575 79,631 69,778 59,718
Diluted..................... 87,575 79,631 69,778 61,860
CONSOLIDATED BALANCE SHEET
DATA:
Cash, cash equivalents, and
short-term investments...... $289,470 $327,395 $167,623 $ 55,814 $ 23,337
Working capital.............. 228,397 282,974 145,383 45,219 13,328
Total assets................. 445,205 456,740 236,213 96,738 56,719
Long-term obligations........ 6,492 3,192 2,189 3,675 7,809
Redeemable convertible
preferred stock............. -- -- -- 14,363 13,430
Stockholders' equity......... 287,176 330,109 162,482 39,018 2,798
</TABLE>
Net loss per common share has not been presented for fiscal 1994 due to the
capitalization of SQA, Inc., a company acquired by the Company in fiscal 1997
and accounted for as a pooling of interests. SQA's capitalization consisted
primarily of redeemable convertible preferred stock and is not included in
historical net loss per share calculations.
23
<PAGE>
ITEM 7--MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The statements contained in "Management's Discussion and Analysis of
Financial Condition and Results of Operations" include forward-looking
information within the meaning of Section 27A of the Securities Act of 1933,
as amended, and Section 21E of the Securities Exchange Act of 1934, as
amended, and are subject to the safe harbor created by those sections. Such
forward-looking statements include without limitation statements regarding
product development plans and schedules, relationships with strategic partners
and other third parties, and trends in overall revenue, revenue mix, expenses,
and other financial statement items. Rational's actual future results could
differ materially from those projected in the forward-looking information.
Factors that could cause actual results to differ materially include, without
limitation, those identified in "Factors That May Affect Future Results."
Rational assumes no obligation to update the forward-looking information or
such factors.
OVERVIEW
General
Rational's revenue is derived from product license fees and charges for
services, including technical consulting, training, and customer support. In
accordance with generally accepted accounting principles, Rational recognizes
software license revenue upon shipment to the customer if collection is
probable and remaining company obligations are insignificant and recognizes
customer-support revenue over the term of the maintenance agreement. Revenue
from consulting and training is recognized when earned. Rational's license
agreements do not provide a right of return, and reserves are maintained for
potential credit losses, of which there have been only immaterial amounts.
International sales accounted for 34%, 27%, and 27% of Rational's revenues
in fiscal 1998, 1997, and 1996, respectively. Rational expects that
international sales will continue to account for a significant portion of
Rational's revenues in future periods. See "Factors That May Affect Future
Results: Risks Associated with International Operations; Limited Protection of
Intellectual Property and Proprietary Rights."
In the fiscal year ended March 31, 1998, Rational's revenues from consulting
and support grew 36% while revenues from product sales were flat, contributing
to a lower gross margin percentage. There can be no assurance that this
revenue mix trend will not continue in future periods. See "Factors That May
Affect Future Results: Fluctuations in Operating Results; Expansion of Product
Lines; Dependence on New Product Introductions; Dependence on Growth of
Emerging Industries; Development of Industry Standards."
Although Rational has experienced increasing revenues in each of the past
three fiscal years, Rational's sales compensation structure has historically
contributed to revenues for the first quarter of a fiscal year being lower
than revenues for the fourth quarter of the prior fiscal year. There can be no
assurance that Rational will continue to experience increasing revenues or
that similar fluctuations will not occur again in the future. See "Factors
That May Affect Future Results: Fluctuations in Operating Results."
As a result of the Company's acquisition of Pure Atria Corporation,
accounted for as a pooling of interests, the information herein and the
accompanying consolidated financial statements are presented on a combined
basis for all periods presented, as described in more detail below.
Recent Acquisitions
The Company has completed several business combinations over the past three
years, accounted for as poolings of interests, which include Pure Atria
Corporation (July 1997), SQA, Inc. (February 1997), Atria Software, Inc.,
(acquired by Pure Software, Inc., August 1996), and Performix (acquired by
Pure Software, Inc., November 1995). See Note 3 of Notes to Consolidated
Financial Statements for details of these combinations.
The Company has completed several business combinations over the past three
years, accounted for as purchases, which include Integrity QA Software, Inc.
(acquired by Pure Atria Corporation, January 1997),
24
<PAGE>
Performance Awareness Corporation (March 1997), and others. See Note 4 of the
Consolidated Financial Statements for details of these combinations. See
"Factors that May Affect Future Results: Risks Associated with Recent or
Future Acquisitions."
Microsoft Relationship
On October 2, 1996, Rational and Microsoft announced the formation of a
business alliance that consisted of Rational's acquisition of Microsoft's
Visual Test product, technology cross-licensing, joint development projects,
and joint marketing programs. The purchase price of the Visual Test product
consisted of a single $23 million cash payment. Rational's operating results
for the quarter ended December 31, 1996, were reduced by a nonrecurring charge
of $17.6 million associated with the acquisition of the Visual Test product.
The charge to operations for acquired in-process research and development
represented the present value of the estimated cash flow expected to be
generated by Visual Test related technology, which at the acquisition date had
not yet reached the point of technological feasibility and did not have an
alternative future use. Rational plans to continue devoting effort to
developing commercially viable products from the acquired in-process research
and development. More specifically, Rational intends to exploit networked
computing resources to accelerate the testing process. Amounts attributed to
other purchased intangible assets are being amortized to operations over their
estimated useful lives, which in most cases are two to four years. Rational's
objective in entering into the cross-licensing arrangements with Microsoft was
not to generate direct product revenue from Microsoft, and Rational does not
expect such arrangements to directly result in a material increase in product
revenue. See "Factors that May Affect Future Results: Business Alliance with
Microsoft; Acquisition of Visual Test Product; Dependence on Strategic
Relationships."
25
<PAGE>
RESULTS OF OPERATIONS
The following table sets forth for the periods indicated the percentage of
total revenue represented by certain line items from Rational's consolidated
statements of operations:
<TABLE>
<CAPTION>
FISCAL YEAR ENDED
MARCH 31,
-----------------------
1998 1997 1996
----- ----- -----
<S> <C> <C> <C>
Net product revenue.................................... 60 % 67 % 67 %
Consulting and support revenue......................... 40 33 33
----- ----- -----
Total revenue...................................... 100 100 100
Cost of product revenue................................ 6 4 5
Cost of consulting and support revenue................. 14 14 14
----- ----- -----
Total cost of revenue.............................. 20 18 19
----- ----- -----
Gross margin........................................... 80 82 81
Operating expenses:
Research and development............................. 20 17 18
Sales and marketing.................................. 45 39 43
General and administrative........................... 9 10 10
Charges for acquired in-process research and
development......................................... -- 21 11
Merger and integration costs......................... 20 15 2
----- ----- -----
Total operating expenses........................... 94 102 84
----- ----- -----
Loss from continuing operations........................ (14) (20) (3)
Other income, net...................................... 5 4 2
----- ----- -----
Loss before provision for income taxes................. (9) (16) (1)
Provision for income taxes............................. 3 2 3
----- ----- -----
Net loss........................................... (12)% (18)% (4)%
===== ===== =====
</TABLE>
See "Factors that May Affect Future Results: Fluctuations in Operating
Results."
FISCAL YEARS ENDED MARCH 31, 1998, 1997, AND 1996
REVENUE
Total revenue increased 12% in fiscal 1998 compared to fiscal 1997 and 48%
in fiscal 1997 compared to fiscal 1996.
Net product revenue. Net product revenue in fiscal 1998 was flat compared to
fiscal 1997. Net product revenue increased 46% in fiscal 1997 compared to
fiscal 1996. The Company continued to expand its product offerings with the
introduction of such products as ClearCase 3.2, RequisitePro 3.0, and Rational
Rose 98. The flat net product revenue in fiscal 1998 when compared to 1997 was
due to several factors surrounding the recent merger and acquisition
activities of the Company. These factors include disruption in the field sales
organization caused by territory realignment and new product training,
conforming business practices, conforming product packaging, and pricing. The
increase in net product revenue in fiscal 1997 compared to 1996 was due to
higher unit sales of software licenses resulting from an increase in the
number of direct sales personnel worldwide and product line expansion through
the release of new products, releases of new versions of existing products,
and expansion of the platforms supported for UNIX-based products. Product line
expansion that contributed to product revenue increases include: the release
of Purify and a new version of ClearCase for the Microsoft Windows NT
operating system in fiscal 1997; and the release of PureDDTS 3.2, PureDDTS
WebTracker, ClearCase 2.1 for UNIX, and the original version of ClearCase for
the Microsoft Windows NT operating system. There was also continued strong
customer acceptance of Rational's visual modeling tools (the Rational Rose
family). In addition, revenues were favorably impacted by increasing SQA
revenues each year through the time
26
<PAGE>
of the SQA acquisition. See "Factors That May Affect Future Results:
Fluctuation in Operating Results; Risks Associated with Recent or Future
Acquisitions; Dependence on Growth of Emerging Industries; Development of
Industry Standards; Expansion of Product Lines; Dependence on New Product
Introductions; Competition."
Consulting and support revenue. Consulting and support revenue increased $33
million or 36% in fiscal 1998 compared to fiscal 1997 and $31.5 million or 51%
in fiscal 1997 compared to fiscal 1996. These increases reflected higher
demand for Rational's consulting expertise in advanced software-development
practices and, to a lesser extent, increased training and customer-support
revenues. The increase in fiscal 1997 consulting and support revenue compared
to fiscal 1996 is also due in part to revenue resulting from the Company's
recent acquisitions, which is included in operations from the date of
acquisition to the end of the fiscal year. See "Factors That May Affect Future
Results: Expansion of Product Lines; Dependence on New Product Introductions;
Dependence on Sales Force and Other Channels of Distribution."
International sales. During fiscal 1998, 1997, and 1996, international
revenues from product sales and related consulting and customer support were
$106.9 million, $73.7 million, and $50 million, representing 34%, 27%, and 27%
of total revenues, respectively. The growth in international sales during 1998
was due principally to increased sales and marketing activities in
international markets. Rational's international sales are priced in local
currencies. Rational has attempted to limit its exposure to fluctuations in
foreign currencies from time to time by utilizing a hedging strategy for
existing receivables denominated in those currencies. At March 31, 1998,
Rational had certain forward foreign exchange contracts all having maturities
of approximately 30 days to exchange various European currencies for U.S.
dollars in the amount of $25.1 million. See "Factors That May Affect Future
Results: Rules Associated with International Operations; Limited Protection of
Intellectual Property."
COST OF REVENUE
Cost of product revenue. Cost of product revenue consists principally of
materials, packaging and freight, amortization of purchased technology, and
royalties. Cost of product revenue increased 67% in fiscal 1998 compared to
fiscal 1997 and 21% in fiscal 1997 compared to fiscal 1996. These costs
represented 11%, 6%, and 8% of net product revenue in fiscal 1998, 1997, and
1996, respectively. In fiscal 1998, the increase in product cost as a
percentage of product revenue was due primarily to amortization of developed
technology acquired in recent mergers. In fiscal 1997, the decrease in product
cost as a percentage of product revenue was due mainly to lower royalty
expense resulting from a decrease in third-party product sales. See "Factors
That May Affect Future Results: Dependence on Sales Force and Other Channels
of Distribution."
Cost of consulting and support revenue. Cost of consulting and support
revenue consists principally of personnel costs for training, consulting, and
customer support. Cost of consulting and support revenue increased 13% in
fiscal 1998 compared to fiscal 1997 and 43% in fiscal 1997 compared to fiscal
1996. These costs represented 34%, 41%, and 44% of consulting and support
revenue in fiscal 1998, 1997, and 1996, respectively. The increases in dollar
amounts were the result of additional personnel and personnel-related expenses
needed to perform professional services in object modeling, advanced software-
development practices, and business process engineering. The cost decreases as
a percentage of consulting and support revenue resulted from an overall higher
mix of support services, which generally have a higher gross margin than
consulting services.
OPERATING EXPENSES
Research and development. Total expenditures for research and development
increased 30% in fiscal 1998 compared to fiscal 1997 and 40% in fiscal 1997
compared to fiscal 1996. Research and development costs represented 20%, 17%,
and 18% of total revenue in fiscal 1998, 1997, and 1996, respectively. The
increases in fiscal 1998 as compared to fiscal 1997, and in fiscal 1997 as
compared to fiscal 1996, were due primarily to the cost of additional
personnel and related costs incurred in maintaining existing products and
developing new product releases. See "Factors That May Affect Future Results:
Rapid Technological Change."
27
<PAGE>
Rational did not capitalize any software-development costs in fiscal 1998,
1997, and 1996 because eligible costs were not material. Rational expects that
the amount of software-development costs capitalized in future periods will be
immaterial to Rational's results of operations and financial position because
the time period and the engineering effort required between demonstration of a
product's economic and technological feasibility and the date of product
release has been very short. See "Factors That May Affect Future Results: Risk
of Software Defects; Expansion of Product Lines; Dependence on New Product
Introductions."
Sales and marketing. Sales and marketing expenses increased 28% in fiscal
1998 compared to fiscal 1997 and 35% in fiscal 1997 compared to fiscal 1996.
These expenses represented 45%, 39%, and 43% of total revenue in fiscal 1998,
1997, and 1996, respectively. The fiscal 1998 and 1997 increases in sales and
marketing expenses reflect the additional personnel, commissions, and related
costs required in sales and marketing departments to expand Rational's sales
channels, to penetrate new markets, and to increase its market share in core
markets, as well as expenses associated with the merger with Pure Atria. See
"Factors That May Affect Future Results: Dependence on Sales Force and Other
Channels of Distribution."
General and administrative. General and administrative expenses increased 7%
in fiscal 1998 compared to fiscal 1997 and 40% in fiscal 1997 compared to
fiscal 1996. General and administrative expenses represented 9%, 10%, and 10%
of total revenue in fiscal 1998, 1997, and 1996, respectively. The increase in
fiscal 1998 resulted from increased employee-related expenses associated with
staffing requirements needed to support the Company's expanding business. The
increased expense for fiscal 1997 resulted from increased employee-related
expenses associated with staffing requirements needed to support the Company's
expanding business and the reimbursements of approximately $1.2 million in
expenses of certain of its stockholders for the underwriting discount
applicable to the shares of common stock sold by them, as well as certain fees
and expenses of such stockholders' legal counsel incurred in connection with
the Company's October 1996 public stock offering. In addition, amortization of
purchased intangible assets, included in general and administrative expenses,
increased to $1.7 million in fiscal 1997 from $442,000 in fiscal 1996 as a
result of the Company's merger and acquisition activity in fiscal 1997. See
"Factors That May Affect Future Results: Management of Growth; Risks
Associated with Recent or Future Acquisitions."
Charges for acquired in-process research and development. In-process
research and development represents the present value of the estimated cash
flow expected to be generated by acquired technology that at the acquisition
date has not yet reached the point of technological feasibility and does not
have an alternative future use. In fiscal 1997, write-offs associated with
acquired in-process research and development included $17.6 million related to
the acquisition of the Visual Test product, $5.7 million related to the
acquisition of Requisite, Inc., $6.1 million related to the acquisition of
Softlab AB, and $27.4 million related to the acquisition of Performance
Awareness Corporation. See "Factors That May Affect Future Results: Risks
Associated with Recent or Future Acquisitions."
Merger and integration costs. Merger-related expenses of $63.8 million were
recorded in fiscal 1998 related to the merger of Rational and Pure Atria to
accrue transaction costs, severance costs associated with employee
terminations, costs associated with conforming employee benefits plans,
charges associated with the closure of duplicate facilities, and asset
writedowns related to duplicate business systems. Merger-related expenses of
$35.3 million and $7.2 million were recorded in fiscal 1997 related to the
mergers of Pure and Atria, and Rational and SQA, respectively. The actions
related to severance and administrative costs are substantially complete. See
"Factors That May Affect Future Results: Risks Associated with Recent or
Future Acquisitions; Management of Growth."
OTHER INCOME, NET
Other income, net, consists of interest income, interest expense, gains and
losses on foreign currency transactions, and miscellaneous items of income and
expense. Other income has fluctuated as a result of operating results, the
amount of cash available for investment in interest-bearing accounts, and the
extent of foreign currency transactions. Other income, net, increased $5.1
million to $16.7 million in fiscal 1998 and $7.4 million to $11.6 million in
fiscal 1997. The increases are due primarily to interest earned on cash
generated from
28
<PAGE>
secondary public offerings completed by Rational, which were completed in
October 1996 and June 1995, and from the initial public offering completed by
SQA, Inc., in December 1995. See "Factors That May Affect Future Results:
Fluctuations in Operating Results."
INCOME TAXES
The income tax provisions for fiscal 1998, 1997, and 1996 differ from tax
computed at the federal statutory income tax rate due to the impact of
nondeductible charges for acquired in-process research and development and
merger-related costs, foreign losses resulting in no U.S. tax benefit, as well
as foreign and state income taxes, offset by the realized benefit of net
operating loss carryforwards.
As of March 31, 1998, Rational had net operating loss carryforwards for
federal income tax purposes of approximately $27.8 million that expire in 2006
through 2012. In addition, Rational had approximately $5.9 million of tax
credit carryforwards that expire in years 1999 through 2012, if not utilized.
As a result of various public offerings and business combinations,
approximately $11.6 million of the Company's net operating loss carryforwards
and approximately $4.8 million of the Company's credits are subject to
limitation under the Internal Revenue Code. The Company has placed a valuation
allowance on such net operating losses and credits as appropriate.
Under Statement of Financial Accounting Standards No. 109 (FAS 109),
deferred tax assets and liabilities are determined based on differences
between financial reporting and tax bases of assets and liabilities and are
measured using the enacted tax rates and laws that will be in effect when the
differences are expected to reverse. FAS 109 provides for the recognition of
deferred tax assets if realization of such assets is more likely than not.
Based on the weight of available evidence, the Company has provided a
valuation allowance against certain deferred tax assets. The Company will
continue to evaluate the realizability of the deferred tax assets on a
quarterly basis. See Note 11 of Notes to Consolidated Financial Statements.
See "Factors That May Affect Future Results: Deferred Tax Assets."
LIQUIDITY AND CAPITAL RESOURCES AT MARCH 31, 1998
As of March 31, 1998, Rational had cash, cash equivalents, and short-term
investments of $289 million and working capital of $228 million. Net cash
provided by operating activities for the period ended March 31, 1998, was
composed primarily of noncash charges for depreciation and amortization and an
increase in accrued merger and integration costs, deferred revenue, and income
taxes payable offset by the Company's net loss and increases in accounts
receivable, prepaid expenses, and deferred tax assets. Cash, cash equivalents,
and short-term investments for the period ended March 31, 1997, was $327
million, and working capital was $283 million. Net cash provided by operating
activities for the period ended March 31, 1997, was composed primarily of
noncash charges for depreciation and amortization and an increase in accrued
merger and integration costs, deferred revenue, and compensation charges
related to stock options, offset by the Company's net loss and increases in
accounts receivable and deferred tax assets.
Net cash used in investing activities resulted primarily from business and
product acquisitions totaling $24.2 million in fiscal 1998 and $70 million in
1997 (See Notes 3 and 4 of Notes to Consolidated Financial Statements). The
Company's investment activity also included net purchases and maturities and
sales of short-term investments of $80.7 million in fiscal 1998, $19.7 million
in fiscal 1997, and $40 million in fiscal 1996 and expenditures for fixed
assets of $30 million in fiscal 1998, $20.6 million in fiscal 1997, and $11.8
million in fiscal 1996.
Financing activities generated $9.6 million for fiscal 1998, of which $11.3
million was received from the issuance of common stock upon the exercise of
common stock options and $1.8 million was used to decrease long-term debt and
capital lease obligations. In fiscal 1997 financing activities generated $206
million, of which approximately $186 million was generated by the public
offering of the Company's common stock in October 1996. Also, the Company
received net proceeds of approximately $20.6 million from the issuance of
common stock upon the exercise of common stock options. In fiscal 1996,
financing activities generated approximately
29
<PAGE>
$93.9 million, of which approximately $28.9 million was generated by the
initial public offering of SQA in December 1995, approximately $30.4 million
was generated by the initial public offering of Pure in August 1995, and
approximately $29.9 million was generated by the public offering of the
Company's common stock in June 1995. Fiscal 1996 financing activities also
included net proceeds of approximately $4.4 million from the issuance of
redeemable convertible preferred stock by SQA and approximately $4.8 million
from the issuance of common stock upon the exercise of common stock options.
In fiscal 1996, $2.9 million was used to decrease long-term debt and capital
lease obligations.
The Company believes that expected cash flow from operations combined with
existing cash, cash equivalents, and short-term investments will be sufficient
to meet its cash requirements for the foreseeable future. See "Factors That
May Affect Future Results: Fluctuations in Operating Results; Risks Related to
Recent or Future Acquisitions."
YEAR 2000 COMPLIANCE
Rational is aware of the problems associated with computer systems as the
year 2000 approaches. Year 2000 problems are the result of common computer
programming techniques that result in systems that do not function properly
when manipulating dates later than December 31, 1999. The problem may affect
transaction processing computer applications used by the Company for
accounting, distribution, and planning. The problem may also affect embedded
systems such as building security systems, machine controllers, and other
equipment.
Rational is in the process of assessing and upgrading systems which fail to
be year 2000 compliant and will continue to review internal system
requirements and correct further issues as they are identified. Based on
recent assessment, the Company does not anticipate incurring material costs to
be year 2000 compliant. However, there can be no assurance that actual costs
will not substantially exceed the Company's assessment due to internal year
2000 problems or year 2000 problems associated with the Company's products.
Further, there can be no guarantee that the systems of other companies on
which the Company's systems rely will be converted in a timely manner, or that
a failure to convert by another company, including without limitation any of
the Company's vendors, customers, or partners, or a conversion that is
incompatible with the Company's systems, would not have a material adverse
effect on the Company.
ITEM 7(A)--QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
None.
ITEM 8--FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
30
<PAGE>
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Board of Directors and Stockholders
Rational Software Corporation
We have audited the accompanying consolidated balance sheets of Rational
Software Corporation as of March 31, 1998 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, 1998. 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 July 1997,
the Company merged with Pure Atria Corporation in a transaction which was
accounted for as a pooling of interests. We did not audit the financial
statements of Pure Atria Corporation for the years prior to fiscal 1998, which
statements reflect total assets constituting 34% of the related 1997
consolidated financial statement totals, and which statements reflect net loss
of approximately $6,657,000 and $3,522,000 of related 1997 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 Pure Atria Corporation is
based solely on the report of the other auditors. 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 net income of
approximately $431,000 of related 1996 consolidated financial statement
totals. 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 reports of other
auditors provide a reasonable basis for our opinion.
In our opinion, based on our audits and the reports 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, 1998 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, 1998, in conformity with generally accepted accounting principles.
/s/ Ernst & Young LLP
Palo Alto, California
April 21, 1998, except for Note Fifteen,
as to which the date is
April 23, 1998
31
<PAGE>
REPORT OF KPMG PEAT MARWICK LLP, INDEPENDENT AUDITORS
The Board of Directors and Stockholders
Rational Software Corporation
We have audited the consolidated balance sheet of Pure Atria Corporation and
subsidiaries as of December 31, 1996, and the related consolidated statements
of operations, redeemable convertible preferred stock and stockholders'
equity, and cash flows for each of the years in the two-year period ended
December 31, 1996 (which are separately presented herein). These consolidated
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial positions of Pure
Atria Corporation and subsidiaries as of December 31, 1996 and the results of
their operations and their cash flows for each of the years in the two-year
period ended December 31, 1996, in conformity with generally accepted
accounting principles.
/s/ KPMG Peat Marwick LLP
Mountain View, California
January 21, 1997, except as to Note 2,
which is as of January 31, 1997
32
<PAGE>
REPORT OF ARTHUR ANDERSEN LLP, INDEPENDENT AUDITORS
The Board of Directors and Stockholders
Rational Software Corporation
We have audited the accompanying consolidated balance sheets of SQA, Inc. (a
Delaware corporation) and its subsidiary as of December 31, 1994 and 1995, and
the related consolidated statements of operations, redeemable convertible
preferred stock and stockholders' equity (deficit), and cash flows for each of
the three years in the period ended December 31, 1995. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the financial statements referred to above present fairly in
all material respects, the financial position of SQA, Inc. and subsidiary as
of December 31, 1994 and 1995, and the results of their operations and their
cash flows for each of the three years in the period ended December 31, 1995,
in conformity with generally accepted accounting principles.
/s/ Arthur Andersen LLP
Boston, Massachusetts
January 26, 1996
33
<PAGE>
RATIONAL SOFTWARE CORPORATION
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
MARCH 31,
--------------------
1998 1997
--------- ---------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents.............................. $ 126,229 $ 244,856
Short-term investments................................. 163,241 82,539
Accounts receivable, net of allowance for doubtful
accounts of $3,638 and $4,001 in 1998 and 1997,
respectively.......................................... 71,379 63,043
Prepaid expenses and other assets...................... 7,239 6,921
Deferred tax assets.................................... 11,846 9,054
--------- ---------
Total current assets................................. 379,934 406,413
Property and equipment, net.............................. 37,988 26,265
Other assets, net........................................ 27,283 24,062
--------- ---------
Total assets............................................. $ 445,205 $ 456,740
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable....................................... $ 13,262 $ 13,783
Accrued employee benefits.............................. 23,929 21,256
Income taxes payable................................... 15,259 4,034
Other accrued expenses................................. 18,345 15,532
Current portion of accrued merger and integration
expenses.............................................. 26,226 24,607
Deferred revenue....................................... 52,707 42,217
Current portion of long-term debt and lease
obligations........................................... 1,809 2,010
--------- ---------
Total current liabilities............................ 151,537 123,439
Accrued rent............................................. 720 535
Long-term accrued merger and integration expenses........ 5,600 916
Long-term debt........................................... 172 1,741
--------- ---------
Total liabilities........................................ 158,029 126,631
--------- ---------
Commitments and contingencies
Stockholders' equity:
Common stock, $0.01 par value, 150,000 shares
authorized, 88,975 and 84,502 shares issued and
outstanding in 1998 and 1997, respectively............ 890 845
Additional paid-in capital............................. 494,718 455,753
Treasury stock......................................... (1,340) (1,340)
Accumulated deficit.................................... (205,262) (123,828)
Cumulative translation adjustment...................... (1,830) (1,321)
--------- ---------
Total stockholders' equity............................... 287,176 330,109
--------- ---------
Total liabilities and stockholders' equity............... $ 445,205 $ 456,740
========= =========
</TABLE>
See Notes to Consolidated Financial Statements
34
<PAGE>
RATIONAL SOFTWARE CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
YEARS ENDED MARCH 31,
----------------------------
1998 1997 1996
-------- -------- --------
<S> <C> <C> <C>
Net product revenue.............................. $184,953 $185,133 $126,876
Consulting and support revenue................... 125,717 92,735 61,261
-------- -------- --------
Total revenue................................ 310,670 277,868 188,137
Cost of product revenue.......................... 19,709 11,777 9,735
Cost of consulting and support revenue........... 43,356 38,305 26,779
-------- -------- --------
Total cost of revenue........................ 63,065 50,082 36,514
-------- -------- --------
Gross margin..................................... 247,605 227,786 151,623
Operating expenses:
Research and development expenses.............. 61,560 47,239 33,773
Sales and marketing expenses................... 138,709 108,403 80,063
General and administrative expenses............ 29,092 27,267 19,481
Charges for acquired in-process research and
development................................... -- 56,798 20,300
Merger and integration costs................... 63,759 42,456 2,961
-------- -------- --------
Total operating expenses....................... 293,120 282,163 156,578
-------- -------- --------
Operating loss................................. (45,515) (54,377) (4,955)
Other income, net................................ 16,689 11,586 4,234
-------- -------- --------
Loss before income taxes....................... (28,826) (42,791) (721)
Provision for income taxes....................... 9,447 6,820 6,391
-------- -------- --------
Net loss......................................... $(38,273) $(49,611) $ (7,112)
======== ======== ========
Net loss per share--basic and diluted............ $ (0.44) $ (0.62)
======== ========
Shares used in computing net loss per share--
basic and diluted............................... 87,575 79,631
======== ========
Pro-forma net loss per share:
Loss before income taxes, as reported.......... $ (721)
Pro-forma provision for income taxes........... 7,115
--------
Pro-forma net loss per share................... $ (7,836)
========
Pro-forma net loss per share--basic and
diluted....................................... $ (0.11)
========
Shares used in computing pro-forma net loss per
share--basic and diluted...................... 69,778
========
</TABLE>
See Notes to Consolidated Financial Statements
35
<PAGE>
RATIONAL SOFTWARE CORPORATION
CONSOLIDATED STATEMENT OF REDEEMABLE CONVERTIBLE PREFERRED STOCK AND
STOCKHOLDERS' EQUITY
(IN THOUSANDS)
<TABLE>
<CAPTION>
REDEEMABLE
CONVERTIBLE
PREFERRED STOCK
-----------------
SHARES AMOUNT
------- --------
<S> <C> <C>
BALANCE AT MARCH 31, 1995.... 11,684 $ 14,363
Issuance of Series D
preferred stock............ 2,102 14,161
Conversion of redeemable
preferred stock to common
stock...................... (13,786) (28,524)
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............... -- --
Issuance of common stock
pursuant to Pure initial
public offering, net of
expenses of $800........... -- --
Exercise of common stock
options.................... -- --
Purchase of treasury stock.. -- --
Issuance of common stock
under Employee Stock
Purchase Plan.............. -- --
Compensation expense for
stock option grants........ -- --
Tax benefit from option
transactions............... -- --
Cumulative translation
adjustment................. -- --
Distributions to
stockholders............... -- --
Reclassification of
undistributed S Corporation
earnings................... -- --
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
under Employee Stock
Purchase Plan.............. -- --
Tax benefit from option
transactions............... -- --
Compensation expense for
stock option grants........ -- --
Cumulative translation
adjustment................. -- --
Net loss.................... -- --
Net transactions of SQA from
January 1, 1997, to
March 31, 1997............. -- --
------- --------
BALANCE AT MARCH 31, 1997.... -- --
Exercise of common stock
options.................... -- --
Issuance of common stock
under Employee Stock
Purchase Plan.............. -- --
Cumulative translation
adjustment................. -- --
Net loss.................... -- --
Net transactions of Pure
Atria from January 1, 1997,
to March 31, 1997.......... -- --
------- --------
BALANCE AT MARCH 31, 1998.... -- --
======= ========
<CAPTION>
STOCKHOLDERS' EQUITY
-------------------------------------------------------------------------
COMMON
STOCK ADDITIONAL CUMULATIVE TOTAL
-------------- PAID-IN TREASURY ACCUMULATED TRANSLATION STOCKHOLDERS'
SHARES AMOUNT CAPITAL STOCK DEFICIT ADJUSTMENT EQUITY
------- ------ ---------- --------- ----------- ----------- -------------
<S> <C> <C> <C> <C> <C> <C> <C>
BALANCE AT MARCH 31, 1995.... 51,946 $520 $ 99,371 $(1,340) $ (59,533) -- $ 39,018
Issuance of Series D
preferred stock............ -- -- (20) -- -- -- (20)
Conversion of redeemable
preferred stock to common
stock...................... 10,736 108 28,416 -- -- -- 28,524
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
Issuance of common stock
pursuant to Pure initial
public offering, net of
expenses of $800........... 1,800 18 30,378 -- -- -- 30,396
Exercise of common stock
options.................... 1,828 19 3,881 -- -- -- 3,900
Purchase of treasury stock.. (86) (1) (8) -- -- -- (9)
Issuance of common stock
under Employee Stock
Purchase Plan.............. 190 1 901 -- -- -- 902
Compensation expense for
stock option grants........ -- -- 229 -- -- -- 229
Tax benefit from option
transactions............... -- -- 800 -- -- -- 800
Cumulative translation
adjustment................. -- -- -- -- -- (12) (12)
Distributions to
stockholders............... -- -- -- -- (1,800) -- (1,800)
Reclassification of
undistributed S Corporation
earnings................... -- -- 1,625 -- (1,625) -- --
Net loss.................... -- -- -- -- (7,112) -- (7,112)
------- ------ ---------- --------- ----------- ----------- -------------
BALANCE AT MARCH 31, 1996.... 75,390 754 233,150 (1,340) (70,070) (12) 162,482
Issuance of common stock,
net of expenses of $675.... 5,446 55 190,673 -- -- -- 190,728
Exercise of common stock
options.................... 2,697 27 10,465 -- -- -- 10,492
Issuance of common stock
under Employee Stock
Purchase Plan.............. 945 9 5,726 -- -- -- 5,735
Tax benefit from option
transactions............... -- -- 9,830 -- -- -- 9,830
Compensation expense for
stock option grants........ -- -- 5,758 -- -- -- 5,758
Cumulative translation
adjustment................. -- -- -- -- -- (1,309) (1,309)
Net loss.................... -- -- -- -- (49,611) -- (49,611)
Net transactions of SQA from
January 1, 1997, to
March 31, 1997............. 24 -- 151 -- (4,147) -- (3,996)
------- ------ ---------- --------- ----------- ----------- -------------
BALANCE AT MARCH 31, 1997.... 84,502 845 455,753 (1,340) (123,828) (1,321) 330,109
Exercise of common stock
options.................... 2,057 22 5,141 -- -- -- 5,163
Issuance of common stock
under Employee Stock
Purchase Plan.............. 698 6 6,178 -- -- -- 6,184
Cumulative translation
adjustment................. -- -- -- -- -- (53) (53)
Net loss.................... -- -- -- -- (38,273) -- (38,273)
Net transactions of Pure
Atria from January 1, 1997,
to March 31, 1997.......... 1,718 17 27,646 -- (43,161) (456) (15,954)
------- ------ ---------- --------- ----------- ----------- -------------
BALANCE AT MARCH 31, 1998.... 88,975 $890 $494,718 $(1,340) $(205,262) $(1,830) $287,176
======= ====== ========== ========= =========== =========== =============
</TABLE>
See Notes to Consolidated Financial Statements
36
<PAGE>
RATIONAL SOFTWARE CORPORATION
CONSOLIDATED STATEMENT OF CASH FLOWS
(IN THOUSANDS)
<TABLE>
<CAPTION>
YEARS ENDED MARCH 31,
-------------------------------
1998 1997 1996
--------- --------- ---------
<S> <C> <C> <C>
OPERATING ACTIVITIES:
Net loss...................................... $ (38,273) $ (49,611) $ (7,112)
Adjustments to reconcile net loss to net cash
provided by operating activities:
Charges for acquired in-process research and
development................................. -- 56,798 20,300
Depreciation................................. 13,387 9,381 6,755
Amortization................................. 7,496 1,985 1,152
Compensation expense related to stock
options..................................... -- 145 229
Tax benefits of stock option exercises....... -- 9,830 800
Noncash merger and integration costs......... 7,625 7,109 331
Changes in operating assets and liabilities:
Accounts receivable......................... (8,336) (22,782) (13,800)
Prepaid expenses and other, net............. (318) (904) (1,713)
Deferred tax assets......................... (4,851) (6,765) (2,236)
Accounts payable............................ (521) 7,112 (714)
Accrued employee benefits and other accrued
expenses................................... 5,671 3,250 10,081
Income taxes payable........................ 11,225 (2,052) 2,295
Accrued merger and integration expenses..... (1,322) 21,288 1,558
Deferred revenue............................ 10,490 10,324 15,392
--------- --------- ---------
Net cash provided by operating activities..... 2,273 45,108 33,318
INVESTING ACTIVITIES:
Purchase of short-term investments............ (486,710) (185,015) (103,202)
Maturities and sales of short-term
investments.................................. 406,008 165,314 63,160
Purchases of property and equipment........... (29,961) (20,648) (11,820)
Proceeds from sale of fixed assets............ 4,850 -- --
Net changes in other assets................... (8,657) 74 (395)
Business combinations, net of cash acquired... (15,498) (69,992) (2,858)
--------- --------- ---------
Net cash used in investing activities......... (129,968) (110,267) (55,115)
FINANCING ACTIVITIES:
Principal payments under long-term debt and
capital lease obligations.................... (1,770) (965) (2,867)
Net proceeds from issuances of common stock... 11,347 206,810 94,085
Net proceeds from the sale of redeemable
convertible preferred stock,
net of issuance costs........................ -- -- 4,435
S Corporation distributions to stockholders... -- -- (1,800)
--------- --------- ---------
Net cash provided by financing activities..... 9,577 205,845 93,853
Effect of changes in foreign currency exchange
rate on cash................................. (509) (502) (155)
--------- --------- ---------
Net (decrease) increase in cash and cash
equivalents.................................. (118,627) 140,184 71,901
Cash and cash equivalents at beginning of
year......................................... 244,856 104,672 32,771
--------- --------- ---------
Cash and cash equivalents at end of year...... $ 126,229 $ 244,856 $ 104,672
========= ========= =========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW
INFORMATION:
Cash paid for income taxes.................... $ 2,577 $ 4,235 $ 4,872
Noncash investing and financing activities:
Conversion of redeemable preferred stock to
common stock................................ -- -- $ 28,524
Redeemable convertible preferred stock issued
in connection with acquisition of QualTrak
Corporation.................................. -- -- $ 9,706
</TABLE>
See Notes to Consolidated Financial Statements
37
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 1998
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 companies
that depend on their ability to develop software. The Company provides an
integrated suite of software products and services designed to improve the
software-development process.
The accompanying consolidated financial statements include the accounts of
the Company and its wholly owned subsidiaries, including Pure Atria
Corporation and SQA, Inc., which merged with the Company effective July 30,
1997, and February 26, 1997, respectively. The historical consolidated
financial statements of the Company for all periods prior to such merger dates
have been restated to reflect the mergers, which have been accounted for as
poolings of interests. The consolidated financial statements at March 31,
1997, and for the years ended March 31, 1997 and 1996, have been restated to
include the financial results of Pure Atria at December 31, 1996, and the
years ended December 31, 1996 and 1995, respectively. The consolidated
statement of operations for the year ended March 31, 1996, has also been
restated to include the December 31, 1995, results of SQA, Inc. 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.
Revenue recognition. The Company recognizes revenue and related costs from
the sale of its software products 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 guarantee 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 with milestone payments, is
recognized under the percentage of completion method in conformity with
Accounting Research Bulletin No. 45, "Long-Term Construction-Type Contracts,"
using the relevant guidance in Statement of Position 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, 1998
and 1997, and software amortization expense was $329,000 for the year ended
March 31, 1996.
Translation of local currencies. The Company's international subsidiaries
operate primarily using local functional currencies. Accordingly, all assets
and liabilities of these subsidiaries are translated using exchange rates in
effect at the end of the period, and revenues and costs are translated using
average exchange rates for the period. The resulting cumulative translation
adjustments are presented as a separate component of stockholders' equity.
Realized and unrealized exchange gains or losses from transaction adjustments
are reflected in operations and are not material.
38
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
MARCH 31, 1998
Derivative financial instruments. A portion of the Company's business is
conducted in currencies other than the U.S. dollar. Changes in the value of
major local currencies relative to the U.S. dollar could adversely affect
operating results.
The Company uses forward foreign exchange contracts that are designated to
reduce a portion of its exposure to foreign currency risk from balance sheet
exposures resulting from the changes in foreign currency exchange rates. Such
exposures result from the portion of the Company's assets and liabilities that
are denominated in currencies other than the functional currency of the legal
entity, including local currency denominated assets and liabilities in U.S.
dollar functional currency entities. Forward contracts are accounted for on a
market-to-market basis with realized and unrealized gains or losses recognized
in the period in which they are settled. Such contracts meet the criteria
established in FASB 52 for hedge accounting treatment. The Company finds it
impractical to hedge all foreign currencies in which it conducts business. As
a result, the Company will continue to experience foreign currency gains and
losses.
The Company does not use derivative financial instruments for speculative
trading purposes, nor does it hold or issue leveraged derivative financial
instruments.
Other income. During the year ended March 31, 1998, 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 loss per share. In 1997, the Financial Accounting Standards Board issued
Statement No. 128 (FAS 128), "Earnings per Share." FAS 128 replaced the
calculation of 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. In addition, in February 1998, the
Securities and Exchange Commission issued Staff Accounting Bulletin No. 98,
"Earnings per Share." Staff Accounting Bulletin No. 98 affected the treatment
of certain stock and warrants (cheap stock) issued within one year of an
initial public offering. Upon the adoption of FAS 128, the staff generally
does not continue to believe that such stock and warrants should be treated as
outstanding for all reporting periods. Earnings per share amounts presented
have been restated to conform to the requirements of FAS 128 and Staff
Accounting Bulletin No. 98. As a result of the Company's net losses, the
effect of stock options on the net loss per share calculation would be
antidilutive, and therefore shares used in computing basic and dilutive net
loss per share are equivalent in all periods presented.
Pro-forma net loss for the year ended March 31, 1996, includes a provision
for income taxes as if Performix, Inc., (Performix) had been a C corporation,
fully subject to federal and state income taxes. Prior to its acquisition by
the Company, Performix had elected S corporation status for income tax
purposes, and consequently, historical results as they relate to Performix do
not include a provision for income taxes.
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 and are recorded at amounts that approximate fair value
based on quoted market prices at March 31, 1998 and 1997. Unrecognized gains
and losses and declines in value judged to be other than temporary on
available-for-sale
39
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
MARCH 31, 1998
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 and are 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.
In accordance with 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," the Company is required to review for impairment
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.
Stock-based compensation. The Company has elected to follow Accounting
Principles Board Opinion No. 25 (APB 25), "Accounting for Stock Issued to
Employees" and related interpretations in accounting for its employee stock
options, because the alternative fair value accounting provided for under FASB
Statement No. 123 (FAS 123), "Accounting for Stock-Based Compensation"
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, and accordingly, no compensation
expense is recorded. The Company recognizes compensation expense for those
options granted with an exercise price less than fair value at the date of
grant.
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 $6.5 million, $4.1 million, and $4 million for the
years ended March 31, 1998, 1997, and 1996, respectively.
Reclassifications. Certain prior-year amounts have been reclassified to
conform with current-year presentation.
Recent pronouncements. In June 1997, the Financial Accounting Standards
Board issued Statement No. 130 (FAS 130), "Reporting Comprehensive Income."
This statement requires that all items required to be recognized under
accounting standards as components of comprehensive income be reported in a
financial statement that is displayed with the same prominence as other
financial statements. This statement is effective for fiscal years beginning
after December 15, 1997, and will be adopted by the Company for the year
ending March 31, 1999.
In addition, during June 1997, the Financial Accounting Standards Board
issued Statement No. 131 (FAS 131), "Disclosures about Segments of an
Enterprise and Related Information." This statement replaces Statement No. 14
and changes the way public companies report segment information. This
statement is effective for fiscal years beginning after December 15, 1997, and
will be adopted by the Company for the year ending March 31, 1999. Adoption of
these pronouncements is not expected to have a material impact on the
Company's consolidated financial statements.
40
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
MARCH 31, 1998
Statement of Position 97-2 (SOP 97-2), "Software Revenue Recognition," was
issued in October 1997, superseding SOP 91-1, and is effective for
transactions entered into for fiscal years beginning after December 15, 1997.
SOP 97-2 addresses software revenue recognition matters primarily from a
conceptual level, and detailed implementation guidelines have not been issued.
The Company believes that adoption of SOP 97-2 will have no material impact on
its existing revenue recognition practices.
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, short-term investments, and accounts receivable. The Company's
investment policy limits its exposure to concentrations of credit risk for
cash equivalents and short-term investments. The Company sells its products
primarily to major corporations that develop software and systems integrators
that serve a wide variety of international 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. No single customer accounted for 10% or more of total revenues
for all periods presented.
International sales. International sales currently account for approximately
34% 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 foreign
exchange contracts to hedge against the impact of foreign currency
fluctuations on accounts receivable denominated in foreign currencies. The
Company's objective is to offset the underlying foreign currency denominated
accounts receivable by the total amount of these contracts. The gains or
losses on the contracts are included in other income as the contracts expire
and are offset by gains and losses on the underlying receivables being hedged.
At March 31, 1998 and 1997, the Company had outstanding forward exchange
contracts, all having maturities of approximately 35 and 30 days,
respectively, to exchange various European currencies for U.S. dollars in the
amounts of $25.1 million and $7.4 million, respectively. Two major U.S.
multinational banks are counterparty to all these contracts. The net gains and
losses associated with all forward exchange contracts in fiscal 1998, 1997,
and 1996 are not material to the Company's results of operations.
3. BUSINESS COMBINATIONS: POOLINGS OF INTERESTS
Merger with Pure Atria Corporation. On July 30, 1997, the Company acquired
Pure Atria Corporation (Pure Atria) pursuant to which the Company issued
39,082,337 shares of common stock. In addition, each outstanding option or
right to purchase Pure Atria common stock under various stock option and
purchase plans were assumed by the Company after first being reduced by the
0.90 exchange ratio and became an option or right to purchase the Company's
common stock. Pure Atria was primarily involved in developing, marketing, and
supporting a comprehensive, integrated suite of software products that enabled
the production of reliable, high-quality software and improved the development
process. For income tax purposes, Pure Atria was acquired in a tax-free
reorganization.
Merger with SQA, Inc. On February 26, 1997, the Company acquired SQA, Inc.,
(SQA) pursuant to which the Company issued approximately 6,997,000 shares of
common stock. In addition, each outstanding option or
41
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
MARCH 31, 1998
right to purchase SQA common stock under various stock option and purchase
plans were assumed by the Company after first being reduced by the 0.86
exchange ratio and became an option or right to purchase the Company's common
stock. SQA was primarily involved in developing and marketing integrated
software products for the automated testing and quality management of Windows-
based client/server applications. For income tax purposes, SQA was acquired in
a tax-free reorganization.
Merger with Atria Software, Inc. On August 26, 1996, the Company acquired
Atria Software, Inc., (Atria) pursuant to which the Company issued 20,014,925
shares of common stock. In addition, each outstanding option or right to
purchase Atria common stock under Atria's various stock option and purchase
plans were assumed by the Company after first being increased by the 1.3902
exchange ratio. Atria was primarily involved in developing, marketing, and
supporting software that facilitated the management of complex software
development, enhancement, and maintenance. For income tax purposes, Atria was
acquired in a tax-free reorganization.
Merger with Performix, Inc. On November 21, 1995, the Company acquired
Performix, pursuant to which the Company issued 1,432,327 shares of common
stock. In addition, all options to purchase Performix common stock then
outstanding were assumed by the Company. Each assumed option continues to
have, and is subject to, the same terms and conditions set forth in the
respective option agreement applicable to such option immediately prior to the
date of acquisition, subject to adjustment of the number of shares and
exercise price thereof to reflect the exchange ratio of Performix shares for
the Company's shares. For income tax purposes, Performix was acquired in a
tax-free reorganization. Performix was an S corporation for federal income tax
purposes prior to its acquisition. Upon acquisition, the S corporation status
terminated, resulting in a one-time deferred tax expense of approximately
$650,000.
These acquisitions were accounted for as poolings of interests, and
accordingly, the Company's consolidated financial statements and notes thereto
have been restated to include the financial position and results of these
mergers for all periods presented.
42
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
MARCH 31, 1998
The following information shows revenue and net income (loss) of the
separate companies for the periods preceding the combination (in thousands):
<TABLE>
<CAPTION>
THREE MONTHS YEAR ENDED MARCH 31,
ENDED JUNE 30, ----------------------
1997 1997 1996
-------------- ---------- ----------
(UNAUDITED)
<S> <C> <C> <C>
Revenues:
Rational............................ $42,928 $ 121,264 $ 91,107
Pure Atria.......................... 23,220 132,495 --
Pure................................ -- -- 44,042
Atria............................... -- -- 40,143
SQA................................. -- 24,109 12,845
------- ---------- ----------
Combined.......................... $66,148 $ 277,868 $ 188,137
======= ========== ==========
Net income (loss):
Rational............................ $ 7,814 $ (40,518) $ (4,021)
Pure Atria.......................... (2,686) 28,598 --
Pure................................ -- -- (8,695)
Atria............................... -- -- 5,173
SQA................................. -- 4,765 431
Merger charges...................... -- (42,456) --
------- ---------- ----------
Combined.......................... $ 5,128 $ (49,611) $ (7,112)
======= ========== ==========
</TABLE>
Revenue and net loss of Pure Atria for the three months ended March 31,
1997, was $30 million and $43.2 million, respectively. These results include
the acquisition of Integrity QA in January 1997. (See Note 4.) Revenue and net
loss of SQA for the three months ended March 31, 1997, was $2.4 million and
$4.1 million, respectively. The net transactions of Pure Atria and SQA for the
three months ended March 31, 1997, have been included in the consolidated
statement of redeemable convertible preferred stock and stockholders' equity
as single line items and excluded from the consolidated statements of
operations and cash flows as a result of the different fiscal year ends of
these merged entities.
4. BUSINESS COMBINATIONS: PURCHASES
Purchase of Integrity QA Software, Inc. During January 1997, the Company
acquired all the outstanding shares of capital stock of Integrity QA Software,
Inc., (Integrity) and assumed all outstanding options to purchase Integrity
common stock in exchange for options to purchase 100,263 shares of the
Company's stock. The Company also assumed all outstanding warrants to purchase
Integrity preferred stock in exchange for 1,113,505 shares of common stock.
Integrity developed, marketed, and supported quality-assurance software
products. As a result of the acquisition, the Company recorded one-time pretax
charges to operations of $43.6 million for acquired in-process research and
development and $1.1 million for certain merger and integration expenses
during the quarter ended March 31, 1997. As a result of the different year
ends of Rational and Pure Atria, net transactions of Pure Atria for the
quarter ended March 31, 1997, which include the charge for acquired in-process
research and development, are reflected in the consolidated statements of
redeemable convertible preferred stock and stockholders' equity. The operating
results of Integrity are included in the consolidated results of the Company
from the date of acquisition.
Purchase of 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
43
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
MARCH 31, 1998
Performance Awareness employee stock options in exchange for options to
purchase 250,000 shares of the Company's common stock. Performance Awareness
developed, marketed, and supported automated software-quality products and
related services that provided solutions for the software-testing market. The
aggregate purchase price (including direct acquisition costs) was $32.9
million in cash and fair value of options that were assumed by the Company.
The operating results of Performance Awareness are included in the
consolidated results of the Company from the date of acquisition.
Other business combinations: purchases. In fiscal 1997, the Company made
four separate purchase transactions relating to different software companies
and products. The aggregate purchase price (including direct acquisition
costs) was $38.9 million plus notes payable of approximately $2.8 million for
those acquisitions. Also, the Company assumed the outstanding employee stock
options from one acquisition in exchange for stock options to purchase 6,450
shares of common stock of the Company. In fiscal 1996, the Company made three
purchase transactions relating to different software companies and products.
The aggregate purchase price (including direct acquisition costs) was $22.2
million for those acquisitions. The Company also issued 740,126 shares of
redeemable convertible preferred stock and 1,496,718 shares of common stock
relating to these acquisitions. The operating results of the companies
acquired are included in the consolidated results of the Company from their
respective dates of acquisition.
The Company has accounted for the acquisitions of Integrity QA, Performance
Awareness Corporation, and the other business combinations using the purchase
method, and accordingly, the operating results of the respective companies are
included in the consolidated results of the Company from the dates of
acquisition. The consolidated balance sheets include the assets and
liabilities of these businesses at March 31, 1998. The total purchase price
paid for each acquisition was allocated based on discounted cash-flow-
valuation techniques and is summarized as follows (in thousands):
<TABLE>
<CAPTION>
MARCH 31,
--------------------------------------------------
1998 1997 1996
------------ ------------------------ ------------
PERFORMANCE OTHER OTHER
AWARENESS BUSINESS BUSINESS
INTEGRITY QA CORPORATION COMBINATIONS COMBINATIONS
------------ ----------- ------------ ------------
<S> <C> <C> <C> <C>
Property and equipment.. $ 184 $ 894 $ 656 $ 608
Intangible assets....... -- 10,094 11,933 2,057
Severance and facility
accruals............... (1,100) (3,573) (163) (312)
Net assets (liabilities)
acquired............... 102 (1,848) (128) (479)
In-process research and
development............ 44,700 27,362 29,436 20,300
------- ------- ------- -------
$43,886 $32,929 $41,734 $22,174
======= ======= ======= =======
</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 $11.4 million and $2.8 million at March 31, 1998 and
1997, respectively. In-process research and development represents the present
value of the estimated cash flows expected to be generated by the related
technology from each acquisition, which at the date of purchase had not yet
reached the point of technological feasibility and did 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.
The unaudited combined pro-forma results of operations of the Company for
fiscal 1997, assuming the business combinations had occurred at the beginning
of fiscal 1997, would have resulted in net revenue of
44
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
MARCH 31, 1998
$291.1 million, net loss of $56.7 million, and net loss per share of $0.71,
including nonrecurring charges for acquired in-process research and
development of $56.8 million. 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 fiscal 1997, nor is it necessarily indicative of future
operating results.
5. CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS
The Company's short-term investments are as follows (in thousands):
<TABLE>
<CAPTION>
MARCH 31,
----------------
1998 1997
-------- -------
<S> <C> <C>
Bank certificates of deposit............................... 10,529 60
U.S. treasury and agency obligations....................... 18,007 35,760
Municipal obligations...................................... 65,077 26,783
Corporate securities....................................... 69,628 19,936
-------- -------
Total.................................................... $163,241 $82,539
======== =======
</TABLE>
Realized gains and losses on sales of available-for-sale securities were
immaterial for the years ended March 31, 1998 and 1997. There were no
significant unrealized holding gains or losses on such securities at March 31,
1998 and 1997.
Debt securities at March 31, 1998 and 1997, by contractual maturity, are
shown below (in thousands). Expected maturities may differ from contractual
maturities because issuers of the securities may have the right to prepay
obligations.
<TABLE>
<CAPTION>
MARCH 31,
------------------
1998 1997
--------- --------
<S> <C> <C>
Short-term investments:
Due in one year or less................................. $ 134,241 $ 82,539
Due after one year...................................... 29,000 --
--------- --------
Total................................................. $ 163,241 $ 82,539
========= ========
</TABLE>
6. PROPERTY AND EQUIPMENT
Property and equipment is as follows (in thousands):
<TABLE>
<CAPTION>
MARCH 31,
------------------
1998 1997
-------- --------
<S> <C> <C>
Computer, office, and manufacturing equipment............ $ 62,063 $ 45,447
Office furniture......................................... 9,184 7,256
Leasehold improvements................................... 7,136 3,789
Construction in progress................................. 3,276 1,216
-------- --------
81,659 57,708
Accumulated depreciation and amortization................ (43,671) (31,443)
-------- --------
Net property and equipment............................... $ 37,988 $ 26,265
======== ========
</TABLE>
45
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
MARCH 31, 1998
7. ACCRUED MERGER AND INTEGRATION EXPENSES
Merger expenses consist principally of transaction fees for investment
bankers, attorneys, accountants, financial printing, and other related
charges. 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. Details
of the merger and integration provisions recorded at the time of the Pure
Atria, SQA, and Atria poolings of interests are as follows (in thousands):
<TABLE>
<CAPTION>
SEVERANCE
AND OTHER ASSET
EMPLOYEE- WRITE-OFFS
TRANSACTION RELATED AND LEASE
COSTS CHARGES CANCELLATIONS OTHER TOTAL
----------- --------- ------------- ------- --------
<S> <C> <C> <C> <C> <C>
Provision recorded at
acquisition of Atria... $ 8,319 $ 16,538 $ 5,998 $ 4,400 $ 35,255
Provision recorded at
acquisition of SQA..... 3,100 1,767 584 1,750 7,201
Change in estimate...... -- 960 (560) (400) --
Noncash write-offs...... -- (4,018) (2,451) (640) (7,109)
Cash payments........... (10,285) (3,469) (550) (2,313) (16,617)
-------- -------- ------- ------- --------
Accrued as of March 31,
1997................... 1,134 11,778 3,021 2,797 18,730
Provision recorded at
acquisition of Pure
Atria.................. 15,629 18,339 19,352 10,439 63,759
Change in estimate...... -- -- -- -- --
Noncash write-offs...... -- -- (6,469) (1,156) (7,625)
Cash payments........... (15,556) (21,773) (2,006) (7,635) (46,970)
-------- -------- ------- ------- --------
Accrued as of March 31,
1998................... $ 1,207 $ 8,344 $13,898 $ 4,445 $ 27,894
======== ======== ======= ======= ========
</TABLE>
Severance and other employee-related charges. As a result of the mergers,
certain technical support, customer service, distribution, sales, marketing,
and administrative functions were combined and reduced. Approximately 37 and
20 employees were terminated in fiscal 1998 and fiscal 1997, respectively, as
a result of this activity. The Company also committed to pay noncontingent
retention bonuses and commissions to other employees, and these costs have
been included in the accrual. In addition, in fiscal 1997, certain employees
received accelerated vesting on their options in conjunction with their
termination subsequent to the merger, for which a compensation charge of $4
million was recorded.
Asset write-offs and lease cancellations. The Company has consolidated
duplicate offices in Europe and has relocated the North American headquarters
to a larger facility. The accrual includes lease payments resulting from the
planned closure of these facilities, which are expected to continue through
the lease term or penalties associated with early termination of the leases.
Certain intangibles that will have no benefit to the combined operations were
written off. Redundant property and equipment were either disposed of or
written down to their estimated net realizable value.
Other. Other consists of incurred costs associated with communication of the
merger to employees and costs associated with existing offices in Europe,
discontinuance of the Pure Vision product line, and termination of European
and Asian distributors. Payments associated with these activities were
primarily expended through the first quarter of 1997.
The Company also has accrued $3.9 million and $6.8 million as of March 31,
1998 and 1997, relating to other business acquisitions during prior years.
46
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
MARCH 31, 1998
8. NOTES PAYABLE AND CAPITAL LEASE OBLIGATIONS
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 $4.5 million and $4.5 million at March 31, 1998 and 1997,
respectively. Notes payable to former Softlab AB stockholders and capitalized
lease obligations consist of the following (in thousands):
<TABLE>
<CAPTION>
MARCH 31,
----------------
1998 1997
------- -------
<S> <C> <C>
Notes payable to former Softlab AB stockholders.......... $ 1,490 $ 2,800
Present value of capital lease obligations............... 197 416
Other.................................................... 294 535
------- -------
1,981 3,751
Less current portion of notes payable and capital lease
obligations............................................. (1,809) (2,010)
------- -------
Due after one year....................................... $ 172 $ 1,741
======= =======
</TABLE>
9. COMMITMENTS AND CONTINGENCIES
The Company leases its primary office space under operating leases. Rental
expense for facilities was approximately $13.4 million, $7.2 million, and $4.8
million for the fiscal years ended March 31, 1998, 1997, and 1996,
respectively. Estimated future rents from sublease agreements are $2 million,
$1.7 million, and $382,000 in fiscal 1999, 2000, and 2001, respectively.
Future minimum rental payments, net of sublease income, are as follows for the
fiscal years indicated as of March 31 (in thousands):
<TABLE>
<S> <C>
1999................................................................. $13,340
2000................................................................. 13,045
2001................................................................. 10,326
2002................................................................. 7,776
2003................................................................. 7,362
Thereafter........................................................... 13,561
-------
$65,410
=======
</TABLE>
As of March 31, 1998, the Company had two letters of credit outstanding in
the amount of $250,000 and $3 million guaranteeing certain rental payments at
its office locations in Lexington, Massachusetts, and Cupertino, California,
respectively.
Legal matters. Certain virtually identical punitive stockholder class action
lawsuits have been filed against the Company, two of its officers, and Cowen &
Company. 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 stockholders who purchased the Company's common stock
on October 8, 1997. Defendants' motions to transfer the cases pending in New
York and Virginia have been granted, and all pending actions will be
consolidated in the Northern District of California. A consolidated amended
complaint has not yet been filed; the case is in its preliminary stages. The
Company believes that the action is without merit and intends to defend the
case vigorously.
47
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
MARCH 31, 1998
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 itself.
From time to time, the Company is subject to legal claims. Historically, the
cost of resolution of the claims has not been significant. However, any
adverse outcome to these or future lawsuits against the Company may result in
a material adverse effect on the Company's financial condition.
10. 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 $186.4 million 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 Stock Option Plan for Directors, the 1997 Stock
Option Plan, and the 1997 Supplemental 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 value in the case of nonstatutory options, or 100% of
fair value in the case of incentive stock options, determined on the date that
the option is granted. Under these plans, the Company has reserved 18,281,590
shares for issuance at March 31, 1998. Options expire at various dates ranging
from 5 to 10 years from the date of grant.
48
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
MARCH 31, 1998
Activity under the plans including options assumed by the Company in mergers
(adjusted for exchange ratios) is summarized as follows:
<TABLE>
<CAPTION>
SHARES UNDER
OUTSTANDING OPTIONS
--------------------------
SHARES WEIGHTED-
AVAILABLE FOR AVERAGE
GRANT OPTIONS EXERCISE PRICE
------------- ---------- --------------
<S> <C> <C> <C>
Balance at March 31, 1995......... 2,507,056 9,079,930 $ 1.98
Additional shares authorized.... 3,109,351 -- --
Granted......................... (3,632,622) 3,632,622 10.48
Exercised....................... -- (1,827,963) 2.14
Canceled........................ 610,881 (610,881) 2.45
Expired or retired.............. (66,002) -- --
---------- ---------- ------
Balance at March 31, 1996......... 2,528,664 10,273,708 4.98
Additional shares authorized.... 6,256,659 -- --
Expiration of SQA option plans.. (123,036) -- --
Granted......................... (9,041,372) 9,041,372 26.82
Exercised....................... -- (2,697,828) 3.79
Canceled........................ 1,279,053 (1,279,053) 19.74
Expired or retired.............. (235,009) -- --
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......... 570,574 15,428,269 17.08
Net transactions of Pure Atria
during the period from January
1, 1997, to March 31, 1997..... 1,611,351 (416,912) 25.65
Additional shares authorized.... 4,350,000 -- --
Granted......................... (6,523,621) 6,523,621 13.71
Exercised....................... -- (2,056,891) 10.52
Canceled........................ 1,910,661 (1,910,661) 20.41
Expired or retired.............. (1,204,801) -- --
---------- ---------- ------
Balance at March 31, 1998......... 714,164 17,567,426 $12.57
========== ========== ======
</TABLE>
In November 1997, the Company entered into agreements with most of its
employees to reprice (at the closing price for the Company's common stock on
November 14, 1997, of $10.00) employees' stock options. Employees
participating in the repricing agreed to certain limitations on the
disposition of repriced options. Approximately 6.9 million options were
repriced under this program. Such repriced options are not reflected in the
foregoing table. Certain executive officers of the Company were not permitted
to participate in the program. See Note 15 of Notes to Consolidated Financial
Statements.
49
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
MARCH 31, 1998
At March 31, 1998, options to purchase 17,567,426 shares of common stock
were exercisable at a weighted-average exercise price of $12.57. At March 31,
1998, the range of options outstanding and exercisable is as follows:
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
------------------------ -------------------------------
WEIGHTED-
AVERAGE
REMAINING WEIGHTED- WEIGHTED-
CONTRACTUAL AVERAGE AVERAGE
RANGE OF SHARES LIFE (YEARS) EXERCISE NUMBER EXERCISE
EXERCISE PRICES OUTSTANDING PRICE EXERCISABLE PRICE
--------------- ----------- ------------ --------- ----------- ---------
<S> <C> <C> <C> <C> <C>
$ 0.03-$ 6.19 2,741,372 5.56 $ 2.25 1,968,247 $ 2.19
$ 6.47-$ 9.89 794,387 7.49 7.92 358,571 8.01
$10.00 6,558,217 8.47 10.00 2,199,620 10.00
$10.06-$12.31 2,735,730 9.33 10.87 382,963 10.77
$13.56-$26.11 2,546,689 9.04 17.97 726,577 20.94
$26.25-$44.17 2,190,676 8.47 30.73 759,647 31.03
$44.72 355 8.07 44.72 355 44.72
---------- ---- ------ --------- ------
17,567,426 8.19 $12.57 6,395,980 $11.27
========== ==== ====== ========= ======
</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 values
as of the beginning or end of the offering period. Stock purchases under the
plan are limited to the lesser of 10% of an employee's compensation or $25,000
per year. At March 31, 1998, 1,538,623 shares had been issued under the plan,
and 661,377 shares were reserved for issuance.
Stock-based compensation. Pro-forma information regarding net income (loss)
and earnings (loss) per share is required by FAS 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 FAS 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>
YEARS ENDED MARCH 31,
-----------------------------
STOCK OPTIONS ESPP
-------------- --------------
1998 1997 1996 1998 1997 1996
---- ---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C> <C>
Expected life (in years)....................... 3.02 4.26 4.24 0.50 0.50 0.50
Expected volatility............................ 0.60 0.55 0.54 0.60 1.02 0.76
Risk-free interest rate........................ 5.80 6.36 6.10 5.54 5.38 5.64
</TABLE>
50
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
MARCH 31, 1998
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 is as follows (in thousands, except
for per share amounts):
<TABLE>
<CAPTION>
YEARS ENDED MARCH 31,
---------------------------
1998 1997 1996
-------- -------- -------
<S> <C> <C> <C>
Net loss:
As reported.................................. $(38,273) $(49,611) $(7,112)
Pro forma.................................... (90,277) (67,636) (9,657)
Basic and diluted net loss per share:
As reported.................................. $ (0.44) $ (0.62) $ (0.10)
Pro forma.................................... (1.03) (0.85) (0.14)
</TABLE>
Because FAS 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 its 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 1998, 1997, and 1996 was $5.63, $12.55, and $4.82 per share,
respectively. The weighted-average fair value of employee stock purchase
rights during fiscal 1998, 1997, and 1996 was $4.17, $4.65, and $1.35 per
share, respectively.
11. INCOME TAXES
The provision for income taxes consists of the following (in thousands):
<TABLE>
<CAPTION>
MARCH 31,
-------------------------
1998 1997 1996
------- ------- -------
<S> <C> <C> <C>
Current:
Federal........................................ $ 9,908 $ 607 $ 5,712
State.......................................... 2,220 896 1,160
Foreign........................................ 2,170 1,877 955
------- ------- -------
Total........................................ 14,298 3,380 7,827
------- ------- -------
Deferred:
Federal........................................ (5,988) (6,358) (1,923)
State.......................................... (375) (32) (313)
------- ------- -------
Total........................................ (6,363) (6,390) (2,236)
------- ------- -------
Charge in lieu of taxes attributable to employee
stock plans..................................... -- 9,830 800
Charge in lieu of taxes resulting from initial
recognition of acquired tax benefits that were
allocated to reduce intangible assets related to
the acquired entity............................. 1,512 -- --
------- ------- -------
$ 9,447 $ 6,820 $ 6,391
======= ======= =======
</TABLE>
51
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
MARCH 31, 1998
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 (in thousands):
<TABLE>
<CAPTION>
YEARS ENDED MARCH 31,
---------------------------
1998 1997 1996
-------- -------- -------
<S> <C> <C> <C>
Income tax benefit at the federal statutory
rate......................................... $(10,089) $(14,977) $ (252)
Tax benefit of net operating loss
carryforwards................................ (19,260) (6,361) (1,616)
Nondeductible charges for acquired in-process
research and development..................... -- 19,879 3,045
State income taxes............................ 1,845 750 673
Foreign taxes in excess of U.S. statutory
rates........................................ 651 1,700 444
Nondeductible merger-related costs............ 6,075 5,781 4,790
Foreign losses not resulting in a U.S. tax
benefit...................................... 21,297 -- --
Change in valuation allowance................. 7,562 315 (37)
Other......................................... 1,366 (267) (656)
-------- -------- -------
Total....................................... $ 9,447 $ 6,820 $ 6,391
======== ======== =======
</TABLE>
Significant components of the Company's deferred tax assets are as follows
(in thousands):
<TABLE>
<CAPTION>
MARCH 31,
------------------
1998 1997
-------- --------
<S> <C> <C>
Net operating loss carryforwards....................... $ 9,734 $ 25,586
Tax credit carryforwards............................... 5,850 4,595
Allowances, reserves, and accrued expenses............. 21,706 8,507
Other.................................................. 2,158 3,801
-------- --------
Total deferred tax assets--current..................... 39,448 42,489
Long-term deferred tax asset--property, equipment, and
intangibles........................................... 6,326 5,863
-------- --------
Total deferred tax assets.............................. 45,774 48,352
Valuation allowance for deferred tax assets............ (31,023) (38,452)
-------- --------
Net deferred tax assets.............................. $ 14,751 $ 9,900
======== ========
</TABLE>
The valuation allowance decreased by $7.4 million in 1998 and increased by
$11.2 million in 1997. Approximately $18.4 million of the valuation allowance
is attributable to the tax benefit associated with the exercise of employee
stock options, which will be credited to additional paid-in capital when
realized.
FASB Statement No. 109 provides for the recognition of deferred tax assets
if realization of such assets is more likely than not. Based on the weight of
available evidence, the Company has provided a valuation allowance against
certain deferred tax assets. The Company will continue to evaluate the
realizability of the deferred tax asset on a quarterly basis.
At March 31, 1998, the Company had net operating loss carryforwards for
federal income tax purposes of approximately $27.8 million and tax credit
carryforwards of $5.9 million that expire in 1999 through 2012. As a result of
various public offerings and business combinations, approximately $11.6
million of the Company's net operating losses and approximately $4.8 million
of the Company's credits are subject to limitation under section 382 of the
Internal Revenue Code of 1986. The Company has placed a valuation allowance on
such net operating losses and credits as appropriate.
52
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
MARCH 31, 1998
12. MAJOR CUSTOMER AND RELATED PARTY
Revenues from Lockheed Martin Corporation, which had a representative on the
Company's board of directors through September 1995, amounted to 3% of the
Company's revenue in fiscal 1996.
13. INTERNATIONAL OPERATIONS
International operations consisted of the following (in thousands):
<TABLE>
<CAPTION>
YEARS ENDED MARCH 31,
----------------------------
1998 1997 1996
-------- -------- --------
<S> <C> <C> <C>
Revenues:
United States............................... $203,810 $204,136 $138,196
Europe...................................... 82,202 56,398 35,578
Other....................................... 24,658 17,334 14,363
-------- -------- --------
Consolidated................................ $310,670 $277,868 $188,137
======== ======== ========
Income (loss) from operations:
United States............................... $(54,268) $(66,255) $ (5,304)
Europe...................................... 8,592 11,082 474
Other....................................... 161 796 (125)
-------- -------- --------
Consolidated................................ $(45,515) $(54,377) $ (4,955)
======== ======== ========
Identifiable assets:
United States............................... $391,951 $424,520 $218,146
Europe...................................... 38,011 28,363 15,732
Other....................................... 15,243 3,857 2,335
-------- -------- --------
Consolidated................................ $445,205 $456,740 $236,213
======== ======== ========
</TABLE>
"Other" represents Canada, Latin America, and Asia Pacific. Export sales out
of the U.S. have been made primarily to customers in Europe, Australia, and
Canada and represent less than 10% of U.S. revenues in all periods.
53
<PAGE>
RATIONAL SOFTWARE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
MARCH 31, 1998
14. 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, 1998.
The quarters prior to the Company's merger with Pure Atria Corporation and SQA
have been restated and presented on a combined basis as follows (in thousands,
except per share amounts).
<TABLE>
<CAPTION>
QUARTER ENDED
-----------------------------------------
JUNE 30 SEPTEMBER 30 DECEMBER 31 MARCH 31
------- ------------ ----------- --------
<S> <C> <C> <C> <C>
Fiscal 1998:
Total revenue................. $66,148 $ 74,968 $ 82,306 $ 87,248
Gross margin.................. 50,865 61,052 65,612 70,076
Operating income (loss)....... 1,919 (69,386) 9,820 12,132
Net income (loss)............. 5,128 (64,619) 10,368 10,850
Net income (loss) per share--
basic........................ .06 (0.74) 0.12 0.12
Net income (loss) per share--
diluted...................... .06 (0.74) 0.11 0.12
Fiscal 1997:
Total revenue................. $60,632 $ 66,018 $ 73,149 $ 78,069
Gross margin.................. 49,870 54,552 60,077 63,287
Operating income (loss)....... 10,025 11,946 (42,043) (34,305)
Net income (loss)............. 8,944 10,510 (33,567) (35,498)
Net income (loss) per share--
basic........................ 0.12 0.14 (0.41) (0.42)
Net income (loss) per share--
diluted...................... 0.11 0.12 (0.41) (0.42)
</TABLE>
15. SUBSEQUENT EVENTS
On April 23, 1998, the board of directors authorized a stock repurchase
program whereby up to six million shares of the Company's common stock may be
repurchased in the open market from time to time.
Effective on April 3, 1998, the Compensation Committee of the Board of
Directors, after consulting with all of the outside directors, approved
repricing agreements with the members of the senior management team who were
not eligible to participate in the November 1997 repricing program. The senior
officer repricing was completed on substantially the same terms, including the
disposition limitations and repurchase provisions, offered to the rest of the
employees in November 1997, except at the price of $13.38.
54
<PAGE>
ITEM 9--CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
PART III
ITEM 10--DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Reference is made to "election of directors" in the Company's proxy
statement for the 1998 annual meeting of stockholders, incorporated by
reference herein.
ITEM 11--EXECUTIVE COMPENSATION
Reference is made to "executive compensation" and "performance graph" in the
Company's proxy statement for the 1998 annual meeting of stockholders,
incorporated by reference herein.
ITEM 12--SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Reference is made to "beneficial ownership of common stock" in the Company's
proxy statement for the annual meeting of stockholders, incorporated by
reference herein.
ITEM 13--CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Reference is made to "certain transactions" in the Company's proxy statement
for the 1998 annual meeting of stockholders, incorporated by reference herein.
PART IV
ITEM 14--EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(A)1. FINANCIAL STATEMENTS
See Item 8 of this Form 10-K.
2. FINANCIAL STATEMENT SCHEDULES
The following financial statement schedule of the Company for each of the
years ended March 31, 1998, 1997, and 1996, is filed as part of this Form 10-K
and should be read in conjunction with the consolidated financial statements
and related notes thereto of the Company.
<TABLE>
<CAPTION>
PAGE NUMBER
-----------
<S> <C>
Schedule II--Valuation and Qualifying Accounts................... S-1
</TABLE>
Schedules other than those listed above have been omitted because they are
either not required or not applicable or because the information is otherwise
included.
55
<PAGE>
3. EXHIBITS
<TABLE>
<CAPTION>
EXHIBIT
-------
<C> <S>
2.01 Stock Purchase Agreement by and among Rational Software Corporation,
Performance Awareness Corporation, ("PAC"), and all of the
Stockholders of PAC is incorporated herein by reference to Exhibit
2.1 filed with the Registrant's Form 8-K Current Report dated March
31, 1997 (File No. 012167) ("March 1997 8-K").
2.02 Agreement and Plan of Reorganization dated November 12, 1996, by and
among Rational Software Corporation, Sunshine Acquisition Corp., and
SQA, Inc., is incorporated herein by reference to Appendix A filed
with the Registrant's Registration Statement on Form S-4, dated
January 13, 1997, as amended on January 17, 1997 (File No. 333-
19669).
2.03 Agreement and Plan of Reorganization dated April 7, 1997, by and
among Rational Software Corporation, Wings Merger Corporation, and
Pure Atria Corporation is incorporated herein by reference to
Appendix A filed with the Registrant's Registration Statement on
Form S-4, dated June 27, 1997 (File No. 333-29799).
3.01 Certificate of Incorporation as amended through July 30, 1997, is
incorporated herein by reference to Exhibit 3.1 filed with the
Registrant's Form 10Q dated November 14, 1997.
3.02 Bylaws as amended through April 1998.
4.01 Reference is made to Exhibits 3.01 and 3.02.
4.02 Specimen of Common Stock Certificate is incorporated by reference to
Exhibit 4.06 filed with the Registrant's Amendment No. 1 to Form S-3
Registration Statement on May 31, 1995 (File No. 33-91740).
10.01 Reference is made to Exhibit 2.01 and 2.02.
10.02 Relocation Agreement with David Bernstein is incorporated herein by
reference to Exhibit 10 filed with the Registrant's Form 10Q dated
November 14, 1997.
10.03* Form of Employment Agreement.
10.04* Form of Employment Agreement.
10.05 Form of Stock Option Repricing Agreement.
10.06 Form of Director and Officer Indemnification Agreement incorporated
herein by reference to Exhibit 10.1 filed with the Registrant's
Registration Statement on Form S-4, dated January 17, 1997, as
amended on January 17, 1997.
10.07 Agreement for Purchase and Sale of Assets between the Registrant and
Microsoft Corporation, dated October 2, 1996, is incorporated herein
by reference to Exhibit 1 filed with the Registrant's Form 8-K
Current Report dated October 2, 1996, as amended by Exhibit 1 filed
with the Registrant's Form 8-K/A Current Report dated October 16,
1996.
10.08 Development and License Agreement between the Registrant and
Microsoft Corporation, dated September 24, 1996, is incorporated
herein by reference to Exhibit 2 filed with the Registrant's Form 8-
K Current Report dated October 2, 1996, as amended by Exhibit 2
filed with the Registrant's Form 8-K/A Current Report dated October
16, 1996.
10.09* Rational Software Corporation Stock Option Plan for Directors is
incorporated herein by reference to Exhibit 1 filed with the
Registrant's Form 8-K Current Report dated October 2, 1996.
10.10* Form of Stock Option Agreements for the Rational Software
Corporation Stock Option Plan for Directors is incorporated herein
by reference to Exhibit 4.6 filed with the Registrant's Form S-8
Registration Statement on September 18, 1995 (Registration No. 33-
97042).
21.01 Subsidiaries of the Registrant.
</TABLE>
56
<PAGE>
<TABLE>
<S> <C>
23.01 Consent of Ernst & Young LLP.
23.02 Consent of KPMG Peat Marwick LLP.
23.03 Consent of Arthur Andersen LLP.
24.01 Power of attorney is contained on the signature pages of this registration statement.
27.1 Annual financial data schedule.
27.2 Quarterly financial data schedule--restated.
27.3 Quarterly financial data schedule--restated.
</TABLE>
- --------
* Indicates those exhibits that are management contracts or compensatory
plans or arrangements required to be filed as an exhibit to this form.
(B)REPORTS ON FORM 8-K
None.
57
<PAGE>
SIGNATURES
PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED
ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED.
Rational Software Corporation
Date: June 1, 1998
/s/ Timothy A. Brennan
_____________________________________
TIMOTHY A. BRENNAN
SENIOR VICE PRESIDENT,
CHIEF FINANCIAL OFFICER, AND
SECRETARY
POWER OF ATTORNEY
KNOW ALL THESE PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints Paul D. Levy and Timothy A. Brennan,
jointly and severally, as such person's true and lawful attorneys-in-fact and
agents, each with full power of substitution, for such person, in any and all
capacities, to sign any and all amendments (including post effective
amendments) to this report on Form 10-K, and to file with same, with all
exhibits thereto and other documents in connection therewith, with the
Securities and Exchange Commission, granting unto said attorneys-in-fact and
agents full power and authority to do and perform each and every act and thing
requisite and necessary to be done in connection therewith, as full to all
intents and purposes as such person might or could do in person, hereby
ratifying and confirming all that said attorney-in-fact and agent, or his
substitutes, may do or be done by virtue hereof. Pursuant to the requirements
of Section 13 or 15(d) of the Securities Exchange Act of 1934, this report has
been signed below by the following persons on behalf of the Registrant and in
the capacities and on the dates indicated:
SIGNATURE TITLE DATE
/s/ Paul D. Levy Chairman of the Board and June 1, 1998
- ------------------------------- Chief Executive Officer,
PAUL D. LEVY Director
/s/ Michael T. Devlin President, Director June 1, 1998
- -------------------------------
MICHAEL T. DEVLIN
/s/ Timothy A. Brennan Senior Vice President, Chief June 1, 1998
- ------------------------------- Financial Officer, and
TIMOTHY A. BRENNAN Secretary (principal
financial officer and
principal accounting
officer)
/s/ James S. Campbell Director June 1, 1998
- -------------------------------
JAMES S. CAMPBELL
/s/ Daniel H. Case III Director June 1, 1998
- -------------------------------
DANIEL H. CASE III
/s/ Leslie G. Denend Director June 1, 1998
- -------------------------------
LESLIE G. DENEND
/s/ John E. Montague Director June 1, 1998
- -------------------------------
JOHN E. MONTAGUE
/s/ Allison R. Schleicher Director June 1, 1998
- -------------------------------
ALLISON R. SCHLEICHER
58
<PAGE>
RATIONAL SOFTWARE CORPORATION
SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS
YEARS ENDED MARCH 31, 1998, 1997, AND 1996
(IN THOUSANDS)
<TABLE>
<CAPTION>
BALANCE AT BALANCE AT
BEGINNING ENDING OF
OF PERIOD ADDITIONS DEDUCTIONS PERIOD
---------- --------- ---------- ----------
<S> <C> <C> <C> <C>
March 31, 1998
Allowance for doubtful accounts.... $4,001 $ 664 $(1,027) $3,638
March 31, 1997
Allowance for doubtful accounts.... 2,124 3,310 (1,433) 4,001
March 31, 1996
Allowance for doubtful accounts.... 1,162 1,653 (691) 2,124
</TABLE>
LIST OF ATTACHED EXHIBITS
<TABLE>
<C> <S>
3.02 Bylaws as amended through April 1998.
10.03 Form of Employment Agreement.
10.04 Form of Employment Agreement.
10.05 Form of Stock Repricing Agreement.
21.01 List of Subsidiaries of Registrant.
23.01 Consent of Ernst & Young LLP.
23.02 Consent of KPMG Peat Marwick LLP.
23.03 Consent of Arthur Andersen LLP.
27.1 Annual financial data schedule.
27.2 Quarterly financial data schedule--restated.
27.3 Quarterly financial data schedule--restated.
</TABLE>
For documents incorporated by reference, see Item 14(a)(3) above.
S-1
<PAGE>
EXHIBIT 3.02
BYLAWS
OF
RATIONAL SOFTWARE CORPORATION
<PAGE>
TABLE OF CONTENTS
<TABLE>
<CAPTION>
Page
----
<S> <C>
ARTICLE I - CORPORATE OFFICES...................................... 1
1.1 REGISTERED OFFICE....................................... 1
1.2 OTHER OFFICES........................................... 1
ARTICLE II - MEETINGS OF STOCKHOLDERS.............................. 1
2.1 PLACE OF MEETINGS....................................... 1
2.2 ANNUAL MEETING.......................................... 1
2.3 SPECIAL MEETING......................................... 2
2.4 NOTICE OF STOCKHOLDERS' MEETINGS........................ 2
2.5 MANNER OF GIVING NOTICE; AFFIDAVIT OF NOTICE............ 2
2.6 QUORUM.................................................. 2
2.7 ADJOURNED MEETING; NOTICE............................... 3
2.8 CONDUCT OF BUSINESS..................................... 3
2.9 VOTING.................................................. 3
2.10 WAIVER OF NOTICE........................................ 3
2.11 STOCKHOLDER ACTION BY WRITTEN CONSENT WITHOUT A
MEETING............................................... 4
2.12 RECORD DATE FOR STOCKHOLDER NOTICE; VOTING; GIVING
CONSENTS............................................... 4
2.13 PROXIES................................................. 5
2.14 LIST OF STOCKHOLDERS ENTITLED TO VOTE................... 5
ARTICLE III - DIRECTORS............................................ 5
3.1 POWERS.................................................. 5
3.2 NUMBER OF DIRECTORS..................................... 6
3.3 ELECTION, QUALIFICATION AND TERM OF OFFICE OF
DIRECTORS.............................................. 6
3.4 RESIGNATION AND VACANCIES............................... 6
3.5 PLACE OF MEETINGS; MEETINGS BY TELEPHONE................ 7
3.6 REGULAR MEETINGS........................................ 7
3.7 SPECIAL MEETINGS; NOTICE................................ 7
3.8 QUORUM.................................................. 8
3.9 WAIVER OF NOTICE........................................ 8
</TABLE>
-i-
<PAGE>
<TABLE>
<S> <C>
3.10 BOARD ACTION BY WRITTEN CONSENT WITHOUT A MEETING.... 8
3.11 FEES AND COMPENSATION OF DIRECTORS................... 9
3.12 APPROVAL OF LOANS TO OFFICERS........................ 9
3.13 REMOVAL OF DIRECTORS................................. 9
ARTICLE IV - COMMITTEES.......................................... 9
4.1 COMMITTEES OF DIRECTORS.............................. 9
4.2 COMMITTEE MINUTES.................................... 10
4.3 MEETINGS AND ACTION OF COMMITTEES.................... 10
ARTICLE V - OFFICERS............................................. 11
5.1 OFFICERS............................................. 11
5.2 APPOINTMENT OF OFFICERS.............................. 11
5.3 SUBORDINATE OFFICERS................................. 11
5.4 REMOVAL AND RESIGNATION OF OFFICERS.................. 11
5.5 VACANCIES IN OFFICES................................. 12
5.6 CHAIRMAN OF THE BOARD................................ 12
5.7 CHIEF EXECUTIVE OFFICER.............................. 12
5.8 PRESIDENT............................................ 12
5.9 VICE PRESIDENTS...................................... 12
5.10 SECRETARY............................................ 13
5.11 CHIEF FINANCIAL OFFICER.............................. 13
5.12 ASSISTANT SECRETARY.................................. 13
5.13 ASSISTANT TREASURER.................................. 14
5.14 REPRESENTATION OF SHARES OF OTHER CORPORATIONS....... 14
5.15 AUTHORITY AND DUTIES OF OFFICERS..................... 14
ARTICLE VI - INDEMNITY........................................... 14
6.1 THIRD PARTY ACTIONS.................................. 14
6.2 ACTIONS BY OR IN THE RIGHT OF THE CORPORATION........ 15
6.3 SUCCESSFUL DEFENSE................................... 15
6.4 DETERMINATION OF CONDUCT............................. 16
6.5 PAYMENT OF EXPENSES IN ADVANCE....................... 16
6.6 INDEMNITY NOT EXCLUSIVE.............................. 16
6.7 INSURANCE INDEMNIFICATION............................ 16
6.8 THE CORPORATION...................................... 17
6.9 EMPLOYEE BENEFIT PLANS............................... 17
</TABLE>
-ii-
<PAGE>
<TABLE>
<S> <C>
6.10 CONTINUATION OF INDEMNIFICATION AND ADVANCEMENT OF
EXPENSES.......................................... 17
ARTICLE VII - RECORDS AND REPORTS.............................. 17
7.1 MAINTENANCE AND INSPECTION OF RECORDS.............. 17
7.2 INSPECTION BY DIRECTORS............................ 18
7.3 ANNUAL STATEMENT TO STOCKHOLDERS................... 18
ARTICLE VIII - GENERAL MATTERS................................ 19
8.1 CHECKS............................................. 19
8.2 EXECUTION OF CORPORATE CONTRACTS AND INSTRUMENTS... 19
8.3 STOCK CERTIFICATES; PARTLY PAID SHARES............. 19
8.4 SPECIAL DESIGNATION ON CERTIFICATES................ 20
8.5 LOST CERTIFICATES.................................. 20
8.6 CONSTRUCTION; DEFINITIONS.......................... 20
8.7 DIVIDENDS.......................................... 20
8.8 FISCAL YEAR........................................ 21
8.9 SEAL............................................... 21
8.10 TRANSFER OF STOCK.................................. 21
8.11 STOCK TRANSFER AGREEMENTS.......................... 21
8.12 INADVERTENT TERMINATION OF S CORPORATION STATUS.... 21
8.13 REGISTERED STOCKHOLDERS............................ 22
ARTICLE IX - AMENDMENTS........................................ 22
</TABLE>
-iii-
<PAGE>
BYLAWS
------
OF
--
RATIONAL SOFTWARE CORPORATION
-----------------------------
ARTICLE I
CORPORATE OFFICES
-----------------
I.1 REGISTERED OFFICE
-----------------
The registered office of the corporation shall be in the City of
Wilmington, County of New Castle, State of Delaware. The name of the registered
agent of the corporation at such location is The Corporation Trust Company.
I.2 OTHER OFFICES
-------------
The board of directors may at any time establish other offices at any place
or places where the corporation is qualified to do business.
ARTICLE II
MEETINGS OF STOCKHOLDERS
------------------------
II.1 PLACE OF MEETINGS
-----------------
Meetings of stockholders shall be held at any place, within or outside the
State of Delaware, designated by the board of directors. In the absence of any
such designation, stockholders' meetings shall be held at the registered office
of the corporation.
II.2 ANNUAL MEETING
--------------
The annual meeting of stockholders shall be held each year on a date and at
a time designated by the board of directors. In the absence of such designation
the annual meeting of stockholders shall be held on the ______________ of ___ of
each year at _________. However, if such day falls on a legal holiday, then the
meeting shall be held at the same time and place on the next succeeding business
day. At the meeting, directors shall be elected and any other proper business
may be transacted.
<PAGE>
II.3 SPECIAL MEETING
---------------
A special meeting of the stockholders may be called at any time by the
board of directors, or by the chairman of the board, or by the president, or by
one or more stockholders holding shares in the aggregate entitled to cast not
less than ten percent of the votes at that meeting.
If a special meeting is called by any person or persons other than the
board of directors, the request shall be in writing, specifying the time of such
meeting and the general nature of the business proposed to be transacted, and
shall be delivered personally or sent by registered mail or by telegraphic or
other facsimile transmission to the chairman of the board, the president or the
secretary of the corporation. No business may be transacted at such special
meeting otherwise than specified in such notice. The officer receiving the
request shall cause notice to be promptly given to the stockholders entitled to
vote, in accordance with the provisions of Sections 2.4 and 2.5 of this Article
II, that a meeting will be held at the time requested by the person or persons
calling the meeting, not less than ten (10) nor more than sixty (60) days after
the receipt of the request. Nothing contained in this paragraph of this Section
2.3 shall be construed as limiting, fixing, or affecting the time when a meeting
of stockholders called by action of the board of directors may be held.
II.4 NOTICE OF STOCKHOLDERS' MEETINGS
--------------------------------
All notices of meetings with stockholders shall be in writing and shall be
sent or otherwise given in accordance with Section 2.5 of these bylaws not less
than ten (10) nor more than sixty (60) days before the date of the meeting to
each stockholder entitled to vote at such meeting. The notice shall specify the
place, date, and hour of the meeting, and, in the case of a special meeting, the
purpose or purposes for which the meeting is called.
II.5 MANNER OF GIVING NOTICE; AFFIDAVIT OF NOTICE
--------------------------------------------
Written notice of any meeting of stockholders, if mailed, is given when
deposited in the United States mail, postage prepaid, directed to the
stockholder at such shareholder's address as it appears on the records of the
corporation. An affidavit of the Secretary or an Assistant Secretary or of the
transfer agent of the corporation that the notice has been given shall, in the
absence of fraud, be prima facie evidence of the facts stated therein.
II.6 QUORUM
------
The holders of a majority of the stock issued and outstanding and entitled
to vote thereat, present in person or represented by proxy, shall constitute a
quorum at all meetings of the stockholders for the transaction of business
except as otherwise provided by statute or by the certificate of incorporation.
If, however, such quorum is not present or represented at any meeting of the
stockholders, then either (i) the Chairman of the meeting or (ii) the
stockholders entitled to vote thereat, present in person or represented by
proxy, shall have power to adjourn the meeting from time
-2-
<PAGE>
to time, without notice other than announcement at the meeting, until a quorum
is present or represented. At such adjourned meeting at which a quorum is
present or represented, any business may be transacted that might have been
transacted at the meeting as originally noticed.
II.7 ADJOURNED MEETING; NOTICE
-------------------------
When a meeting is adjourned to another time or place, unless these bylaws
otherwise require, notice need not be given of the adjourned meeting if the time
and place thereof are announced at the meeting at which the adjournment is
taken. At the adjourned meeting the corporation may transact any business that
might have been transacted at the original meeting. If the adjournment is for
more than thirty (30) days, or if after the adjournment a new record date is
fixed for the adjourned meeting, a notice of the adjourned meeting shall be
given to each stockholder of record entitled to vote at the meeting.
II.8 CONDUCT OF BUSINESS
-------------------
The chairman of any meeting of stockholders shall determine the order of
business and the procedure at the meeting, including such regulation of the
manner of voting and the conduct of business.
II.9 VOTING
------
The stockholders entitled to vote at any meeting of stockholders shall be
determined in accordance with the provisions of Section 2.12 of these bylaws,
subject to the provisions of Sections 217 and 218 of the General Corporation Law
of Delaware (relating to voting rights of fiduciaries, pledgors and joint owners
of stock and to voting trusts and other voting agreements).
Except as provided in the last paragraph of this Section 2.9, or as may be
otherwise provided in the certificate of incorporation, each stockholder shall
be entitled to one vote for each share of capital stock held by such
stockholder.
II.10 WAIVER OF NOTICE
----------------
Whenever notice is required to be given under any provision of the General
Corporation Law of Delaware or of the certificate of incorporation or these
bylaws, a written waiver thereof, signed by the person entitled to notice,
whether before or after the time stated therein, shall be deemed equivalent to
notice. Attendance of a person at a meeting shall constitute a waiver of notice
of such meeting, except when the person attends a meeting for the express
purpose of objecting, at the beginning of the meeting, to the transaction of any
business because the meeting is not lawfully called or convened. Neither the
business to be transacted at, nor the purpose of, any regular or special meeting
of the stockholders need be specified in any written waiver of notice unless so
required by the certificate of incorporation or these bylaws.
-3-
<PAGE>
II.11 STOCKHOLDER ACTION BY WRITTEN CONSENT WITHOUT A MEETING
-------------------------------------------------------
Unless otherwise provided in the certificate of incorporation, any action
required by this chapter to be taken at any annual or special meeting of
stockholders of a corporation, or any action that may be taken at any annual or
special meeting of such stockholders, may be taken without a meeting, without
prior notice, and without a vote if a consent in writing, setting forth the
action so taken, is signed by the holders of outstanding stock having not less
than the minimum number of votes that would be necessary to authorize or take
such action at a meeting at which all shares entitled to vote thereon were
present and voted.
Prompt notice of the taking of the corporate action without a meeting by
less than unanimous written consent shall be given to those stockholders who
have not consented in writing. If the action which is consented to is such as
would have required the filing of a certificate under any section of the General
Corporation Law of Delaware if such action had been voted on by stockholders at
a meeting thereof, then the certificate filed under such section shall state, in
lieu of any statement required by such section concerning any vote of
stockholders, that written notice and written consent have been given as
provided in Section 228 of the General Corporation Law of Delaware.
II.12 RECORD DATE FOR STOCKHOLDER NOTICE; VOTING; GIVING CONSENTS
-----------------------------------------------------------
In order that the corporation may determine the stockholders entitled to
notice of or to vote at any meeting of stockholders or any adjournment thereof,
or entitled to express consent to corporate action in writing without a meeting,
or entitled to receive payment of any dividend or other distribution or
allotment of any rights, or entitled to exercise any rights in respect of any
change, conversion or exchange of stock or for the purpose of any other lawful
action, the board of directors may fix, in advance, a record date, which shall
not be more than sixty (60) nor less than ten (10) days before the date of such
meeting, nor more than sixty (60) days prior to any other action.
If the board of directors does not so fix a record date:
(i) The record date for determining stockholders entitled to notice
of or to vote at a meeting of stockholders shall be at the close of business on
the day next preceding the day on which notice is given, or, if notice is
waived, at the close of business on the day next preceding the day on which the
meeting is held.
(ii) The record date for determining stockholders entitled to
express consent to corporate action in writing without a meeting, when no prior
action by the board of directors is necessary, shall be the day on which the
first written consent is expressed.
(iii) The record date for determining stockholders for any other
purpose shall be at the close of business on the day on which the board of
directors adopts the resolution relating thereto.
-4-
<PAGE>
A determination of stockholders of record entitled to notice of or to vote
at a meeting of stockholders shall apply to any adjournment of the meeting;
provided, however, that the board of directors may fix a new record date for the
adjourned meeting.
II.13 PROXIES
-------
Each stockholder entitled to vote at a meeting of stockholders or to
express consent or dissent to corporate action in writing without a meeting may
authorize another person or persons to act for the stockholder by a written
proxy, signed by the stockholder and filed with the secretary of the
corporation, but no such proxy shall be voted or acted upon after three (3)
years from its date, unless the proxy provides for a longer period. A proxy
shall be deemed signed if the stockholder's name is placed on the proxy (whether
by manual signature, typewriting, telegraphic transmission or otherwise) by the
stockholder or the stockholder's attorney-in-fact. The revocability of a proxy
that states on its face that it is irrevocable shall be governed by the
provisions of Section 212(c) of the General Corporation Law of Delaware.
II.14 LIST OF STOCKHOLDERS ENTITLED TO VOTE
-------------------------------------
The officer who has charge of the stock ledger of a corporation shall
prepare and make, at least ten (10) days before every meeting of stockholders, a
complete list of the stockholders entitled to vote at the meeting, arranged in
alphabetical order, and showing the address of each stockholder and the number
of shares registered in the name of each stockholder. Such list shall be open
to the examination of any stockholder, for any purpose germane to the meeting,
during ordinary business hours, for a period of at least ten (10) days prior to
the meeting, either at a place within the city where the meeting is to be held,
which place shall be specified in the notice of the meeting, or, if not so
specified, at the place where the meeting is to be held. The list shall also be
produced and kept at the time and place of the meeting during the whole time
thereof, and may be inspected by any stockholder who is present. Such list shall
presumptively determine the identity of the stockholders entitled to vote at the
meeting and the number of shares held by each of them.
ARTICLE III
DIRECTORS
---------
III.1 POWERS
------
Subject to the provisions of the General Corporation Law of Delaware and
any limitations in the certificate of incorporation or these bylaws relating to
action required to be approved by the
-5-
<PAGE>
stockholders or by the outstanding shares, the business and affairs of the
corporation shall be managed and all corporate powers shall be exercised by or
under the direction of the board of directors.
III.2 NUMBER OF DIRECTORS
-------------------
The Board of Directors shall consist of seven (7) persons and shall be
divided into three (3) classes as specified or determined pursuant to the
Certificate of Incorporation of the corporation as in effect from time to time.
No reduction of the authorized number of directors shall have the effect of
removing any director before that director's term of office expires.
III.3 ELECTION, QUALIFICATION AND TERM OF OFFICE OF DIRECTORS
-------------------------------------------------------
Except as provided in Section 3.4 of these bylaws, directors shall be
elected at each annual meeting of stockholders to hold office until the next
annual meeting. Directors need not be stockholders unless so required by the
certificate of incorporation or these bylaws, wherein other qualifications for
directors may be prescribed. Each director, including a director elected to
fill a vacancy, shall hold office until his or her successor is elected and
qualified or until the director's earlier resignation or removal.
Elections of directors need not be by written ballot.
III.4 RESIGNATION AND VACANCIES
-------------------------
Any director may resign at any time upon written notice to the attention of
the Secretary of the corporation. When one or more directors so resigns and the
resignation is effective at a future date, a majority of the directors then in
office, including those who have so resigned, shall have power to fill such
vacancy or vacancies, the vote thereon to take effect when such resignation or
resignations shall become effective, and each director so chosen shall hold
office as provided in this section in the filling of other vacancies.
Unless otherwise provided in the certificate of incorporation or these
bylaws:
(i) Vacancies and newly created directorships resulting from any
increase in the authorized number of directors elected by all of the
stockholders having the right to vote as a single class may be filled by a
majority of the directors then in office, although less than a quorum, or by a
sole remaining director.
(ii) Whenever the holders of any class or classes of stock or series
thereof are entitled to elect one or more directors by the provisions of the
certificate of incorporation, vacancies and newly created directorships of such
class or classes or series may be filled by a majority of the
-6-
<PAGE>
directors elected by such class or classes or series thereof then in office, or
by a sole remaining director so elected.
If at any time, by reason of death or resignation or other cause, the
corporation should have no directors in office, then any officer or any
stockholder or an executor, administrator, trustee or guardian of a stockholder,
or other fiduciary entrusted with like responsibility for the person or estate
of a stockholder, may call a special meeting of stockholders in accordance with
the provisions of the certificate of incorporation or these bylaws, or may apply
to the Court of Chancery for a decree summarily ordering an election as provided
in Section 211 of the General Corporation Law of Delaware.
If, at the time of filling any vacancy or any newly created directorship,
the directors then in office constitute less than a majority of the whole board
(as constituted immediately prior to any such increase), then the Court of
Chancery may, upon application of any stockholder or stockholders holding at
least ten (10) percent of the total number of the shares at the time outstanding
having the right to vote for such directors, summarily order an election to be
held to fill any such vacancies or newly created directorships, or to replace
the directors chosen by the directors then in office as aforesaid, which
election shall be governed by the provisions of Section 211 of the General
Corporation Law of Delaware as far as applicable.
III.5 PLACE OF MEETINGS; MEETINGS BY TELEPHONE
----------------------------------------
The board of directors of the corporation may hold meetings, both regular
and special, either within or outside the State of Delaware.
Unless otherwise restricted by the certificate of incorporation or these
bylaws, members of the board of directors, or any committee designated by the
board of directors, may participate in a meeting of the board of directors, or
any committee, by means of conference telephone or similar communications
equipment by means of which all persons participating in the meeting can hear
each other, and such participation in a meeting shall constitute presence in
person at the meeting.
III.6 REGULAR MEETINGS
----------------
Regular meetings of the board of directors may be held without notice at
such time and at such place as shall from time to time be determined by the
board.
III.7 SPECIAL MEETINGS; NOTICE
------------------------
Special meetings of the board of directors for any purpose or purposes may
be called at any time by the chairman of the board, the president, any vice
president, the secretary or any two (2) directors.
-7-
<PAGE>
Notice of the time and place of special meetings shall be delivered
personally or by telephone to each director or sent by first-class mail or
telegram, charges prepaid, addressed to each director at that director's address
as it is shown on the records of the corporation. If the notice is mailed, it
shall be deposited in the United States mail at least four (4) days before the
time of the holding of the meeting. If the notice is delivered personally or by
telephone or by telegram, it shall be delivered personally or by telephone or to
the telegraph company at least forty-eight (48) hours before the time of the
holding of the meeting. Any oral notice given personally or by telephone may be
communicated either to the director or to a person at the office of the director
who the person giving the notice has reason to believe will promptly communicate
it to the director. The notice need not specify the purpose or the place of the
meeting, if the meeting is to be held at the principal executive office of the
corporation.
III.8 QUORUM
------
At all meetings of the board of directors, a majority of the authorized
number of directors shall constitute a quorum for the transaction of business
and the act of a majority of the directors present at any meeting at which there
is a quorum shall be the act of the board of directors, except as may be
otherwise specifically provided by statute or by the certificate of
incorporation. If a quorum is not present at any meeting of the board of
directors, then the directors present thereat may adjourn the meeting from time
to time, without notice other than announcement at the meeting, until a quorum
is present.
A meeting at which a quorum is initially present may continue to transact
business notwithstanding the withdrawal of directors, if any action taken is
approved by at least a majority of the required quorum for that meeting.
III.9 WAIVER OF NOTICE
----------------
Whenever notice is required to be given under any provision of the General
Corporation Law of Delaware or of the certificate of incorporation or these
bylaws, a written waiver thereof, signed by the person entitled to notice,
whether before or after the time stated therein, shall be deemed equivalent to
notice. Attendance of a person at a meeting shall constitute a waiver of notice
of such meeting, except when the person attends a meeting for the express
purpose of objecting, at the beginning of the meeting, to the transaction of any
business because the meeting is not lawfully called or convened. Neither the
business to be transacted at, nor the purpose of, any regular or special meeting
of the directors, or members of a committee of directors, need be specified in
any written waiver of notice unless so required by the certificate of
incorporation or these bylaws.
-8-
<PAGE>
III.10 BOARD ACTION BY WRITTEN CONSENT WITHOUT A MEETING
-------------------------------------------------
Unless otherwise restricted by the certificate of incorporation or these
bylaws, any action required or permitted to be taken at any meeting of the board
of directors, or of any committee thereof, may be taken without a meeting if all
members of the board or committee, as the case may be, consent thereto in
writing and the writing or writings are filed with the minutes of proceedings of
the board or committee.
III.11 FEES AND COMPENSATION OF DIRECTORS
----------------------------------
Unless otherwise restricted by the certificate of incorporation or these
bylaws, the board of directors shall have the authority to fix the compensation
of directors.
III.12 APPROVAL OF LOANS TO OFFICERS
-----------------------------
The corporation may lend money to, or guarantee any obligation of, or
otherwise assist any officer or other employee of the corporation or of its
subsidiary, including any officer or employee who is a director of the
corporation or its subsidiary, whenever, in the judgment of the directors, such
loan, guaranty or assistance may reasonably be expected to benefit the
corporation. The loan, guaranty or other assistance may be with or without
interest and may be unsecured, or secured in such manner as the board of
directors shall approve, including, without limitation, a pledge of shares of
stock of the corporation. Nothing in this section contained shall be deemed to
deny, limit or restrict the powers of guaranty or warranty of the corporation at
common law or under any statute.
III.13 REMOVAL OF DIRECTORS
--------------------
Unless otherwise restricted by statute, by the certificate of incorporation
or by these bylaws, any director or the entire board of directors may be
removed, with or without cause, by the holders of a majority of the shares then
entitled to vote at an election of directors; provided, however, that, so long
as shareholders of the corporation are entitled to cumulative voting, if less
than the entire board is to be removed, no director may be removed without cause
if the votes cast against the director's removal would be sufficient to elect
the director if then cumulatively voted at an election of the entire board of
directors.
No reduction of the authorized number of directors shall have the effect of
removing any director prior to the expiration of such director's term of office.
ARTICLE IV
COMMITTEES
----------
-9-
<PAGE>
IV.1 COMMITTEES OF DIRECTORS
-----------------------
The board of directors may, by resolution passed by a majority of the whole
board, designate one or more committees, with each committee to consist of one
or more of the directors of the corporation. The board may designate one or
more directors as alternate members of any committee, who may replace any absent
or disqualified member at any meeting of the committee. In the absence or
disqualification of a member of a committee, the member or members thereof
present at any meeting and not disqualified from voting, whether or not such
member or members constitute a quorum, may unanimously appoint another member of
the board of directors to act at the meeting in the place of any such absent or
disqualified member. Any such committee, to the extent provided in the
resolution of the board of directors or in the bylaws of the corporation, shall
have and may exercise all the powers and authority of the board of directors in
the management of the business and affairs of the corporation, and may authorize
the seal of the corporation to be affixed to all papers that may require it; but
no such committee shall have the power or authority to (i) amend the certificate
of incorporation (except that a committee may, to the extent authorized in the
resolution or resolutions providing for the issuance of shares of stock adopted
by the board of directors as provided in Section 151(a) of the General
Corporation Law of Delaware, fix the designations and any of the preferences or
rights of such shares relating to dividends, redemption, dissolution, any
distribution of assets of the corporation or the conversion into, or the
exchange of such shares for, shares of any other class or classes or any other
series of the same or any other class or classes of stock of the corporation or
fix the number of shares of any series of stock or authorize the increase or
decrease of the shares of any series), (ii) adopt an agreement of merger or
consolidation under Sections 251 or 252 of the General Corporation Law of
Delaware, (iii) recommend to the stockholders the sale, lease or exchange of all
or substantially all of the corporation's property and assets, (iv) recommend to
the stockholders a dissolution of the corporation or a revocation of a
dissolution, or (v) amend the bylaws of the corporation; and, unless the board
resolution establishing the committee, the bylaws or the certificate of
incorporation expressly so provide, no such committee shall have the power or
authority to declare a dividend, to authorize the issuance of stock, or to adopt
a certificate of ownership and merger pursuant to Section 253 of the General
Corporation Law of Delaware.
IV.2 COMMITTEE MINUTES
-----------------
Each committee shall keep regular minutes of its meetings and report the
same to the board of directors when required.
IV.3 MEETINGS AND ACTION OF COMMITTEES
---------------------------------
Meetings and actions of committees shall be governed by, and held and taken
in accordance with, the provisions of Article III of these bylaws, Section 3.5
(place of meetings and meetings by telephone), Section 3.6 (regular meetings),
Section 3.7 (special meetings and notice), Section 3.8 (quorum), Section 3.9
(waiver of notice), and Section 3.10 (action without a meeting), with such
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changes in the context of those bylaws as are necessary to substitute the
committee and its members for the board of directors and its members; provided,
however, that the time of regular meetings of committees may be determined
either by resolution of the board of directors or by resolution of the
committee, that special meetings of committees may also be called by resolution
of the board of directors and that notice of special meetings of committees
shall also be given to all alternate members, who shall have the right to attend
all meetings of the committee. The board of directors may adopt rules for the
government of any committee not inconsistent with the provisions of these
bylaws.
ARTICLE V
OFFICERS
--------
V.1 OFFICERS
--------
The officers of the corporation shall be a president, a chief executive
officer, a chief financial officer and a secretary. The corporation may also
have, at the discretion of the board of directors, a chairman of the board, one
or more vice presidents, one or more assistant vice presidents, one or more
assistant secretaries, one or more assistant treasurers, and any such other
officers as may be appointed in accordance with the provisions of Section 5.3 of
these bylaws. Any number of offices may be held by the same person.
V.2 APPOINTMENT OF OFFICERS
-----------------------
The officers of the corporation, except such officers as may be appointed
in accordance with the provisions of Sections 5.3 or 5.5 of these bylaws, shall
be appointed by the board of directors, subject to the rights, if any, of an
officer under any contract of employment.
V.3 SUBORDINATE OFFICERS
--------------------
The board of directors may appoint, or empower the president to appoint,
such other officers and agents as the business of the corporation may require,
each of whom shall hold office for such period, have such authority, and perform
such duties as are provided in these bylaws or as the board of directors may
from time to time determine.
V.4 REMOVAL AND RESIGNATION OF OFFICERS
-----------------------------------
Subject to the rights, if any, of an officer under any contract of
employment, any officer may be removed, either with or without cause, by an
affirmative vote of the majority of the board of directors at any regular or
special meeting of the board or, except in the case of an officer chosen by
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the board of directors, by any officer upon whom such power of removal may be
conferred by the board of directors.
Any officer may resign at any time by giving written notice to the
corporation. Any resignation shall take effect at the date of the receipt of
that notice or at any later time specified in that notice; and, unless otherwise
specified in that notice, the acceptance of the resignation shall not be
necessary to make it effective. Any resignation is without prejudice to the
rights, if any, of the corporation under any contract to which the officer is a
party.
V.5 VACANCIES IN OFFICES
--------------------
Any vacancy occurring in any office of the corporation shall be filled by
the board of directors.
V.6 CHAIRMAN OF THE BOARD
---------------------
The chairman of the board, if such an officer be elected, shall, if
present, preside at meetings of the board of directors and exercise and perform
such other powers and duties as may from time to time be assigned to him or her
by the board of directors or as may be prescribed by these bylaws. If there is
no chief executive officer and no president, then the chairman of the board
shall also be the chief executive officer of the corporation and shall have the
powers and duties prescribed in Section 5.7 of these bylaws.
V.7 CHIEF EXECUTIVE OFFICER
-----------------------
Subject to the supervisory powers, if any, as may be given by the board of
directors to the chairman of the board, if there be such an officer, the chief
executive officer shall, subject to the control of the board of directors, have
general supervision, direction, and control of the business and the officers of
the corporation. In the absence or nonexistence of a chairman of the board, the
chief executive officer shall preside at meetings of the board of directors.
The chief executive officer shall have such other powers and duties as may be
prescribed by the board of directors or these bylaws.
V.8 PRESIDENT
---------
The president shall preside at all meetings of the stockholders and, in the
absence or nonexistence of a chairman of the board and a chief executive
officer, at all meetings of the board of directors. The president shall have the
general powers and duties of management usually vested in the office of
president of a corporation and shall have such other powers and duties as may be
prescribed by the board of directors or these bylaws. If there is no chief
executive officer, then the president shall also be the chief executive officer
of the corporation and shall have the powers and duties prescribed in Section
5.7 of these bylaws.
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V.9 VICE PRESIDENTS
---------------
In the absence or disability of the president, the vice presidents, if any,
in order of their rank as fixed by the board of directors or, if not ranked, a
vice president designated by the board of directors, shall perform all the
duties of the president and when so acting shall have all the powers of, and be
subject to all the restrictions upon, the president. The vice presidents shall
have such other powers and perform such other duties as from time to time may be
prescribed for them respectively by the board of directors, these bylaws, the
president or the chairman of the board.
V.10 SECRETARY
---------
The secretary shall keep or cause to be kept, at the principal executive
office of the corporation or such other place as the board of directors may
direct, a book of minutes of all meetings and actions of directors, committees
of directors, and stockholders. The minutes shall show the time and place of
each meeting, whether regular or special (and, if special, how authorized and
the notice given), the names of those present at directors' meetings or
committee meetings, the number of shares present or represented at stockholders'
meetings, and the proceedings thereof.
The secretary shall keep, or cause to be kept, at the principal executive
office of the corporation or at the office of the corporation's transfer agent
or registrar, as determined by resolution of the board of directors, a share
register, or a duplicate share register, showing the names of all stockholders
and their addresses, the number and classes of shares held by each, the number
and date of certificates evidencing such shares, and the number and date of
cancellation of every certificate surrendered for cancellation.
The secretary shall give, or cause to be given, notice of all meetings of
the stockholders and of the board of directors required to be given by law or by
these bylaws. The secretary shall keep the seal of the corporation, if one be
adopted, in safe custody and shall have such other powers and perform such other
duties as may be prescribed by the board of directors or by these bylaws.
V.11 CHIEF FINANCIAL OFFICER
-----------------------
The chief financial officer shall keep and maintain, or cause to be kept
and maintained, adequate and correct books and records of accounts of the
properties and business transactions of the corporation, including accounts of
its assets, liabilities, receipts, disbursements, gains, losses, capital
retained earnings, and shares. The books of account shall at all reasonable
times be open to inspection by any director.
The chief financial officer shall deposit all moneys and other valuables in
the name and to the credit of the corporation with such depositories as may be
designated by the board of directors. The chief financial officer shall disburse
the funds of the corporation as may be ordered by the board of directors, shall
render to the president and directors, whenever they request it, an account of
all his
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or her transactions as chief financial officer and of the financial condition of
the corporation, and shall have other powers and perform such other duties as
may be prescribed by the board of directors or these bylaws.
The chief financial officer shall be the treasurer of the corporation.
V.12 ASSISTANT SECRETARY
-------------------
The assistant secretary, or, if there is more than one, the assistant
secretaries in the order determined by the stockholders or board of directors
(or if there be no such determination, then in the order of their election)
shall, in the absence of the secretary or in the event of his or her inability
or refusal to act, perform the duties and exercise the powers of the secretary
and shall perform such other duties and have such other powers as may be
prescribed by the board of directors or these bylaws.
V.13 ASSISTANT TREASURER
-------------------
The assistant treasurer, or, if there is more than one, the assistant
treasurers, in the order determined by the stockholders or board of directors
(or if there be no such determination, then in the order of their election),
shall, in the absence of the chief financial officer or in the event of his or
her inability or refusal to act, perform the duties and exercise the powers of
the chief financial officer and shall perform such other duties and have such
other powers as may be prescribed by the board of directors or these bylaws.
V.14 REPRESENTATION OF SHARES OF OTHER CORPORATIONS
----------------------------------------------
The chairman of the board, the president, any vice president, the chief
financial officer, the secretary or assistant secretary of this corporation, or
any other person authorized by the board of directors or the president or a vice
president, is authorized to vote, represent, and exercise on behalf of this
corporation all rights incident to any and all shares of any other corporation
or corporations standing in the name of this corporation. The authority granted
herein may be exercised either by such person directly or by any other person
authorized to do so by proxy or power of attorney duly executed by such person
having the authority.
V.15 AUTHORITY AND DUTIES OF OFFICERS
--------------------------------
In addition to the foregoing authority and duties, all officers of the
corporation shall respectively have such authority and perform such duties in
the management of the business of the corporation as may be designated from time
to time by the board of directors or the stockholders.
ARTICLE VI
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INDEMNITY
---------
VI.1 THIRD PARTY ACTIONS
-------------------
The corporation shall indemnify any person who was or is a party or is
threatened to be made a party to any threatened, pending, or completed action,
suit or proceeding, whether civil, criminal, administrative or investigative
(other than an action by or in the right of the corporation) by reason of the
fact that he is or was a director, officer, employee or agent of the
corporation, or is or was serving at the request of the corporation as a
director, officer, employee or agent of another corporation, partnership, joint
venture trust or other enterprise, against expenses (including attorneys' fees),
judgments, fines and amounts paid in settlement (if such settlement is approved
in advance by the corporation, which approval shall not be unreasonably
withheld) actually and reasonably incurred by him in connection with such
action, suit or proceeding if he acted in good faith and in a manner he
reasonably believed to be in or not opposed to the best interests of the
corporation, and, with respect to any criminal action or proceeding, had no
reasonable cause to believe his conduct was unlawful. The termination of any
action, suit or proceeding by judgment, order, settlement, conviction, or upon a
plea of nolo contendere or its equivalent, shall not, of itself, create a
---- ----------
presumption that the person did not act in good faith and in a manner which such
person reasonably believed to be in or not opposed to the best interest of the
corporation, and, with respect to any criminal action or proceeding, had
reasonable cause to believe that his conduct was unlawful.
VI.2 ACTIONS BY OR IN THE RIGHT OF THE CORPORATION
---------------------------------------------
The corporation shall indemnify any person who was or is a party or is
threatened to be made a party to any threatened, pending or completed action or
suit by or in the right of the corporation to procure a judgment in its favor by
reason of the fact that such person is or was a director, officer, employee or
agent of corporation, or is or was serving at the request of the corporation as
a director, officer, employee or agent of another corporation, partnership,
joint venture, trust or other enterprise against expenses (including attorneys'
fees) and amounts paid in settlement (if such settlement is approved in advance
by the corporation, which approval shall not be unreasonably withheld) actually
and reasonably incurred by such person in connection with the defense or
settlement of such action or suit if the person acted in good faith and in
manner the person reasonably believed to be in or not opposed to the best
interests of the corporation, except that no indemnification shall be made in
respect of any claim, issue or matter as to which such person shall have been
adjudged to be liable to the corporation unless and only to the extent that the
Delaware Court of Chancery or the court in which such action or suit was brought
shall determine upon application that, despite the adjudication of liability but
in view of all the circumstances of the case, such person is fairly and
reasonably entitled to indemnity for such expenses which the Delaware Court of
Chancery or such other court shall deem proper. Notwithstanding any other
provision of this Article VI, no person shall be indemnified hereunder for any
expenses or amounts paid in settlement with respect to any action to recover
short-swing profits under Section 16(b) of the Securities Exchange Act of 1934,
as amended.
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VI.3 SUCCESSFUL DEFENSE
------------------
To the extent that a director, officer, employee or agent of the
corporation has been successful on the merits or otherwise in defense of any
action, suit or proceeding referred to in Sections 6.1 and 6.2, or in defense of
any claim, issue or matter therein, such person shall be indemnified against
expenses (including attorneys' fees) actually and reasonably incurred by the
person in connection therewith.
VI.4 DETERMINATION OF CONDUCT
------------------------
Any indemnification under Sections 6.1 and 6.2 (unless ordered by a court)
shall be made by the corporation only as authorized in the specific case upon a
determination that the indemnification of the director, officer, employee or
agent is proper in the circumstances because the person has met the applicable
standard of conduct set forth in Sections 6.1 and 6.2. Such determination shall
be made (1) by the Board of Directors or the Executive Committee by a majority
vote of a quorum consisting of directors who were not parties to such action,
suit or proceeding or (2) or if such quorum is not obtainable or, even if
obtainable, a quorum of disinterested directors so directs, by independent legal
counsel in a written opinion, or (3) by the stockholders. Notwithstanding the
foregoing, a director, officer, employee or agent of the Corporation shall be
entitled to contest any determination that the director, officer, employee or
agent has not met the applicable standard of conduct set forth in Sections 6.1
and 6.2 by petitioning a court of competent jurisdiction.
VI.5 PAYMENT OF EXPENSES IN ADVANCE
------------------------------
Expenses incurred in defending a civil or criminal action, suit or
proceeding, by an individual who may be entitled to indemnification pursuant to
Section 6.1 or 6.2, shall be paid by the corporation in advance of the final
disposition of such action, suit or proceeding upon receipt of an undertaking by
or on behalf of the director, officer, employee or agent to repay such amount if
it shall ultimately be determined that the individual is not entitled to be
indemnified by the corporation as authorized in this Article VI.
VI.6 INDEMNITY NOT EXCLUSIVE
-----------------------
The indemnification and advancement of expenses provided by or granted
pursuant to the other sections of this Article VI shall not be deemed exclusive
of any other rights to which those seeking indemnification or advancement of
expenses may be entitled under any by-law, agreement, vote of stockholders or
disinterested directors or otherwise, both as to action in their official
capacity and as to action in another capacity while holding such office.
VI.7 INSURANCE INDEMNIFICATION
-------------------------
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The corporation shall have the power to purchase and maintain insurance on
behalf of any person who is or was a director, officer, employee or agent of the
corporation, or is or was serving at the request of the corporation as a
director, officer, employee or agent of another corporation, partnership, joint
venture, trust or other enterprise, against any liability asserted against the
person and incurred by the person in any such capacity or arising out of the
person's status as such, whether or not the corporation would have the power to
indemnify such person against such liability under the provisions of this
Article VI.
VI.8 THE CORPORATION
---------------
For purposes of this Article VI, references to "the corporation" shall
include, in addition to the resulting corporation, any constituent corporation
(including any constituent of a constituent) absorbed in a consolidation or
merger which, if its separate existence had continued, would have had power and
authority to indemnify its directors, officers, and employees or agents, so that
any person who is or was a director, officer, employee or agent of such
constituent corporation, or is or was serving at the request of such constituent
corporation as a director, officer, employee or agent of another corporation,
partnership, joint venture, trust or other enterprise, shall stand in the same
position under and subject to the provisions of this Article VI (including,
without limitation the provisions of Section 6.4) with respect to the resulting
or surviving corporation as the person would have with respect to such
constituent corporation if its separate existence had continued.
VI.9 EMPLOYEE BENEFIT PLANS
----------------------
For purposes of this Article VI, references to "other enterprises" shall
include employee benefit plans; references to "fines" shall include any excise
taxes assessed on a person with respect to an employee benefit plan; and
references to "serving at the request of the corporation" shall include any
service as a director, officer, employee or agent of the corporation which
imposes duties on, or involves services by, such director, officer, employee, or
agent with respect to an employee benefit plan, its participants, or
beneficiaries; and a person who acted in good faith and in a manner he
reasonably believed to be in the interest of the participants and beneficiaries
of an employee benefit plan shall be deemed to have acted in a manner "not
opposed to the best interests of the corporation" as referred to in this Article
VI.
VI.10 CONTINUATION OF INDEMNIFICATION AND ADVANCEMENT OF EXPENSES
-----------------------------------------------------------
The indemnification and advancement of expenses provided by, or granted
pursuant to, this Article VI shall, unless otherwise provided when authorized or
ratified, continue as to a person who has ceased to be a director, officer,
employee or agent and shall inure to the benefit of the heirs, executors and
administrators of such person.
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ARTICLE VII
RECORDS AND REPORTS
-------------------
VII.1 MAINTENANCE AND INSPECTION OF RECORDS
-------------------------------------
The corporation shall, either at its principal executive officer or at such
place or places as designated by the board of directors, keep a record of its
stockholders listing their names and addresses and the number and class of
shares held by each stockholder, a copy of these bylaws as amended to date,
accounting books, and other records.
Any stockholder of record, in person or by attorney or other agent, shall,
upon written demand under oath stating the purpose thereof, have the right
during the usual hours for business to inspect for any proper purpose the
corporation's stock ledger, a list of its stockholders, and its other books and
records and to make copies or extracts therefrom. A proper purpose shall mean a
purpose reasonably related to such person's interest as a stockholder. In every
instance where an attorney or other agent is the person who seeks the right to
inspection, the demand under oath shall be accompanied by a power of attorney or
such other writing that authorizes the attorney or other agent so to act on
behalf of the stockholder. The demand under oath shall be directed to the
corporation at its registered office in Delaware or at its principal place of
business.
The officer who has charge of the stock ledger of the corporation shall
prepare and make, at least ten (10) days before every meeting of stockholders, a
complete list of the stockholders entitled to vote at the meeting, arranged in
alphabetical order, showing the address of each stockholder and the number of
shares registered in the name of each stockholder. Such list shall be open to
the examination of any stockholder, for any purpose germane to the meeting,
during ordinary business hours, for a period of at least ten (10) days prior to
the meeting, either at a place within the city where the meeting is to be held,
which place shall be specified in the notice of the meeting, or, if not so
specified, at the place where the meeting is to be held. The list shall also be
produced and kept at the time and place of the meeting during the whole time
thereof, and may be inspected by any stockholder who is present.
VII.2 INSPECTION BY DIRECTORS
-----------------------
Any director shall have the right to examine the corporation's stock
ledger, a list of its stockholders, and its other books and records for a
purpose reasonably related to his or her position as a director. The Court of
Chancery is hereby vested with the exclusive jurisdiction to determine whether a
director is entitled to the inspection sought. The Court may summarily order
the corporation to permit the director to inspect any and all books and records,
the stock ledger, and the stock list and to make copies or extracts therefrom.
The Court may, in its discretion, prescribe any
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limitations or conditions with reference to the inspection, or award such other
and further relief as the Court may deem just and proper.
VII.3 ANNUAL STATEMENT TO STOCKHOLDERS
--------------------------------
The board of directors shall present at each annual meeting, and at any
special meeting of the stockholders when called for by vote of the stockholders,
a full and clear statement of the business and condition of the corporation.
ARTICLE VIII
GENERAL MATTERS
---------------
VIII.1 CHECKS
------
From time to time, the board of directors shall determine by resolution
which person or persons may sign or endorse all checks, drafts, other orders for
payment of money, notes or other evidences of indebtedness that are issued in
the name of or payable to the corporation, and only the persons so authorized
shall sign or endorse those instruments.
VIII.2 EXECUTION OF CORPORATE CONTRACTS AND INSTRUMENTS
------------------------------------------------
The board of directors, except as otherwise provided in these bylaws, may
authorize any officer or officers, or agent or agents, to enter into any
contract or execute any instrument in the name of and on behalf of the
corporation; such authority may be general or confined to specific instances.
Unless so authorized or ratified by the board of directors or within the agency
power of an officer, no officer, agent or employee shall have any power or
authority to bind the corporation by any contract or engagement or to pledge its
credit or to render it liable for any purpose or for any amount.
VIII.3 STOCK CERTIFICATES; PARTLY PAID SHARES
--------------------------------------
The shares of the corporation shall be represented by certificates,
provided that the board of directors of the corporation may provide by
resolution or resolutions that some or all of any or all classes or series of
its stock shall be uncertificated shares. Any such resolution shall not apply
to shares represented by a certificate until such certificate is surrendered to
the corporation. Notwithstanding the adoption of such a resolution by the board
of directors, every holder of stock represented by certificates and upon request
every holder of uncertificated shares shall be entitled to have a certificate
signed by, or in the name of the corporation by the chairman or vice-chairman of
the board of directors, or the president or vice-president, and by the chief
financial officer or an assistant treasurer, or the secretary or an assistant
secretary of such corporation representing the
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number of shares registered in certificate form. Any or all of the signatures on
the certificate may be a facsimile. In case any officer, transfer agent or
registrar who has signed or whose facsimile signature has been placed upon a
certificate has ceased to be such officer, transfer agent or registrar before
such certificate is issued, it may be issued by the corporation with the same
effect as if the person were such officer, transfer agent or registrar at the
date of issue.
The corporation may issue the whole or any part of its shares as partly
paid and subject to call for the remainder of the consideration to be paid
therefor. Upon the face or back of each stock certificate issued to represent
any such partly paid shares, upon the books and records of the corporation in
the case of uncertificated partly paid shares, the total amount of the
consideration to be paid therefor and the amount paid thereon shall be stated.
Upon the declaration of any dividend on fully paid shares, the corporation shall
declare a dividend upon partly paid shares of the same class, but only upon the
basis of the percentage of the consideration actually paid thereon.
VIII.4 SPECIAL DESIGNATION ON CERTIFICATES
-----------------------------------
If the corporation is authorized to issue more than one class of stock or
more than one series of any class, then the powers, the designations, the
preferences, and the relative, participating, optional or other special rights
of each class of stock or series thereof and the qualifications, limitations or
restrictions of such preferences and/or rights shall be set forth in full or
summarized on the face or back of the certificate that the corporation shall
issue to represent such class or series of stock; provided, however, that,
except as otherwise provided in Section 202 of the General Corporation Law of
Delaware, in lieu of the foregoing requirements there may be set forth on the
face or back of the certificate that the corporation shall issue to represent
such class or series of stock a statement that the corporation will furnish
without charge to each stockholder who so requests the powers, the designations,
the preferences, and the relative, participating, optional or other special
rights of each class of stock or series thereof and the qualifications,
limitations or restrictions of such preferences and/or rights.
VIII.5 LOST CERTIFICATES
-----------------
Except as provided in this Section 8.5, no new certificates for shares
shall be issued to replace a previously issued certificate unless the latter is
surrendered to the corporation and cancelled at the same time. The corporation
may issue a new certificate of stock or uncertificated shares in the place of
any certificate theretofore issued by it, alleged to have been lost, stolen or
destroyed, and the corporation may require the owner of the lost, stolen or
destroyed certificate, or the owner's legal representative, to give the
corporation a bond sufficient to indemnify it against any claim that may be made
against it on account of the alleged loss, theft or destruction of any such
certificate or the issuance of such new certificate or uncertificated shares.
VIII.6 CONSTRUCTION; DEFINITIONS
-------------------------
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Unless the context requires otherwise, the general provisions, rules of
construction, and definitions in the Delaware General Corporation Law shall
govern the construction of these bylaws. Without limiting the generality of
this provision, the singular number includes the plural, the plural number
includes the singular, and the term "person" includes both a corporation and a
natural person.
VIII.7 DIVIDENDS
---------
The directors of the corporation, subject to any restrictions contained in
(i) the General Corporation Law of Delaware or (ii) the certificate of
incorporation, may declare and pay dividends upon the shares of its capital
stock. Dividends may be paid in cash, in property, or in shares of the
corporation's capital stock.
The directors of the corporation may set apart out of any of the funds of
the corporation available for dividends a reserve or reserves for any proper
purpose and may abolish any such reserve. Such purposes shall include but not be
limited to equalizing dividends, repairing or maintaining any property of the
corporation, and meeting contingencies.
VIII.8 FISCAL YEAR
-----------
The fiscal year of the corporation shall be fixed by resolution of the
board of directors and may be changed by the board of directors.
VIII.9 SEAL
----
The corporation may adopt a corporate seal, which shall be adopted and
which may be altered by the board of directors, and may use the same by causing
it or a facsimile thereof to be impressed or affixed or in any other manner
reproduced.
VIII.10 TRANSFER OF STOCK
-----------------
Upon surrender to the corporation or the transfer agent of the corporation
of a certificate for shares duly endorsed or accompanied by proper evidence of
succession, assignation or authority to transfer, it shall be the duty of the
corporation to issue a new certificate to the person entitled thereto, cancel
the old certificate, and record the transaction in its books.
VIII.11 STOCK TRANSFER AGREEMENTS
-------------------------
The corporation shall have power to enter into and perform any agreement
with any number of stockholders of any one or more classes of stock of the
corporation to restrict the transfer of shares of stock of the corporation of
any one or more classes owned by such stockholders in any manner not prohibited
by the General Corporation Law of Delaware.
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VIII.12 INADVERTENT TERMINATION OF S CORPORATION STATUS
-----------------------------------------------
No stockholder shall sell or transfer any stock of the corporation in a
transaction which would cause termination of an otherwise valid election to
receive tax treatment under Subchapter S of the Internal Revenue Code or
analogous provision of a successor statute, or termination of S Corporation
status under the California Revenue and Taxation Code or successor statute.
This paragraph shall not apply if the majority of the voting power of the
corporation has consented by stockholder vote or written consent to such sale or
transfer.
VIII.13 REGISTERED STOCKHOLDERS
-----------------------
The corporation shall be entitled to recognize the exclusive right of a
person registered on its books as the owner of shares to receive dividends and
to vote as such owner, shall be entitled to hold liable for calls and
assessments the person registered on its books as the owner of shares, and shall
not be bound to recognize any equitable or other claim to or interest in such
share or shares on the part of another person, whether or not it shall have
express or other notice thereof, except as otherwise provided by the laws of
Delaware.
ARTICLE IX
AMENDMENTS
----------
The bylaws of the corporation may be adopted, amended or repealed by the
stockholders entitled to vote; provided, however, that the corporation may, in
its certificate of incorporation, confer the power to adopt, amend or repeal
bylaws upon the directors. The fact that such power has been so conferred upon
the directors shall not divest the stockholders of the power, nor limit their
power to adopt, amend or repeal bylaws.
-22-
<PAGE>
EXHIBIT 10.03
EMPLOYMENT AGREEMENT
--------------------
This Employment Agreement (the "Agreement") is made and entered into
effective as of ___________, 1998 (the "Effective Date") between ______________
(the "Employee") and Rational Software Corp. (the "Company").
RECITALS
A. The Employee is and has been employed by the Company and is currently
the Company's _______________________.
B. The Company and the Employee desire to enter into this Agreement to
provide additional financial security and benefits to the Employee and to
encourage the Employee to continue employment with the Company.
C. Certain capitalized terms used in the Agreement are defined in Section
7 below.
AGREEMENT
In consideration of the mutual covenants herein contained, and in
consideration of the continuing employment of the Employee by the Company, the
parties agree as follows:
1. Duties and Scope of Employment.
------------------------------
(a) Position. The Company shall employ the Employee in the position
--------
of ______________________, as such position has been defined in terms of duties
and responsibilities as of the Effective Date; provided, however, that the CEO
shall have the right, at any time prior to the occurrence of a Change of
Control, to revise such duties and responsibilties as the CEO in his discretion
may deem necessary or appropriate. The Employee shall comply with and be bound
by the Company's operating policies, procedures and practices from time to time
in effect during employment.
(b) Obligations. During the term of the Employee's employment with
-----------
the Company, the Employee shall devote substantially all of his full business
efforts and time to the Company. The foregoing, however, shall not preclude the
Employee from engaging in such activities and services as do not materially
interfere or conflict with the Employee's duties and responsibilities to the
Company.
2. At-Will Employment. The Company and the Employee acknowledge that the
------------------
Employee's employment is and shall continue to be at-will, as defined under
applicable law. If the Employee's employment terminates for any reason, the
Employee shall not be entitled to any payments, benefits, damages, awards or
compensation other than as provided by this Agreement, or
<PAGE>
as may otherwise be available in accordance with the Company's established
employee plans. The terms of this Agreement shall terminate upon the earlier of
(i) the date that all obligations of the parties hereunder have been satisfied
or (ii) four years after the Effective Date; provided, however, that until such
time as notice of non-renewal or termination of the Agreement is given by either
the Company or the Employee to the other, beginning three years after the
Effective Date, this Agreement shall automatically be extended by one month
effective as of the end of each month so that the remaining outstanding term of
this Agreement is approximately one year: provided further that in no event
-------- -------
shall the term of this Agreement be so extended to a date more than seven years
from the Effective Date. A termination of the terms of this Agreement pursuant
to the preceding sentence shall be effective for all purposes, except that such
termination shall not affect the payment or provision of compensation or
benefits on account of a termination of employment occurring prior to the
termination of the term of this Agreement.
3. Base Compensation. The Company shall pay the Employee as compensation
-----------------
for his services a base salary at the annualized rate of $_________. Such
salary shall be paid periodically in accordance with normal Company payroll
practices. The annualized compensation specified in this Section 3, as such
compensation may be increased by the Board or the Compensation Committee of the
Board, is referred to in this Agreement as "Base Compensation."
4. Annual Incentive. For each fiscal year thereafter during the term of
----------------
this Agreement, the Employee shall be eligible to receive additional cash
compensation under the Company's management incentive bonus plan (the "Annual
Incentive") based upon specific financial and/or other targets approved by the
Board or the Compensation Committee of the Board (the "Target Incentive").
The Annual Incentive payable hereunder shall be payable in accordance with the
Company's normal practices and policies.
5. Employee Benefits. The Employee shall be eligible to participate in
-----------------
the employee benefit plans and executive compensation programs maintained by the
Company applicable to other key executives of the Company, including (without
limitation) retirement plans, savings or profit-sharing plans, stock option,
incentive or other bonus plans, life, disability, health, accident and other
insurance programs, paid vacations, and similar plans or programs, subject in
each case to the generally applicable terms and conditions of the applicable
plan or program in question and to the sole determination of the Board or any
committee administering such plan or program.
6. Severance Benefits.
------------------
(a) Involuntary Termination. If the Employee's employment terminates
-----------------------
as a result of Involuntary Termination other than for Cause, the Employee shall
be entitled to receive a severance payment equal to the sum of (i) one times the
Employee's Base Compensation for the Company's fiscal year then in effect or if
greater, one times the Employee's Base Compensation for the Company's fiscal
year immediately preceding the Termination Date, plus (ii) one times the
Employee's Target Incentive for the fiscal year then in effect (or, if no Target
Incentive is in effect for such year, the highest Target Incentive in the three
(3) preceding fiscal years). Any severance
-2-
<PAGE>
payments to which the Employee is entitled pursuant to this Section 6(a) shall
be paid to the Employee (or to the Employee's estate or beneficiary in the event
of the Employee's death) in a lump sum within fifteen (15) calendar days of the
Employee's Termination Date.
(b) Voluntary Resignation: Termination For Cause. If the Employee
--------------------------------------------
voluntarily resigns from the Company (other than as an Involuntary Termination),
or if the Company terminates the Employee's employment for Cause, then the
Employee shall not be entitled to receive severance or other benefits except for
those (if any) as may then be established under the Company's then existing
severance and benefits plans and policies at the time of such resignation or
termination.
(c) Options. In the event the Employee is entitled to severance benefits
-------
pursuant to Section 6(a), then, in addition to such severance benefits, the
unvested portion of any stock option(s) held by the Employee under the Company's
stock option plans (or under any successor company's stock option plans) shall
vest and become exercisable in full. In addition, any such option(s) granted to
the Employee prior to the date of this Agreement with an exercise price higher
than the per-share fair market value of the Company's Common Stock on the date
of this Agreement, and all such stock options granted to the Employee on or
after the date of this Agreement, shall remain exercisable for the twelve (12)-
month period following the Employee's Termination Date, subject to the original
term of such option(s).
(d) Medical Benefits. In the event the Employee is entitled to severance
----------------
benefits pursuant to Section 6(a), then in addition to such severance benefits
the Company shall pay the Employee a lump sum payment in an amount equivalent to
the reasonably estimated cost the Employee may incur to extend for a period of
twelve (12) months under the COBRA continuation laws the Employee's group
medical coverage in effect on the Termination Date. The Employee may use this
payment, as well as any other payment made under this Section 6, for such
continuation coverage or for any other purpose.
(e) Other Benefits. In the event the Employee is entitled to severance
--------------
benefits pursuant to Section 6(a), then in addition to such severance benefits,
the Company shall continue to provide the Employee, for a period of twelve (12)
months after the Termination Date, life and disability insurance benefits or
such comparable benefits as the Company may, in its discretion, determine to be
sufficient to satisfy its obligations to the Employee under this Agreement.
Notwithstanding the foregoing, if the Employee becomes covered under any life or
disability insurance plan(s) provided by a subsequent employer, then the amount
of coverage required to be provided by the Company hereunder shall be reduced by
the amount of coverage provided by the subsequent employer's life or disability
insurance plan(s).
7. Definition of Terms. The following terms referred to in this Agreement
-------------------
shall have the following meanings:
(a) Board. "Board" means the Board of Directors of the Company.
-----
-3-
<PAGE>
(b) Cause. "Cause" means (i) the Employee's willful failure to
-----
substantially perform his material duties for a period of sixty (60) days after
a written demand for substantial performance is delivered to the Employee by the
CEO that specifically identifies the manner in which the CEO believes that the
Employee has not substantially performed his duties, (ii) conviction of or
entry of a plea of guilty or nolo contendere to a felony or a crime causing
material harm to the Company, and (iii) a willful act by the Employee that
constitutes gross misconduct and that is injurious to the Company.
(c) Change of Control. "Change of Control" means the occurrence of
-----------------
any of the following events:
(i) The acquisition by any "person" (as such term is used in
Sections 13(d) and 14(d) of the Exchange Act)(other than the Company or a person
that directly or indirectly controls, is controlled by, or is under common
control with, the Company) of the "beneficial ownership" (as defined in Rule
13d-3 under said Act), directly or indirectly, of securities of the Company
representing thirty percent (30%) or more of the total voting power represented
by the Company's then outstanding voting securities: or
(ii) A change in the composition of the Board occurring within
a rolling two-year period, as a result of which fewer than a majority of the
directors are Incumbent Directors. "Incumbent Directors" shall mean directors
who either (A) are members of the Board as of the Effective Date, or (B) are
elected, or nominated for election, to the Board with the affirmative votes of
at least a majority of the Incumbent Directors at the time of such election or
nomination (but shall not include an individual not otherwise an Incumbent
Director whose election or nomination is in connection with an actual or
threatened proxy contest relating to the election of directors to the Board); or
(iii) A merger or consolidation of the Company with any other
corporation, other than a merger or consolidation which would result in the
voting securities of the Company outstanding immediately prior thereto
continuing to represent (either by remaining outstanding or by being converted
into voting securities of the surviving entity (including the parent corporation
of such surviving entity)) at least fifty percent (50%) of the total voting
power represented by the voting securities of the Company or such surviving
entity outstanding immediately after such merger or consolidation, or the
approval by the stockholders of the Company of a plan of complete liquidation of
the Company or of an agreement for the sale or disposition by the Company of all
or substantially all the Company's assets.
(d) Disability. "Disability" means that the Employee has been
----------
unable to substantially perform his duties under this Agreement as the result of
his incapacity due to physical or mental illness, and such inability, at least
twenty-six (26) weeks after its commencement, is determined to be permanent by a
physician selected by the Company or its insurers and acceptable to the Employee
or the Employee's legal representative (such agreement as to acceptability not
to be unreasonably withheld).
-4-
<PAGE>
(e) Exchange Act. "Exchange Act" means the Securities Exchange Act
------------
of 1934, as amended.
(f) Involuntary Termination. "Involuntary Termination" means (i) any
-----------------------
purported termination of the Employee by the Company which is not effected for
Cause, or any purported termination for which the grounds relied upon are not
valid; (ii) termination of the Employee's employment with the Company by reason
of the Employee's death or Disability; or (iii) the failure of the Company to
obtain the assumption of this agreement by any successors contemplated in
Section 10 below. In addition, "Involuntary Termination" means termination of
the Employee's employment as a result of one or more of the following that
occurs within two (2) years after the occurrence of a Change of Control; (i)
without the Employee's express written consent, the relocation of the Employee
to a facility or a location more than 50 miles from the Employee's then present
location; (ii) without the Employee's express written consent, a reduction by
the Company in the Employee's Base Compensation or Target Incentive relative to
the Base Compensation or Target Incentive as in effect immediately prior to such
reduction (unless reductions comparable in amount and duration are concurrently
made for all other employees of the Company with responsibilities,
organizational level and title comparable to the Employee), (iii) without the
Employee's express written consent, the significant reduction of the Employee's
duties, authority or responsibilities relative to the Employee's duties,
authority and responsibilities as in effect immediately prior to such reduction
or the assignment to the Employee of such reduced duties, authority or
responsibilities; or (iv) without the Employee's express written consent,
material reduction by the Company in the kind or level of employee benefits to
which the Employee is entitled immediately prior to such reduction with the
result that the Employee's overall benefits package is significantly reduced.
(g) Termination Date. "Termination Date" means (i) the date on which
----------------
the Company delivers notice of termination to the Employee or such later date,
not to exceed ninety (90) days, specified in the notice of termination, (ii) in
the event the term of employment ends by reason of the Employee's death, the
date of death, or (iii) if the Agreement is terminated by the Employee, the date
on which the Employee delivers notice of termination to the Company.
8. Limitation on Payments. Notwithstanding anything to the contrary
----------------------
contained herein, in the event it shall be determined that any payment by the
Company to or for the benefit of the Employee, whether paid or payable but
determined without regard to any additional payments required under this Section
8 (a "Payment"), would be subject to the excise tax imposed by Section 4999 of
the Internal Revenue Code of 1986, as amended (the "Code"), or any comparable
federal, state, or local excise tax (such excise tax, together with any interest
and penalties, are hereinafter collectively referred to as the "Excise Tax"),
then the Employee shall be entitled to receive an additional payment from the
Company (a "Gross-Up Payment") in such an amount that after the payment of all
taxes (including, without limitation, any interest and penalties on such taxes
and the Excise Tax) on the payment and on the Gross-Up Payment, the Employee
shall retain an amount equal to the Payment minus all applicable taxes on the
Payment. The intent of the parties is that the Company shall be solely
responsible for, and shall pay, any Excise Tax on the Payment and Gross-Up
Payment and any income and employment taxes (including, without limitation,
penalties and interest) imposed on any Gross-Up Payment, as well as any loss of
tax
-5-
<PAGE>
deduction caused by the Gross-Up Payment. All determinations required to be
made under this Section, including without limitation, whether and when a
Gross-Up Payment is required and the amount of such Gross-Up Payment and the
assumptions to be utilized in arriving at such determinations, shall be made
in writing in good faith by the accounting firm serving as the Company's
independent public accountants immediately prior to the event giving rise to
such Payment (the "Accountants"). For purposes of making the calculations
required by this Section 8, the accountants may make reasonable assumptions and
approximations concerning the application of Sections 280G and 4999 of the Code.
The Company and the Employee shall furnish to the Accountants such information
and documents as the Accountants may reasonably request to make a determination
under this Section. The Company shall bear all costs the Accountants may
reasonably incur in connection with any calculations contemplated by this
Section.
9. Non-Compete: Non-Solicit.
------------------------
(a) The parties hereto recognize that the Employee's services are
special and unique and that the level of compensation and the provisions herein
for compensation upon Involuntary Termination are partly in consideration of and
conditioned upon the Employee's not competing with the Company, and that the
Employee's covenant not to compete or solicit as set forth in this Section 9
during and after employment is essential to protect the business and good will
of the Company.
(b) The Employee agrees that during the term of employment with the
Company and for a period ending twelve (12) months following the Termination
Date (the "Covenant Period"), the Employee will not either directly or
indirectly, whether as a director, officer, consultant, employee or advisor or
in any other capacity render any planning, marketing or other services
respecting [the creation, design, license or sale of software products used to
develop mission critical software applications for use by any business, agency,
partnership or entity other than the Company. For purposes of this Section 9,
the term "Company" shall mean and include the Company, any subsidiary or
affiliate of the Company, any successor to the business of the Company (by
merger, consolidation, sale of assets or stock or otherwise) and any other
corporation or entity in which the Employee may serve as a director, officer or
employee at the request of the Company or any successor of the Company.
(c) During the Covenant Period, the Employee will not, directly or
indirectly, induce or attempt to influence any employee of the Company to leave
its employ and the Employee will not, directly or indirectly, become involved in
decisions to hire any employee who has left the Company's employ within the
three (3)-month period preceding the Termination Date or the three (3)-month
following the Termination Date. This provision shall not apply to individuals
who were employed by the Employee's present employer during the three (3)-month
period ending on the Effective Date, and, in addition, shall not be construed to
affect any responsibility the Employee has with respect to the bonafide hiring
and firing of Company personnel.
(d) The Employee agrees that the Company would suffer an irreparable
injury if the Employee were to breach the covenants contained in Sections 9(b)
or (c) and that the Company would by reason of such breach or threatened breach
be entitled to injunctive relief in a court of
-6-
<PAGE>
appropriate jurisdiction and the Employee hereby stipulates to the entering of
such injunctive relief prohibiting the Employee from engaging in such breach.
(e) If any of the restrictions contained in this Section 9 shall be
deemed to be unenforceable by reason of the extent, duration or geographical
scope or other provisions thereof, then the parties hereto contemplate that the
court shall reduce such extent, duration, geographical scope or other provision
hereof and enforce this Section 9 in its reduced form for all purposes in the
manner contemplated hereby.
10. Successors.
----------
(a) Company's Successors. Any successor to the Company (whether
--------------------
direct or indirect and whether by purchase, lease, merger, consolidation,
liquidation or otherwise) to all or substantially all of the Company's business
and assets shall assume the obligations under this Agreement and agree expressly
to perform the obligations under this Agreement in the same manner and to the
same extent as the Company would be required to perform such obligations in the
absence of a succession. For all purposes under this Agreement, the term
"Company" shall include any successor to the Company's business and assets which
executes and delivers the assumption agreement described in this Section 10(a)
or which becomes bound by the terms of this Agreement by operation of law.
(b) Employee's Successors. The terms of this Agreement and all
---------------------
rights of the Employee hereunder shall inure to the benefit of, and be
enforceable by, the Employee's personal or legal representatives, executors,
administrators, successors, heirs, devisees and legatees.
11. Notice.
------
(a) General. Notices and all other communications contemplated by
-------
this Agreement shall be in writing and shall be deemed to have been duly given
when personally delivered or when mailed by U.S. registered or certified mail,
return receipt requested and postage prepaid. In the case of the Employee,
mailed notices shall be addressed to him at the home address which he most
recently communicated to the Company in writing. In the case of the Company,
mailed notices shall be addressed to its corporate headquarters, and all notices
shall be directed to the attention of its Secretary.
(b) Notice of Termination. Any termination by the Company for Cause
---------------------
or by the Employee as a result of an Involuntary Termination shall be
communicated by a notice of termination to the other party hereto given in
accordance with Section 11(a) of this Agreement. Such notice shall indicate the
specific termination provision in this Agreement relied upon, shall set forth in
reasonable detail the facts and circumstances claimed to provide a basis for
termination under the provision so indicated, and shall specify the Termination
Date (which shall be not more than ninety (90) days after the giving of such
notice). The failure by the Employee to include in the notice any fact or
circumstance which contributes to a showing of Involuntary Termination shall not
waive any right of
-7-
<PAGE>
the Employee hereunder or preclude the Employee from asserting such fact or
circumstance in enforcing his rights hereunder.
12. Miscellaneous Provisions.
------------------------
(a) No Duty to Mitigate. The Employee shall not be required to
-------------------
mitigate the amount of any payment contemplated by this Agreement (whether by
seeking new employment or in any other manner), nor shall any such payment be
reduced by any earnings that the Employee may receive from any other source.
(b) Waiver. No provision of this Agreement shall be modified,
------
waived or discharged unless the modification, waiver or discharge is agreed to
in writing and signed by the Employee and by an authorized officer of the
Company (other than the Employee). No waiver by either party of any breach
of, or of compliance with, any condition or provision of this Agreement by the
other party shall be considered a waiver of any other condition or provision
or of the same condition or provision at another time.
(c) Whole Agreement. No agreements, representations or
---------------
understandings (whether oral or written and whether express or implied) which
are not expressly set forth in this Agreement have been made or entered into by
either party with respect to the subject matter hereof.
(d) Choice of Law. The validity, interpretation, construction and
-------------
performance of this Agreement shall be governed by the laws of the State of
California.
(e) Severability. The invalidity or unenforceability of any
------------
provision or provisions of this Agreement shall not affect the validity or
enforceability of any other provision hereof, which shall remain in full force
and effect.
(f) Arbitration. Any dispute or controversy arising out of,
-----------
relating to or in connection with this Agreement shall be settled exclusively by
binding arbitration in San Jose, California, in accordance with the National
Rules for the Resolution of Employment Disputes of the American Arbitration
Association then in effect. Judgment may be entered on the arbitrator's award
in any court having jurisdiction. The Company and the Employee shall each pay
one-half of the costs and expenses of such arbitration, and each shall
separately pay its counsel fees and expenses. Punitive damages shall not be
awarded.
(g) No Assignment of Benefits. The rights of any person to
-------------------------
payments or benefits under this Agreement shall not be made subject to option or
assignment, either by voluntary or involuntary assignment or by operation of
law, including (without limitation) bankruptcy, garnishment, attachment or other
creditor's process, and any action in violation of this Section 12(g) shall be
void.
-8-
<PAGE>
(h) Employment Taxes. All payments made pursuant to this
----------------
Agreement will be subject to withholding of applicable income and employment
taxes.
(i) Assignment by Company. The Company may assign its rights under
---------------------
this Agreement to an affiliate, and an affiliate may assign its rights under
this Agreement to another affiliate of the Company or to the Company; provided,
however, that no assignment shall be made if the net worth of the assignee is
less than the net worth of the Company at the time of assignment. In the case of
any such assignment, the term "Company" when used in a section of this
Agreement shall mean the corporation that actually employs the Employee.
(j) Counterparts. This Agreement may be executed in counterparts,
------------
each of which shall be deemed an original, but all of which together will
constitute one and the same instrument.
IN WITNESS WHEREOF, each of the parties has executed this Agreement, in the
case of the Company by its duly authorized officer, as of the day and year first
above written.
COMPANY: RATIONAL SOFTWARE CORP.
By: ____________________________
Title: _________________________
EMPLOYEE: _________________________________
-9-
<PAGE>
EXHIBIT 10.04
EMPLOYMENT AGREEMENT
--------------------
This Employment Agreement (the "Agreement") is made and entered into
effective as of ___________, 1998 (the "Effective Date") between ___________
(the "Employee") and Rational Software Corp. (the "Company").
RECITALS
A. The Employee is and has been employed by the Company and is currently
the Company's Chief Executive Officer.
B. The Company and the Employee desire to enter into this Agreement to
provide additional financial security and benefits to the Employee and to
encourage the Employee to continue employment with the Company.
C. Certain capitalized terms used in the Agreement are defined in Section
7 below.
AGREEMENT
In consideration of the mutual covenants herein contained, and in
consideration of the continuing employment of the Employee by the Company, the
parties agree as follows:
1. Duties and Scope of Employment.
------------------------------
(a) Position. The Company shall employ the Employee in the position
--------
of _____________________, as such position has been defined in terms of duties
and responsibilities as of the Effective Date. The Employee shall comply with
and be bound by the Company's operating policies, procedures and practices from
time to time in effect during employment.
(b) Obligations. During the term of the Employee's employment with
-----------
the Company, the Employee shall devote substantially all of his business efforts
and time to the Company. The foregoing, however, shall not preclude the
Employee from engaging in such activities and services as do not materially
interfere or conflict with the Employee's duties and responsibilities to the
Company.
2. At-Will Employment. The Company and the Employee acknowledge that the
------------------
Employee's employment is and shall continue to be at-will, as defined under
applicable law. If the Employee's employment terminates for any reason, the
Employee shall not be entitled to any payments, benefits, damages, awards or
compensation other than as provided by this Agreement, or as may otherwise be
available in accordance with the Company's established employee plans. The
terms of this Agreement shall terminate upon the earlier of (i) the date all
obligations of the parties hereunder have been satisfied or (ii) four years
after the Effective Date; provided, however,
<PAGE>
that until such time as notice of non-renewal or termination of the Agreement is
given by either the Company or the Employee to the other, beginning three years
after the Effective Date, this Agreement shall automatically be extended by one
month effective as of the end of each month so that the remaining outstanding
term of this Agreement is approximately one year: provided further that in no
-------- -------
event shall the term of this Agreement be so extended to a date more than seven
years from the Effective Date. A termination of the terms of this Agreement
pursuant to the preceding sentence shall be effective for all purposes, except
that such termination shall not affect the payment or provision of compensation
or benefits on account of a termination of employment occurring prior to the
termination of the term of this Agreement.
3. Base Compensation. The Company shall pay the Employee as compensation
-----------------
for his services a base salary at the annualized rate of $_________. Such
salary shall be paid periodically in accordance with normal Company payroll
practices. The annualized compensation specified in this Section 3, as such
compensation may be increased by the Board or the Compensation Committee of the
Board, is referred to in this Agreement as "Base Compensation."
4. Annual Incentive. For each fiscal year thereafter during the term of
----------------
this Agreement, the Employee shall be eligible to receive additional cash
compensation under the Company's management incentive bonus plan (the "Annual
Incentive") based upon specific financial and/or other targets approved by the
Board or the Compensation Committee of the Board (the "Target Incentive").
The Annual Incentive payable hereunder shall be payable in accordance with the
Company's normal practices and policies.
5. Employee Benefits. The Employee shall be eligible to participate in
-----------------
the employee benefit plans and executive compensation programs maintained by the
Company applicable to other key executives of the Company, including (without
limitation) retirement plans, savings or profit-sharing plans, stock option,
incentive or other bonus plans, life, disability, health, accident and other
insurance programs, paid vacations, and similar plans or programs, subject in
each case to the generally applicable terms and conditions of the applicable
plan or program in question and to the sole determination of the Board or any
committee administering such plan or program.
6. Severance Benefits.
------------------
(a) Involuntary Termination. If the Employee's employment terminates
-----------------------
as a result of Involuntary Termination other than for Cause, the Employee shall
be entitled to receive a severance payment equal to the sum of (i) two times the
Employee's Base Compensation for the Company's fiscal year then in effect or if
greater, two times the Employee's Base Compensation for the Company's fiscal
year immediately preceding the Termination Date, plus (ii) two times the
Employee's Target Incentive for the fiscal year then in effect (or, if no Target
Incentive is in effect for such year, the highest Target Incentive in the three
(3) preceding fiscal years). Any severance payments to which the Employee is
entitled pursuant to this Section 6(a) shall be paid to the Employee (or to the
Employee's estate or beneficiary in the event of the Employee's death) in a lump
sum within fifteen (15) calendar days of the Employee's Termination Date.
-2-
<PAGE>
(b) Voluntary Resignation: Termination For Cause. If the Employee
--------------------------------------------
voluntarily resigns from the Company (other than as an Involuntary Termination),
or if the Company terminates the Employee's employment for Cause, then the
Employee shall not be entitled to receive severance or other benefits except for
those (if any) as may then be established under the Company's then existing
severance and benefits plans and policies at the time of such resignation or
termination.
(c) Options. In the event the Employee is entitled to severance benefits
-------
pursuant to Section 6(a), then, in addition to such severance benefits, the
unvested portion of any stock option(s) held by the Employee under the Company's
stock option plans (or under any successor company's stock option plans) shall
vest and become exercisable in full. In addition, any such option(s) granted to
the Employee prior to the date of this Agreement with an exercise price higher
than the per-share fair market value of the Company's Common Stock on the date
of this Agreement, and all such stock options granted to the Employee on or
after the date of this Agreement, shall remain exercisable for the twelve (12)-
month period following the Employee's Termination Date, subject to the original
term of such option(s).
(d) Medical Benefits. In the event the Employee is entitled to severance
----------------
benefits pursuant to Section 6(a), then in addition to such severance benefits
the Company shall pay the Employee a lump sum payment in an amount equivalent to
the reasonably estimated cost the Employee may incur to extend for a period of
twenty-four (24) months under the COBRA continuation laws the Employee's group
medical coverage in effect on the Termination Date. The Employee may use this
payment, as well as any other payment made under this Section 6, for such
continuation coverage or for any other purpose.
(e) Other Benefits. In the event the Employee is entitled to severance
--------------
benefits pursuant to Section 6(a), then in addition to such severance benefits,
the Company shall continue to provide the Employee; for a period of twenty-four
(24) months after the Termination Date, life and disability insurance benefits
or such comparable benefits as the Company may, in its discretion, determine to
be sufficient to satisfy its obligations to the Employee under this Agreement.
Notwithstanding the foregoing, if the Employee becomes covered under any life or
disability insurance plan(s) provided by a subsequent employer, then the amount
of coverage required to be provided by the Company hereunder shall be reduced by
the amount of coverage provided by the subsequent employer's life or disability
insurance plan(s).
7. Definition of Terms. The following terms referred to in this Agreement
-------------------
shall have the following meanings:
(a) Board. "Board" means the Board of Directors of the Company.
-----
(b) Cause. "Cause" means (i) the Employee's willful failure to
-----
substantially perform this material duties for a period of sixty (60) days after
a written demand for substantial performance is delivered to the Employee by the
Board that specifically identifies the manner in which the Board believes that
the Employee has not substantially performed his duties. (ii) conviction of or
-3-
<PAGE>
entry of a plea of guilty or nolo contendere to a felony or a crime causing
material harm to the Company, and (iii) a willful act by the Employee that
constitutes gross misconduct and that is injurious to the Company.
(c) Change of Control. "Change of Control" means the occurrence of
-----------------
any of the following events:
(i) The acquisition by any "person" (as such term is used in
Sections 13(d) and 14(d) of the Exchange Act)(other than the Company or a person
that directly or indirectly controls, is controlled by, or is under common
control with the Company) of the "beneficial ownership" (as defined in Rule
13d-3 under said Act), directly or indirectly, of securities of the Company
representing thirty percent (30%) or more of the total voting power represented
by the Company's then outstanding voting securities: or
(ii) A change in the composition of the Board occurring within
a rolling two-year period, as a result of which fewer than a majority of the
directors are Incumbent Directors. "Incumbent Directors" shall mean directors
who either (A) are members of the Board as of the Effective Date, or (B) are
elected, or nominated for election, to the Board with the affirmative votes of
at least a majority of the Incumbent Directors at the time of such election or
nomination (but shall not include an individual not otherwise an Incumbent
Director whose election or nomination is in connection with an actual or
threatened proxy contest relating to the election of directors to the Board); or
(iii) A merger or consolidation of the Company with any other
corporation other than a merger or consolidation which would result in the
voting securities of the Company outstanding immediately prior thereto
continuing to represent (either by remaining outstanding or by being converted
into voting securities of the surviving entity (including the parent corporation
of such surviving entity)) at least fifty percent (50%) of the total voting
power represented by the voting securities of the Company or such surviving
entity outstanding immediately after such merger or consolidation, or the
approval by the stockholders of the Company of a plan of complete liquidation of
the Company or of an agreement for the sale or disposition by the Company of all
or substantially all the Company's assets.
(d) Disability. "Disability" means that the Employee has been
----------
unable to substantially perform his duties under this Agreement as the result of
his incapacity due to physical or mental illness, and such inability, at least
twenty-six (26) weeks after its commencement, is determined to be permanent by a
physician selected by the Company or its insurers and acceptable to the Employee
or the Employee's legal representative (such agreement as to acceptability not
to be unreasonably withheld).
(e) Exchange Act. "Exchange Act" means the Securities Exchange Act
------------
of 1934, as amended.
-4-
<PAGE>
(f) Involuntary Termination. "Involuntary Termination" means (i) any
-----------------------
purported termination of the Employee by the Company which is not effected for
Cause, or any purported termination for which the grounds relied upon are not
valid; (ii) termination of the Employee's employment with the Company by reason
of the Employee's death or Disability; (iii) the failure of the Company to
obtain the assumption of this agreement by any successors contemplated in
Section 10 below; (iv) Termination of the Employee's employment with the Company
for any reason other than by the Company for Cause during the six (6)-month
period following a Change in Control; (v) without the Employee's express written
consent, the relocation of the Employee to a facility or a location more than 50
miles from the Employee's then present location; (vi) without the Employee's
express written consent, a reduction by the Company in the Employee's Base
Compensation or Target Incentive relative to the Base Compensation or Target
Incentive as in effect immediately prior to such reduction; (vii) without the
Employee's express written consent, the significant reduction of the Employee's
duties, authority or responsibilities relative to the Employee's duties,
authority and responsibilities as in effect immediately prior to such reduction
or the assignment to the Employee of such reduced duties, authority or
responsibilities; (viii) without the Employee's express written consent,
material reduction by the Company in the kind or level of employee benefits to
which the Employee is entitled immediately prior to such reduction with the
result that the Employee's overall benefits package is significantly reduced;
(ix) failure to nominate the Employee to the Board or the Employee's failure to
win reelection to the Board; or (x) provision of notice of non-renewal or
extension or the term of this Agreement as provided for in Section 2.
(g) Termination Date. "Termination Date" means (i) the date on which
----------------
the Company delivers notice of termination to the Employee or such later date,
not to exceed ninety (90) days, specified in the notice of termination, (ii) in
the event the term of employment ends by reason of the Employee's death, the
date of death, or (iii) if the Agreement is terminated by the Employee, the date
on which the Employee delivers notice of termination to the Company.
8. Limitation on Payments. Notwithstanding anything to the contrary
----------------------
contained herein, in the event it shall be determined that any payment by the
Company to or for the benefit of the Employee, whether paid or payable but
determined without regard to any additional payments required under this Section
8 (a "Payment"), would be subject to the excise tax imposed by Section 4999 of
the Internal Revenue Code of 1986, as amended (the "Code"), or any comparable
federal, state, or local excise tax (such excise tax, together with any interest
and penalties, are hereinafter collectively referred to as the "Excise Tax"),
then the Employee shall be entitled to receive an additional payment from the
Company (a "Gross-Up Payment") in such an amount that after the payment of all
taxes (including, without limitation, any interest and penalties on such taxes
and the Excise Tax) on the payment and on the Gross-Up Payment, the Employee
shall retain an amount equal to the Payment minus all applicable taxes on the
Payment. The intent of the parties is that the Company shall be solely
responsible for, and shall pay, any Excise Tax on the Payment and Gross-Up
Payment and any income and employment taxes (including, without limitation,
penalties and interest) imposed on any Gross-Up Payment,as well as any loss of
tax deduction caused by the Gross-Up Payment. All determinations required to be
made under this Section, including without limitation, whether and when a
Gross-Up Payment is required and the amount of such Gross-Up Payment and the
assumptions to be utilized in arriving at such determinations, shall be made
-5-
<PAGE>
in writing in good faith by the accounting firm serving as the Company's
independent public accountants immediately prior to the event giving rise to
such Payment (the "Accountants"). For purposes of making the calculations
required by this Section 8, the accountants may make reasonable assumptions and
approximations concerning the application of Sections 280G and 4999 of the Code.
The Company and the Employee shall furnish to the Accountants such information
and documents as the Accountants may reasonably request to make a determination
under this Section. The Company shall bear all costs the Accountants may
reasonably incur in connection with any calculations contemplated by this
Section.
9. Non-Compete: Non-Solicit.
------------------------
(a) The parties hereto recognize that the Employee's services are
special and unique and that the level of compensation and the provisions herein
for compensation upon Involuntary Termination are partly in consideration of and
conditioned upon the Employee's not competing with the Company, and that the
Employee's covenant not to compete or solicit as set forth in this Section 9
during and after employment is essential to protect the business and good will
of the Company.
(b) The Employee agrees that during the term of employment with the
Company and for a period ending twenty-four (24) months following the
Termination Date (the "Covenant Period"), the Employee will not either directly
or indirectly, whether as a director, officer, consultant, employee or advisor
or in any other capacity render any planning, marketing or other services
respecting the creation, design, license or sale of software products used to
develop mission critical software applications for use by any business, agency,
partnership or entity. For purposes of this Section 9, the term "Company"
shall mean and include the Company, any subsidiary or affiliate of the Company,
any successor to the business of the Company (by merger, consolidation, sale of
assets or stock or otherwise) and any other corporation or entity in which the
Employee may serve as a director, officer or employee at the request of the
Company or any successor of the Company.
(c) During the Covenant Period, the Employee will not, directly or
indirectly, induce or attempt to influence any employee of the Company to leave
its employ and the Employee will not, directly or indirectly, become involved in
decisions to hire any employee who has left the Company's employ within the
three (3)-month period preceding the Termination Date or the three (3)-month
following the Termination Date. This provision shall not apply to individuals
who were employed by the Employee's present employer during the three (3)-month
period ending on the Effective Date, and, in addition, shall not be construed to
affect any responsibility the Employee has with respect to the bonafide hiring
and firing of Company personnel.
(d) The Employee agrees that the Company would suffer an irreparable
injury if the Employee were to breach the covenants contained in Sections 9(b)
or (c) and that the Company would by reason of such breach or threatened breach
be entitled to injunctive relief in a court of appropriate jurisdiction and the
Employee hereby stipulates to the entering of such injunctive relief prohibiting
the Employee from engaging in such breach.
-6-
<PAGE>
(e) If any of the restrictions contained in this Section 9 shall be
deemed to be unenforceable by reason of the extent, duration or geographical
scope or other provisions thereof, then the parties hereto contemplate that the
court shall reduce such extent, duration, geographical scope or other provision
hereof and enforce this Section 9 in its reduced form for all purposes in the
manner contemplated hereby.
10. Successors.
----------
(a) Company's Successors. Any successor to the Company (whether
--------------------
direct or indirect and whether by purchase, lease, merger, consolidation,
liquidation or otherwise) to all or substantially all of the Company's business
and assets shall assume the obligations under this Agreement and agree expressly
to perform the obligations under this Agreement in the same manner and to the
same extent as the Company would be required to perform such obligations in the
absence of a succession. For all purposes under this Agreement, the term
"Company" shall include any successor to the Company's business and assets which
executes and delivers the assumption agreement described in this Section 10(a)
or which becomes bound by the terms of this Agreement by operation of law.
(b) Employee's Successors. The terms of this Agreement and all
---------------------
rights of the Employee hereunder shall inure to the benefit of, and be
enforceable by, the Employee's personal or legal representatives, executors,
administrators, successors, heirs, devisees and legatees.
11. Notice.
------
(a) General. Notices and all other communications contemplated by
-------
this Agreement shall be in writing and shall be deemed to have been duly given
when personally delivered or when mailed by U.S. registered or certified mail,
return receipt requested and postage prepaid. In the case of the Employee,
mailed notices shall be addressed to him at the home address which he most
recently communicated to the Company in writing. In the case of the Company,
mailed notices shall be addressed to its corporate headquarters, and all notices
shall be directed to the attention of its Secretary.
(b) Notice of Termination. Any termination by the Company for Cause
---------------------
or by the Employee as a result of an Involuntary Termination shall be
communicated by a notice of termination to the other party hereto given in
accordance with Section 11(a) of this Agreement. Such notice shall indicate the
specific termination provision in this Agreement relied upon, shall set forth in
reasonable detail the facts and circumstances claimed to provide a basis for
termination under the provision so indicated, and shall specify the Termination
Date (which shall be not more than ninety (90) days after the giving of such
notice). The failure by the Employee to include in the notice any fact or
circumstance which contributes to a showing of Involuntary Termination shall not
waive any right of the Employee hereunder or preclude the Employee from
asserting such fact or circumstance in enforcing his rights hereunder.
-7-
<PAGE>
12. Miscellaneous Provisions.
------------------------
(a) No Duty to Mitigate. The Employee shall not be required to
-------------------
mitigate the amount of any payment contemplated by this Agreement (whether by
seeking new employment or in any other manner), nor shall any such payment be
reduced by any earnings that the Employee may receive from any other source.
(b) Waiver. No provision of this Agreement shall be modified,
------
waived or discharged unless the modification, waiver or discharge is agreed to
in writing and signed by the Employee and by an authorized officer of the
Company (other than the Employee). No waiver by either party of any breach
of, or of compliance with, any condition or provision of this Agreement by the
other party shall be considered a waiver of any other condition or provision
or of the same condition or provision at another time.
(c) Whole Agreement. No agreements, representations or
---------------
understandings (whether oral or written and whether express or implied) which
are not expressly set forth in this agreement have been made or entered into by
either party with respect to the subject matter hereof.
(d) Choice of Law. The validity, interpretation, construction and
-------------
performance of this Agreement shall be governed by the laws of the State of
California.
(e) Severability. The invalidity or unenforceability of any
------------
provision or provisions of this Agreement shall not affect the validity or
enforceability of any other provision hereof, which shall remain in full force
and effect.
(f) Arbitration. Any dispute or controversy arising out of,
-----------
relating to or in connection with this Agreement shall be settled exclusively by
binding arbitration in San Jose, California, in accordance with the National
Rules for the Resolution of Employment Disputes of the American Arbitration
Association then in effect. Judgment may be entered on the arbitrator's award
in any court having jurisdiction. The Company and the Employee shall each pay
one-half of the costs and expenses of such arbitration, and each shall
separately pay its counsel fees and expenses. Punitive damages shall not be
awarded.
(g) No Assignment of Benefits. The rights of any person to
-------------------------
payments or benefits under this Agreement shall not be made subject to option or
assignment, either by voluntary or involuntary assignment or by operation of
law, including (without limitation) bankruptcy, garnishment, attachment or other
creditor's process, and any action in violation of this Section 12(g) shall be
void.
(h) Employment Taxes. All payments made pursuant to this
----------------
Agreement will be subject to withholding of applicable income and employment
taxes.
-8-
<PAGE>
(i) Assignment by Company. The Company may assign its rights under
---------------------
this Agreement to an affiliate, and an affiliate may assign its rights under
this Agreement to another affiliate of the Company or to the Company; provided,
however, that no assignment shall be made if the net worth of the assignee is
less than the net worth of the Company at the time of assignment. In case of
any such assignment, the term "Company" when used in a section of this
Agreement shall mean the corporation that actually employs the Employee.
(j) Counterparts. This Agreement may be executed in counterparts,
------------
each of which shall be deemed an original, but all of which together will
constitute one and the same instrument.
IN WITNESS WHEREOF, each of the parties has executed this Agreement, in the
case of the Company by its duly authorized officer, as of the day and year first
above written.
COMPANY: RATIONAL SOFTWARE CORP.
By: ____________________________
Title: _________________________
EMPLOYEE: _________________________________
-9-
<PAGE>
EXHIBIT 10.05
RATIONAL SOFTWARE CORPORATION
April 1, 1998
Re: REPRICING OF OPTIONS
--------------------
Dear Optionee:
The Compensation Committee of the Board of Directors of Rational Software
Corporation (the "Company") has authorized the repricing of stock options held
by certain of the officers of the Company. This program covers those options
(collectively, the "Old Options") whose exercise price exceeds the closing price
of the Company's Common Stock on April 2, 1998. Participation by each option
holder is, of course, voluntary. In order to participate, you must execute the
enclosed form entitled "Repricing of Stock Options" and return it to my
attention at the Company either by facsimile transmission at (408) 863-4141 or
by mail to: 18880 Homestead Road, Cupertino, CA 95014, for receipt by me no
later than 1:00 p.m. Pacific Standard Time, on April 3, 1998.
The principal features of the repriced options (collectively, the "Repriced
Options") will be the same as the Old Options (including number of shares,
vesting and expiration date), except as follows:
1. Limitations On Disposition. None of the shares purchased pursuant to
--------------------------
Repriced Options may be sold or otherwise disposed of until April 3, 1999. On or
after April 3, 1999, up to fifty percent (50%) of the then-vested shares subject
to Repriced Options may be sold or otherwise disposed of. On or after April 3,
2000, 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.
2. Buy Back Right. 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 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%)
<PAGE>
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, though
offerings to "the public" shall not constitute such a change in control).
Nothing in this stock option repricing program derogates from or changes
the economic benefits as intended by and set forth in any employment agreement
between the optionee and the Company ("Employment Agreement"), and that in the
event of any conflict or inconsistency between the provisions of the Employment
Agreement and this repricing program, then the provisions of the Employment
Agreement shall govern. If, in connection with any involuntary termination (as
such term or any similar term may be defined in any Employment Agreement), the
optionee shall become entitled to full vesting and exercisability of stock
options pursuant to such Employment Agreement, then all lock-up and buy-back
provisions contained in this repricing program shall cease and be of no further
force or effect with respect to any shares issued or issuable to such person
pursuant to any stock options.
3. Exercise Price. The exercise price of the Repriced Options will be
--------------
the closing price of the Company's Common Stock on April 2, 1998.
If you elect to reprice an incentive stock option, the two-year holding
period applicable to incentive stock options will commence on April 3, 1998, the
grant date that the Compensation Committee of the Board has set for such
Repriced Options.
Please note that in the event you receive a repriced incentive stock option
for which the aggregate exercise price of shares first becoming purchasable in
any calendar year exceeds $100,000, the portion so purchasable in excess of
$100,000 will be treated for federal tax purposes as a nonstatutory stock option
rather than as an incentive stock option. For this purpose, shares that first
become purchasable in 1998 under the Repriced Option include the carryover
vesting for the Old Option. A summary of the difference in the tax treatment
between nonstatutory stock options and incentive stock options is attached
hereto as Exhibit A.
Attached hereto as Exhibit B is a schedule showing your outstanding stock
options as of April 1, 1998.
Please note that, for your protection, if you submit the above-enumerated
-------------------------------------------------------------------------
paperwork to reprice an Old Option and the exercise price of the Repriced
- -------------------------------------------------------------------------
Options ultimately exceeds that of the Old Option, that Old Option will NOT be
- ------------------------------------------------------------------------------
repriced.
- ---------
After April 3, 1998, the option repricing program will lapse.
- ------------------------------------------------------------
Very truly yours,
Timothy A. Brennan
Senior Vice President,
Chief Financial Officer and Secretary
<PAGE>
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 April 1, 1998 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 April 1, 1998
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 April 3, 1999. On or after April 3, 1999,
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 April 3, 2000, 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 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
1
<PAGE>
REPRICING OF STOCK OPTIONS
--------------------------
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, though 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.
Nothing in this stock option repricing program derogates from or changes
the economic benefits as intended by and set forth in any employment agreement
between the optionee and the Company ("Employment Agreement"), and that in the
event of any conflict or inconsistency between the provisions of the Employment
Agreement and this repricing program, then the provisions of the Employment
Agreement shall govern. If, in connection with any involuntary termination (as
such term or any similar term may be defined in any Employment Agreement), the
optionee shall become entitled to full vesting and exercisability of stock
options pursuant to such Employment Agreement, then all lock-up and buy-back
provisions contained in this repricing program shall cease and be of no further
force or effect with respect to any shares issued or issuable to such person
pursuant to any stock options.
(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.
- ------------------------------------------------
Please Fax to: Timothy A. Brennan, (408) 863-4141
- -------------
Mail original to: Rational Software Corporation
- ---------------- Attn.: Timothy A. Brennan
18888 Homestead Road
Cupertino, CA 95014
2
<PAGE>
EXHIBIT 21.01
LIST OF WHOLLY OWNED SUBSIDIARIES
RATIONAL SOFTWARE CORPORATION
NAME JURISDICTION OF INCORPORATION
- ------------------------------------- --------------------------------------
Pure Atria Corporation Delaware
Rational SQA, Inc. Delaware
Integrity QA Software, Inc. Delaware
Pure Atria Software Ltd Canada
Rational Software Corporation Ltd United Kingdom
Rational SARL France
Rational GmbH Germany
Rational Software Holdings BV Netherlands
Rational Software Benelux BV Netherlands
Rational Software Scandinavia AB Sweden
Softlabs AB Sweden
63
<PAGE>
Rational Software Switzerland GmbH Switzerland
Rational Software Corp Pty Ltd. Australia
Rational Software Korea Limited Korea
Rational Software Do Brasil Ltda. Brazil
Rational Software Corporation Pvt. India
Rational Software New Zealand Limited New Zealand
Rational Software China Ltd Hong Kong
Nihon Rational KK Japan
Rational International California
Rational Software FSC, Inc. Barbados
64
<PAGE>
EXHIBIT 23.01
CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
We have audited the consolidated financial statements of Rational
Software Corporation as of March 31, 1998 and 1997, and for each of the three
years in the period ended March 31, 1998, and have issued our report thereon
dated April 21, 1998, except for Note Fifteen, as to which the date is April 23,
1998 (included elsewhere in this Annual Report on Form 10-K). Our audits also
included the financial statement schedule of Rational Software Corporation
listed in Item 14(a). This schedule is the responsibility of the Company's
management. Our responsibility is to express an opinion based on our audits. In
our opinion, the financial statement schedule referred to above, when considered
in relation to the basic financial statements taken as a whole, presents fairly
in all material respects the information set forth therein.
We also consent to the incorporation by reference in the Registration
Statements (Form S-8 No. 33-77382, No. 33-85906, No. 33-97044, No. 333-15015,
No. 333-15007, No. 333-21563, No. 333-22687, No. 333-25815, No. 333-31505, No.
333-32991, No. 333-39455, No. 333-39569, No. 333-45393 and No. 333-52017)
pertaining to the Rational 1983 Incentive Stock Option Plan, Verdix
Corporation 1983 Incentive Stock Option Plan, Verdix Corporation 1986 Stock
Option Plan, Rational 1993 Stock Option, Rational Software Corporation 1994
Stock Option Plan, Rational Software 1994 Employee Stock Purchase Plan,
Requisite, Inc., 1994 Stock Option Plan, SQA 1995 Stock Plan, SQA 1995
Employee Stock Purchase Plan, SQA 1995 NonEmployee Director Stock Option Plan,
SQA 1990 Incentive and Nonqualified Stock Option Plan, Rational Software
Corporation 1997 Stock Plan, Performance Awareness Corporation 1997 Stock
Plan, Rational Software Corporation 1997 Supplemental Stock Plan, Pure Atria
1995 Stock Plan, Pure Software, Inc. 1992 Stock Option/Stock Issuance Plan,
Atria Software, Inc. 1994 Stock Plan, Atria Software, Inc. 1994 Non-Employee
Director Stock Option Plan, Atria Software, Inc. 1990 Stock Option Plan,
Integrity QA Software, Inc. 1995 Stock Option Plan, Performix, Inc. 1991 Stock
Option Plan, QualTrak 1994 Stock Option Plan, Vigor Technology, Inc. 1996
Stock Option Plan and 1998 Indian Stock Option Plan of our report dated April
21, 1998, except for Note Fifteen, as to which the date is April 23, 1998,
with respect to the consolidated financial statements included herein and our
report included in the preceding paragraph with respect to the financial
statement schedule included in this Annual Report (Form 10-K) of Rational
Software Corporation.
/s/ Ernst & Young LLP
Palo Alto, California
May 28, 1998
<PAGE>
EXHIBIT 23.02
CONSENT OF KPMG PEAT MARWICK LLP, INDEPENDENT AUDITORS
The Board of Directors
Rational Software Corporation
We consent to incorporation by reference in the registrations statements
(Nos. 33-77832, 33-85906, 33-97044, 333-15007, 333-15015, 333-21563, 333-
22687, 333-25815, 333-31505, 333-32991, 333-39455, 333-39569, 333-45393 and
333-52017) on form S-8 of Rational Software Corporation of our report dated
January 21, 1997, except as to Note 2, which is as of January 21, 1997,
relating to the consolidated balance sheet of Pure Atria Corporation and
subsidiaries as of December 31, 1996 and the related consolidated statements
of operations, redeemable convertible preferred stock and stockholders'equity,
and cash flows for each of the years in the two-year period ended December 31,
1996 which report appears in the March 31, 1998, annual report on Form 10-K of
Rational Software Corporation.
/s/ KPMG Peat Marwick LLP
Mountain View, California
May 28, 1998
<PAGE>
EXHIBIT 23.03
CONSENT OF ARTHUR ANDERSEN LLP, INDEPENDENT AUDITORS
The Board of Directors
Rational Software Corporation
As independent public accountants, we hereby consent to the incorporation by
reference of our report dated January 26, 1996 relating to the consolidated
balance sheets of SQA, Inc. as of December 31, 1994 and 1995 and the related
consolidated statements of operations, stockholders' equity (deficit) and cash
flows for each of the three years in the period ended December 31, 1995,
included in this annual report on Form 10-K, into Rational Software's previously
filed Registration Statement No.'s 33-77382, 33-85906, 333-15007, 333-15015,
333-21563, 333-22687, 333-25815, 333-31505, 333-32991, 333-39455, 333-39569,
333-45393 and 333-52017 on form S-8.
/s/ Arthur Andersen LLP
Boston, Massachusetts
May 26, 1998
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