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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 2054
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997
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COMMISSION FILE NUMBER 000-20873
CONNECT, INC.
(Exact Name of Registrant as Specified in Its Charter)
__________________
DELAWARE 77-0431045
(State or Other Jurisdiction (I.R.S. Employer Identification Number)
of Incorporation or Organization)
CONNECT, INC.
515 ELLIS STREET
MOUNTAIN VIEW, CA 94043-2242
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (650)254-4000
__________________
Securities registered pursuant to Section 12(b) of the Act: NONE
Securities registered pursuant to Section 12(g) of the Act:
COMMON STOCK, $.001 PAR VALUE PER SHARE
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate 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 amendments to
this Form 10-K. [X]
As of February 28, 1998 there were 4,091,010 shares of Registrant's common
stock outstanding (as adjusted to reflect the one-for-five reverse stock split
effected in February, 1998), and the aggregate market value of such shares held
by non-affiliates of the Registrant (based upon the closing sale price of such
shares on the Nasdaq National Market on March 3, 1998) was approximately $3.0
million. Shares of Registrant's common stock held by each executive officer
and director and their affiliated entities have been excluded in that such
persons may be deemed to be affiliates. This determination of affiliate status
is not necessarily a conclusive determination for other purposes.
DOCUMENTS INCORPORATED BY REFERENCE
-----------------------------------
Designated portions of Registrant's definitive proxy statement for the 1998
Annual Meeting of Stockholders to be held on May 28, 1998 are incorporated by
reference into this Form 10-K where indicated.
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PART I.
ITEM I. BUSINESS
BUSINESS
This description contains certain forward-looking statements that involve
risks and uncertainties. The Company's actual results could differ materially
from the results discussed in the forward-looking statements as a result of
certain of the risk factors set forth below and elsewhere in this Form 10-K.
The Company assumes no obligation to update any forward-looking statements
contained herein.
OVERVIEW
CONNECT provides enterprise-class software for Internet-based electronic
commerce. The Company's flagship applications, OrderStream and PurchaseStream,
allow global companies to automate order capture and sales channels, improve
customer service and streamline distribution and requisitioning processes.
The Company's software supports key functions necessary for large-scale
electronic commerce and Intranet requisitioning, including user registration,
multimedia catalog and content management, dynamic merchandising, order capture
and management, security, payment processing, customer service, procurement
management and purchase controls, enterprise integration and systems
administration.
CONNECT's end-to-end software solutions are designed to reduce the time and
overall cost for businesses to implement and maintain a secure sales and order
capture capability on the World Wide Web or an Intranet requisitioning system
via an Intranet.
The Company's products and services offer the following benefits versus
competing products:
. Extensive packaged functionality. CONNECT applications provide comprehensive
and robust functionality to address buying and selling over the Internet.
From electronic order formulation and capture, personalized catalogs and
transaction management, to online order status checking, CONNECT applications
have extensive, out-of-the-box features, functions and business rules to
support buying and selling over the Internet. This allows companies to focus
on tailoring the Company's applications for their specific business.
. Business-to-business focus. CONNECT application functionality is focused on
the unique requirements of relationship-centric, business-to-business
commerce. Supported business-to-business features include custom catalog
views, complex order management, purchase controls, approval routing, and
support for procurement cards and blanket purchase orders.
. Faster time to market. The Company believes that time to market is a critical
objective for most enterprises, The Company launched the QuickStart program
to accelerate customer application implementations. CONNECT QuickStart is
directed at companies who wish to take a phased approach to interactive
commerce--creating a live, revenue-generating Web site as quickly as possible
with less assistance, reduced transaction capacity and reduced initial
license fees. Customers can then scale the application, adding more
transaction capacity at a later date for an additional license fee.
QuickStart not only helps companies "go live" faster, but reduces the cost
and risks associated with launching a commerce site.
. Lower cost of ownership. CONNECT's applications are designed to reduce the
overall cost of maintaining as well as deploying an Internet-based commerce
system. The Company's open architecture, pre-built functions and integrated
approach limit custom coding, thereby reducing implementation and ongoing
maintenance costs.
. Easy integration with enterprise systems. Most companies have invested
significant amounts building their back-end enterprise systems. CONNECT lets
companies leverage those investments by offering tight integration with
existing Order Management, Inventory, Accounting, and other systems. Using
CONNECT's Information Exchange Gateway (IEG), companies have a powerful
graphical data mapping and translation tool with built-in support for SAP,
Baan, EDI and other common data formats.
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. Extensible architecture. CONNECT's applications are based on a firm
foundation of industry-standard technology, and support all relevant Internet
and electronic commerce standards. With CONNECT's Application Workbench,
companies can more easily design, deploy and maintain their commerce sites.
PRODUCTS AND SERVICES
CONNECT's OrderStream and PurchaseStream are enterprise-class applications
designed to support high volumes of business-to-business electronic commerce
transactions at global, Fortune-class companies. Based on CONNECT's OneServer
commerce platform, OrderStream and PurchaseStream enable companies to quickly
automate order capture and customer service, and streamline distribution and
purchasing processes. With applications that automate both buy- and sell-side
electronic commerce transactions, plus toolsets for application development and
back-end integration, the Company believes that it currently provides one of the
most comprehensive product lines available on the market today.
OrderStream
OrderStream is an Internet-based order capture and customer service system
designed to automate and streamline the selling of contract-based goods and
services. OrderStream is an integrated solution that can accelerate the process
of launching a robust, transaction-enabled commerce site. OrderStream is a
vertically targeted solution ideal for manufacturers and resellers of various
finished goods such as industrial equipment and supplies, computers and software
and office supplies.
Features of the OrderStream application include personalized catalog browse
and search capabilities, purchase controls, electronic order creation and
submission, online order status checking, order approval routing, real-time
access by customer service personnel, and catalog and product-database
management. OrderStream allows sellers to offer a complementary sales channel
for their customers or channel partners 24 hours a day, 7 days a week. This
sales channel is fully transaction-enabled and robust, enabling customers to
easily browse and search through catalogs, place orders and check on previously
placed orders. Other key benefits to the seller include lowered order
processing costs, decreased order cycle time and increased marketing
capabilities to customers, all of which can translate to higher revenues and
market share.
OrderStream version 1.0 was commercially released in June 1996. Version 1.1
was commercially released in December 1996. Version 2.0 was released in May
1997.
The Company has licensed its OrderStream software to customers for fees
ranging from approximately $100,000 to more than $1 million. The amount of
revenue derived from a particular sale depends on a number of factors, including
the number of computer processors, complexity of the customer application
supported, amount of necessary customization and other factors. The Company
charges separately for professional services and annual fees for maintenance and
support.
Purchase Stream
PurchaseStream is an Intranet-based requisitioning system that simplifies and
streamlines acquisition of indirect goods and services. With PurchaseStream,
end-user requisitioners can browse and search across approved supplier catalogs
and place secure online orders for routine transactions. The purchasing
department maintains control over this distributed requisitioning environment
through automated purchase controls and user profiles which enforce purchasing
restrictions and rules typically enforced in a manual review process.
PurchaseStream is a horizontal solution that addresses the needs of any large
corporation with hundreds to thousands of requisitioners, seeking to reduce
purchasing and processing costs. Aside from cost savings, buying organizations
using PurchaseStream benefit from increased productivity from their purchasing
department, reduced non-contract purchases, reduced inventory carrying costs and
increased volume discounts.
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Features of the PurchaseStream application include powerful search and browse
capabilities for viewing approved supplier catalogs, real-time order creation,
multiple payment options, purchase controls, approval routing, consolidated
order dispatches, and order-status tracking. PurchaseStream is a buyer-centric
application, so buying organizations control supplier catalog content as well as
user and department views.
PurchaseStream version 1.0 was released for general availability in December
1997.
The Company will be licensing its PurchaseStream software to customers for
fees ranging from approximately $150,000 to more than $1 million. The amount of
revenue derived from a particular sale depends on a number of factors, including
the number of computer processors, complexity of the customer application
supported, amount of necessary customization and other factors. The Company
charges separately for professional services and annual fees for maintenance and
support.
Other Products
In addition to these two applications, the Company also markets a
comprehensive development environment for building horizontal web applications.
This development environment consists of OneServer, a robust technology platform
for Web commerce and the Application Workbench, a suite of tools for managing
and deploying Web applications.
OneServer provides a scaleable and extensible development platform for
Internet commerce. OneServer integrates the key features and functions
necessary to implement large-scale applications, including built-in features
such as sales, marketing and order capture.
OneServer Version 1.0 was commercially released in September 1995, Version 2.0
was released in February 1997 and Version 2.5 was released in September 1997.
The Company has licensed its OneServer software to customers for fees ranging
from approximately $100,000 to over $1 million. Fees for professional services
and annual fees for maintenance and support are additional. The amount of
revenue derived from a particular sale depends upon a number of factors
including the number of computer processors, complexity of the customer
application supported, amount of necessary customization and other factors.
The CONNECT Application Workbench is a suite of industry-standard software
tools to automate the lifecycle management of OrderStream, PurchaseStream and
OneServer applications. Key components of the Application Workbench include an
Operations Monitoring tool for observing server and site performance, a Site
Manager for loading new objects and making modifications to the site, an Object
Designer for modifying the application design, an Application Component
Environment for Java and reporting and OLAP tools. The CONNECT Application
Workbench is available as an option to customers using OrderStream,
PurchaseStream and OneServer.
Finally, the Company markets a back-end integration tool as another option
available with its applications. Called Information Exchange Gateway (IEG), it
includes TSI Software's Mercator product pre-integrated with either OrderStream
or PurchaseStream. IEG simplifies linking to enterprise systems such as
Inventory, Order Entry, Accounting, etc. using a high performance graphical data
mapping and translation tool. This option is available to customers using the
Company's applications.
Services
The Company provides a full range of services to support the licensing of its
software applications. These services include project implementation and
training, maintenance and support, system hosting and online services. To retain
its focus on technology and software development, the Company leverages its own
capabilities through relationships with leading third-party providers of systems
integration and design services. The Company believes that the quality and
breadth of these services are an important competitive advantage.
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Implementation and Training. The Company offers fee-based services to help
customers design and implement OrderStream, PurchaseStream, and OneServer
applications. The Company and its Solution Partners work closely with customers
to clarify the project business case, define project scope and establish a
project plan and schedule. In addition, the Company offers fee-based education
and training on the use of its products to customers and third-party
implementation partners.
Maintenance and Support. The Company provides software maintenance including
product updates and technical support to its customers and Solutions Partners.
Fees charged depend upon the support level and size of the customer's
application.
Hosting Services. CONNECT offers system hosting services for its customers'
OrderStream, PurchaseStream and OneServer applications. These services include
installing the application on a remote server located at CONNECT's headquarters
or a Solution Partner's site, maintaining and administering the database, and
other system management services. The Company provides these services on a fee
basis to customers who do not want to operate and manage their own Internet-
based applications. The Company is actively recruiting Solutions Partners to
provide such hosting services.
Online Services. From 1988, the Company provided private online services to
various businesses and other organizations. These services through fiscal 1997
included e-mail, user forums and access to public and private information
resources and are marketed under the CONNECT Online brand name. The Company
transferred effective December 31, 1997, the online services business to a new
company formed primarily by former CONNECT employees, thus allowing the Company
to focus entirely on its electronic commerce applications software business.
Licensing and Third-Party Software. The Company typically provides its
software products to its customers under nonexclusive object code licenses.
Generally, CONNECT sublicenses to its customers third-party software integrated
in the Company's software, including a relational database management system
from Oracle, a web server from Netscape, a text search engine from Fulcrum and
encryption technology from RSA. In addition, the Company bundles certain
reporting software from COGNOS with each copy of OneServer. The Company's
customers also may obtain such licenses directly from such third-party software
vendors.
CUSTOMERS
As of December 31, 1997, CONNECT had licensed either OneServer or OrderStream
to over thirty customers. The Company shipped its first two copies of Purchase
Stream in late December.
There can be no assurance that the applications that have not yet been
implemented will be deployed on a timely basis. Delays on implementation could
have an adverse effect on the Company's revenues and results of operations.
Two customers accounted for 18% and 12% of the Company's revenue in 1997.
TECHNOLOGY
The Company's technology represents a third generation software architecture
based on the Company's experience in the electronic commerce applications
market. The two flagship applications, OrderStream and PurchaseStream are built
on a 3-tier model, consisting of a presentation layer, a business rules layer
and finally the business objects layer. This framework separates the
presentation from business logic and enables a manageable, scaleable and
extensible application.
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The Company's underlying OneServer platform has a software architecture is
comprised of six tightly integrated layers:
Business Objects. OneServer includes pre-packaged business functionality or
objects designed for use in electronic commerce. Customers can extend these
objects or build new objects quickly and easily to match precise business
requirements. The pre-packaged objects support common sales and marketing and
other business functions including user registration, advertising, multimedia
catalog and content management, dynamic merchandising, browsing and searching,
order management, security and authorization, transaction processing,
enterprise integration and system administration.
Client Support. OneServer works with leading Web browsers and supports HTML
and Web standards such as HTTP (Hypertext Transfer Protocol) and SSL (Secure
Sockets Layer), an encryption-based security protocol. In addition, for more
complex applications, OneServer supports Microsoft's Visual Basic, ActiveX and
Visual C++ programming languages, as well as Sun Microsystems' Java, a
network-specific programming language.
HTML Template Engine. The OneServer HTML Template Engine separates the
management of database content from the presentation format. The HTML Template
Engine combined with the Object Manager reduces the amount of custom code and
CGI (Common Gateway Interface, a standard for interfacing external
applications with information servers) scripting needed to dynamically create
HTML pages, thereby improving time to market, lowering maintenance costs and
improving system performance.
Transaction Manager. OneServer's Transaction Manager offers robust security
and authentication protection. The Transaction Manager features multi-
processing and multi-threading, thereby enabling OneServer and OrderStream to
scale across multiple processors to accommodate large numbers of purchasers,
products and transactions. In addition, the Transaction Manager ensures
application-wide data consistency regardless of data type (e.g., text, graphic
and structured), and includes the Company's RAMP (Reprioritizable Asynchronous
Multi-threaded Protocol), a client/server protocol for handling transactions,
as well as a transaction dispatcher and monitor.
Object Manager. The OneServer Object Manager defines and manages objects
thereby extending the capabilities of the Oracle 7 database to handle custom
and predefined objects, including multimedia objects. These capabilities are
designed to allow customers to create robust, complex and flexible data
models. The Object Manager hides storage and access complexities, allowing the
customer to focus on automating business processes. The Object Manager allows
objects to be extended by inheriting characteristics from multiple parent
objects, reducing data redundancies and extraneous coding requirements. An
object's attributes can be accessed through the Internet-based URL reference
instead of custom code.
Industry Standard Technology. OneServer incorporates industry-leading
technology as part of its architecture, including the Oracle 7 relational
database management system, the Netscape Enterprise Server web server, the
Fulcrum text search engine and RSA encryption. The tight integration between
the Oracle 7 database and OneServer results in increased system performance
and transaction capacity. The Company's software applications run on the HP-UX
10 and Sun Solaris 2.4/2.5 versions of the UNIX operating system.
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MARKETING AND SALES
CONNECT's marketing efforts are focused on increasing awareness of CONNECT and
its products in selected target markets, and positioning CONNECT as a leading
electronic commerce software provider. CONNECT marketing programs have four
primary goals: lead generation, market education and awareness, sales
effectiveness and product management. The Company's market education and
awareness activities include seminars, speaking engagements and sponsorship of
market studies by leading industry analysts. In addition, CONNECT utilizes
direct mail, public relations, trade shows, telemarketing and innovative sales
tools to disseminate its marketing message, generate sales leads, and improve
sales effectiveness. CONNECT's product management staff works with customers and
industry experts to ensure that the Company's products will satisfy market
requirements.
The Company currently sells its products and related services using two
channels: a direct sales model and a "leveraged" direct sales model (using leads
referred by Solution Partners). The Company's selling efforts generally focus on
senior level executives in large corporations. The Company intends to expand
distribution of its OneServer product in the future to include indirect sales
channels, such as value-added resellers (VARs).
The Company markets and sells its products and services through an
organization consisting of 24 employees as of December 31, 1997, based
principally at the Company's corporate office in Mountain View, California, and
an office in Oak Brook Terrace, Illinois.
SOLUTION PARTNERS
A key element of the Company's strategy is to continue to expand its strategic
alliances with Solution Partners. The Company believes that such relationships
promote the visibility of its applications and enable the Company to supplement
its core products and services to provide a complete solution. The Company's
Solution Partners can be segmented into the following three categories:
Technology Providers. CONNECT has incorporated industry-leading software into
its products. The Company licenses and resells software from Oracle (relational
database management system), Netscape (web server), Fulcrum (text search engine)
and RSA (encryption). The Company also engages in joint marketing activities
with other technology companies, including Hewlett-Packard and Sun Microsystems.
Solution Enhancement. CONNECT is working with other companies that offer
additional complementary solution elements. These include TSI (data
mapping/backend integration), Rational Software (object modeling tool),
CyberCash, Inc. (payment processing), Verisign, Inc. (authentication), and
COGNOS (reporting tools).
Professional Services. CONNECT works with a group of leading professional
services organizations to assist customers in implementing OneServer and
OrderStream. These organizations are Ernst & Young LLP, Andersen Consulting,
Computer Sciences Corporation, Compuware Corporation, and Cambridge Technology
Partners. These providers perform services such as business process
reengineering and integration, database design and application development.
RESEARCH AND DEVELOPMENT
Since inception, the Company has made substantial investments in research and
product development. The Company's research and development expenses were $5.0
million in 1997, $4.7 million in 1996, and $4.8 million in 1995, and the Company
expects research and development expenses in 1998 to remain similar to 1997
levels. The Company's current software products have been developed primarily by
its internal product development staff. A significant portion of the Company's
development efforts during 1995 was performed under the Development Projects. In
general, under these Development Projects the Company retained ownership of the
technology being developed subject, in certain cases, to nonexclusive licenses
granted to the Company's customers.
The Company's research and development efforts are currently focused primarily
on adding functionality to the Company's PurchaseStream and OrderStream
application products. The Company's research and development
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staff consisted of 27 employees in the US plus, on a project contract basis,
approximately 8 developers in Malaysia as of December 31, 1997. The level of
research and development costs will vary, however, depending upon the amount of
development work being performed by the Company.
The Company's success will depend upon its ability to develop new products and
provide new services that meet changing customer requirements. The market for
the Company's products is characterized by rapidly changing technology, evolving
industry standards and customer requirements, emerging competition and frequent
new product and service introductions. As a result, the Company may be required
to change and improve its products in response to changes in operating systems,
application and networking software, computer and communications hardware,
programming tools and computer language technology. There can be no assurance
that the Company can successfully respond to changing technology, identify new
product opportunities or develop and bring new products and services to market
in a timely manner. Failure of the Company, for technological or other reasons,
to develop and introduce new products and product enhancements and new services
that are compatible with industry standards and that satisfy customer
requirements would have a material adverse effect on the Company's business,
operating results and financial condition.
COMPETITION
The market for electronic commerce software is new, rapidly evolving and
intensely competitive. The Company expects competition to intensify in the
future.
The Company competes with vendors of prepackaged electronic commerce software,
vendors of software tools for developing electronic commerce applications,
system integrators and providers of business application software. In addition,
potential customers may elect to develop their own electronic commerce
solutions. The Company's competitors may compete with one or more of the
Company's applications. Competitors currently include Open Market, BroadVision,
Ariba and CommerceOne. The Company expects additional competition from other
emerging and established companies, including Microsoft, IBM/Lotus, Oracle,
Interworld, and Netscape (specifically the former Actra division) all of which
have announced or released products for Internet-based electronic commerce or
Intranet requisitioning. The Company's potential competitors also include a
number of successful client/server applications software companies, such as
Baan, PeopleSoft, Vantive and SAP, and EDI solution vendors, including Sterling
Commerce and General Electric Information Services ("GEIS").
Many of these competitors have longer operating histories and significantly
greater financial, technical, marketing and other resources than the Company and
thus may be able to respond more quickly to new or changing opportunities,
technologies and customer requirements. Also, many current and potential
competitors have greater name recognition and more extensive customer bases that
could be leveraged, thereby gaining market share to the Company's detriment.
Such competitors may be able to undertake more extensive promotional activities,
adopt more aggressive pricing policies and offer more attractive terms to
purchasers than the Company and to bundle their products in a manner that may
discourage users from purchasing products offered by the Company. In addition,
current and potential competitors have established or may establish cooperative
relationships among themselves or with third parties to enhance their products.
Accordingly, it is possible that new competitors or alliances among competitors
may emerge and rapidly acquire significant market share. There can be no
assurance that the Company will be able to compete effectively with competitors
or that the competitive pressures faced by the Company will not have a material
adverse effect on the Company's business, operating results and financial
condition.
The Company believes that rapid implementation of software applications is
critical to success in the Internet-based electronic commerce applications
market. The Company has a limited history in implementing its products and there
can be no assurance that the Company will be able to meet customer needs and
expectations in this regard. Additional competitive factors affecting the market
for the Company's services and software products include vendor and product
reputation, architecture, functionality and features, ease of use, time-to-
market, quality of support, product quality, performance and price. In order to
be successful in the future, the Company must continue to respond promptly and
effectively to the challenges of technical change and competitors' innovations.
Performance in these areas will, in turn, depend upon the Company's ability to
attract and retain highly qualified
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technical and sales personnel in a competitive market for experienced and
talented software developers, sales representatives and managers.
PROPRIETARY RIGHTS
The Company relies on trademark, copyright and trade secret laws, employee and
third-party non-disclosure agreements and other methods to protect its
proprietary rights. The Company does not currently have any patents or pending
patent applications. The Company believes that, due to the rapid pace of
technological innovation for Internet products, the Company's ability to
establish and maintain a position of technology leadership in the industry
depends more on the skills of its development personnel, new product
developments, frequent product enhancements, and name recognition than upon the
legal protections afforded its existing technology. The Company seeks to protect
its software, documentation and other written materials under trade secret and
copyright laws, which afford only limited protection. Despite the Company's
efforts to protect its proprietary rights, unauthorized parties may attempt to
copy aspects of the Company's products or to obtain and use information that the
Company regards as proprietary. Policing unauthorized use of the Company's
products is difficult, and while the Company is unable to determine the extent
to which piracy of its software products exists, software piracy can be expected
to be a persistent problem. In addition, the laws of some foreign countries do
not protect the Company's proprietary rights as fully as do the laws of the
United States. There can be no assurance that the Company's means of protecting
its proprietary rights in the United States or abroad will be adequate. There
can be no assurance that its agreements with employees, consultants and others
who participate in the development of its software will not be breached, that
the Company will have adequate remedies for any breach, or that the Company's
trade secrets will not otherwise become known to or independently developed by
competitors. Furthermore, there can be no assurance that the Company's efforts
to protect its rights through trademark and copyright laws will not fail to
prevent the development and design by others of products or technology similar
to or competitive with those developed by the Company.
The Company expects that software product developers will increasingly be
subject to infringement claims as the number of products and competitors in the
Company's industry segment grows and the functionality of products in different
industry segments overlaps and there can be no assurance that third parties will
not assert infringement claims against the Company. Any such claims, with or
without merit, could be time consuming to defend, result in costly litigation,
divert management's attention and resources, cause product shipment delays or
require the Company to enter into royalty or licensing agreements. Such royalty
or licensing agreements, if required, may not be available on terms acceptable
to the Company, if at all. In the event of a successful claim of product
infringement against the Company and failure or inability of the Company to
license the infringed or similar technology, the Company's business, operating
results and financial condition would be materially adversely affected.
EMPLOYEES
At December 31, 1997, CONNECT employed 93 people full time, 24 of whom were
involved in sales and marketing, 31 were involved in services, 27 were involved
in research and development and 11 were involved in finance and administration.
The Company reduced its workforce by 20% in April 1997 in an effort to reduce
operating expenses. The Company has not experienced any work stoppages and
considers its employee relations to be good.
FACTORS AFFECTING FUTURE RESULTS AND FINANCIAL CONDITION-RISK FACTORS
RECENT OPERATING RESULTS; ACCUMULATED DEFICIT AND ANTICIPATED FUTURE LOSSES.
The Company's recent operating results have been lower than expected. Total
revenues for the quarter ended December 31, 1997 and for the year ended December
31, 1997 were $2.3 million and $9.4 million, respectively, compared to revenues
of $3.2 million and $10.2 million for the same periods in the prior year. In
addition, the Company incurred net losses for the quarter ended December 31,
1997 and for the year ended December 31, 1997 of $3.1 million and $14.6 million,
respectively, compared to net losses of $3.1 million and $16.1 million for the
same periods in the prior year. The Company has not realized a profit in any
year, and as of December 31, 1997 had an accumulated deficit of approximately
$61.6 million. In 1997, 1996 and 1995, the Company experienced significant
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negative cash flow from operations. The Company has reduced its headcount from
144 at December 31, 1996 to 93 at December 31, 1997 as part of its efforts to
reduce operating expenses. Although the reduction in headcount could help the
Company meet its operating expense objectives, such reduction could adversely
impact the Company's sales, marketing and product development efforts. The
Company anticipates that operating expenses will continue to exceed revenues,
resulting in continuing net losses and negative cash flow from operations for
the foreseeable future. There can be no assurance that the Company can generate
revenue growth, or that any revenue growth that is achieved can be sustained. To
the extent that increases in such operating expenses precede or are not
subsequently followed by increased revenues, the Company's business, results of
operations and financial condition would be materially adversely affected. There
can be no assurance that the Company will ever achieve or sustain profitability.
POTENTIAL DILUTION TO STOCKHOLDERS. Each of the outstanding shares of Series
A Preferred Stock of the Company is convertible at the option of the holder into
that number of shares of Common Stock equal to the greater of (i) the quotient
obtained by dividing $2.00, plus accumulated but unpaid dividends, by the
conversion price (which initially is $10.00 per share and adjusts to $7.50 per
share on December 15, 1999) or (ii) the quotient obtained by dividing $2.00,
plus accumulated but unpaid dividends, by 80% (or 60% if the conversion occurs
after December 15, 1999) of the average closing bid price for the 10 trading
days prior to conversion. Existing stockholders could experience substantial
dilution as a result of the conversion of the Series A Preferred Stock into
shares of Common Stock.
FUTURE CAPITAL NEEDS. The Company has incurred net losses and experienced
significant negative cash flow from operations since inception. As of December
31, 1997, the Company had an accumulated deficit of approximately $61.6 million.
Based upon its current operating plan, the Company believes it has adequate cash
balances to fund its operations through at least December 31, 1998. There can
be no assurance, however, that the Company's actual cash requirements will not
exceed anticipated levels, or that the Company will generate sufficient revenue
to fund its operations in the absence of additional funding sources. If
additional funds are raised through the issuance of equity securities,
stockholders of the Company may experience additional dilution, or the
securities may have rights, preferences or privileges senior to those of the
Company's Common Stock. There can be no assurance that such additional
financing will be available on acceptable terms, if at all. If adequate funds
are not available or are not available on acceptable terms, the Company may be
unable to continue its operations, develop or enhance its products, take
advantage of future opportunities or respond to competitive pressures or other
requirements, any of which would have a material adverse effect on the Company's
business, operating results and financial condition.
FLUCTUATIONS IN QUARTERLY OPERATING RESULTS. The Company has experienced and
expects to continue to experience significant fluctuations in quarterly
operating results that may be caused by many factors including, among others,
the number, timing and significance of product enhancements and new product
announcements by the Company or its competitors, the ability of the Company to
develop, introduce and market new and enhanced versions of the Company's
products on a timely basis, the length of the Company's sales cycle, market
acceptance of and demand for the Company's products, the pace of development of
electronic commerce conducted on the Internet, the mix of the Company's products
sold, customer order deferrals in anticipation of enhancements or new products
offered by the Company or its competitors, nonrenewal of service agreements,
software defects and other product quality problems, the Company's ability to
attract and retain key personnel, the extent of international sales, changes in
the level of operating expenses and general economic conditions. The Company
anticipates that a significant portion of its revenue will be derived from a
limited number of orders placed by large corporations, and the timing of receipt
and fulfillment of any such orders is expected to cause material fluctuations in
the Company's operating results, particularly on a quarterly basis. The Company
expects to recognize the majority of its license revenue in the last month of
each quarter. As a result, any delay in delivery of products at the end of a
quarter could materially adversely affect operating results for that quarter.
Furthermore, the operating results of many software companies reflect seasonal
trends, and the Company expects to be affected by such trends in the future.
Due to the foregoing factors, quarterly revenue and operating results are
difficult to forecast. Revenue is also difficult to forecast because the market
for Internet-based packaged applications software is rapidly evolving and the
Company's sales cycle may vary substantially from customer to customer. Further,
the Company's expense levels are based, in significant part, on the Company's
expectations as to future revenue and are therefore relatively
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fixed in the short term. If revenue levels fall below expectations, as has
occurred during 1997, results of operations are likely to be disproportionately
adversely affected because a proportionately smaller amount of the Company's
expenses varies with its revenue. There can be no assurance that the Company
will be able to achieve or maintain profitability on a quarterly or annual basis
in the future. Due to the foregoing factors, the Company's operating results may
fall below the expectations of securities analysts and investors, would could
have a material adverse effect on the market price of the Company's Common
Stock.
RISKS ASSOCIATED WITH FAILURE TO MEET NASDAQ NATIONAL MARKET LISTING
REQUIREMENTS. In November 1997, the Company was informed by The Nasdaq Stock
Market, Inc. ("Nasdaq") that it did not meet the requirements for the continued
listing of its Common Stock on The Nasdaq National Market. Specifically,
Nasdaq's listing rules require the Company to maintain net tangible assets of at
least $4 million (the "NTA Requirement"), as set forth in Rule 4450 of Nasdaq's
Marketplace Rules (the "Rule"). The Company's net tangible assets were $2.4
million as of September 30, 1997. While the Company completed the sale and
issuance of convertible notes (the "Notes") in November 1997, which increased
the Company's cash assets by approximately $10 million, the Notes were
considered as debt and, therefore, the Company's net tangible assets did not
increase as a result of the transaction. In contrast, the Series A Preferred
Stock is considered as equity for financial accounting purposes. As a result,
the Company's net assets increased as a result of the exchange of the
outstanding Notes for shares of Series A Preferred Stock in February 1998.
Accordingly, the Company believes that it is in compliance with the NTA
Requirement as of the date hereof. Nevertheless, in order for the Company to
remain listed on The Nasdaq National Market, the Company must continue to meet
the following Nasdaq continuing listing criteria on an ongoing basis in addition
to the NTA Requirement: (i) nonaffiliates of the Company must hold at least
750,000 shares of Common Stock; (ii) nonaffiliates of the Company must hold at
least $5 million of Common Stock (the "Float Requirement"); (iii) the Company
must have at least 400 stockholders each holding at least 100 shares of Common
Stock; (iv) the minimum bid price of the Common Stock must be at least $1.00 per
share; and (v) the Company must have at least two market makers. There can be no
assurance that the Company will be able to maintain compliance with
the NTA Requirement or any such additional listing requirements. Recently, the
minimum bid price of the Common Stock has been below $1.00 at certain times. In
addition, the Company will only be deemed to be in compliance with the Float
Requirement if the shares of Series A Preferred Stock held by nonaffiliates of
the Company (which are convertible at the option of the holder into shares of
Common Stock) are deemed to be included in the calculation of Common Stock held
by nonaffiliates and the Company has not confirmed with Nasdaq that such
inclusion is appropriate. Furthermore, the Company had net operating losses of
$5.2 million, $3.2 million, $3.2 million and $3.1 million for the quarters ended
March 31, June 30, September 30 and December 31, 1997, respectively. Continued
significant losses by the Company would cause the Company's net tangible assets
to decline below $4 million. As a result of any or a combination of these
factors or the failure of the Company to satisfy any other requirements under
the Rule, the Common Stock would likely be delisted from The Nasdaq National
Market. The removal of the Common Stock from listing on The Nasdaq National
Market most likely would have a material adverse effect on the market price of
the Common Stock and on the ability of stockholders and investors to buy and
sell shares of the Common Stock in the public markets.
RECENT INTRODUCTION OF PRIMARY PRODUCTS; PRODUCT CONCENTRATION. Although the
Company was founded in 1987, in 1995 it initiated a new business strategy
focused on providing packaged software applications for Internet-based
electronic commerce. Consequently, the Company is dependent upon the successful
development, market acceptance and sales of OneServer, released in September
1995, OrderStream, released in June 1996, and PurchaseStream, released in
December 1997. Accordingly, the Company's business must be considered in light
of the risks, expenses and problems frequently encountered by companies in an
early stage of development, particularly companies in new and rapidly evolving
markets such as the Internet. Such risks include a lack of acceptance of
products and services by target customers, the development of equal or superior
products or services by competitors, the failure of electronic commerce in
general, and Internet-based electronic commerce in particular, to be broadly
adopted, the inability of the Company to develop and enhance competitive
products or to successfully commercialize any such products, and the inability
of the Company to identify, attract, retain and motivate qualified personnel.
There can be no assurance that the Company will succeed in addressing such
risks.
As of December 31, 1997, CONNECT had licensed OneServer or OrderStream to 30
customers and had licensed PurchaseStream to two customers. The Company expects
OneServer, OrderStream and PurchaseStream and related services to account for
most of its revenues for the foreseeable future. As a result, factors adversely
affecting the pricing of, or demand for OneServer, OrderStream and
PurchaseStream, such as competition, technological change, failure of the market
for Internet-based packaged applications to develop as the Company anticipates,
lack of customer acceptance of OneServer, OrderStream and PurchaseStream, or
failure of the Company to develop and introduce new and enhanced versions of
OneServer, OrderStream and PurchaseStream on a timely basis, could have a
material adverse effect on its business, operating results and financial
condition. Further, if any of the Company's customers are not able to
successfully develop and deploy electronic commerce applications with OneServer,
OrderStream or PurchaseStream or for any other reason are not satisfied with its
products or services, the Company's reputation could be damaged, which could
have a material adverse effect on its business, operating results and financial
condition.
DEPENDENCE UPON PRODUCT DEVELOPMENT; RISKS OF TECHNOLOGICAL CHANGE AND
EVOLVING INDUSTRY STANDARDS. The Company's success will depend upon its ability
to develop new products and provide new services that meet changing customer
requirements. The market for the Company's
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products is characterized by rapidly changing technology, evolving industry
standards and customer requirements, emerging competition and frequent new
product and service introductions. As a result, the Company may be required to
change and improve its products in response to changes in operating systems,
application and networking software, computer and communications hardware,
programming tools and computer language technology. In particular, the Company's
software operates on the HP-UX 10 and Sun Solaris 2.4/2.5 versions of the UNIX
operating system. The Company plans to port its software to the Windows NT
operating system from Microsoft Corporation ("Microsoft") in the future due to
increasing adoption of Windows NT by the Company's potential customers. The
Company has not begun the development work necessary to port its software to
Windows NT. There can be no assurance that the Company will be successful in
developing and marketing, on a timely basis, products ported to the Windows NT
operating system or any other operating system. As a result, any shift in the
market toward products running on operating systems other than UNIX, including
Windows NT, before the Company offers versions of its software running on such
operating systems, could have a material adverse effect on the Company's
business, operating results and financial condition. There can be no assurance
that the Company can successfully respond to changing technology, identify new
product opportunities or develop and bring new products and services to market
in a timely manner. The Company has in the past experienced delays in software
development and there can be no assurance that the Company will not experience
delays in connection with its current or future product development activities.
Delays and difficulties associated with new product introductions or product
enhancements could have a material adverse effect on the Company's business,
operating results and financial condition. Failure of the Company, for
technological or other reasons, to develop and introduce new products and
product enhancements and new services on a timely basis that are compatible with
industry standards and that satisfy customer requirements would have a material
adverse effect on the Company's business, operating results and financial
condition.
In addition, the Company or its competitors may announce enhancements to
existing products or services, or new products or services embodying new
technologies, industry standards or customer requirements that have the
potential to supplant or provide lower cost alternatives to the Company's
existing products and services. The introduction of such enhancements or new
products and services could render the Company's existing products and services
obsolete and unmarketable. There can be no assurance that the announcement or
introduction of new products or services by the Company or its competitors or
any change in industry standards will not cause customers to defer or cancel
purchases of existing products or services, which could have a material adverse
effect on the Company's business, operating results and financial condition.
Furthermore, introduction by the Company of products or services with
reliability, quality or compatibility problems could result in reduced orders,
delays in collecting accounts receivable and additional service costs. The
failure to introduce a new product, service or product enhancement on a timely
basis could delay or hinder market acceptance. Any such event could have a
material adverse effect on the Company's business, operating results and
financial condition.
COMPETITION. The market for electronic commerce software is new, rapidly
evolving and intensely competitive. The Company expects competition to intensify
in the future. The Company competes with vendors of prepackaged electronic
commerce software, vendors of software tools for developing electronic commerce
applications, system integrators and providers of business application software.
In addition, potential customers may elect to develop their own electronic
commerce solutions. The Company's current competitors include Open Market, Inc.,
BroadVision, Inc., Ariba and CommerceOne, and the Company expects additional
competition from other companies, including Microsoft, IBM/Lotus, Oracle
Corporation ("Oracle"), Interworld and Netscape Communications, Inc.
("Netscape") (specifically, its former Actra division), all of which have
announced or released products for Internet-based electronic commerce or
intranet requisitioning. The Company's potential competitors also include a
number of successful client/server applications software companies, such as Baan
Company, PeopleSoft, Inc., Vantive Corporation and SAP AG, and electronic data
interchange (EDI) solution vendors, including Sterling Commerce, Inc. and
General Electric Information Services Corporation.
Many of these competitors have longer operating histories and significantly
greater financial, technical, marketing and other resources than the Company and
thus may be able to respond more quickly to new or changing opportunities,
technologies and customer requirements. Also, many current and potential
competitors have greater
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name recognition and more extensive customer bases that could be leveraged,
thereby gaining market share to the Company's detriment. Such competitors may be
able to undertake more extensive promotional activities, adopt more aggressive
pricing policies and offer more attractive terms to purchasers than the Company
and to bundle their products in a manner that may discourage users from
purchasing products offered by the Company. In addition, current and potential
competitors have established or may establish cooperative relationships among
themselves or with third parties to enhance their products. Accordingly, it is
possible that new competitors or alliances among competitors may emerge and
rapidly acquire significant market share. There can be no assurance that the
Company will be able to compete effectively with competitors or that the
competitive pressures faced by the Company will not have a material adverse
effect on the Company's business, operating results and financial condition.
The Company believes that rapid implementation of software applications is
critical to success in the Internet-based electronic commerce applications
market. The Company has a limited history in implementing its products, and
there can be no assurance that the Company will be able to meet customer needs
and expectations in this regard. Additional competitive factors affecting the
market for the Company's services and software products include vendor and
product reputation, architecture, functionality and features, ease of use, time-
to-market, quality of support, product quality, performance and price. In order
to succeed, the Company must respond promptly and effectively to the challenges
of technical change and competitive innovations. Performance in these areas
will, in turn, depend upon the Company's ability to attract and retain highly
qualified technical and sales personnel in a highly competitive market.
MANAGEMENT OF RAPIDLY CHANGING BUSINESS; DEPENDENCE ON KEY PERSONNEL. The
Company's anticipated expansion of operations will place a significant strain on
the Company's managerial, operational and financial resources. To manage this
anticipated expansion, the Company must continue to implement and improve its
operational and financial controls and systems and to expand, train and manage
its employee base. Further, the Company will need to manage multiple
relationships with various customers and other third parties. There can be no
assurance that the Company will be able to implement on a timely basis the
systems, procedures or controls required to support its operations or that will
enable the Company to successfully market its products and services. The
Company's future operating results will also depend on its ability to expand its
sales and marketing organization, establish a distribution channel to penetrate
different and broader markets and expand its support organization. If the
Company is unable to respond effectively to changing business conditions, its
business, operating results and financial condition would be materially
adversely affected.
The Company's performance depends substantially on the performance of its
executive officers and key employees. The Company's future success also depends
on its continuing ability to identify, hire, train and retain other highly
qualified technical and managerial personnel. Competition for such personnel is
intense, and there can be no assurance that the Company will be able to attract,
assimilate or retain other highly qualified technical and managerial personnel
in the future. The inability to attract and retain its executive officers and
other key technical and managerial personnel could have a material adverse
effect upon the Company's business, operating results and financial condition.
UNCERTAIN ACCEPTANCE OF THE INTERNET AS A MEDIUM FOR ELECTRONIC COMMERCE. The
Company's future operating results depend upon the development and growth of the
market for Internet-based packaged software applications, including electronic
commerce applications. This market is new and rapidly evolving. The acceptance
of electronic commerce in general and, in particular, the Internet as a sales,
marketing and order capture medium are highly uncertain and subject to a number
of risks. Critical issues concerning the commercial use of the Internet
(including security, reliability, cost, ease of use, quality of service and the
effect of government regulation) remain unresolved and may impact the growth of
the Internet. If widespread use of the Internet for commercial transactions does
not develop or if the Internet does not develop as an effective sales, marketing
and order capture medium, the Company's business, operating results and
financial condition would be materially adversely affected.
The adoption of the Internet for sales, marketing, order capture and other
commercial transactions, and the development of a market for packaged electronic
commerce applications require acceptance of new ways of transacting business and
exchanging information. In particular, enterprises that have already invested
substantial
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resources in other means of transacting business may be particularly reluctant
to adopt a new strategy that may make certain of their existing personnel and
infrastructure obsolete. If the market for Internet-based packaged applications
fails to develop or develops more slowly than the Company anticipates, or if the
Company's products do not achieve market acceptance, the Company's business,
operating results and financial condition would be materially adversely
affected.
RISKS ASSOCIATED WITH COMPLEX SOFTWARE PRODUCTS; LENGTHY SALES AND
IMPLEMENTATION CYCLES. The Company's products are complex and expensive and
will generally involve significant investment decisions by prospective
customers. Accordingly, the license of the Company's software products is often
an executive-level decision by prospective customers and can be expected to
require the Company to engage in a lengthy sales cycle to provide a significant
level of education to prospective customers regarding the use and benefits of
the Company's products. In addition, the implementation of the Company's
products involves a significant commitment of resources by customers over an
extended period of time. As a result, the Company's sales and customer
implementation cycles are subject to a number of significant delays over which
it has little or no control. The Company has limited experience with
implementing its applications, and most of the Company's OneServer, OrderStream
and PurchaseStream customers are at an early stage in the process of
implementing the application and rolling it out for commercial use. The Company
believes that rapid implementation is critical to success in the Internet-based
electronic commerce applications market. Significant delays in implementation,
whether or not such delays are within the Company's control, could materially
adversely affect its business, operating results and financial condition. From
time to time, the Company enters into fixed price arrangements for its
implementation services and currently has three such arrangements. Fixed price
arrangements have resulted in the past, and could in the future result in,
losses primarily due to delays in the implementation process or other
complexities associated with completion of the project. Such losses have had a
material adverse effect on the Company's business, operating results and
financial condition. In addition, delays in license transactions due to lengthy
sales cycles or delays in customer production or deployment of a system could
have a material adverse effect on the Company's business, operating results and
financial condition and could be expected to cause the Company's operating
results to vary significantly from quarter to quarter.
The marketability and acceptance of OneServer, OrderStream and PurchaseStream
also will be highly dependent on the success of initial implementations of these
products by the Company's customers. Problems or delays experienced by the
Company's initial customers in the installation and use of OneServer,
OrderStream or PurchaseStream, even if such problems or delays are not
attributable to the Company or its products, or a failure of the Company's
customers to successfully attract purchasers to interactive commerce Web sites,
could slow the rate of adoption of the Company's products by other potential
customers. Moreover, products as complex as those offered by the Company may
contain undetected errors when first introduced or when new versions are
released. There can be no assurance that, despite testing by the Company, errors
will not occur in current or new products after commencement of commercial
shipments, resulting in adverse publicity, in loss of or delay in market
acceptance, or in claims by the customer against the Company, which would have a
material adverse effect on the Company's business, operating results and
financial condition.
DEPENDENCE UPON SERVICE PROVIDERS. The Company expects that its customers
will typically rely on professional services organizations, such as consulting
firms and systems integrators, as well as design firms to assist with
implementation of the Company's products. If the Company is unable to adequately
train a sufficient number of such firms or if for any reason a large number of
such firms support or promote competing products or technologies, the Company's
business, operating results and financial condition could be materially
adversely affected. Many of these relationships are not subject to formal
agreements and none of such providers are under any obligation to provide
services to the Company or its customers. Failure of the Company to develop and
maintain relationships with leading service providers and design firms could
adversely impact the Company's ability to successfully market, sell and deploy
its products, which would have a material adverse effect on the Company's
business, operating results and financial condition.
DEPENDENCE UPON CERTAIN LICENSES. The Company relies on certain technology
that it licenses from third parties, including a relational database management
system from Oracle, a text search engine from Fulcrum Technologies Inc.
("Fulcrum"), a web server from Netscape, encryption technology from RSA Data
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Security, Inc. ("RSA") and other software that is integrated with internally
developed software and used in the Company's software to perform key functions.
Oracle also offers products that are competitive with those offered by the
Company. There can be no assurance that the Company's third-party technology
licenses will continue to be available to the Company on commercially reasonable
terms, or at all. The loss or inability to maintain any of these technology
licenses could result in delays in introduction of the Company's products and
services until equivalent technology, if available, is identified, licensed and
integrated, which could have a material adverse effect on the Company's
business, operating results and financial condition.
DEPENDENCE UPON THE INTERNET INFRASTRUCTURE. The use of the Company's
products and services will depend in large part upon the continued development
of the infrastructure for providing Internet access and services. Because global
commerce and online exchange of information on the Internet is new and evolving,
it is difficult to predict with any assurance whether the Internet will prove to
be a viable commercial marketplace. The Internet has experienced, and is
expected to continue to experience, substantial growth in the number of users
and amount of traffic. There can be no assurance that the Internet
infrastructure will continue to be able to support the demands placed on it by
this continued growth. In addition, the Internet could lose its viability due to
delays in the development or adoption of new standards and protocols to handle
increased levels of Internet activity, or due to increased governmental
regulation. Further, the costs of use of the Internet could increase to a degree
which reduces its attraction as a platform for electronic commerce. As a result,
there can be no assurance that the infrastructure or complementary services
necessary to make the Internet a viable commercial marketplace will be
developed, or, if developed, that the Internet will become a viable commercial
marketplace for products and services such as those offered by the Company. If
the necessary infrastructure or complementary services or facilities are not
developed, or if the Internet does not become a viable commercial marketplace,
the Company's business, operating results and financial condition would be
materially adversely affected.
RISKS ASSOCIATED WITH EXPANDING DISTRIBUTION. To date, the Company has sold
its products through a direct sales force. The Company's ability to achieve
revenue growth in the future will depend in large part upon its success in
recruiting and training sufficient direct sales personnel and establishing and
maintaining relationships with distributors, resellers, systems integrators and
other third parties. Although the Company is currently investing, and plans to
continue investing, significant resources to expand its sales force and to
develop distribution relationships with third-party distributors and resellers,
the Company may at times experience difficulty in recruiting qualified sales
personnel and in establishing necessary third-party alliances. In addition, as
the Company hires new sales personnel it is anticipated that there will be a
delay before such personnel become productive. There can be no assurance that
the Company will be able to successfully expand its direct sales force or other
distribution channels or that any such expansion will result in an increase in
revenues. Any failure by the Company to expand its direct sales force or other
distribution channels would materially adversely affect the Company's business,
operating results and financial condition.
RISKS ASSOCIATED WITH SECURITY, SYSTEM DISRUPTIONS AND COMPUTER
INFRASTRUCTURE. Despite the implementation in the Company's products of various
security mechanisms, the Company's products may be vulnerable to break-ins and
similar disruptive problems caused by Internet users. The level of security
provided by the Company's products is dependent upon the level of security
selected by the Company's customers and the proper configuration and use of the
products' security mechanisms. Such computer break-ins and other disruptions
would jeopardize the security of information stored in and transmitted through
the computer systems of users of the Company's products, which may result in
significant liability to the Company and may also deter potential customers.
Persistent security problems continue to plague public and private data
networks. Recent break-ins reported in the press and otherwise have included
incidents involving hackers bypassing firewalls by posing as authorized
computers and involving the theft of confidential information. Alleviating
problems caused by third parties may require significant expenditures of capital
and resources by the Company. Such expenditures could have a material adverse
effect on the Company's business, operating results and financial condition.
Moreover, the security and privacy concerns of existing and potential customers,
as well as concerns related to computer viruses, may inhibit the growth of the
Internet marketplace generally, and the Company's customer base and revenues in
particular. There can be no assurance that the Company's attempts to limit its
liability to customers, including liability arising from a failure of the
security feature contained in the Company's products, through contractual
provisions will be enforceable. The Company currently does not have product
liability insurance to protect against
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these risks and there can be no assurance that such insurance will be available
to the Company on commercially reasonable terms, or at all.
As part of the Company's services, the Company operates and manages online
networks for certain of its customers on a seven day per week, 24-hour basis,
and provides hosting for certain customers' OneServer, OrderStream and
PurchaseStream applications. These services depend upon the Company's ability to
protect the computer equipment and the information stored in its data center
against damage that may be caused by fire, earthquakes, power loss,
telecommunications failures, unauthorized entry and other similar events. Any
such damage or failure that causes interruptions in the Company's operations
could materially adversely affect the businesses of the Company's customers,
which could expose the Company to liability for these adverse effects.
DEPENDENCE UPON PROPRIETARY RIGHTS; RISKS OF INFRINGEMENT. The Company
relies on trademark, copyright and trade secret laws, employee and third-party
non-disclosure agreements and other methods to protect its proprietary rights.
The Company does not currently have any patents or pending patent applications.
The Company believes that, due to the rapid pace of technological innovation for
Internet products, the Company's ability to establish and maintain a position of
technology leadership in the industry depends more on the skills of its
development personnel, new product developments, frequent product enhancements,
and name recognition than upon the legal protections afforded its existing
technology. The Company seeks to protect its software, documentation and other
written materials under trade secret and copyright laws, which afford only
limited protection. Despite the Company's efforts to protect its proprietary
rights, unauthorized parties may attempt to copy aspects of the Company's
products or to obtain and use information that the Company regards as
proprietary. Policing unauthorized use of the Company's products is difficult,
and while the Company is unable to determine the extent to which piracy of its
software products exists, software piracy can be expected to be a persistent
problem. In addition, the laws of some foreign countries do not protect the
Company's proprietary rights as fully as do the laws of the United States. There
can be no assurance that the Company's means of protecting its proprietary
rights in the United States or abroad will be adequate. There can be no
assurance that its agreements with employees, consultants and others who
participate in the development of its software will not be breached, that the
Company will have adequate remedies for any breach, or that the Company's trade
secrets will not otherwise become known to or independently developed by
competitors. Furthermore, there can be no assurance that the Company's efforts
to protect its rights through trademark and copyright laws will not fail to
prevent the development and design by others of products or technology similar
to or competitive with those developed by the Company.
The Company expects that software product developers will increasingly be
subject to infringement claims as the number of products and competitors in the
Company's industry segment grows and the functionality of products in different
industry segments overlaps and there can be no assurance that third parties will
not assert infringement claims against the Company. Any such claims, with or
without merit, could be time consuming to defend, result in costly litigation,
divert management's attention and resources, cause product shipment delays or
require the Company to enter into royalty or licensing agreements. Such royalty
or licensing agreements, if required, may not be available on terms acceptable
to the Company, if at all. In the event of a successful claim of product
infringement against the Company and failure or inability of the Company to
license the infringed or similar technology, the Company's business, operating
results and financial condition would be materially adversely affected.
POSSIBLE VOLATILITY OF STOCK PRICE. The market price of the Common Stock has
been subject to significant fluctuations in response to quarter-to-quarter
variations in the Company's operating results, announcements of technological
innovations or new products and services by the Company or its competitors, and
other events or factors. In addition, the stock market in recent years, and in
particular the market for stocks relating to the Internet, has experienced
extreme price and volume fluctuations that have particularly affected the market
prices of many high technology companies and that have often been unrelated or
disproportionate to the operating performance of companies. These fluctuations,
as well as general economic and market conditions, may adversely affect the
market price for the Common Stock.
GOVERNMENT REGULATION AND LEGAL UNCERTAINTIES. The Company is not currently
subject to direct regulation by any government agency, other than regulations
applicable to businesses generally, and there are currently few laws or
regulations directly applicable to access to, or commerce on, the Internet.
However, due to the
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increasing popularity and use of the Internet, it is possible that a number of
laws and regulations may be adopted with respect to the Internet, covering
issues such as user privacy, pricing and characteristics and quality of products
and services. The Telecommunications Reform Act of 1996 imposes criminal
penalties on anyone who distributes obscene, lascivious or indecent
communications on the Internet. The adoption of any such laws or regulations may
decrease the growth of the Internet, which could in turn adversely affect the
Company's business, operating results or financial condition. Moreover, the
applicability to the Internet of existing laws governing issues such as property
ownership, libel and personal privacy is uncertain. Further, due to the
encryption technology contained in the Company's products, such products are
subject to U.S. export controls. There can be no assurance that such export
controls, either in their current form or as may be subsequently enacted, will
not delay the introduction of new products or limit the Company's ability to
distribute products outside of the United States or electronically. While the
Company intends to take precautions against unlawful exportation, the global
nature of the Internet makes it difficult to effectively control the
distribution of the Company's products. In addition, federal or state
legislation or regulation may further limit levels of encryption or
authentication technology. Further, various countries regulate the import of
certain encryption technology and have adopted laws relating to personal privacy
issues which could limit the Company's ability to distribute products in those
countries. Any such export or import restrictions, new legislation or regulation
or government enforcement of existing regulations could have a material adverse
impact on the Company's business, operating results and financial condition.
CONTROL BY EXISTING SECURITY HOLDERS. As of February 28, 1998, the Company's
officers and directors, together with entities affiliated with them, own
approximately 41% of the outstanding Common Stock of the Company. Such persons
will have sufficient power to significantly influence the outcome of many
matters (including the election of directors, and any merger, consolidation or
sale of all or substantially all of the Company's assets) submitted to the
stockholders for approval. As a result, certain transactions are unlikely to be
approved without the approval of these stockholders.
ANTITAKEOVER EFFECT OF CERTAIN CHARTER PROVISIONS. The Board of Directors
has the authority to issue up to 3.5 million shares of Preferred Stock (in
addition to the 6.5 million shares designated as Series A Preferred Stock) and
to determine the price, rights, preferences, privileges and restrictions,
including voting rights, of those shares without any further vote or action by
the stockholders. The rights of the holders of Common Stock will be subject to,
and may be adversely affected by, the rights of the holders of any Preferred
Stock that may be issued in the future. The issuance of Preferred Stock may have
the effect of delaying, deferring or preventing a change of control of the
Company without further action by the stockholders and may adversely affect the
voting and other rights of the holders of Common Stock. Except for up to 6.5
million shares of Series A Preferred Stock which were issued in connection with
the Exchange and which in the future may be issued as dividends on the Series A
Preferred Stock, the Company has no other present plans to issue shares of
Preferred Stock. Further, certain provisions of the Company's charter
documents, including provisions eliminating the ability of stockholders to take
action by written consent and limiting the ability of stockholders to raise
matters at a meeting of stockholders without giving advance notice, may have the
effect of delaying or preventing changes in control or management of the
Company, which could have an adverse effect on the market price of the Company's
Common Stock.
SHARES ELIGIBLE FOR FUTURE SALE. Sales of substantial amounts of the
Company's Common Stock in the public market or the anticipation of such sales
could materially affect then prevailing market prices. The effect of such sales
may be exacerbated further by the relatively low trading volume of the Company's
Common Stock. The Securities and Exchange Commission has recently adopted
changes to Rule 144 under the Securities Act of 1933, as amended (the
"Securities Act"), which changes became effective in April 1997. As a result of
such changes, substantially all of the unregistered shares of the Company's
Common Stock which are not already eligible for resale under Rule 144 or Rule
701 under the Securities Act are eligible for resale pursuant to Rule 144,
subject in some cases to volume limitations and other requirements.
YEAR 2000 COMPLIANCE. The Company has determined that it will need to modify
or replace significant portions of its software so that its internal computer
systems will function properly with respect to dates in the Year 2000 and
beyond. The Company has initiated discussions with its significant suppliers and
financial institutions, to ensure that those parties have appropriate plans to
remediate Year 2000 issues where their systems interface with the Company's
systems or
17
<PAGE>
otherwise impact its operations. The Company is assessing the extent
to which its operations would be affected in the event that such third parties
fail to remediate Year 2000 issues.
The Company's Year 2000 initiative is being managed by a team of internal
staff. The team's activities are designed to ensure that there is no adverse
effect on the Company's core business operations and that transactions with
suppliers and financial institutions are fully supported. While the
Company believes its planning efforts are adequate to address Year 2000
concerns, there can be no assurance that the systems of third parties on which
the Company's systems and operations rely will be converted on a timely basis.
The cost of the Year 2000 initiatives is not expected to be material to the
Company's results of operations or financial condition. There can be no
assurance that a third party's failure to ensure Year 2000 compliance would not
have an adverse effect on the Company.
The Company believes that all of its existing products are Year 2000 compliant
and new products are being designed to be Year 2000 compliant. Although products
have undergone, and will undergo, the Company's normal quality testing
procedures, there can be no assurance that the Company's products will contain
all necessary date code changes.
ITEM 2. PROPERTIES
FACILITIES
The Company is headquartered in Mountain View, California, where it leases an
aggregate of approximately 30,000 square feet of space which houses
administrative, sales and marketing, customer service and product development
activities. The Company's field operations occupy a leased facility in Oakbrook
Terrace, Illinois. The Company believes that its existing facilities are
adequate to meet current needs.
ITEM 3.
LEGAL PROCEEDINGS
On March 25, 1996, PhotoDisc, one of the Company's licensees of OneServer, was
sued, along with 21 other defendants including AGFA, Axcis, SPC and others, in
the Federal District Court in Connecticut, by E-data. In the litigation against
PhotoDisc, E-data alleges that PhotoDisc is infringing E-data's U.S. Patent No.
4,528,643 issued July 9, 1985, entitled "System for Reproducing Information in
Material Objects at Point of Sale Location," in connection with electronic
distribution of images on the Internet. E-data has also sued other defendants
including Broderbund, CompuServe, Adobe and others in the Federal District Court
in New York City. PhotoDisc tendered the defense of its E-data litigation to the
Company.
During 1997, E-data did not pursue the patent infringement claim against the
customer, and the claim was dismissed from Federal District Court in Connecticut
on August 22, 1997.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the fourth
quarter of fiscal year ended December 31, 1997.
ITEM 5. MARKET FOR THE COMPANY'S EQUITY AND RELATED STOCKHOLDER MATTERS
COMMON STOCK MARKET PRICES AND DIVIDENDS
The Company's common stock is traded on the National Association of Securities
Dealers Automated Quote system (NASDAQ). The Company's Nasdaq National Market
symbol is "CNKT." The number of record holders of the Company's common stock as
of February 26, 1998 was approximately 142.
18
<PAGE>
High and low stock prices and dividends since its initial public offering on
August 15, 1996 were as follows (as adjusted to reflect the one-for-five reverse
stock split effected in February 1998):
<TABLE>
<CAPTION>
SALE PRICE
QUARTER ENDED HIGH LOW CASH DIVIDENDS DECLARED
-------------------- -------- ------ -----------------------
<S> <C> <C> <C>
September 30, 1996 $ 33-3/4 25-5/8 None
December 31, 1996 $ 50 26-1/4 None
March 31, 1997 $ 40-5/8 19-3/8 None
June 30, 1997 $ 20-5/8 4-5/8 None
September 30, 1997 $ 15 7-1/2 None
December 31, 1997 $10-5/16 2-1/2 None
</TABLE>
The Company expects to continue its current policy of not paying cash dividends
to holders of Common Stock for the foreseeable future.
RECENT SALES OF UNREGISTERED SECURITIES
On November 18, 1997, the Company closed the private placement (the "Private
Placement") of 250 Units, each such Unit consisting of one (1) convertible note
(a "Note") in the principal amount of $40,000 and one (1) warrant (a "Warrant")
to purchase 2,666 shares of Common Stock of the Company. The Units were priced
at $40,000 per Unit, resulting in gross proceeds of approximately $10 million.
Lehman Brothers, Inc. received a placement fee of 8% of gross proceeds
(excluding proceeds from sales of up to $2,000,000 of Units to current
stockholders of the Company) from the Private Placement for services rendered in
connection with the Private Placement, 50% of which has been paid in cash and
the balance of which has been paid in Units (consisting of 8 Units issued to LBI
Holdings, an affiliate of Lehman Brothers, Inc.). The Company relied on Rule 506
of Regulation D under the Securities Act of 1933, as amended (the "Act"), which,
among other things, provides an exemption from the registration requirements of
the Act for sales to accredited investors (as defined by Rule 501(a) of
Regulation D under the Act).
In November 1997, the Company was informed by The Nasdaq Stock Market, Inc.
("Nasdaq") that it did not meet the requirements for the continued listing of
its Common Stock on The Nasdaq National Market. Specifically, Nasdaq's listing
rules require the Company to maintain net tangible assets of at least $4
million, and the Company's net tangible assets were $2.4 million as of September
30, 1997. While the Company completed the Private Placement in November 1997,
which increased the Company's cash assets by approximately $10 million, the
Notes are considered as debt and, therefore, the Company's net tangible assets
did not increase as a result of the Private Placement.
In order to achieve compliance with the foregoing listing requirements, on
February 26, 1998, the Company and each holder of the Notes exchanged all of the
Notes that had not been converted as of such date (which Notes had an aggregate
principal amount of $9,744,250) for 4,905,209 shares of the Company's Series A
Preferred Stock, plus accrued interest on such Notes (the "Exchange"). As a
result, the Company's net tangible assets were increased and the Company
believes that as of the date hereof it is currently in compliance with the
Nasdaq net tangible assets requirements. Nevertheless, in order for the Company
to remain listed on The Nasdaq National Market, the Company must continue to
meet the following Nasdaq continuing listing criteria on an ongoing basis in
addition to the NTA Requirement: (i) nonaffiliates of the Company must hold at
least 750,000 shares of Common Stock; (ii) nonaffiliates of the Company must
hold at least $5 million of Common Stock (the "Float Requirement"); (iii) the
Company must have at least 400 stockholders each holding at least 100 shares of
Common Stock; (iv) the minimum bid price of the Common Stock must be at least
$1.00 per share; and (v) the Company must have at least two market makers. There
can be no assurance that the Company will be able to maintain compliance with
the NTA Requirement or any such additional listing requirements. Recently, the
minimum bid price of the Common Stock has been below $1.00 at certain times. In
addition, the Company will only be deemed to be in compliance with the Float
Requirement if the shares of Series A Preferred Stock held by nonaffiliates of
the Company (which are convertible at the option of the holder into shares of
Common Stock) are deemed to be included in the calculation of Common Stock held
by nonaffiliates and the Company has not confirmed with Nasdaq that such
inclusion is appropriate. Furthermore, the Company had net operating losses of
$5.2 million, $3.2 million, $3.2 million and $3.1 million for the quarters ended
March 31, June 30, September 30 and December 31, 1997, respectively. Continued
significant losses by the Company would cause the Company's net tangible assets
to decline below $4 million. As a result of any or a combination of these
factors or the failure of the Company to satisfy any other requirements under
the Rule, the Common Stock would likely be delisted from The Nasdaq National
Market. The removal of the Common Stock from listing on The Nasdaq National
Market most likely would have a material adverse effect on the market price of
the Common Stock and on the ability of stockholders and investors to buy and
sell shares of the Common Stock in the public markets.
Each share of Series A Preferred Stock issued in exchange for the Notes is
convertible at the option of the holder into that number of shares of Common
Stock equal to the greater of (i) the quotient obtained by dividing $2.00, plus
accumulated but unpaid dividends, by the conversion price (which initially is
$10.00 per share and shifts to $7.50 per share on December 15, 1999) or (ii) the
quotient obtained by dividing $2.00, plus accumulated but
19
<PAGE>
unpaid dividends, by 80% (or 60% if the conversion occurs after December 15,
1999) of the average closing bid price for the 10 trading days prior to
conversion. The initial conversion price will be subject to adjustment in the
event of issuances of capital stock at a purchase price of less than $10.00
(other than issuances of Common Stock to employees, directors or consultants of
the Company) and convertible securities with a conversion price of less than
$10.00 per share, as well as stock splits, stock combinations and the like. For
information regarding the rights, preferences and privileges of the Series A
Preferred Stock, see the Company's Form 8-A/A, filed with the Securities and
Exchange Commission on March 9, 1998.
TRANSFER AGENT AND REGISTRAR
The Transfer Agent and Registrar for the Common Stock is U.S. Stock Transfer
Corporation. Its telephone number is (800) 835-8778.
20
<PAGE>
ITEM 6. SELECTED FINANCIAL DATA
SUMMARY FINANCIAL INFORMATION
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
Years Ended December 31,
------------------------------------------------------------------------------
1997 1996 1995 1994 1993
-------------- -------------- -------------- -------------- --------------
<S> <C> <C> <C> <C> <C>
Statement of Operations Data:
Revenue:
License............................... $ 3,131 $ 4,693 $ 288 $ 1,627 $ 1,015
Service............................... 6,231 5,487 8,285 6,345 2,847
-------- -------- -------- ------- -------
Total revenue........................ $ 9,362 $ 10,180 $ 8,573 $ 7,972 $ 3,862
Loss from operations(1)................ $(14,518) $(16,358) $(13,194) $(1,540) $(1,648)
Net loss(1)............................ $(14,585) $(16,142) $(14,139) $(1,765) $(1,921)
Pro forma net loss per share(2)........ $(3.85) $(4.81) $(15.57)
Shares used in computing pro forma
Net loss per share(2)................. 3,784 3,358 908
BALANCE SHEET DATA:
Cash and cash equivalents.............. $ 9,644 $ 12,214 $ 12,929 $ 1,594 $ 64
Working capital (deficit).............. $ 7,434 $ 10,344 $ 11,302 $(2,786) $(1,045)
Total assets........................... $ 15,364 $ 19,154 $ 18,063 $ 5,161 $ 1,743
Long-term debt......................... $ 10,593 $ 790 $ 1,636 $ 1,167 $ 1,570
Stockholders' equity (deficit)......... $ (633) $ 13,355 $ 13,318 $(1,538) $(1,979)
</TABLE>
(1) Includes a one-time expense of $4.1 million in the first quarter of 1995
from the Company's termination of exclusive distribution rights of its
European distributor. See Note 10 of Notes to Financial Statements.
(2) See Note 1 of Notes to Financial Statements.
ITEM 7.
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion of the financial condition and results of operations
of the Company should be read in conjunction with the Financial Statements and
the Notes thereto included elsewhere in this Form 10-K. This discussion contains
forward-looking statements that involve risks and uncertainties. The Company's
actual results could differ materially from those anticipated in the forward-
looking statements as a result of certain factors, including, but not limited to
those discussed in "Factors Affecting Future Results and Financial Condition-
Risk Factors."
OVERVIEW
CONNECT designs, develops, markets and supports packaged application software
for Internet-based electronic commerce. The Company was founded in 1987 to
provide online information services to businesses. During the period 1987
through 1992, the Company's primary business was the operation and management of
a private online service and the licensing of related client software. In 1993
and 1994, the Company also offered software for creation, access and operation
of custom online systems. In late 1994, the Company began to shift its focus
from providing online services to developing packaged software applications for
Internet-based electronic commerce. During 1994 and 1995, the Company derived a
significant portion of its revenue from contract software development projects
(the "Development Projects") with two companies under which the Company retained
ownership of the technology developed. These projects formed the foundation for
the development of OneServer, the Company's core software application, which was
commercially released in September 1995, and OrderStream,
21
<PAGE>
the first preconfigured implementation of OneServer, which was commercially
released in June 1996. In the second quarter of 1997, the Company announced its
newest product, PurchaseStream. The PurchaseStream application is an internet-
based purchasing system that simplifies and streamlines acquisition of indirect
goods and services. PurchaseStream became commercially available in December
1997.
The Company transferred, effective December 31, 1997, its legacy online
services business to a new company formed primarily by former CONNECT employees,
thus allowing the Company to focus entirely on its electronic commerce
applications software business. The online services business accounted for $1.7
million of revenue in 1997. As a result, the Company will be dependent solely
on OrderStream and PurchaseStream products and related services for revenue in
fiscal 1998, and the Company's past results of operations should not be relied
upon as indicative of future results.
The Company derives revenue from software license fees and services. License
fees primarily consist of revenue from licenses of the Company's application
software. Service revenue consists of fees from implementation (including
customization of licensed software), training, maintenance and support, contract
software development projects, and system hosting and online services. License
revenue is recognized on shipment of the application software provided there are
no significant remaining obligations and collectability is deemed probable by
management. License fees under contracts requiring significant implementation,
including customization, of licensed application software are recognized on a
percentage-of-completion basis. Revenue from implementation services is
recognized as the services are performed.
The Company also enters into maintenance agreements in connection with
licenses of its application software under which revenue is recognized ratably
over the term of the agreement, generally one year. Usage fees related to the
Company's training, system-hosting services, private online services and
consulting services are recognized as the services are performed. Additionally,
service revenue from contract software development projects, in which the
Company develops specific technology for its customers, has been recognized on a
percentage-of-completion basis.
The Company has incurred net losses in each fiscal year since inception and,
as of December 31, 1997, had an accumulated deficit of $61.6 million. The
Company's operating expenses increased in 1995 and 1996 as the Company made
investments related to the development and introduction of OneServer,
OrderStream and PurchaseStream. To date, all research and development costs have
been expensed as incurred and have not been capitalized because capitalizable
costs have not been material. The Company does not anticipate significant
increases in operating expenses during the 1998 fiscal year as compared to 1997.
The market for Internet-based electronic commerce continues to evolve. The
combination of an evolving market and the Company's dependence on a relatively
small number of large value transactions have created additional complexities in
forecasting revenues and, therefore, staffing requirements. Because of these
conditions, and the Company's limited resources, the Company has focused on
controlling expenses and staff growth until a clearer picture of market demands,
and its abilities to meet them, exist.
The Company's prospects are dependent upon the successful acceptance of
OrderStream and PurchaseStream by the market, and must be evaluated in light of
the risks and uncertainties frequently encountered by companies dependent upon
such early stage products. In addition, the Company's markets are new and
rapidly evolving, which heightens these risks and uncertainties. To address
these risks, the Company must, among other things, successfully implement its
marketing strategy, respond to competitive developments, continue to develop and
upgrade its products and technologies more rapidly than its competitors, and
commercialize its products and services incorporating these enhanced
technologies. There can be no assurance that the Company will succeed in
addressing any or all of these risks.
22
<PAGE>
RESULTS OF OPERATIONS
The following table sets forth, as a percentage of total revenue, items from
the Company's statements of operations for the periods indicated.
<TABLE>
<CAPTION>
Years Ended December 31,
------------------------------------------
1997 1996 1995
------------ ------------- -------------
<S> <C> <C> <C>
Revenue:
License................................................................. 33% 46% 3%
Service................................................................. 67 54 97
----- ----- -----
Total revenue.......................................................... 100 100 100
Cost of revenue:
License................................................................. 8 8 2
Service................................................................. 89 81 63
----- ----- -----
Total cost of revenue.................................................. 97 89 65
Operating expenses:
Research and development................................................ 53 46 56
Sales and marketing..................................................... 77 103 47
General and administrative.............................................. 28 23 39
Termination of distribution rights...................................... -- -- 47
----- ----- -----
Total operating expenses............................................... 158 172 189
----- ----- -----
Loss from operations..................................................... (155) (161) (154)
Other income (expense)................................................... (1) 2 (11)
----- ----- -----
Loss before income taxes................................................. (156) (159) (165)
Provision (benefit) for income taxes..................................... -- -- --
----- ----- -----
Net loss................................................................. (156)% (159)% (165)%
===== ===== =====
Gross margin:
License................................................................. 76% 83% 51%
Service................................................................. (33)% (51)% 34%
</TABLE>
Revenue
License. License revenue was $3.1 million in 1997, $4.7 million in 1996, and
$287,000 in 1995. The decrease in 1997 from 1996 resulted from lower unit sales
associated with increased length of sales cycles The increase in 1996 from 1995
results from fees from licenses of the Company's OneServer and OrderStream
application software which were first licensed in the fourth quarter of 1995 and
in the second quarter of 1996, respectively.
Service. Service revenue was $6.2 million in 1997, $5.5 million in 1996, and
$8.3 million in 1995. The increase in 1997 from 1996 resulted from completion
of fixed price contracts early in 1997, allowing more effective utilization of
staff and outside consultants. Service revenue in 1996 was lower than 1995
primarily due to the completion of contract software development projects. The
Company expects in the future that service revenue will decline as a percentage
of total revenue due to the Company's focus on licensing OrderStream and
PurchaseStream.
Costs of Revenue
Cost of License. Cost of license revenue includes sub-license fees and
expenses relating to product media, duplication and manuals. Cost of license
revenue was $753,000 in 1997, $790,000 in 1996 and $140,000 in 1995,
representing 24%, 17% and 49% of license revenue, respectively. The slight
decrease in 1997 from 1996 is due to decreasing license revenue. The increase
in cost in 1996 from 1995 is primarily related to the costs of documentation and
third party royalties on the sale of OneServer and OrderStream.
23
<PAGE>
Cost of Service. Cost of service revenue consists of costs of implementation
services including fees of third-party contract developers and Company personnel
costs; training and customer support costs for OneServer; costs associated with
contract software development projects; and telecommunications, personnel costs
and depreciation related to hosting services and the operation of the Company's
private online service. Cost of service revenue was $8.3 million in 1997, $8.3
million in 1996 and $5.5 million in 1995. Cost of services as a percentage of
service revenue was 133%, 151% and 66% for 1997, 1996 and 1995, respectively.
In 1997 and 1996, the cost of service percentage was negatively impacted by
costs incurred in connection with certain fixed price contracts. The charges
related to fixed price contracts were due to implementation costs which exceeded
the implementation fees due under the agreements.
Operating Expenses
Research and Development. Research and development expenses consist primarily
of personnel and equipment costs. Research and development expenses were $5
million in 1997, $4.7 million in 1996 and $4.8 million in 1995. Research and
development expenses, as a percentage of total revenue were 53%, 46% and 56% in
1997, 1996, and 1995 respectively. The increase in 1997 from 1996 is
attributable to increased use of outside contractors, primarily in Malaysia, to
assist in the development efforts for the Company's PurchaseStream product. The
slight decrease in 1996 from 1995 in total dollars and as a percentage of total
revenue was attributable to relatively consistent staffing and associated
support costs of software engineers required to expand and enhance the Company's
product line, including development of OneServer and OrderStream. The Company
expects research and development expense in 1998 to remain relatively similar to
1997 levels.
Sales and Marketing. Sales and marketing expenses consist primarily of
salaries and commissions of sales and marketing personnel, and travel, marketing
and promotional expenses. Sales and marketing expenses were $7.2 million in
1997, $10.4 million in 1996 and $4.0 million in 1995, representing 77%, 103% and
47% of revenue, respectively. The decrease in 1997 from 1996 was attributable
to decreased staffing and reduced marketing expenditures. The increase in sales
and marketing expenses from 1995 to 1996 was attributable to building a direct
sales force and increasing marketing and promotional activities directed at
developing the Company's position in the emerging Internet-based packaged
application software market. Prior to 1996, a large portion of the Company's
revenue was generated without any related commission expense as such revenue was
largely comprised of non-commissioned services. This changed in 1996 with the
growth of the commissioned sales force.
General and Administrative. General and administrative expenses consist
primarily of salaries of financial, administrative and management personnel and
related travel expenses, as well as legal and accounting expenses. General and
administrative expenses were $2.6 million in 1997, $2.4 million in 1996 and $3.3
million in 1995, representing 28%, 23% and 39% of revenue, respectively. The
increase in 1997 from 1996 in total dollars and as a percentage of revenue
resulted from increased costs associated with being a public company. The
decrease in 1996 from 1995 in total dollars and as a percentage of revenue
resulted from lower professional service fees. The Company expects 1998 general
and administrative expenses to remain relatively constant in absolute dollars
with general and administrative expenses in 1997.
Termination of Distribution Rights. The Company incurred a charge to
operations of $4.1 million in 1995 related to its termination of exclusive
European distribution rights of its former European distributor. The distributor
had acquired exclusive rights for distributing certain of the Company's software
and services in Europe. The Company negotiated the termination of the
distributor's rights primarily because the distributor was not performing to the
Company's standards and the Company wanted to reestablish control over its
European distribution channel.
Other Income (Expense)
Other income (expense) consists primarily of interest expense and interest
income. Interest expense, which results principally from interest incurred under
notes payable and capital lease obligations, was $414,000 in 1997, $331,000 in
1996, and $1.0 million in 1995. Interest expense increased in 1997 from 1996 due
to interest associated with the convertible notes issued in November, 1997.
Interest expense decreased in 1996 from 1995 due to reduction in obligations
associated with capital leases. Interest income and other, principally
represents interest
24
<PAGE>
earned on cash balances, was $347,000 in 1997, $547,000 in 1996, and $32,000 in
1995. The decrease in 1997 interest income is due to lower average cash balances
over prior years. The increase in interest income in 1996 is attributable to the
earnings on cash balances from the December 1995 private financing and the 1996
initial public offering of the Company's common stock.
Year 2000 Compliance
The Company has determined that it will need to modify or replace significant
portions of its software so that its internal computer systems will function
properly with respect to dates in the Year 2000 and beyond. The Company has
initiated discussions with its significant suppliers and financial institutions
to ensure that those parties have appropriate plans to remediate Year 2000
issues where their systems interface with the Company's systems or otherwise
impact its operations. The Company is assessing the extent to which its
operations would be affected in the event that such third parties fail to
remediate Year 2000 issues.
The Company's Year 2000 initiative is being managed by a team of internal
staff. The activities are designed to ensure that there is no adverse effect on
the Company's core business operations and that transactions with suppliers and
financial institutions are fully supported. While the Company believes its
planning efforts are adequate to address Year 2000 concerns, there can be no
assurance that the systems of third parties on which the Company's systems and
operations rely will be converted on a timely basis. The cost of the Year 2000
initiatives is not expected to be material to the Company's results of
operations or financial condition. There can be no assurance that another
company's failure to ensure year 2000 capability would not have an adverse
effect on the Company.
The Company believes that all of its existing products are Year 2000 compliant
and new products are being designed to be Year 2000 compliant. Although products
have undergone, and will undergo, the Company's normal quality testing
procedures, there can be no assurance that the Company's products will contain
all necessary date code changes.
LIQUIDITY AND CAPITAL RESOURCES
The Company has financed its operations to date primarily through the private
and public sale of debt and equity securities and the use of capitalized leases
for equipment financing. The Company had working capital of $7.4 million at
December 31, 1997.
During 1997, 1996 and 1995, net cash used in operating activities was $12.9
million, $14.0 million and $14.9 million, respectively, primarily due to net
losses incurred by the Company.
During 1997, 1996 and 1995 the Company used $540,000, $2.0 million and $1.8
million, respectively, in investing activities, as a result of the purchase of
property and equipment. Net cash provided by financing activities in 1997, 1996
and 1995 was $10.9 million, $15.3 million and $28.0 million, respectively. Net
cash provided by financing activities in 1997 resulted primarily from net
proceeds of $9.7 million related to convertible notes issued in November 1997
and $1.7 million of proceeds from the notes payable secured by specific
unencumbered equipment. Net cash provided by financing activities in 1996
resulted primarily from net proceeds of $12.1 million from the Company's initial
public offering of its common stock in August 1996, and net proceeds of $3.9
million from the issuance of preferred stock. Net cash provided by financing
activities in 1995 resulted primarily from the Company's private equity
financing in December 1995.
The Company has incurred net losses and experienced significant negative cash
flow from operations since inception. As of December 31, 1997, the Company had
an accumulated deficit of approximately $61.6 million. Based upon its current
operating plan, the Company believes it has adequate cash balances to fund its
operations through at least December 31, 1998. There can be no assurance,
however, that the Company's actual cash requirements will not exceed anticipated
levels, or that the Company will generate sufficient revenue to fund its
operations in the absence of additional funding sources. If additional funds are
raised through the issuance of equity securities, stockholders of the Company
may experience additional dilution, or the securities may have rights,
preferences or privileges senior to those of the Company's Common Stock. There
can be no assurance that such additional financing will be available on
acceptable terms, if at all. If adequate funds are not available or are not
available on acceptable terms, the Company may be unable to continue its
operations, develop or enhance its products, take advantage of future
opportunities or respond to competitive pressures or other requirements, any of
which would have a material adverse effect on the Company's business, operating
results and financial condition.
25
<PAGE>
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
CONNECT, INC.
INDEX TO FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
Page
-----
<S> <C>
Report of Ernst & Young LLP, Independent Auditors....................................................... 27
Balance Sheets.......................................................................................... 28
Statements of Operations................................................................................ 29
Statements of Stockholders' Equity (Deficit)............................................................ 30
Statements of Cash Flows................................................................................ 31
Notes to Financial Statements........................................................................... 32
</TABLE>
26
<PAGE>
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Board of Directors and Stockholders
CONNECT, Inc.
We have audited the accompanying balance sheets of CONNECT, Inc. as of
December 31, 1997 and 1996, and the related statements of operations,
stockholders' equity and cash flows for each of the three years in the period
ended December 31, 1997. 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 CONNECT, Inc., at December 31,
1997 and 1996, and the results of its operations and its cash flows for each of
the three years in the period ended December 31, 1997, in conformity with
generally accepted accounting principles.
Ernst & Young LLP
San Jose, California
January 27, 1998
except for Note 14 as to which, the date is
February 26, 1998
27
<PAGE>
CONNECT, INC.
BALANCE SHEETS
<TABLE>
<CAPTION>
December 31,
-------------------------------------
1997 1996
------------------ -----------------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents............................................................... $ 9,643,883 $ 12,214,042
Accounts receivable, less allowances for doubtful accounts of $642,270 at
December 31, 1997 and $222,000 at December 31, 1996................................... 2,298,759 2,533,890
Prepaid expenses and other current assets............................................... 894,786 605,682
------------ ------------
Total current assets...................................................................... 12,837,428 15,353,614
Property and equipment, net............................................................... 2,442,059 3,646,809
Deposits and other assets................................................................. 84,444 153,974
------------ ------------
Total assets...................................................................... $ 15,363,931 $ 19,154,397
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Notes payable........................................................................... $ 619,921 $ 61,456
Accounts payable........................................................................ 1,279,284 1,688,280
Accrued payroll and related expenses.................................................... 608,516 941,029
Other accrued liabilities............................................................... 1,588,264 1,321,270
Deferred revenue........................................................................ 681,540 189,142
Current portion of extended vendor liabilities.......................................... 271,694 260,458
Obligations under capital leases........................................................ 354,460 547,786
------------ ------------
Total current liabilities................................................................. 5,403,679 5,009,421
Notes payable..................................................................... 713,053 9,066
Long-term portion of extended vendor liabilities.................................. 223,512 417,433
Long-term obligations under capital leases........................................ 2,119 363,672
Convertible notes................................................................. 9,654,158 ---
Commitments and contingencies
Stockholders' equity (deficit):
Preferred Stock:
Authorized shares--10,000,000. Issued and outstanding shares--none. --- ---
Common Stock: $.001 par value. Authorized shares--40,000,000.
Issued and outstanding shares--3,827,806 at December 31, 1997
and 3,706,294 at December 31, 1996................................................... 19,139 18,531
Additional paid-in capital.............................................................. 61,001,741 60,448,304
Deferred compensation................................................................... (96,055) (139,411)
Accumulated deficit..................................................................... (61,557,415) (46,972,619)
------------ ------------
Total stockholders' equity (deficit)...................................................... (632,590) 13,354,805
------------ ------------
Total liabilities and stockholders' equity (deficit)...................................... $ 15,363,931 $ 19,154,397
============ ============
</TABLE>
See accompanying notes.
28
<PAGE>
CONNECT, INC.
STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
Years Ended December 31,
-------------------------------------------------------
1997 1996 1995
--------------- ----------------- -------------------
<S> <C> <C> <C>
Revenue:
License...................................................... $ 3,130,942 $ 4,693,068 $ 287,471
Service...................................................... 6,231,496 5,486,720 8,285,427
------------ ------------ ------------
Total revenue.............................................. 9,362,438 10,179,788 8,572,898
Cost of revenue:
License...................................................... 752,793 790,652 139,961
Service...................................................... 8,311,870 8,277,358 5,451,893
------------ ------------ ------------
Total cost of revenue...................................... 9,064,663 9,068,010 5,591,854
Operating expenses:
Research and development..................................... 4,990,156 4,652,633 4,810,166
Sales and marketing.......................................... 7,194,058 10,444,510 3,978,361
General and administrative................................... 2,632,027 2,372,702 3,329,400
Termination of distribution rights........................... -- -- 4,057,292
------------ ------------ ------------
Total operating expenses................................... 14,816,241 17,469,845 16,175,219
Loss from operations........................................... (14,518,466) (16,358,067) (13,194,175)
Interest expense............................................... (413,788) (330,913) (1,002,761)
Interest income and other income
(expense), net............................................... 347,458 546,940 32,005
-------------- ------------ ------------
Loss before income taxes....................................... (14,584,796) (16,142,040) (14,164,931)
Provision (benefit) for income taxes........................... -- -- (26,000)
------------ ------------ ------------
Net loss....................................................... $(14,584,796) $(16,142,040) $(14,138,931)
============ ============ ============
Pro forma basic and diluted net loss per share................. $(3.85) $(4.81) $(15.57)
============ ============ ============
Weighted average common shares outstanding..................... 3,783,881 3,357,833 908,088
============ ============ ============
</TABLE>
See accompanying notes.
29
<PAGE>
CONNECT, INC.
STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
<TABLE>
<CAPTION>
CONVERTIBLE
PREFERRED STOCK COMMON STOCK TOTAL
-------------------------- ---------------------- DEFERRED ACCUMULATED STOCKHOLDERS'
SHARES AMOUNT SHARES AMOUNT COMPENSATION DEFICIT EQUITY (DEFICIT)
----------- ------------- --------- ----------- ------------- ------------- ----------------
<S> <C> <C> <C> <C> <C> <C> <C>
Balance at December 31, 1994 .. 629,693 $ 8,059,888 73,997 $ 7,093,557 $ -- $(16,691,648) $ (1,538,203)
Conversion of notes payable to
stockholders and accrued
interest for Series D
preferred stock .............. 11,764 152,933 -- -- -- -- 152,933
Termination of distribution
rights settled in Series
E preferred stock ............ 35,000 1,417,500 -- -- -- -- 1,417,500
Issuance of Series F preferred
stock for cash and notes,
net of issuance costs
of $917,888 .................. 2,146,123 27,410,938 -- -- -- -- 27,410,938
Exercise of employee
stock options and other ...... -- -- 5,728 13,917 -- -- 13,917
Net loss ...................... -- -- -- -- -- (14,138,931) (14,138,931)
---------- ------------ --------- ----------- --------- ------------ ------------
Balance at December 31, 1995 .. 2,822,580 37,041,259 79,725 7,107,474 -- (30,830,579) 13,318,154
Issuance of Series F preferred
stock for cash ............... 72,000 937,849 -- -- -- -- 937,849
Issuance of Series G preferred
stock for cash ............... 54,550 2,963,532 -- -- -- -- 2,963,532
Issuance of common stock
in connection with initial
public offering .............. -- -- 480,000 12,130,474 -- -- 12,130,474
Conversion of preferred to
common stock...................(2,949,130) (40,942,640) 3,100,661 40,942,640 -- -- --
Exercise of warrants............ -- -- 21,296 3,970 -- -- 3,970
Exercise of employee stock
options and other, net of
repurchases.................... -- -- 24,612 112,844 -- -- 112,844
Deferred compensation related
to grant of stock options .... -- -- -- 169,433 (169,433) -- --
Amortization of deferred
compensation.................. -- -- -- -- 30,022 -- 30,022
Net loss ...................... -- -- -- -- -- (16,142,040) (16,142,040)
---------- ------------ --------- ----------- --------- ------------ ------------
Balance at December 31, 1996 .. -- -- 3,706,294 60,466,835 (139,411) (46,972,619) 13,354,805
Exercise of employee stock
options net of repurchases..... -- -- 100,440 204,780 -- -- 204,780
Issuance of common stock under
Employee Stock Purchase Plan... -- -- 21,072 349,265 -- -- 349,265
Amortization of deferred
compensation.................. -- -- -- -- 43,356 -- 43,356
Net loss ...................... -- -- -- -- -- (14,584,796) (14,584,796)
---------- ------------ --------- ----------- --------- ------------ ------------
Balance at December 31, 1997 .. -- $ -- 3,827,806 $61,020,880 $ (96,055) $(61,557,415) $ (632,590)
========== ============ ========= =========== ========= ============ ============
</TABLE>
See accompanying notes.
30
<PAGE>
CONNECT, INC.
STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
Years Ended December 31,
---------------------------------------------------
1997 1996 1995
---------------- ---------------- ---------------
<S> <C> <C> <C>
Operating activities
Net loss........................................................ $(14,584,796) $(16,142,040) $(14,138,931)
Adjustments to reconcile net loss to net
cash used in operating activities:
Depreciation and amortization................................. 1,744,535 1,674,757 987,829
Amortization of deferred compensation......................... 43,356 30,022 --
Termination of distribution rights settled in Series E
preferred stock............................................. -- -- 1,417,500
Deferred income tax........................................... -- -- 77,000
Changes in operating assets and liabilities:
Accounts receivable........................................ 235,131 (1,524,266) (280,679)
Prepaid expenses and other current assets.................. (289,104) (133,863) (124,503)
Deposits and other assets.................................. 69,530 235,171 (215,882)
Accounts payable, accrued payroll and related
expenses, other accrued liabilities, and extended
vendor liabilities....................................... (657,200) 2,084,220 (52,153)
Deferred revenue........................................... 492,398 (233,842) (2,562,834)
------------ ------------ ------------
Net cash used in operating activities........................... (12,946,150) (14,009,841) (14,892,653)
INVESTING ACTIVITIES
Purchases of property and equipment............................. (539,785) (2,044,533) (1,772,591)
FINANCING ACTIVITIES
Proceeds from sale and leaseback of equipment................... -- -- 1,197,393
Proceeds from issuance of common stock.......................... 554,045 12,247,288 13,917
Net proceeds from issuance of preferred stock................... -- 3,901,381 27,410,938
Net proceeds from issuance of convertible debentures............ 9,654,158 -- --
Proceeds from issuance of notes payable......................... 1,748,640 -- 133,534
Repayment of principal on notes payable......................... (486,188) (191,425) (180,974)
Repayment of principal under capital lease obligations.......... (554,879) (617,739) (574,524)
----------- ----------- -----------
Net cash provided by financing activities...................... 10,915,776 15,339,505 28,000,284
----------- ----------- -----------
Net increase (decrease) in cash and cash equivalents........... (2,570,159) (714,869) 11,335,040
Cash and cash equivalents at beginning of period............... 12,214,042 12,928,911 1,593,871
----------- ----------- -----------
Cash and cash equivalents at end of period..................... $ 9,643,883 $12,214,042 $12,928,911
=========== =========== ===========
Supplemental disclosure of cash flow information
Cash paid for interest.......................................... $ 284,925 $ 328,448 $ 373,948
Supplemental noncash investing and financing information
Notes payable to stockholders, including $26,583 of accrued
interest, converted into Series D preferred stock.............. $ -- $ -- $ 152,933
Capital lease obligations incurred.............................. $ -- $ 14,003 $ 332,084
</TABLE>
31
<PAGE>
CONNECT, INC.
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1997
1. ORGANIZATION
CONNECT (the "Company") designs, develops, markets and supports packaged
application software for Internet-based electronic commerce. The Company was
founded in 1987 to provide online information services to businesses. During the
period 1987 through 1992, the Company's primary business was the operation and
management of a private online service and the licensing of related client
software. In 1993 and 1994, the Company also offered software for creation,
access and operation of custom online systems. In late 1994, the Company began
to shift its focus from providing online services to developing packaged
software applications for Internet-based interactive commerce. During 1994 and
1995, the Company derived a significant portion of its revenue from contract
software development projects with two companies under which the Company
retained ownership of the technology developed. These projects formed the
foundation for the development of OneServer, the Company's core software
application, which was commercially released in September 1995, and OrderStream,
the first preconfigured implementation of OneServer, which was commercially
released in June 1996.
For the years ended December 31, 1997, 1996 and 1995, the Company derived 83%,
75% and 5%, respectively, of its revenues from its OneServer, OrderStream and
PurchaseStream products. The remaining revenue was derived from the Company's
online products and services. The Company transferred, effective December 31,
1997, the online services business to a new company formed primarily by former
CONNECT employees, thus allowing the Company to focus entirely on its electronic
commerce applications software business. The Company did not receive any
consideration upon consummation of this transaction; however, the Company will
receive future royalty payments based upon revenue levels achieved by the new
company.
The Company has incurred net losses and experienced significant negative cash
flow from operations since inception. As of December 31, 1997, the Company had
an accumulated deficit of approximately $61.6 million. Based upon its current
operating plan, the Company believes it has adequate cash and investment
balances to fund its operations through December 31, 1998. There can be no
assurance, however, that the Company's actual cash requirements will not exceed
anticipated levels, or that the Company will generate sufficient revenue to fund
its operations in the absence of additional funding sources. If additional funds
are raised through the issuance of equity securities, stockholders of the
Company may experience additional dilution, or the securities may have rights,
preferences or privileges senior to those of the Company's Common Stock. There
can be no assurance that such additional financing will be available on
acceptable terms, if at all. If adequate funds are not available or are not
available on acceptable terms, the Company may be unable to continue its
operations, develop or enhance its products, take advantage of future
opportunities or respond to competitive pressures or other requirements, any of
which would have a material adverse effect on the Company's business, operating
results and financial condition.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
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.
Concentration of Credit Risk
The Company licenses products and provides services to a variety of customers.
The Company generally does not perform credit evaluations or require collateral
on individual customer service or license transactions that involve relatively
small amounts. However, credit worthiness on larger service or license
transactions are evaluated on a case-by-case basis.
Cash and Cash Equivalents
The Company considers all highly liquid investments with an original maturity
(at the date of purchase) of three months or less to be cash equivalents. The
Company has classified all investments in debt securities as available-for-sale.
Available-for-sale securities are carried at amounts which approximate fair
value. Unrealized gains and losses, if
32
<PAGE>
CONNECT, INC.
NOTES TO FINANCIAL STATEMENTS-(CONTINUED)
DECEMBER 31, 1997
material, are reported in a separate component of stockholders' equity. Realized
gains and losses and declines in value judged to be other-than-temporary are
included in interest income and other, net.
All of the Company's available-for-sale securities mature in three months or
less and are included in cash and cash equivalents. Available for sale
securities at December 31, 1997 and 1996 totaled $4,982,813 and $8,935,132,
respectively, and are comprised of U.S. government obligations and commercial
paper. At December 31, 1997 and 1996, gross unrealized gains and losses were not
significant. There were no gross realized gains or losses on available-for-sale
securities for 1997, 1996, and 1995.
Property and Equipment
Property and equipment are stated at cost and are depreciated on a straight-
line basis over their estimated useful lives of three to seven years. Leasehold
improvements are amortized on a straight-line basis over the shorter of the
lease term or the estimated useful life of the improvements.
Property and equipment consisted of the following:
<TABLE>
<CAPTION>
December 31,
-----------------------
1997 1996
----------- ----------
<S> <C> <C>
Computer equipment............................................................................. $3,998,709 $3,523,022
Equipment under capital leases................................................................. 2,255,069 2,307,869
Furniture and fixtures......................................................................... 314,842 225,521
Leasehold improvements......................................................................... 655,842 619,331
---------- ----------
7,224,462 6,675,743
Accumulated depreciation and amortization...................................................... 4,782,403 3,028,934
---------- ----------
$2,442,059 $3,646,809
========== ==========
</TABLE>
Revenue Recognition and Deferred Revenue
The Company derives revenue from software license fees and services. License
fees consist primarily of revenue from licenses of the Company's application
software. Service revenue consists of fees from implementation (including
customization of licensed software products), training, maintenance and support,
contract software development projects, system hosting and online services.
License Revenue
The Company licenses application software to end-users under non-cancelable
license agreements. License revenue is recognized on shipment of the application
software provided there are no significant remaining obligations and
collectability is deemed probable by management. License fees under contracts
requiring significant implementation, including customization of licensed
software products are recognized on the percentage-of-completion method based on
the ratio of incurred costs to total estimated costs. Actual costs and gross
margins on such contracts could differ from management's estimates and such
differences could be material to the financial statements. Provisions for
estimated losses on uncompleted contracts are made in the period in which such
losses are determined.
Service Revenue
Fees for implementation services are recognized as the services are performed,
except for such fees under fixed price contracts which are recognized on the
percentage-of-completion method as noted above.
33
<PAGE>
CONNECT, INC.
NOTES TO FINANCIAL STATEMENTS-(CONTINUED)
DECEMBER 31, 1997
The Company also enters into maintenance agreements in connection with
licenses of its application software under which revenue is recognized ratably
over the term of the agreement, generally one year. Usage fees related to
the Company's private online services, system-hosting services, training and
other consulting services are recognized as the services are performed.
Revenue from contract software development projects, in which the Company
developed specific technology for its customers, has been recognized on the
percentage-of-completion method based on the ratio of incurred costs to total
estimated costs.
Deferred Revenue
Deferred revenue includes cash collections in excess of revenue recognized on
development arrangements, deferred maintenance, and other payments received in
advance of services to be performed.
Research and Development
Research and development expenditures are generally charged to operations as
incurred. Statement of Financial Accounting Standards No. 86, "Accounting for
the Costs of Computer Software to be Sold, Leased or Otherwise Marketed,"
requires the capitalization of certain software development costs subsequent to
the establishment of technological feasibility. Based on the Company's product
development process, technological feasibility is established upon the
completion of a working model. Costs incurred by the Company between the
completion of the working model and the point at which the product is ready for
general release have been insignificant. Accordingly, the Company has charged
all such costs to research and development expenses in the accompanying
statements of operations.
Advertising and Promotion Costs
The Company's policy is to expense advertising and promotion costs as they are
incurred. The Company's advertising and promotion expenses were approximately
$800,000, $1,064,000, and $372,000 in 1997, 1996, and 1995, respectively.
Net Loss Per Share
In 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 128, "Earnings per Share" ("FAS 128"). FAS
128 replaced the calculation of primary and fully diluted net income (loss) per
share with basic and diluted net income (loss) per share. Unlike primary net
income (loss) per share, basic net income (loss) per share excludes any dilutive
effects of options, warrants and convertible securities. Diluted net income
(loss) per share is very similar to the previously reported fully diluted net
income (loss) per share. Diluted net loss per share excludes the effect of
outstanding stock options and warrants because it is antidilutive.
In February 1998, the Securities and Exchange Commission issued Staff
Accounting Bulletin No. 98 ("SAB 98"). Under SAB 98, certain shares of
convertible preferred stock, options, and warrants to purchase common stock,
issued at prices substantially below the per share price sold in the Company's
initial public offering in August 1996, previously included in the computation
of shares outstanding pursuant to Staff Accounting Bulletin Nos. 55, 64, and 83
are now excluded from the computation. Basic and diluted net loss per share for
the years ended December 31, 1996 and 1995 have been retroactively restated to
apply the requirements of SAB 98 and FAS 128.
34
<PAGE>
CONNECT, INC.
NOTES TO FINANCIAL STATEMENTS-(CONTINUED)
DECEMBER 31, 1997
Per share information calculated on the above noted basis is as follows:
<TABLE>
<CAPTION>
Year ended December 31,
-----------------------
1997 1996 1995
---- ---- ----
(in thousands, except
per share amounts)
<S> <C> <C> <C>
Basic and diluted restated net
loss per share under FAS 128
and SAB 98 $(3.85) $(11.06) $(186.04)
Shares used in computing
net loss per share 3,784 1,460 76
</TABLE>
Pro Forma Net Loss Per Share
The pro forma basic and diluted net loss per share as shown in the statement
of operations gives effect, even if antidilutive, to common equivalent shares
from convertible preferred stock that were automatically converted to common
stock upon the closing of the Company's initial public offering, using the if
converted method.
Stock-Based Compensation
In October 1995, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation" ("FAS 123"). The Company adopted FAS123 in 1996. The Company
accounts for employee stock options in accordance with Accounting Principles
Board Opinion No. 25 and has adopted the "disclosure only" alternative described
in FAS 123.
Recent Pronouncements
In October 1997, the American Institute of Certified Public Accountants issued
Statement of Position No. 97-2, "Software Revenue Recognition" ("SOP 97-2"),
which supercedes SOP 91-1. The Company will be required to adopt this standard
in the first quarter of fiscal 1998. Restatement of prior financial statements
is prohibited. SOP 97-2 addresses software revenue recognition matters
primarily from a conceptual level and detailed implementation guidelines have
not yet been issued. Accordingly, the Company is uncertain as to the effect of
SOP 97-2 on its existing revenue recognition practices.
The Company intends to adopt Statement of Financial Accounting Standards No.
130, "Reporting Comprehensive Income," ("FAS 130") and Statement of Financial
Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and
Related Information," ("FAS 131") in 1998. Both will require additional
disclosure but will not have a material effect on the Company's financial
position or results of operations. FAS 130 will first be reflected in the
Company's first quarter of 1998 interim financial statements. Components of
comprehensive income include items such as net income and changes in unrealized
gain or loss on available-for-sale securities. FAS 131 requires segments to be
determined based on how management measures performance and makes decisions
about allocating resources. FAS 131 will first be reflected in the Company's
1998 financial statements.
3. CONVERTIBLE NOTES
In November 1997, the Company completed a private placement of 258 Units, each
unit consisting of one convertible note (each a "Note") in the principal amount
of $40,000 and one warrant to purchase 2,667 shares of
35
<PAGE>
CONNECT, INC.
NOTES TO FINANCIAL STATEMENTS-(CONTINUED)
DECEMBER 31, 1997
Common Stock of the Company. The Units were priced at $40,000 per Unit, and net
proceeds were approximately $9.7 million.
Each Note accrues interest at a rate of 5% per annum and is convertible at the
option of the holder into shares of the Company's Common Stock at a price per
share equal to the lesser of (i) $2.00 or (ii) 80% of the average closing bid
price of the Company's Common Stock during the 10 trading days prior to
conversion. Interest is payable quarterly and may be paid, at the option of the
Company, either in cash or in additional notes with one-year maturities and
principal amounts equal to the interest then due. Each warrant is exercisable
at any time within three years after the date of issuance, at a price of $2.50
per share.
The Company entered into exchange agreements with each holder of the Notes,
pursuant to which such holders agreed to exchange all of the outstanding Notes,
with an aggregate principal amount of $10.3 million, for shares of the Company's
Series A Preferred Stock at an exchange rate equal to one share of Series A
Preferred Stock for each $2.00 of principal amount under the Notes, plus accrued
interest. (See Note 14)
4. NOTES PAYABLE
At December 31, 1997 the Company has a series of notes payable totaling
$1,332,974 of which $619,921 is due within a year.
Unsecured notes totaling $12,931 bear interest at 11% and are due in monthly
payments through March 1, 1998. Notes totaling $1,320,043 bear interest at 8.5%,
are due in monthly payments through May 1, 2000, and are secured by
equipment, furniture and fixtures.
5. EXTENDED VENDOR LIABILITIES
In April 1994, the Company terminated its service and license agreement with a
vendor, resulting in a reduction of $253,656 in extended vendor liabilities. In
addition, the repayment terms for certain amounts due the vendor were extended
from three to five years. Beginning in December 1994, the total liability due
the vendor of $1,000,000 became due in monthly installments, plus interest, at
an annual rate of 6% through November 1999.
Principal payments due as of December 31, 1997 relating to the above
agreements are as follows:
<TABLE>
<S> <C>
1998....................................................................................... $271,694
1999....................................................................................... $223,512
--------
$495,206
========
</TABLE>
36
<PAGE>
CONNECT, INC.
NOTES TO FINANCIAL STATEMENTS-(CONTINUED)
DECEMBER 31, 1997
6. COMMITMENTS AND CONTINGENCIES
Operating Leases
The lease agreement for the Company's primary facility expires December 9,
1999. At December 31, 1997, the future minimum lease payments related to
operating lease agreements are as follows:
<TABLE>
<S> <C>
1998........................................................................................ $ 426,437
1999........................................................................................ 400,924
2000........................................................................................ 95,583
2001........................................................................................ 98,451
----------
$1,021,395
==========
</TABLE>
Rental expense for 1997, 1996 and 1995, was $446,125, $290,690, $317,690,
respectively.
Capital Leases
The Company leases certain equipment under capital leases having terms of 36
to 42 months. Accumulated amortization on these assets was $1,560,402 and
$1,196,394 at December 31, 1997 and 1996, respectively.
The following is a schedule by year of future minimum lease payments under
capital leases as of
December 31, 1997:
<TABLE>
<S> <C>
1998........................................................................................ $380,313
1999........................................................................................ 2,187
--------
Total minimum lease payments................................................................ 382,500
Amount representing interest................................................................ 25,921
--------
356,579
Less current portion........................................................................ 354,460
--------
$ 2,119
========
</TABLE>
Contingencies
On March 25, 1996, one of the Company's licensees of OneServer (the
"Customer") was sued, along with 21 other defendants in the Federal District
Court in Connecticut, by E-data Corporation ("E-data"), in which E-data alleged
that each defendant was infringing E-data's U.S. patent in connection with
electronic distribution of images on the Internet. In 1997, E-data did not
pursue the patent infringement claim against the Customer, and the claim was
dismissed from Federal District Court in Connecticut on August 22, 1997.
7. EMPLOYEE BENEFIT PLAN
The Company maintains an employee savings plan for all of its full-time
employees that qualifies under Section 401(k) of the Internal Revenue Code (the
"Code"). The plan allows employees to make specified percentage pre-tax
contributions up to the maximum dollar limitation prescribed by the Code. The
Company has the option to contribute to the plan. There have been no Company
contributions to date.
37
<PAGE>
CONNECT, INC.
NOTES TO FINANCIAL STATEMENTS-(CONTINUED)
DECEMBER 31, 1997
8. STOCK OPTION AND STOCK PURCHASE PLANS
The Company has elected to follow Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees" ("APB 25") and related
Interpretations in accounting for its employee stock options because, as
discussed below, the alternative fair value accounting provided for under FAS
123, "Accounting for Stock-Based Compensation" requires use of option valuation
models that were not developed for use in valuing employee stock options. Under
APB 25, because the exercise price of the Company's employee stock options
equals the market price of the underlying stock on the date of grant, no
compensation expense is recognized.
The Company maintains a 1989 Stock Option Plan that authorized the issuance
of up to 540,000 shares of common stock. A committee, as appointed by the Board
of Directors, grants incentive or non-qualified stock options. Options are
generally granted at an exercise price of no less than the fair value per share
of the common stock on the date of grant. The options issued under the 1989
Plan generally vest over four years and are immediately exercisable, expiring no
later than ten years from the date of grant. Unvested shares may be repurchased
by the Company at the original purchase price.
In 1996, stockholders approved the adoption of the 1996 Stock Option Plan
pursuant to which 500,000 shares of the Company's common stock have been
reserved. A committee, as appointed by the Board of Directors, grants incentive
or non-qualified stock options. Options issued under the 1996 Stock Option Plan
are generally exercisable twelve months from the date of grant and vest over
four years, expiring no later than 10 years from the date of grant.
In 1996, the Company offered to each employee with stock options having an
exercise price greater than the prevailing fair market value of the common
stock, the opportunity to amend the terms of such option to reduce the exercise
price to the prevailing fair market value. The reduced exercise price was not
less than fair market value per share of common stock. The new options have the
same vesting terms as the surrendered options. Options representing 163,334
shares of common stock were repriced, and are included in option grants and
cancellations in the year ended December 31, 1996.
In 1997, the Company offered to each employee with stock options having an
exercise price greater than the prevailing fair market value of the common
stock, the opportunity to amend the terms of such option to reduce the reduced
exercise price to the prevailing fair market value. The new options have the
same vesting terms as the surrendered options. Options representing 166,708
shares of common stock were repriced, and have been included in option grants
and cancellations in 1997.
38
<PAGE>
CONNECT, INC.
NOTES TO FINANCIAL STATEMENTS-(CONTINUED)
DECEMBER 31, 1997
A summary of activity under the Stock Option Plans is as follows:
<TABLE>
<CAPTION>
OUTSTANDING OPTIONS
-----------------------------
SHARES WEIGHTED AVERAGE
AVAILABLE NUMBER OF PRICE EXERCISE PRICE
FOR GRANT SHARES PER SHARE PER SHARE
---------- --------- -------------- --------------------
<S> <C> <C> <C> <C>
Balance at December 31, 1994............................ 10,740 129,404 $ 1.00 $20.00
Additional shares reserved........................... 369,000
Options granted...................................... (95,100) 95,100 $2.50 - $65.00
Options exercised.................................... -- (5,159) $ 1.00 $20.00
Options canceled..................................... 11,919 (11,919) $ 1.30 $65.00
-------- -------- --------------
Balance at December 31, 1995............................ 296,559 207,426 $ 1.00 $65.00
Additional shares reserved........................... 500,000
Options granted...................................... (691,429) 691,429 $ 2.50 $54.00 $15.05
Options exercised.................................... -- (29,313) $1.00 $ 2.50 $ 2.10
Options canceled..................................... 198,869 (198,869) $ 1.00 $65.00 $32.70
Options repurchased.................................. 4,700 -- $ 1.30 $3.50 $ 2.50
-------- -------- -------------- ------
Balance at December 31, 1996............................ 308,699 670,673 $ 1.00 $54.00 $ 9.35
Options granted...................................... (544,987) 544,987 $ 5.45 $30.65 $10.40
Options exercised.................................... (102,318) $ 1.00 $8.15 $ 2.10
Options canceled..................................... 446,150 (446,150) $ 1.30 -$41.25 $17.20
Options repurchased.................................. 1,878 -- $ 1.75 $2.50 $ 2.40
-------- -------- -------------- ------
Balance at December 31, 1997............................ 211,740 667,192 $ 1.00 $15.00 $ 6.00
-------- -------- --------------
</TABLE>
At December 31, 1997, options to purchase 215,903 shares of common stock were
vested and exercisable. At December 31, 1997, 5,507 shares of common stock
issued upon exercise of options were subject to repurchase by the Company.
In connection with certain of the Company's stock options granted in 1996, the
Company recorded deferred compensation of $169,433 for the difference between
the option grant price and the deemed fair value of the Company's common stock
at the date of grant. The amount is being amortized over the vesting period of
the individual options, generally a 48-month period. Amortization expense
related to deferred compensation was $43,356 and $30,022 for the years ended
December 31, 1997 and December 31,1996 respectively.
The following table summarizes stock options outstanding and options exercisable
at December 31, 1997:
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING Options Exercisable
- ---------------------------------------------------------------------------------------------------------------------------------
Range of Outstanding as of Weighted Average Weighted Exercisable as Weighted
Exercise Prices December 31, Remaining Average as of Dec. 31, Average
1997 Contractual life Exercise Price 1997 Exercise Price
- ---------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
$1.00 - $2.50 262,983 6.6 $ 2.35 155,175 $ 2.25
$5.05 - $7.50 174,262 9.5 $ 6.50 17,742 $ 6.25
$7.55 -$10.00 148,369 7.9 $ 8.25 37,166 $ 8.15
$10.05 -$12.50 45,578 9.6 $11.25 --- ---
$12.55 -$15.00 36,000 9.4 $15.00 5,820 $15.00
------- --- ------ ------- ------
667,192 8.0 $ 6.00 215,903 $ 3.90
------- ------- ------
</TABLE>
Pro forma information regarding net loss and net loss per share is required by
FAS 123, which also requires that the information be determined as if the
Company had accounted for its employee stock options granted subsequent to
December 31, 1994 under the fair value method. In 1997, the fair value of each
option grant was estimated on the date of the grant using the
Black-Scholes option-pricing model. In 1996, prior to the completion of the
initial public offering of common stock, and in 1995, the fair value of each
option grant was estimated using the
39
<PAGE>
CONNECT, INC.
NOTES TO FINANCIAL STATEMENTS-(CONTINUED)
DECEMBER 31, 1997
minimum value method. The minimum value method differs from other methods of
valuing options, such as the Black-Scholes option pricing model, because it does
not consider the effect of expected volatility. The fair value of options was
estimated at the date of grant using the following weighted average assumptions
for the years ended December 31, 1997, 1996 and 1995:
<TABLE>
<CAPTION>
1997 1996 1995
------ ----- -----
<S> <C> <C> <C>
Risk Free interest rate................................................................. 6.27% 5.88% 6.17%
Dividend yield.......................................................................... None None None
Volatility.............................................................................. .94 .18 --
Expected life of options in years....................................................... 5 5 5
</TABLE>
The Black-Scholes option valuation model was developed for use in estimating
the fair value of traded options which have no vesting restrictions and are
fully transferable. In addition, option valuation models require the input of
highly subjective assumptions including the expected stock price volatility.
Because the Company's employee stock options 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 employee stock options.
The Company maintains an Employee Stock Purchase Plan pursuant to which
100,000 shares of the Company's common stock are reserved for future issuance. A
total of 21,072 shares were issued under the Plan in 1997, and 78,928 shares
were available for grant as of December 31, 1997. The Company also maintains a
Director's Stock Option Plan pursuant to which 50,000 shares of common stock are
reserved for future issuance. A total of 5,000 options were issued under the
Director's Plan in 1997 at an exercise price of $15.00 per share, and 45,000
were available for issuance as of December 31, 1997.
For purposes of pro forma disclosures, the estimated fair value of the options
is amortized to expense over the options' vesting period. The Company's pro
forma information is as follows:
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
1997 1996 1995
------------- ------------- -------------
<S> <C> <C> <C>
Pro forma net loss Pro forma net loss per share.............. $(15,102,671) $(16,675,027) $(14,154,076)
Pro forma net loss per share.................................. $ (3.99) $ (11.42) $ (186.24)
</TABLE>
The pro forma net loss per share above does not assume the conversion of
preferred stock prior to completion of the initial public offering in August
1996, and is calculated using the weighted average number of shares of common
stock outstanding as described in Note 1.
The weighted average fair value of options granted during the years ended
December 31, 1997, 1996 and 1995 was $3.10, $7.50 and $0.95, respectively.
Because FAS 123 is applicable only to options granted subsequent to December 31,
1994, its pro forma effects will not be fully reflected until the year ended
December 31, 1999.
9. STOCK WARRANTS
In November 1997, the Company issued 258 warrants in connection with the
Convertible notes financing in November 1997. Each warrant entitles the holder
to purchase 2,667 shares of common stock at a price of $12.50 per share.
10. TERMINATION OF DISTRIBUTION RIGHTS
In December 1994, the Company signed an agreement that provided the Company
the option to terminate the marketing and distribution rights of its European
distributor. In connection with this option agreement, the Company paid its
European distributor a nonrefundable $250,000 fee, which the Company expensed in
1994. The Company exercised its option on March 13, 1995 and paid its European
distributor approximately $2,640,000 in cash and issued 35,000 shares of its
Series E preferred stock. Due to impairment of the net realizable value of the
European distribution rights, the Company expensed all payments made in
connection with the transaction in 1995. The amount paid was negotiated between
the Company and its European distributor on an arm's-length basis. The
40
<PAGE>
CONNECT, INC.
NOTES TO FINANCIAL STATEMENTS-(CONTINUED)
DECEMBER 31, 1997
company received an opinion from an independent financial advisor as to the fair
market value of the shares of Series E preferred stock at the time of the
negotiation to support its determination as to the value of the amount paid.
11. MAJOR CUSTOMERS
Customers comprising 10% or greater of the Company's revenue are summarized as
follows:
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-----------------------
1997 1996 1995
------- ------ ------
<S> <C> <C> <C>
Customer A........................................................................................... 18% * 52%
Customer B........................................................................................... 12% * -
Customer C........................................................................................... * 13% -
</TABLE>
* Revenue less than 10%.
-- Customer provided no revenue to the Company.
12. INCOME TAXES
<TABLE>
<CAPTION>
Years Ended December 31,
-------------------------
1997 1996 1995
------ ----- ----------
<S> <C> <C> <C>
Federal:
Current...................................................................... $ -- $ -- $(94,000)
Deferred..................................................................... -- -- 77,000
------ ----- --------
-- -- (17,000)
State:
Current...................................................................... -- -- (9,000)
------ ----- --------
-- -- (9,000)
------ ----- --------
Provision (benefit) for income taxes............................................ $ -- $ -- $(26,000)
====== ===== ========
</TABLE>
The difference between the provision (benefit) for income taxes and the amount
computed by applying the federal statutory income tax rate to income (loss)
before taxes is as follows:
<TABLE>
<CAPTION>
1997 1996 1995
------------ ------------ ------------
<S> <C> <C> <C>
Tax at federal statutory rate................................................... $(4,958,000) $(5,650,000) $(4,958,000)
State taxes..................................................................... -- -- (9,000)
Losses not currently benefited.................................................. 4,958,000 5,650,000 4,941,000
----------- ----------- -----------
Provision (benefit) for income taxes............................................ $ -- $ -- $ (26,000)
=========== =========== ===========
</TABLE>
41
<PAGE>
CONNECT, INC.
NOTES TO FINANCIAL STATEMENTS-(CONTINUED)
DECEMBER 31, 1997
The components of deferred income taxes consist of the following:
<TABLE>
<CAPTION>
December 31,
----------------------------
1997 1996
------------- -------------
<S> <C> <C>
Deferred tax assets:
Net operating loss carryforwards............................................................. $ 13,000,000 $ 11,100,000
Research credit carryforwards................................................................ 250,000 167,000
Deferred revenue............................................................................. 400,000 200,000
Depreciation and amortization................................................................ 1,500,000 1,800,000
Other........................................................................................ 700,000 400,000
------------ ------------
Total deferred tax assets....................................................................... 15,850,000 13,667,000
Valuation allowance............................................................................. (15,850,000) (13,667,000)
------------ ------------
Total net deferred taxes........................................................................ $ -- $ --
============ ============
</TABLE>
A valuation allowance has been recorded for the entire deferred tax asset as a
result of uncertainties regarding the realization of the asset due to the lack
of earnings history of the Company. To support the Company's conclusion that a
full allowance was required, management primarily considered the Company's
history of operating losses and expected net losses for the foreseeable future.
The Company will continue to assess the realizability of the deferred tax assets
based on actual and forecasted operating results. The valuation allowance
increased by $2,183,000 in 1997 and $6,005,000 in 1996.
At December 31, 1997, the Company had available federal net operating loss
carryforwards of approximately $38,400,000, which will expire in 2010 through
2012, if not utilized. Also available at December 31, 1997 are federal research
credit carryforwards of approximately $250,000, which will expire in 2011, if
not utilized. The Company's issuance of Series F preferred stock in December
1995 was considered to have caused a change in ownership as prescribed in the
Internal Revenue Code. Accordingly, approximately $8,100,000 of the Company's
net operating loss carryforwards will be subject to an annual limitation of
approximately $540,000 per year.
13. RELATED PARTY TRANSACTIONS
In 1995, $126,350 of notes payable to a stockholder was converted into Series
D preferred stock. Accrued interest outstanding on the notes payable of $26,583
was also converted into Series D preferred stock.
14. SUBSEQUENT EVENTS
On February 26, 1998, the Company completed an exchange of $9,744,250
principal amount of outstanding convertible notes and accrued interest, which
were originally issued in November 1997 as described in Note 3, for 4,905,209
shares of Series A preferred stock (the "Exchange"). Prior to the Exchange,
$575,750 principal amount of convertible notes were converted into 1,245,028
shares of common stock under the original terms of the convertible note
agreement. The remaining convertible notes, pursuant to the Exchange, were
exchanged for shares of the Company's Series A preferred stock at an exchange
rate equal to one share of Series A preferred stock for each $2.00 of principal
amount of the convertible notes, plus accrued interest. Each share of Series A
preferred stock issued in exchange for the convertible notes is convertible at
the option of the holder into that number of shares of common stock equal to the
greater of (i) the quotient obtained by dividing $2.00, plus accumulated but
unpaid dividends, by the conversion price (which initially is $10.00 per share
and shifts to $7.50 per share on December 31, 1999) or (ii) the quotient
obtained by dividing $2.00, plus accumulated but unpaid dividends, by 80
42
<PAGE>
CONNECT, INC.
NOTES TO FINANCIAL STATEMENTS-(CONTINUED)
DECEMBER 31, 1997
percent (or 60 percent if the conversion occurs after December 15, 1999) of the
average closing bid price for the ten trading days prior to conversion. The
initial conversion price will be subject to adjustment in the event of issuances
of capital stock at a purchase price of less than $10.00 (other than issuance of
common stock to employees, directors or consultants of the Company) and
convertible securities with a conversion price of less than $10.00 per share, as
well as stock splits and stock combinations.
On February 26, 1998, the Company effected a reverse split of all outstanding
shares of common stock such that each five shares of common stock were converted
into one share of common stock. All common shares in the accompanying financial
statements have been retroactively adjusted to reflect the reverse stock split.
In connection with the reverse stock split, the conversion and exercise
provisions of all outstanding shares, stock options, and warrants have been
adjusted accordingly. On February 26, 1998, the Company increased the number of
authorized shares of Common Stock from 40,000,000 to 60,000,000.
43
<PAGE>
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
We have audited the financial statements of CONNECT, Inc. as of December 31,
1997 and 1996 and for each of the three years in the period ended December 31,
1997, and have issued our report thereon dated January 24, 1997, except for Note
14, as to which the date is February 26, 1998, (included elsewhere in this
Annual Report ( Form 10-K )). Our audits also included the financial statement
schedule listed in Item 14 of this Annual Report ( Form 10-K ). 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.
ERNST & YOUNG LLP
San Jose, California
January 27, 1998
44
<PAGE>
SCHEDULE II
CONNECT, INC.
VALUATION AND QUALIFYING ACCOUNTS
YEAR ENDED DECEMBER 31, 1997, 1996, AND 1995
<TABLE>
<CAPTION>
ADDITIONS
BALANCE CHARGED TO
BEGINNING OF COST AND BALANCE
PERIOD EXPENSES DEDUCTIONS END OF PERIOD
----------- ------------ ---------- -------------
<S> <C> <C> <C> <C>
Year ended December 31, 1997 $222,000 $560,000 $(140,000) $642,000
Allowance for doubtful accounts
Year ended December 31, 1996 $320,000 $157,000 $(255,000) $222,000
Allowance for doubtful accounts
Year ended December 31, 1995 $174,000 $166,842 $ (20,842) $320,000
Allowance for doubtful accounts
</TABLE>
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
Not Applicable.
PART III.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
(a) Executive Officers:
The information concerning the Company's Executive Officers is incorporated by
reference from the Proxy Statement for the 1998 Annual Meeting of Shareholders
to be held on May 28, 1998, a copy of which will be filed with the Securities
and Exchange Commission no later than 120 days from the end of the Company's
last fiscal year.
(b) Identification of Directors:
The information concerning the Company's directors and nominees is
incorporated by reference from the section entitled "Proposal No. 1 Election of
Directors" in the Proxy Statement for the 1998 Annual Meeting of Shareholders to
be held on May 28, 1998, a copy of which will be filed with the Securities and
Exchange Commission no later than 120 days from the end of the Company's last
fiscal year.
ITEM 11. EXECUTIVE COMPENSATION
The information concerning the Company's Executive Compensation is
incorporated by reference from the section entitled "Executive Compensation" in
the Proxy Statement for the 1998 Annual Meeting of Shareholders to be held on
May 28, 1998, a copy of which will be filed with the Securities and Exchange
Commission no later than 120 days from the end of the Company's last fiscal
year.
45
<PAGE>
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Incorporated by reference from the section entitled "Stock Ownership of
Certain Beneficial Owners and Management" in the Proxy Statement for the 1998
Annual Meeting of Shareholders to be held on May 28, 1998, a copy of which will
be filed with the Securities and Exchange Commission no later than 120 days from
the end of the Company's last fiscal year.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Incorporated by reference from the section entitled "Certain Relationships and
Related Transactions" in the Proxy Statement for the 1998 Annual Meeting of
Shareholders to be held on May 28, 1998, a copy of which will be filed with the
Securities and Exchange Commission no later than 120 days from the end of the
Company's last fiscal year.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) 1. Index to Financial Statements. The following financial statements and
supplemental data are included in Item 8 of this Form 10-K:
<TABLE>
<CAPTION>
Page Number
<S> <C>
Report of Ernst & Young, LLP, Independent Auditors
27
Balance Sheets at December 31, 1997 and 1996 28
Statements of Operations for each of the three years in the period
ended December 31, 1997 29
Statement of Stockholders' Equity for each of the three years in the
period ended December 31, 1997 30
Statement of Cash Flows for each of the three years for the period
ended December 31, 1997 31
Notes to Financial Statements 32
Report of Ernst & Young LLP, Independent Auditors
on the financial statement schedule 44
</TABLE>
2. Financial Statement Schedules. Schedule II - Valuation and Qualifying
Accounts
All other schedules are omitted because they are not applicable, or not
required, or because the required information was filed by the Company's
previously, or is included the consolidated financial statements or notes
thereto.
46
<PAGE>
3. Exhibits
1.1 Form of Underwriting Agreement. (1)
2.1 Form of Agreement and Plan of Merger between the Company and
Connect, Inc., a California corporation. (1)
3.1 Certificate of Incorporation of the Company. (1)
3.2 Bylaws of the Company. (1)
3.3 Form of Amended and Restated Certificate of Incorporation of the
Company. (1)
3.4 Certificate of Amendment of Certificate of Incorporation. (1)
3.5 Form of Certificate of Designation of Rights, preferences and
privileges of Series A preferred stock(3)
3.6 Form of Certificate of Amendment of Certificate of Incorporation
4.1 Form of the Company's Common Stock Certificate. (1)
9.1 Amended Stockholders Agreement dated July 3, 1996 by and among the
Company and certain holders of the Company's securities. (1)
10.1 Form of Indemnification Agreement. (1)
10.2 1989 Stock Option Plan, as amended, and form of stock option
agreement. (1)
10.3 1996 Stock Option Plan, as amended, and form of stock option
agreement. (1)
10.4 1996 Employee Stock Purchase Plan and form of subscription
agreement. (1)
10.5 1996 Directors' Stock Option Plan and form of stock option
agreement. (1)
10.6 Amended and Restated Registration Rights Agreement dated July 3,
1996 between the Company and certain holders of the Company's
securities. (1)
10.7 Lease Agreement dated September 19, 1994 between the Company and
BRE Properties, Inc. (1)
10.8 Master Equipment Lease dated January 19, 1995 between the Company
and Phoenix Leasing Incorporated. (1)
10.9 Software License Agreement dated February 5, 1996 between the
Company and Entex Information Services Inc. (1)(2)
10.10 Software License Agreement dated March 26, 1996 between the
Company and Union Underwear Company, Inc. (1)(2)
10.11 Software License Agreement dated November 7, 1995 between the
Company and PhotoDisc, Inc. (1)(2)
10.12 Amendment to Software License Agreement dated March 29, 1996
between the Company and PhotoDisc, Inc. (1)(2)
10.13 Software Development and Distribution License Agreement dated
September 16, 1994 between the Company and Fulcrum Technologies
Inc. and related Amending Agreement, amending Agreement No. 2 and
Amending Agreement No. 3. (1)(2)
10.14 OEM Master License Agreement dated June 30, 1995 between the
Company and RSA Data Security, Inc. (1)(2)
10.15 Letter Agreement dated May 10, 1995 between the Company and
Hambrecht & Quist Incorporated and related mutual release dated
June 6, 1996. (1)
10.16 Option agreement dated January 16, 1996 between the Company and
Thomas P. Kehler. (1)
10.17 Option agreement dated January 16, 1996 between the Company and
Gordon J. Bridge. (1)
10.18 Option agreement dated April 24, 1996 between the Company and
Gordon J. Bridge. (1)
10.19 Letter agreement dated October 19, 1995 between the Company and
Gordon J. Bridge, and related interpretive letter. (1)
10.20 Consulting Agreement dated March 9, 1992 between the Company and
Quaestus Limited Partnership. (1)
10.21 Form of Common Stock Warrant issued to Hambrecht & Quist LLC and
Volpe, Welty & Company on December 27, 1995. (1)
10.22 Business Alliance Program Agreement dated June 11, 1996 between the
Company and Oracle Corporation and related Runtime Sublicense
Addendum, and Amendments One and Two to Runtime Sublicense
Addendum. (1)(2)
47
<PAGE>
10.23 Agreement and Mutual Release dated May 24, 1996 between the
Company and Henry V. Morgan. (1)
10.24 Development and License Agreement dated March 29, 1996 between the
Company and Time Warner Cable. (1)(2)
10.25 Form of Exchange Agreement between the Company and certain
security holders. (4)
10.26 Agreement dated January 28, 1998 between the Company and Impresso.
10.27 1998 Employment letter Agreement dated January 29, 1998 between
the Company and Gordon J. Bridge.
23 Consent of Independent Auditors.
24 Power of Attorney. (see p. 49)
27.1 Financial Data Schedule.
27.2 Restated Financial Data Schedule for year ended December 31,
1996.
27.3 Restated Financial Data Schedule for year ended December 31,
1995.
----------------
(1) Incorporated by reference to identically numbered exhibits to the
Company's Registration Statement on Form S-1, as amended (File No.
333-05901), which became effective on August 14, 1996.
(2) Confidential treatment has been previously granted with respect to
this exhibit.
(3) Incorporated by reference to Exhibit 3.4 to the Company's current
report on Form 8-K filed on December 24, 1997.
(4) Incorporated by reference to Exhibit 4.3 to the Company's current
report on Form 8-K filed on December 24, 1997.
(b) Form 8-K
The Company filed the following reports on Form 8-K during the fourth quarter
of the fiscal year 1997.
(1) Form 8-K filed on November 12, 1997, reporting the Company's
announcement on November 5, 1997 that it had entered into agreements to
raise $10 million through the sale and issuance of convertible notes
and warrants to purchase Common Stock in a private placement
transaction.
(2) Form 8-K filed on November 21, 1997, reporting the Company's
announcement on November 20, 1997 that it had completed a private
placement transaction in which it raised $10 million through the sale
and issuance of convertible notes and warrants to purchase Common
Stock.
(3) Form 8-K filed on December 24, 1997, reporting the Company's agreement
with the holders of the Company's outstanding convertible notes to
exchange such convertible notes for shares of Series A Preferred Stock.
48
<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.
CONNECT, Inc.
Date: March 27, 1998 By: /s/ Gordon J. Bridge
---------------------
Gordon J. Bridge
Chairman, President and
Chief Executive Officer
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints Gordon J. Bridge and Joseph G. Girata, and each
of them, his attorneys-in-fact and agents, on Form 10-K, and to file the same,
with exhibits thereto and other documents in connection therewith, with the
Securities and Exchange Commission, hereby ratifying and confirming all that
each of said attorneys-in-fact, or his substitute or substitutes may do or cause
to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this
Report has been signed below by the following persons in the capacities and on
the dates indicated.
<TABLE>
<CAPTION>
Signature Title Date
- ------------------------------------ --------------------------------------------------------------------------- --------------
<S> <C> <C>
/s/ Gordon J. Bridge Chairman, President and Chief Executive Officer March 27, 1998
- ------------------------------------
(Gordon J. Bridge)
/s/ Joseph G. Girata Chief Financial Officer (Principal Financial and Accounting Officer) and March 27, 1998
- ------------------------------------ Vice President of Finance & Administration
(Joseph G. Girata)
/s/ Promod Haque Director March 27, 1998
- ------------------------------------
(Promod Haque)
/s/ Richard H. Lussier Director March 27, 1998
- ------------------------------------
(Richard H. Lussier)
/s/ Rory T. O'Driscoll Director March 27, 1998
- ------------------------------------
(Rory T. O'Driscoll)
/s/ Richard W. Weening Director March 27, 1998
- ------------------------------------
(Richard W. Weening)
- ------------------------------------
</TABLE>
49
<PAGE>
Exhibit 10.26
AGREEMENT
This Agreement is made and entered into on January 28,1998 by and between
CONNECT, Inc., a Delaware corporation (the "Company") and Impresso, a Delaware
corporation ("Buyer").
1. Definitions.
------------
(a) "Online Business" shall mean the online services currently
provided by the Company which allows users to access information such as
newsletters, bulletins and e-mail from the Company's computers.
(b) "Pyramid Systems" shall mean two computer systems, identified by
Connect Property Tag #0032 and #0041, and associated operating systems, Oracle
and Fulcrum Software, as well as disks, identified by Tag #0099, #0100, #0101,
#0102 and #0103, that perform online transactions.
(c) "x.25" shall mean the online service specific T1 and 56KBPS
communication circuits to Pacific Bell, AT&T, Sprint and CompuServe that
terminate as the Verilink DSU Rack which connects to the Pyramid Computer
Systems.
2. The Transaction. The Company hereby transfers to the Buyer all right,
---------------
title and interest in the Online Business effective as of January 1, 1998. The
Buyer will continue to occupy the Company's facility, pursuant to Section 3
below, during a transition period which will end on September 30, 1998.
3. Rental Program.
--------------
(a) The rental program described in Section 3(b) shall begin on
January 1, 1998 and end of September 30, 1998. Buyer will pay the Company a fee
of $20,000 per month, payable on or before the 10th day of each calendar month.
(b) The rental fee referred to in Section 3(a) above shall cover the
following: (i) the rental of space at the Company's facility, which space is
currently occupied and used by the Online Business, including access to public
areas, (ii) utilities for the space occupied, including the computer operations
center utilized by the Online Business, (iii) costs of receptionist service,
(iv) general office overhead, (v) reasonable use of copiers, (vi) reasonable use
of office supplies, (vii) lunch room goodies, (viii) continued support on a
seven day, 24 hour basis by operators as long as the Company provides this to
its other customers, (ix) all reasonable telephone costs and data connection
costs, provided, however, that Buyer shall be responsible for the costs incurred
on x.25, (x) storage of backup tapes, (xi) offsite storage and (xii) rent of the
existing computer system equipment or their equivalent currently used by the
Online Business including the Pyramid Systems through September 30, 1998. Buyer
shall be responsible for maintenance on all of these machines commencing January
1, 1998. After December 31, 1997 and at such time as the equipment becomes
unencumbered, the Company shall offer Buyer the
<PAGE>
right to buy such unencumbered equipment. The price of the Nile 150 and the 12ES
Pyramid Systems is established to be $18,000 and $4,000, respectively. Buyer
shall cover its own postage, supplies for mass mailings and costs of employee
special events. Buyer may use Madsen's office at the Company's facility and up
to eight mutually agreeable cubes during the term of the rental period.
(c) Existing internet circuits and service costs incurred by the
Company and/or Buyer during the rental period shall be borne on a pro rata basis
in accordance with actual usage between such parties. If the usage cannot be
accurately determined, Buyer will pay 20% of the Company's total cost for as
long as the Company provides commercial hosting services to its customers.
(d) Buyer will provide the Company with its existing e-mail system as
long as the Pyramid Systems are operational but in no case shall this e-mail
system be terminated prior to March 31, 1998. There will be no charge to the
Company for this service except that users connecting via the x.25 from Malaysia
will incur a charge defined as cost based surcharge in the billing system.
4. Employment Issues.
-----------------
(a) No later than October 31, 1997, all Company employees who are
engaged in the Online Business must submit their resignation to the Company
effective at the end of business on December 31, 1997. Should an employee
decide not to submit their resignation by such date, then the Company may
terminate such employees in accordance with the Company's standard policy then
in effect. No later than October 31, 1997, Buyer shall select the employees
working in the Online Business which it intends to hire on January 1, 1998. The
Company shall be responsible for any applicable severance expenses for employees
not hired by Buyer. Should Buyer subsequently hire any person terminated in
this manner, whether the hiring of the person is as an employee, consultant or
through other such arrangement, within 12 months of such termination by the
Company, then Buyer shall pay $30,000 to the Company within 10 days of the date
of hire of such person to reimburse the Company for the severance costs
incurred. Notwithstanding the above, Buyer shall not incur a penalty if this
person is gainfully employed by the Company or another third party and is
willing to provide assistance to Buyer on a part time basis for compensation.
(b) Buyer will use a temporary agency or other service for payroll
matters and shall be responsible for all payroll and personnel matters related
to its employees and consultants.
(c) Buyer will ensure that its employees have workers' compensation
insurance and that Buyer is in compliance with other rules and regulations
relating to employment matters.
(d) Buyer shall carry a liability insurance policy of at least $1
million. Buyer shall provide to the Company a certificate of insurance naming
the Company as an additional insured as long as Buyer is renting space from the
Company pursuant to this Agreement.
-2-
<PAGE>
(e) Buyer shall be responsible for all legal and formation costs
relating to the formation of the Buyer.
(f) The Company and Buyer will act in good faith in working out which
employees are retained by the Company, which employees are employed by Buyer and
which employees are terminated. After this has been completed, there will be no
hiring by either the Company or Buyer of employees of the other party for a
period of 12 months without the permission of the other party in writing. Prior
to the end of the twelve month period, each party agrees that the liquidated
damages from hiring an employee currently employed by the other party shall be
$30,000 unless such employee is hired with the permission of the other entity.
This $30,000 amount is payable within 10 days of such employment.
(g) All personnel employed by Buyer will enter into a proprietary
information agreement with Buyer and shall also sign an agreement requiring them
to maintain the confidentiality of any confidential matters relating to the
Company.
5. Technology.
----------
(a) The Company shall maintain the ownership of the Online Software
(as defined below). Buyer is hereby granted an exclusive, worldwide perpetual
right and license to use the Online Software (as defined below). The Company
shall deliver a copy of the source code for such software to Buyer upon
execution of this Agreement. The license shall include the right to sublicense.
For purposes of this Agreement, "Online Software" shall be defined as
Connect Client Software Version 1.9 for both Macintosh and Windows, the Online
Software version __ Associated Billing Code which is operated on the Pyramid
Systems and the Newsletters Online Version v0-0-131 which is operated on the
Pyramid Systems and a Sun Sparc Station.
(b) Buyer shall pay the Company a royalty equal to 12% of the revenue
received by Buyer from sublicensing or otherwise utilizing the Software in a
given month provided that no royalty will be paid on the first $80,000 of such
revenue in a given month ($960,000 in a given year). No royalty will be payable
on revenues received by the Company prior to December 31, 1997. Royalties will
be payable within 30 days following the date on which payment is received by the
Buyer. The maximum cumulative royalty payable by Buyer to the Company is $1
million at which time this license shall be fully paid and the Company shall be
free to continue to license and otherwise use the software without the payment
of additional amounts to the Company.
(c) Buyer shall provide the Company with monthly statements setting
forth its calculation of the amount of the royalty payment in detail reasonably
satisfactory to the Company. The Company shall have the right, at its own
expense, to have an independent auditor inspect Buyer's records to confirm the
accuracy of such calculations; provided, however, that it may not exercise such
right more than twice in any twelve-month period. In the event that such
-3-
<PAGE>
auditor determines that the royalties have been underpaid by more than 5% of the
actual account owed in any three-month period, Buyer shall bear the reasonable
costs of such audit.
(d) THE ONLINE SOFTWARE IS PROVIDED "AS IS" WITHOUT WARRANTY OF ANY
KIND INCLUDING WITHOUT LIMITATION, ANY WARRANTY OF MERCHANTABILITY OR FITNESS
FOR A PARTICULAR PURPOSE. FURTHER, THE COMPANY DOES NOT WARRANT, GUARANTEE, OR
MAKE ANY REPRESENTATIONS REGARDING THE USE, OR THE RESULTS OF THE USE, OF THE
NEURON DATA SOFTWARE OR WRITTEN MATERIALS IN TERMS OF CORRECTNESS, ACCURACY,
RELIABILITY, OR OTHERWISE. Buyer understands that the Company is not
responsible for and will have no liability for hardware, software, or other
items not licensed from or through the Company hereunder or for any services
provided by any persons other than the Company.
6. Assignments.
-----------
(a) The Company shall transfer to Buyer all accounts receivable
relating to the Online Business existing on December 31, 1997. The purchase
price for such receivables will be equal to the amount of the accounts
receivable which are less than or equal 90 days old. Payment of such amount
shall be made in three equal installments on January 31, 1998, February 28, 1998
and March 31, 1998. Buyer will make a good faith effort to collect all
receivables acquired from the Company and will pay the Company 50% of the amount
collected on receivables having a date prior to October 1, 1997.
(b) The Company hereby assigns to Buyer all customer contracts
relating to the Online Business and Buyer hereby assumes all obligations
thereunder. To the extent the assignment of any such contract requires the
consent of any other person thereto, the Company agrees that it will use
commercially reasonable efforts to obtain any such consent. The Company agrees
to cooperate with Buyer in any reasonable arrangement designed to provide Buyer
with the benefits under the applicable contract. The Company and Buyer will
notify all customers of the Online Business of the assignment to Buyer. This
notification will be done no later than October 31, 1997. This notification
will provide for termination of any contracts on December 31, 1997 if Buyer does
not desire to honor such agreement after the proposed sale of the Online
Business.
7. Indemnification.
---------------
(a) For a period of 36 months after the date of this Agreement (or
until the expiration of the applicable statutes of limitations, in the case of a
Loss (as defined below) relating to taxes, environmental or employee benefit
matters), Buyer shall indemnify, defend and hold harmless the Company and its
officers, directors, agents and stockholders ("Company Indemnified Parties")
against all claims, losses, liabilities, damages, deficiencies, costs and
expenses, including reasonable attorneys, accountants and expert witness' and
the costs and expenses of enforcing this indemnification ("Losses"), including
without limitation, Losses resulting from the defense, settlement or compromise
of a claim or demand or assessment incurred by such Company Indemnified Parties
(1) as a result of or with respect to a breach of
-4-
<PAGE>
this Agreement by Buyer, or (2) arising in connection with the Online Business
on or after the date of this Agreement.
(b) For a period of 36 months after the date of this Agreement (or
until the expiration of the applicable statutes of limitations, in the case of a
Loss relating to taxes, environmental or employee benefit matters), the Company
shall indemnify, defend and hold harmless Buyer and its officers, directors,
agents and stockholders (the "Buyer Indemnified Parties") against all Losses,
including without limitation, Losses resulting from the defense, settlement or
compromise of a claim or demand or assessment incurred by such Buyer Indemnified
Parties (1) as a result of or with respect to a breach of this Agreement by the
Company, or (2) arising in connection with the Online Business before the date
of this Agreement.
8. Limitation of Liability. NEITHER PARTY SHALL BE RESPONSIBLE OR LIABLE
-----------------------
WITH RESPECT TO ANY SUBJECT MATTER OF THIS AGREEMENT OR ANY ATTACHMENT, PRODUCT
ORDER, SCHEDULE OR TERMS AND CONDITIONS RELATED THERETO UNDER ANY CONTRACT,
NEGLIGENCE, STRICT LIABILITY OR OTHER THEORY: (a) FOR LOSS OR INACCURACY OF
DATA OR COST OF PROCUREMENT OF SUBSTITUTE GOODS, SERVICES OR TECHNOLOGY, (b) FOR
ANY INDIRECT, INCIDENTAL OR CONSEQUENTLY DAMAGES INCLUDING, BUT NOT LIMITED TO
LOSS OF PROFITS; OR (c) FOR ANY MATTER BEYOND ITS REASONABLE CONTROL.
9. Miscellaneous.
-------------
(a) This Agreement sets forth the entire agreement and understanding
between the parties as to the subject matter hereof and supersedes all prior
discussions, agreements and understandings of every kind and nature between them
and their officers, directors and agents. This Agreement shall not be changed,
modified or amended except by a writing signed by the party to be charged.
(b) This Agreement and its validity, construction and performance
shall be governed in all respects by the laws of the State of California.
(c) This Agreement shall be binding upon and shall enure to the
benefit of the parties hereto and their successors and permitted assigns. This
Agreement may not be assigned by any party hereto except with the prior written
consent of the other party, provided, however, that Buyer may assign all of its
rights under this Agreement to any party acquiring substantially all of its
business.
(d) Notices. Any notice required or permitted by this Agreement shall
-------
be in writing and shall be deemed sufficient upon receipt, when delivered
personally or by courier, overnight delivery service or confirmed facsimile, or
forty-eight (48) hours after being deposited in the regular mail as certified or
registered mail (airmail if sent internationally) with postage prepaid, if such
notice is addressed to the party to be notified at such party's address or
facsimile number as set forth below, or as subsequently modified by written
notice.
-5-
<PAGE>
(e) Severability. If one or more provisions of this Agreement are
------------
held to be unenforceable under applicable law, the parties agree to renegotiate
such provision in good faith, in order to maintain the economic position enjoyed
by each party as close as possible to that under the provision rendered
unenforceable. In the event that the parties cannot reach a mutually agreeable
and enforceable replacement for such provision, then (i) such provision shall be
excluded from this Agreement, (ii) the balance of the Agreement shall be
interpreted as if such provision were so excluded and (iii) the balance of the
Agreement shall be enforceable in accordance with its terms.
(f) Independent Contractor. Neither party shall, for any purpose, be
----------------------
deemed to be an agent of the other party and the relationship between the
parties shall only be that of independent contractors. Neither party shall have
any right or authority to assume or create any obligations or to make any
representations or warranties on behalf of any other party, whether express or
implied, or to bind the other party in any respect whatsoever.
(g) Force Majeure. In the event that either party is prevented from
-------------
performing or is unable to perform any of its obligations under this Agreement
(other than a payment obligation) due to any Act of God, fire, casualty, flood,
earthquake, war, strike, lockout, epidemic, destruction of production
facilities, riot, insurrection, material or component unavailability or
shortage, or any other cause beyond the reasonable control of the party invoking
this Section (a "Force Majeure") and if such party shall have used its best
-------------
efforts to mitigate its effects, such party shall give prompt written notice to
the other party, its performance shall be excused, and the time for the
performance shall be extended for the period of delay or inability to perform
due to such occurrences. Notwithstanding the foregoing, if such party is not
able to perform within 30 days after the event giving rise to excuse of Force
Majeure, the other party may terminate the Agreement.
IN WITNESS WHEREOF, the parties hereto have caused this Agreement to be
executed on the day and year first above written.
CONNECT, INC. January 28, 1998
---------------------------------------
By: /s/ GORDON J. BRIDGE By: /s/ IMPRESSO
------------------------- ----------------------------------
Title: CEO Title: President
---------------------- -------------------------------
-6-
<PAGE>
Exhibit 10.27
January 28, 1998
Mr. Gordon J. Bridge
CONNECT, Inc.
515 Ellis Street
Mountain View, CA 94043
1998 EMPLOYMENT LETTER
----------------------
Dear Gordon:
This letter supersedes to the extent set forth below the letter agreement
between you and CONNECT, Inc. (the "Company") dated April 28, 1997 (the "1997
------- ----
Letter"), a copy of which is attached to this letter as Attachment A pursuant to
- ------ ------------
which the Company's Board of Directors offered you, and you accepted, a position
with the Company as its Chairman, President and Chief Executive Officer, which
position you continue to hold. By your signature below, you acknowledge that
this letter agreement (the "1998 Letter") governs your employment relationship
-----------
with the Company for the calendar year 1998. This 1998 Letter is effective as
of the date set forth above.
1. SALARY. Your salary for the calendar year 1998 will be $225,000 per
------
annum, payable in accordance with the Company's standard payroll policy,
commencing effective as of January 1, 1998.
2. PERFORMANCE BONUS. During the calendar year 1998, you will be
-----------------
eligible to receive aggregate bonus payments of up to $200,000 payable in
accordance with the Company's standard Executive Bonus Plan for the 1998 Fiscal
Year, a copy of which is attached to this 1998 Letter as Attachment B.
------------
You acknowledge by your signature below that the Company is under no
obligation to pay to you any of the bonus payments set forth in the 1997 Letter
which have not been paid to you as of the date of this 1998 Letter.
3. STRATEGIC BONUS. During the 1998 calendar year, you will be eligible
---------------
to receive a strategic bonus of up to $500,000 payable when, in the good faith
judgment of the Company's Board of Directors, you have met the strategic
objectives set by the Board.
4. GRANT OF STOCK OPTIONS. Effective as of the date of this 1998 Letter,
----------------------
the Board of Directors has approved a grant to you of nonstatutory stock options
(the "1998 Options") to purchase 400,000 shares of the Company's Common Stock
------------
with an exercise price equal to the
-1-
<PAGE>
Mr. Gordon Bridge
January 28, 1998
Page 2
fair market value of such shares as of the grant date. The 1998 Options will
vest on a monthly basis over a period of 36 months, with such vesting beginning
as of January 1, 1998 and the 1998 Options becoming fully vested on December 31,
2000, assuming that you satisfy certain conditions related to your continued
employment with the Company,. In connection with the grant of the 1998 Options,
you will be required to execute the Company's standard form of stock option
agreement, which will set forth with greater specificity the terms of the 1998
Options.
5. CHANGE OF CONTROL BENEFITS. You entered into a Change of Control
--------------------------
Agreement, dated June 11, 1997, with the Company (the "Agreement"), a copy of
---------
which is attached hereto as Attachment C, pursuant to which you became entitled
------------
to receive certain benefits in the event the Company should engage in certain
significant corporate events as set forth in the Agreement. Capitalized terms
used but not defined in this 1998 Letter shall have the same meaning set forth
in the Agreement.
In addition to any benefits to which you are entitled under the Agreement,
in the event the Company engages in a Change of Control transaction during the
calendar year 1998, the Company will, immediately prior to the consummation of
such Change of Control, forgive its loan to you in the principal amount of
$150,000, plus all accrued but unpaid interest as of such date.
6. WHOLE AGREEMENT. This 1998 Letter supersedes any previous letters and
---------------
e-mails between you and the Company relating to the subject matter of this
letter, as well as any current employment and consulting agreements you may have
with the Company, except that the benefits provided pursuant to this 1998 Letter
are in addition to (i) any benefits provided by the third, fourth, fifth and
sixth paragraphs of the 1997 Letter (it being understood that the acceleration
provisions referenced in such sixth paragraph shall not apply to the 1998
Options), (ii) any benefits provided by the Agreement, and (iii) any benefits
provided under those stock option agreements entered into by you and the Company
prior to the date of this 1998 Letter.
[Signature Page Follows]
-2-
<PAGE>
Mr. Gordon Bridge
January 28, 1998
Page 3
This 1998 Letter may be signed in one or more counterparts, all of which
together shall constitute one original.
Regards,
Richard Lussier
For the Board of Directors
CONNECT, Inc.
I accept this offer. _____________________________ _____________
Gordon Bridge Date
-3-
<PAGE>
ATTACHMENT B
------------
EXECUTIVE BONUS PLAN
1998 Fiscal Year
(Gordon Bridge Form)
General guidelines:
- - Bonus plans apply to:
<TABLE>
<CAPTION>
Base Target Bonus Total Comp
---- ------------ ----------
<S> <C> <C> <C>
Bridge 225 200 425
</TABLE>
- - 50% of each executive's bonus eligible for quarterly payment (12.5%/quarter)
with the balance tied to achievement of annual target. All executive bonuses
tied 100% to revenue and operating margin components with each component
comprising 50% of total for both quarterly and annual objectives.
Payouts: Two components:
1. Revenues - 85% of quarterly/annual targets must be achieved to receive
any payout; 85% attainment pays 85% with 1% additional payout for each 1%
additional attainment up to 100%.
2. Operating margin - 100% must be achieved for payouts to occur. Payout
increase for 101-120% performance by 2% for each 1% achievement where quarterly
and annual targets are overachieved (i.e., 110% performance equals 120% payout,
up to 140% payout in event of 120% performance achieved).
- - License revenue and operating margins as follows (in millions):
<TABLE>
<CAPTION>
1Q 2Q 3Q 4Q Total
-------------- -------------- -------------- -------------- --------------
<S> <C> <C> <C> <C> <C>
Targets: Rev. 1.20 1.50 2.00 2.80 7.50
Op Mar. (2.73) (1.99) (1.38) (0.65) (6.75)
</TABLE>
<PAGE>
EXHIBIT 23
CONSENT OF INDEPENDENT AUDITORS
We consent to the incorporation by reference in the Registration Statements
(Form S-8 Nos. 333-12791 and 333-21477) pertaining to the 1996 Employee Stock
Purchase Plan, 1996 Director's Stock Option Plan, 1989 Stock Option Plan and
1996 Stock Option Plan and to the incorporation by reference in Amendment No. 1
to the Registration Statement (Form S-3 No. 333-47055) of CONNECT, Inc. of our
report dated January 27, 1998, except for Note 14 as to which the date is
February 26, 1998 with respect to the financial statements and our report dated
January 27, 1998 with respect to the financial statement schedule of CONNECT,
Inc. included in the Annual Report (Form 10-K) for the year ended December 31,
1997.
/s/ Ernst & Young LLP
---------------------
San Jose, California
March 27, 1998
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-START> JAN-01-1997
<PERIOD-END> DEC-31-1997
<CASH> 9,643,883
<SECURITIES> 0
<RECEIVABLES> 2,298,759
<ALLOWANCES> 642,270
<INVENTORY> 0
<CURRENT-ASSETS> 12,837,428
<PP&E> 2,442,059
<DEPRECIATION> 4,782,403
<TOTAL-ASSETS> 15,363,931
<CURRENT-LIABILITIES> 5,403,679
<BONDS> 9,654,158
0
0
<COMMON> 19,139
<OTHER-SE> (651,729)
<TOTAL-LIABILITY-AND-EQUITY> 15,363,931
<SALES> 3,130,942
<TOTAL-REVENUES> 9,362,438
<CGS> 752,793
<TOTAL-COSTS> 9,064,663
<OTHER-EXPENSES> 14,816,241
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 413,788
<INCOME-PRETAX> 14,584,796
<INCOME-TAX> 0
<INCOME-CONTINUING> 14,584,796
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 14,584,796
<EPS-PRIMARY> (3.85)
<EPS-DILUTED> (3.85)
</TABLE>
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE YEAR
ENDED DECEMBER 31, 1996 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH
FORM 10-K FILED WITH THE SECURITIES AND EXCHANGE COMMISSION.
</LEGEND>
<RESTATED>
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> DEC-31-1996
<PERIOD-START> JAN-01-1996
<PERIOD-END> DEC-31-1996
<CASH> 12,214
<SECURITIES> 0
<RECEIVABLES> 2,534
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 15,354
<PP&E> 6,676
<DEPRECIATION> 3,029
<TOTAL-ASSETS> 19,154
<CURRENT-LIABILITIES> 5,009
<BONDS> 0
0
0
<COMMON> 60,467
<OTHER-SE> (47,112)
<TOTAL-LIABILITY-AND-EQUITY> 19,154
<SALES> 4,693
<TOTAL-REVENUES> 10,180
<CGS> 791
<TOTAL-COSTS> 9,068
<OTHER-EXPENSES> 17,470
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 331
<INCOME-PRETAX> (16,142)
<INCOME-TAX> 0
<INCOME-CONTINUING> (16,142)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (16,142)
<EPS-PRIMARY> (4.81)
<EPS-DILUTED> (4.81)
</TABLE>
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<RESTATED>
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> DEC-31-1995
<PERIOD-START> JAN-01-1995
<PERIOD-END> DEC-31-1995
<CASH> 12,928,911
<SECURITIES> 0
<RECEIVABLES> 1,329,624
<ALLOWANCES> 320,000
<INVENTORY> 0
<CURRENT-ASSETS> 14,410,354
<PP&E> 5,348,278
<DEPRECIATION> 2,085,248
<TOTAL-ASSETS> 18,062,529
<CURRENT-LIABILITIES> 3,108,195
<BONDS> 0
0
37,041,259
<COMMON> 7,107,474
<OTHER-SE> 30,830,579
<TOTAL-LIABILITY-AND-EQUITY> 18,062,529
<SALES> 287,471
<TOTAL-REVENUES> 8,572,898
<CGS> 139,961
<TOTAL-COSTS> 5,591,854
<OTHER-EXPENSES> 16,175,219
<LOSS-PROVISION> 182,984
<INTEREST-EXPENSE> 1,002,761
<INCOME-PRETAX> (14,164,931)
<INCOME-TAX> (26,000)
<INCOME-CONTINUING> (13,194,175)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (14,138,931)
<EPS-PRIMARY> (15.57)<F1>
<EPS-DILUTED> 0
<FN>
<F1>Includes deferred compensation
</FN>
</TABLE>
