<PAGE>
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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
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FORM 10-K
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[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the fiscal year ended December 31, 1998
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ____________ to ______________
Commission File Number: 0-24087
ITERATED SYSTEMS, INC.
(exact name of registrant specified in its charter)
<TABLE>
<S> <C>
GEORGIA 58-1741516
(State or other jurisdiction of incorporation or (I.R.S. Employer Identification No.)
organization)
3525 Piedmont Road 30305-1530
Seven Piedmont Center, Suite 600 (zip code)
Atlanta, Georgia
(Address of principal executive office)
</TABLE>
Registrant's telephone number, including area code: (404) 264-8000
--------------------
Securities registered pursuant to Section 12(b) of the Act:
None
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Securities registered pursuant to Section 12(g) of the Act:
<TABLE>
<S> <C>
Title of each class Name of exchange on which registered
------------------- ------------------------------------
Common Stock, par value $.01 per share Oslo Stock Exchange
</TABLE>
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 amendment to this
Form 10-K. Yes X No ___
---
The aggregate market value of the voting stock held by non-affiliates of
the Registrant, based upon the closing price for the Common Stock on February
28, 1999 as reported by the Oslo Stock Exchange, was approximately $4,469,571.
The shares of Common Stock held by each officer and director and by each person
known to the Registrant who owns 5% or more of the outstanding Common Stock 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. As of February 28, 1999, Registrant had outstanding
13,073,025 shares of Common Stock.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's Annual Report to Shareholders for the fiscal
year ended December 31, 1998 are incorporated by reference in Parts II and IV of
this Form 10-K to the extent stated herein. The Registrant's definitive Proxy
Statement for the Annual Meeting of Shareholders to be held April 12, 1999 is
incorporated by reference in Part III of this Form 10-K to the extent stated
herein.
<PAGE>
PART I
ITEM 1. BUSINESS.
INTRODUCTION
Iterated Systems, Inc. ("Iterated" or "Company") develops, licenses and
markets digital still image software, based on its STiNG(TM) technology, to
corporations who need to use digital images efficiently and consistently for
cross-media print and Internet/on-line image production. Such corporations
include major retailers with large brand-management concerns, and the
advertising agencies and print production companies that serve them.
The Company was founded in 1987 by Dr. Michael Barnsley and Dr. Alan Sloan,
who at that time were tenured members of the mathematics faculty at the Georgia
Institute of Technology. Their early work was based on the discovery that real-
world images could be generated by plotting fractal equations. An early
experiment produced the Iterated Systems fern logo from only a few bits of data,
using a fractal process known as an Iterated Function System. Iterated's initial
products provided fractal image compression based on Dr. Barnsley's patented
Fractal Transform algorithm method, which was used to store and display fractal-
compressed images in Microsoft's Encarta CD-ROM encyclopedia, the Great Artists
CD-ROM series, and other CD-ROM and screen saver titles.
Iterated's latest technology, named STiNG(TM), was born from the Company's
continued research and development expertise in digital image science and
fractal-based mathematics, which have evolved over more than ten years in the
digital image business. STiNG reXpress(TM) is an application developed by the
Company that allows large digital images and entire print jobs to be scaled to
the desired output resolution automatically, and it enables job distribution and
archiving using smaller digital files.
The Company was organized under the laws of the State of Georgia on May 28,
1987. On May 20, 1991, Iterated Systems Limited (ISL) was incorporated in the
United Kingdom as a wholly-owned subsidiary of the Company to function as the
Company's European sales office.
DESCRIPTION OF THE PRODUCTS
Iterated's products are in a position to help alleviate a growing
problem in the graphic arts industry--a problem experienced by high-level
corporate brand managers as well as independent digital designers: the
proliferation of digital image data. The proliferation of digital data creates
problems in three areas: (i) scaling to produce high quality images of vastly
different sizes; (ii) transfer of images electronically; and (iii) archiving.
STiNG reXpress is a client/server application that automatically scales
image files (separately, or in QuarkXPress or Adobe Illustrator documents) and
creates archives of print jobs. The product can also generate a self-extracting
archive of a print job, which can be decoded without the client application
installed. Because STiNG reXpress manages the resolution of images, it is called
a "resolution server." The STiNG reXpress server is an NT-based workgroup
application that is accessible from either a Mac- or Widows-based STiNG reXpress
client and supports EPS, TIFF, QuarkXPress, Photoshop, and STiNG files.
The benefits of STiNG reXpress are (a) automatic scaling to repurpose
content for all output resolutions from a single digital asset; (b) highly
efficient transfer of images and print jobs quickly over the Internet; and (c)
very compact archiving of large images and print jobs. STiNG reXpress saves
layers, channels and paths generated by Adobe Photoshop, so that image editing
work can be archived and transferred with the image. Scaling and repurposing
involve situations where large corporations develop promotional campaigns for
their products and want to advertise in many different media. For example, they
may want to send out a direct mail piece, put an ad in a magazine, on a
billboard, on the web site, and maybe even on buses and taxicabs. All of these
advertisements will have the same look and use the same set of images for
consistency. Using existing technology to output all these different pieces
with such a wide range of sizes typically requires a great deal of reworking.
The images used have to be rescanned for each new use, so that the designers
have enough data for high quality output. Then any color correction that is done
for one output has to be redone for all the others. The images being used can be
very large. Sending them to clients for proofing and approval often requires a
courier or overnight delivery service. This can add days to the production
schedule. STiNG reXpress eliminates these inefficiencies by allowing all work to
be done on a single image which can then be used to generate all needed outputs.
According to a 1998 study by GISTICS, Inc., one global manufacturer
estimated it could save $70 million per year just by reusing existing digital
image assets. The same study asserts that integrated marketing communications
(the consistent use of multiple media to promote brand awareness) places a
premium on creating agile, multipurpose assets, usable for multiple media. The
greater savings, therefore, is not in managing image assets well, but in making
multiple uses of the assets.
STiNG reXpress is being marketed to corporate brand managers and
advertising agencies that manage large databases of image assets for large
campaigns, through the Company's own sales efforts and by establishing a network
of value-added resellers already well established with this market. Early
clients have realized substantial savings in time and expenses, and are using
the product in branding campaigns with high public exposure. STiNG technology
has received multiple awards including the Publish magazine Impact award and the
MacWorld Eddy award.
<PAGE>
STiNG reXpress version 1.0 was released in January 1999 with initial sales
recorded in the first quarter of 1999. The product is currently being enhanced
to integrate with open prepress interface (OPI) systems, digital asset
management (DAM) systems, and other complementary systems used by corporate
brand managers, graphic artists, prepress shops and printers. Through continued
research and development, the Company plans an extensive offering of STiNG-based
technology to further eliminate redundancies and waste in the use and management
of digital images.
COMPETITION
There are a few companies marketing products that perform some, but not
all, of the functions of the STiNG reXpress product. These companies include
Warp 10, Equilibrium, Live Picture, and Alladin.
The Digital Toolkit from Warp 10 is a media management system that enables
systems integrators, web developers and others to build applications to manage
their digital resources using a DAM system. Since STiNG reXpress reduces the
number of files designers have to manage, and because it enables more efficient
archiving, STiNG reXpress could be seen as a competitor of Warp 10. However,
STiNG reXpress is really a complement to DAM systems. DAMs track files, manage
version control, and other system-related issues, whereas STiNG reXpress tracks
the internal data of documents and images, making the archived files more
meaningful and enabling DAMs to track fewer files, making the entire system more
efficient.
Equilibrium's DeBabelizer is an image conversion tool that enables users
to, among other tasks, scale images for different output. However, DeBabelizer
does not enable users to repurpose images automatically in many different sizes
while delivering the extremely high quality images clients demand.
Live Picture's Image Server claims to deliver resolution-on-demand images,
a feature of STiNG reXpress. However, the technology behind Image Server is
Flashpix, a file format optimized for video displays only in which several
preset sizes of an image are stored in one file. These multiple images create
large files. The STiNG technology used in STiNG reXpress delivers resolution
independence in a single, very small file and can do so for video displays or
for print output. Users can request any output size. They are not limited to
preset sizes.
One feature of STiNG reXpress is the ability to compress files to very
small sizes for easier transport across networks and more efficient archiving.
There are many common utilities available, such as Alladin's Stuff-It, that also
compress files. Compression is a key benefit of STiNG reXpress, but STiNG
reXpress combines two different kinds of compression into an application that
also enables repurposing. Stuff-It provides only lossless compression. STiNG
reXpress provides lossless compression, but also includes visually lossless
compression for even higher compression ratios while maintaining the high
quality needed to produce high quality images.
HISTORY
The Company's current strategies and business direction, including the
decision to focus its primary efforts on the development of software for the
corporate digital image management market, were developed during 1997 and 1998
based on internal and external factors affecting the Company and its markets.
Prior to that time one of its significant focuses was for the development of
software products to be sold to end users for use on the Internet. Developments
in that market lead the Company to believe that its expertise was better suited
to developing and delivering its technology to OEMs for inclusion in their
products. As a result of this shift, during 1997 the Company experienced a
significant reduction and restructuring in its workforce. During 1998, the
Company further focused its development and marketing efforts to target large
corporate users of digital images with needs for cross-media production. The
Company expects its business plans to continue to evolve based on competitive
forces and the ongoing need to generate new and innovative products on a
continual basis. These external market factors make estimates of product
acceptance and financial performance of the Company difficult to predict, and in
response thereto the Company expects to make ongoing revisions to its business
plan.
In September 1994, the Company entered into an agreement (the 1994
Agreement) with MCI Telecommunications Corporation (MCI) to provide for
development of certain advanced compression technology for use in
telecommunications applications. MCI paid the Company approximately $36,000,000
over the next three years for development of specific technology and the
exclusive rights to use and sublicense specified technology in
telecommunications markets until September 1997. The 1994 Agreement expired in
September 1997. Effective August 7, 1998, the Company and MCI entered into a new
agreement that provides MCI with a non-exclusive, royalty-free license to use
certain deliverables developed by the Company. In addition, the Company granted
MCI a warrant to purchase up to 1,452,570 shares of common stock at $5 per
share. The term of the warrant is four years.
MAJOR CUSTOMERS
As discussed above, since the Company is refining its market to focus on
users of high quality digital imaging systems, its major customers in the future
will probably not be ones that have contributed significantly in the past. A
discussion of the contributions of major customers during 1996-1998 is included
in the footnotes to the Company's Financial Statements referred to in Item 8 of
this Form 10-K and incorporated by reference.
-2-
<PAGE>
RESEARCH AND DEVELOPMENT/PATENTS
During 1996, 1997 and 1998, the Company has spent $8,966,000, $8,261,000
and $5,237,000, respectively, in the research and development of new
technologies, refining and improving its technologies and the customization of
its technologies to the needs of specific customers. During 1996 and 1997, the
majority of these expenditures were made under the 1994 Agreement discussed
above. The Company expects that continued significant expenditures in this area
will be necessary to successfully introduce new products and improve its core
technology and no assurances can be made that these development efforts will be
successful.
Consistent with its emphasis on research and development, the Company
maintains an aggressive patent filing program. To date, the Company holds 17
issued U.S. patents with expiration dates from 2009-2016 and holds an exclusive
license to a seventh issued U.S. patent expiring in 2007.
The Company's patents and patent applications are intended to provide a
degree of patent protection of the Company's technology as applied to products
developed under the Company's Imaging Systems Architecture(TM) (ISA),
particularly as applied in the area of real time video codecs, store and forward
video codecs and still image codecs. The markets for these codecs are highly
competitive, and the Company believes that its research and development efforts
and resulting patents are essential to an effective market presence.
EMPLOYEES
The Company currently has approximately 53 full time employees based in its
offices in Atlanta, Georgia and Reading, England. The Company also makes
extensive use of independent contractors to fulfill short term specialized
needs.
FORWARD-LOOKING STATEMENTS - CAUTIONARY STATEMENTS
The discussions herein contain trend information and other forward-looking
statements that involve a number of risks and uncertainties. The actual results
of the Company could differ materially from its historical results of operations
and those discussed in the forward-looking statements. The forward-looking
statements are based on the beliefs of the Company's management as well as
assumptions made by and information currently available to the Company's
management. When used herein, the words "anticipate," "believe," "estimate,"
"expect" and "intend" and words or phrases of similar import, as they relate to
the Company or the Company's management, are intended to identify forward-
looking statements. The forward-looking statements should be read in light of
these factors and the factors identified in "Item 1. Business" and in "Item 7.
Financial Information--Management's Discussion and Analysis of Financial
Condition and Results of Operations." All references to year periods refer to
the Company's fiscal year ended December 31, 1998.
ITEM 2. PROPERTIES.
The Company leases approximately 21,000 square feet of office space (net of
a 9,000 sublease) in Atlanta, Georgia for its corporate, sales and development
operations. The lease runs through July 31, 2000.
The Company also leases approximately 3,000 square feet of office space
near Reading, England for its European office. The lease runs through June 27,
2012 with an option to terminate in June 2007.
The aggregate net monthly rental for these leased offices and facilities is
currently approximately $35,000, and the Company's management believes that
these facilities are adequate for its intended activities in the foreseeable
future.
ITEM 3. LEGAL PROCEEDINGS.
The nature of the Company's business exposes it to the risk of lawsuits for
damages or penalties relating to, among other things, breach of contract,
employment disputes and copyright, trademark or patent infringement. The Company
is not currently a party to any pending material litigation.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
There were no matters submitted to a vote of security holders during the
fourth quarter of the fiscal year ended December 31, 1998.
-3-
<PAGE>
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS.
The Company's Common Stock had been traded on the Oslo Stock Exchange under
the symbol "ITR" since October 1,1997. Prior to that time there was no
established market for the shares. The Company has not registered any securities
with the United States Securities and Exchange Commission other than pursuant to
its Form S-8 Registration Statement filed on December 9, 1998. Securities of the
Company may not be offered for sale or sold in the U.S. or to or for the account
or benefit of any U.S. person unless the securities are registered or an
exemption from registration requirements is available.
The price per share reflected in the table below represents the range of
low and high closing sale prices for the Company's Common Stock as reported by
the Oslo Stock Exchange for the periods indicated:
<TABLE>
<CAPTION>
FISCAL PERIOD HIGH PRICE LOW PRICE
------------------- ------------------- -------------------
<S> <C> <C>
10/01/97 - 12/31/97 $13.92 $6.86
01/01/98 - 03/31/98 9.24 5.99
04/01/98 - 06/30/98 7.51 3.92
07/01/98 - 09/30/98 3.23 0.95
10/01/98 - 12/31/98 1.63 0.22
</TABLE>
The closing sale price of the Company's Common Stock as reported by the
Oslo Stock Exchange on February 28, 1999, was U.S. $1.14.
The number of shareholders of record of the Company's Common Stock as of
February 28, 1999, was approximately 800.
The Company currently has 4,721,470 options and warrants outstanding to
acquire Common Stock of the Company, of which 2,725,395 are currently
exercisable.
The Company has never paid cash dividends on its capital stock. The Company
currently intends to retain any earnings for use in the business and does not
anticipate paying any cash dividends in the foreseeable future.
ITEM 6. SELECTED FINANCIAL DATA.
The information set forth under the section entitled "Summary Consolidated
Financial Data" on page 8 of the Company's 1998 Annual Report to Shareholders is
incorporated herein by reference and filed herewith as part of Exhibit 13.1.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
The information set forth under the section entitled "Management's
Discussion and Analysis of Financial Condition and Results of Operations" on
pages 9 through 12 of the Company's 1998 Annual Report to Shareholders is
incorporated herein by reference and filed herewith as a part of Exhibit 13.1.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Financial instruments that potentially subject the Company to significant
concentrations of market risk consist principally of short-term investments,
trade accounts receivable, and accounts payable.
ISL considers the British pound to be its functional currency. The Company
considers its functional currency to be the U.S. dollar. ISL's assets and
liabilities are translated at year-end rates of exchange and its revenues and
expenses are translated at the average rates of exchange during the year.
The Company believes that the potential effects of market risk is not
material to its operations.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The quarterly results of operations set forth on page 8 of the Company's
1998 Annual Report to Shareholders and the following financial statements,
related notes thereto and report of independent auditors set forth on pages 13
through 29 of the Company's 1998 Annual Report to Shareholders are incorporated
herein by reference and filed herewith as a part of Exhibit 13.1.
-4-
<PAGE>
Balance Sheets as of December 31, 1998 and 1997.
Statements of Operations for the years ended December 31, 1998, 1997 and
1996.
Statements of Shareholders' Equity for the years ended December 31, 1998,
1997 and 1996.
Statements of Cash Flows for the years ended December 31, 1998, 1997 and
1996.
Notes to Financial Statements.
Independent Auditors' Report.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
None.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The information required by this item is contained in the Company's Proxy
Statement for the Annual Meeting of Shareholders to be filed with the Commission
not later than 120 days after the close of the Company's fiscal year ended
December 31, 1998 under the caption "Election of Directors" and is incorporated
by reference herein.
ITEM 11. EXECUTIVE COMPENSATION.
The information required by this item will be included in the Company's
Proxy Statement for the Annual Meeting of Shareholders to be filed with the
Commission not later than 120 days after the close of the Company's fiscal year
ended December 31, 1998 under the caption "Executive Compensation" and is
incorporated by reference herein.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The information required by this item will be included in the Company's
Proxy Statement for the Annual Meeting of Shareholders to be filed with the
Commission not later than 120 days after the close of the Company's fiscal year
ended December 31, 1998 under the caption "Security Ownership of Certain
Beneficial Owners and Management" and is incorporated by reference herein.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The information required by this item will be included in the Company's
Proxy Statement for the Annual Meeting of Shareholders to be filed with the
Commission not later than 120 days after the close of the Company's fiscal year
ended December 31, 1998 under the caption "Certain Transactions" and is
incorporated by reference herein.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a) The following documents are filed as part of this report:
1. Financial Statements
The financial statements of Iterated Systems, Inc. and reports of
independent auditors as set forth under Item 8 of this report on Form 10-K are
incorporated by reference herein.
2. Financial Statement Schedules
(i) The following Financial Statement Schedule of Iterated Systems, Inc.
for the Years Ended December 31, 1996, 1997 and 1998 is filed as a part of this
report on Form 10-K and should be read in conjunction with the Financial
Statements, and related notes thereto, of Iterated Systems, Inc.
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<PAGE>
ITERATED SYSTEMS, INC.
SCHEDULE II
VALUATION AND QUALIFYING ACCOUNTS
(IN THOUSANDS)
VALUATION AND QUALIFYING ACCOUNTS WHICH ARE DEDUCTED IN THE
BALANCE SHEET FROM THE ASSETS TO WHICH THEY APPLY
<TABLE>
<CAPTION>
Additions
--------------------------------------
Balance at Charged to
Beginning of Charged to Costs Other Balance at
Period and Expenses Accounts Deductions End of Period
--------------- ------------------- --------------- ---------------- -------------
<S> <C> <C> <C> <C> <C>
Allowance for doubtful
accounts:
Year Ended:
December 31, 1998 $ 9 $ 0 $ 0 $ (3) $ 6
December 31, 1997 70 399 0 (460) 9
December 31, 1996 71 29 0 (30) 70
Additions
--------------------------------------
Balance at Charged to
Beginning of Charged to Costs Other Balance at
Period and Expenses Accounts Deductions End of Period
--------------- ------------------- --------------- ---------------- -------------
<S> <C> <C> <C> <C> <C>
Reserve for inventory
obsolescence:
Year Ended:
December 31, 1998 $ 0 $ 0 $ 0 $ 0 $ 0
December 31, 1997 581 0 0 (581) 0
December 31, 1996 380 238 0 (37) 581
Additions
--------------------------------------
Balance at Charged to
Beginning of Charged to Costs Other Balance at
Period and Expenses Accounts Deductions End of Period
--------------- ------------------- --------------- ---------------- -------------
<S> <C> <C> <C> <C> <C>
Valuation allowance for deferred
income tax assets:
Year Ended:
December 31, 1998 $ 6,862 $ 4,123 $ -- $ -- $ 10,985
December 31, 1997 4,378 2,484 -- -- 6,862
December 31, 1996 3,425 953 -- -- 4,378
</TABLE>
(b) Reports on Form 8-K. None.
(c) Exhibits. The following exhibits are filed as part of, or are incorporated
by reference into, this report on Form 10-K:
EXHIBIT
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NUMBER DESCRIPTION
------ ----------------------------------------------------------------
3.1* Amended and Restated Articles of Incorporation of the Registrant
3.2* Restated Bylaws of the Registrant
4.1* Warrant for the Purchase of Shares of Common Stock of the
Registrant issued to Mosvold Farsund AS dated May 31, 1996
10.1* Loan Agreement between Mosvold Farsund AS and the Registrant, dated
May 31, 1996, as amended June 30, 1997
10.2* Lease between California State Teachers' Retirement System and the
Registrant dated January 31, 1995 for premises situated at 3525
Piedmont Road, N.E., Seven Piedmont Center, Suite 600, Atlanta,
Georgia 30305
-6-
<PAGE>
10.3* Lease between T.A. Fisher & Sons Limited and Iterated Systems
Limited dated June 27, 1997 relating to land and office buildings
forming Unit No. 32 at Wellington Business Park, Dukes Ride,
Crowthorne, Berkshire
10.4* Amended and Restated Executive Employment Agreement between the
Registrant and John C. Bacon, dated as of February 16, 1998
10.5* Executive Severance Agreement between the Registrant and John R.
Festa, dated February 16, 1998
10.6* Employment Agreement between the Registrant and Michael F.
Barnsley, dated May 1, 1994, as amended
10.7* Employment Agreement between the Registrant and Alan D. Sloan,
dated May 1, 1994, as amended
10.8* Iterated Systems, Inc. 1994 Amended and Restated Stock Option Plan
10.9* Iterated Systems, Inc. Amended and Restated 1994 Directors Stock
Option Plan
13.1 The following financial information included within the Company's
Annual Report to Shareholders for the fiscal year ended December
31, 1998:
(i) Summary Consolidated Financial Data;
(ii) Selected Quarterly Operating Results;
(iii) Management's Discussion and Analysis of Financial
Condition and Results of Operations; and
(iv) Financial Statements, Notes to Financial Statements,
and Independent Auditor's Report.
21* Subsidiaries of the Registrant
23.1 Consent of Ernst & Young LLP
27.1 Financial Data Schedule (SEC use only)
___________________
* Incorporated by reference to Exhibits filed in response to Item 16(a),
"Exhibits" of the Company's Registration Statement on Form 10 (File No.
000-24087) filed on April 24, 1998, as amended.
(d) Financial Statement Schedules. None.
-7-
<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.
ITERATED SYSTEMS, INC.
By: /s/ John C. Bacon
-------------------------------
John C. Bacon
President and Chief Executive Officer
(Principal Executive Officer) and
Director
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant in the capacities and on the dates indicated.
<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
<S> <C> <C>
/s/ John C. Bacon President, Chief Executive March 25, 1999
- ---------------------------------------- Officer; Director (Principal
John C. Bacon Executive Officer)
/s/ Haines H. Hargrett Chief Financial Officer, March 25, 1999
- ----------------------------------------
Haines H. Hargrett (Principal Financial Officer;
Principal Accounting Officer)
/s/ Michael F. Barnsley Director March 30, 1999
- ----------------------------------------
Michael F. Barnsley
/s/ John R. Festa Director and Vice Chairman of the March 26, 1999
- ---------------------------------------- Board of Directors
John R. Festa
/s/ Terje Mikalsen Director March 23, 1999
- ----------------------------------------
Terje Mikalsen
/s/ Alan D. Sloan Executive Vice President and March 25, 1999
- ---------------------------------------- Director
Alan D. Sloan
/s/ Asmund R. Slogedal Director and Chairman of the March 23, 1999
- ---------------------------------------- Board of Directors
Asmund R. Slogedal
</TABLE>
<PAGE>
EXHIBIT 13.1
SUMMARY CONSOLIDATED FINANCIAL DATA
(in thousands except per share data)
<TABLE>
<CAPTION>
DECEMBER 31,
------------------------------------------------------------------------
1994 1995 1996 1997 1998
------------ ------------ ------------ ------------ -------------
<S> <C> <C> <C> <C> <C>
Total revenues $ 8,385 $ 14,430 $ 15,558 $ 9,471 $ 753
Operating loss (1,218) (612) (1,701) (6,551) (10,689)
Net loss (1,190) (509) (1,606) (6,329) (10,025)
Basic and diluted net loss per share (0.11) (0.05) (0.15) (0.56) (0.77)
Weighted average shares outstanding 10,421 10,501 10,564 11,320 13,084
Cash and short-term investments 3,034 6,281 4,151 17,633 7,977
Total assets 4,468 10,032 7,487 19,775 9,084
Non-current liabilities 66 1,429 208 54 14
Stockholders' equity $ 2,689 $ 2,514 $ 3,211 $ 18,716 $ 8,518
</TABLE>
SELECTED QUARTERLY OPERATING RESULTS
(in thousands except per share data)
<TABLE>
<CAPTION>
QUARTER ENDED
----------------------------------------------------------------------------------------
1997 1998
----------------------------------------------------------------------------------------
MARCH 31 JUNE 30 SEPT. 30 DEC. 31 MARCH 31 JUNE 30 SEPT. 30 DEC. 31
-------- -------- --------- -------- --------- -------- --------- --------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Total revenues $ 3,028 $ 3,018 $ 2,571 $ 854 $ 281 $ 153 $ 149 $ 170
Operating loss (1,429) (1,264) (943) (2,915) (3,037) (2,861) (2,653) (2,137)
Net loss (1,409) (1,264) (979) (2,678) (2,811) (2,670) (2,472) (2,042)
Basic and diluted net loss per share (0.13) (0.12) (0.09) (0.21) (0.21) (0.20) (0.19) (0.16)
Weighted average shares outstanding 10,715 10,717 10,836 12,991 13,106 13,084 13,073 13,073
</TABLE>
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
OVERVIEW
Historically, the Company has derived its revenues from development fees,
software license fees, and packaged software products. The Company expects that
revenues from development fees and packaged software products will continue its
recent decline as business efforts are focused on developing and licensing
software based on its digital image science technology to users of high quality
digital image systems. During 1997 the Company reduced its workforce to focus on
a more effective implementation of this market strategy. If this plan is
successful, the Company believes that a majority of its future revenues will be
derived from license fees for its software.
In September 1994 the Company entered into an agreement (1994 Agreement)
with MCI Telecommunications Corporation (MCI) to provide for development of
certain advanced compression technology for use in telecommunications
applications. MCI paid the Company approximately $36,000,000 over the next three
years for development of specific technology and the exclusive rights to use and
sublicense specified technology in telecommunications markets until September
1997. The 1994 Agreement expired in September 1997. Effective August 7, 1998,
the Company and MCI entered into a new agreement that provides MCI with a non-
exclusive, royalty-free license to use certain deliverables developed by the
Company under the 1994 Agreement. In addition the Company granted MCI warrants
to purchase up to 1,452,570 shares of common stock at $5 per share. The term of
the warrant is four years.
FINANCIAL CONDITION
In an initial public offering on September 29, 1997, on the Oslo Stock
Exchange, the Company sold 2,040,000 shares and certain shareholders sold
710,300 shares of common stock at $10 per share resulting in net proceeds to the
Company of $18,579,000.
The Company has not registered any securities with the U.S. Securities and
Exchange Commission under the Securities Act of 1933, as amended, other than
pursuant to its Form S-8 Registration Statement filed on December 9, 1998.
Securities of the Company may not be offered for sale or sold in the U.S., or to
or for the account or benefit of any "U.S. person" (as defined in the Securities
Act), unless the securities are registered under the Securities Act or an
exemption from such registration requirements is available.
As shown in the financial statements, the Company incurred a net loss of
$10,025,000 in 1998, and an accumulated deficit of $21,462,000. The Company
experienced negative cash flows from operations of $9,043,700, and revenues
decreased approximately 92% from the prior year. The Company maintains a
combined cash and short-term investment balance of $7,977,000 as of December 31,
1998. The funds were generated by the proceeds of the September 1997 initial
public stock offering and have enabled the Company to meet its obligations
during 1998 despite negative cash flows. However, the Company may not be able to
depend solely on such funds to meet its planned obligations during 1999. The
Company is finalizing the development of its new software products and expects
initial revenues in the first quarter of 1999. The Company may also seek to
raise additional investment capital and cash in order to fund operations. The
Company may also undertake certain cost cutting measures that would slow down
its research and development efforts. It is not possible to predict the outcome
of the Company's efforts and there is no assurance that the Company will be
successful in increasing revenues or obtaining financing.
In 1997 and 1998, operating activities used cash of $7,511,000 and
$9,044,000, respectively.
In 1997 and 1998 investing activities (used) provided cash of $(10,445,000)
and $5,475,000, respectively. In 1997 cash was primarily used for the purchase
of short-term investments with the proceeds from the Company's initial public
offering. During 1998 short-term investments provided funds for purchase of
property and equipment and to fund operating activities.
In 1997 and 1998 financing activities provided (used) funds of $21,439,000
and ($358,000), respectively. In 1997 cash provided by financing activities was
primarily attributable to borrowings of $3,000,000 under the shareholder credit
facility described below and $18,579,000 net proceeds from the Company's initial
public offering. In 1998 cash used in financing activities was primarily for the
repurchase of the Company's common stock on the open market.
On June 30, 1997, the Company amended its Bridge Financing Credit Facility
with Mosvold Farsund AS, one of its shareholders. The amended Credit Facility
allowed the Company to borrow up to $6,000,000 from Mosvold until June 30, 1998,
at which time the Company could convert any outstanding balance into a four year
term loan. During the second quarter of 1997, the Company borrowed $3,000,000
from Mosvold under this financing agreement and during the fourth quarter of
1997, Mosvold exercised its option to convert the $3,000,000 borrowings into
300,000 shares of the Company's Common Stock at $10 per share. No further
borrowings occurred under the Credit Facility which expired on June 30, 1998.
<PAGE>
RESULTS OF OPERATIONS
YEAR ENDED DECEMBER 31, 1998, COMPARED TO YEAR ENDED DECEMBER 31, 1997
Revenues. Total revenues decreased 92% to $753,000 during 1998 from
$9,471,000 in 1997. The decrease in revenues is mainly due to MCI making its
final development fee payment in 1997 under the 1994 Agreement and to the
Company's shift in market strategy to increased emphasis on the development of
its software to be licensed to users of high quality digital image systems.
Cost of Product Revenues. Cost of product revenues decreased 100% to $0
during 1998 from $128,000 in 1997 as the Company pursued its strategy of exiting
its package software product business.
Sales and Marketing. Sales and marketing expenses decreased 16% to
$4,172,000 during 1998 from $4,993,000 in 1997. The Company initiated sales and
marketing workforce reductions in 1997 as part of the implementation of its
revised market strategy.
Research, Development, and Engineering. Research, development, and
engineering expenses decreased 37% to $5,237,000 during 1998 from $8,261,000 in
1997. The decrease is primarily the result of the workforce reductions resulting
from ending the 1994 Agreement and the implementation of the Company's revised
market strategy.
General and Administrative. General and administrative expenses decreased
23% to $2,024,000 during 1998 from $2,640,000 in 1997. The decrease is primarily
due to $519,000 of one-time charges the Company recorded in the fourth quarter
of 1997, the largest component of which was a $399,000 write-off of an
uncollectible receivable from a single customer.
During 1998 the Company wrote off the remaining balance of its inventory
relating to the Company's older compression accelerator hardware boards.
Interest Income. Interest income increased 80% to $715,000 during 1998 from
$396,000 in 1997. The increase is due to the higher levels of interest on cash
equivalents and short-term investments the Company experienced during 1998 from
the proceeds of its initial public offering of Common Stock.
Interest Expense. Interest expense decreased by 91% to $16,000 during 1998
from $176,000 in 1997. The decrease is primarily due to the decrease in interest
expense on the $3,000,000 in outstanding borrowings under the Mosvold Credit
Facility. Prior to its conversion to equity in October 1997, interest expense on
these borrowings amounted to $112,000.
YEAR ENDED DECEMBER 31, 1997, COMPARED TO YEAR ENDED DECEMBER 31, 1996
Revenues. Total revenues decreased 39% to $9,471,000 during 1997 compared
to $15,558,000 in 1996. The decrease in revenues is mainly due to the expiration
of the 1994 Agreement, and by the execution of a one-time sale of custom built
decompression hardware boards resulting in revenue of $1,484,000 in 1996.
Cost of Product Revenues and Inventory Writedowns. Cost of product revenues
decreased 86% to $128,000 during 1997 from $923,000 in 1996. The decrease is the
result of the one-time sale of custom-built decompression hardware boards
discussed above which produced cost of product revenues of $685,000 in 1996.
During 1996, there was an inventory writedown of $238,000 relating to the
Company's older compression accelerator hardware boards.
Sales and Marketing. Sales and marketing expenses decreased 3% to
$4,993,000 during 1997 from $5,146,000 in 1996. Sales and marketing workforce
reductions in the third quarter of 1997 offset the higher levels of staffing
during the first six months of 1997, and resulted in slightly lower expenses for
the year ended December 31, 1997.
Research, Development, and Engineering. Research, development, and
engineering expenses decreased 8% to $8,261,000 during 1997 from $8,966,000 in
1996. The decrease is primarily the result of the workforce reductions discussed
previously.
General and Administrative. General and administrative expenses increased
33% to $2,640,000 during 1997 from $1,986,000 in 1996. This increase is
attributable to the charges discussed previously that the Company took during
the fourth quarter of 1997.
Interest Income. Interest income increased 107% to $396,000 during 1997
from $191,000 in 1996. The increase is due to the higher levels of interest
earnings on cash equivalents and short-term investments the Company experienced
during the fourth quarter of 1997 as a result of the initial public offering of
common stock in the third quarter.
Interest Expense. Interest expense increased 105% to $176,000 during 1997
from $86,000 in 1996. The increase is due to interest expense on the $3,000,000
in outstanding borrowings under the Mosvold Credit Facility. Prior to its
conversion to equity in October 1997, interest expense on these borrowings
amounted to $112,000 while it was outstanding during 1997.
<PAGE>
IMPACT OF YEAR 2000
The Company is in the process of evaluating the potential impact of what is
commonly referred to as the year 2000 issue, concerning the inability of certain
computer systems to properly recognize and process dates starting with the year
2000 and beyond. The Company is taking steps to ensure that its business systems
software and equipment will continue to function properly after December 31,
1999. In doing so, the Company has established a team, which will work directly
with management to (1) assess and test all internal information systems and
other systems that may be affected by the year 2000 date change; (2) assess and
test its products that may be affected by the year 2000 date change; (3)
communicate with third parties that supply its products to ensure they are
addressing the year 2000 issue; and (4) compose a contingency and disaster
recovery plan to ensure resolution of problems that may arise as a result of the
year 2000 date change. Until this assessment is completed, the Company will not
be able to determine the costs of becoming year 2000 compliant, the risks of
non-compliance, and its ability to conduct its business under a contingency
plan.
The Company's products do not contain any real-time clocks and therefore
the products themselves do not present any year 2000 issues.
With respect to its information technology accounting systems, the
assessment of equipment and software was started in June 1998. The Company will
have completed the upgrade of these systems to versions that are stated to be
2000 compliant by June 30, 1999.
The Company has commenced testing to determine that its internal systems
are year 2000 compliant. The Company expects to complete testing and establish
compliance with respect to all of its systems and products by June 30, 1999,
subject to possible equipment upgrades during 1999 and ongoing communications
with third parties. The Company believes that this time frame will allow
internal auditing and testing of its systems, as well as further remediation, if
necessary.
The Company plans to devote the necessary resources to resolve all
significant year 2000 issues in a timely manner. Based upon current estimates,
the Company believes that its direct costs for year 2000 compliance will consist
primarily of costs related to the staff time devoted to year 2000 compliance.
The Company does not expect material capital expenditures will be necessary for
year 2000 related compliance costs and capital expenditures in these areas have
not been material for historical periods.
Regardless of the year 2000 compliance of its systems and products, the
Company may be adversely affected by disruptions in the operations of the
enterprises with which it interacts. These business enterprises include
suppliers, corporate partners, both domestic and international, government
agencies, and other third parties. The Company cannot reasonably predict the
impact on its operations and financial condition if any such businesses are
adversely affected by the year 2000 issue.
Statements made herein about the implementation of various phases of the
Company's year 2000 program, the costs expected to be associated with that
program, and the results it expects to achieve constitute forward-looking
information. There are many uncertainties involved in the year 2000 issue and
the following important factors, among others, could affect the impact of the
year 2000 issue: (1) the inherent uncertainty of the costs and timing of
achieving compliance on the wide variety of systems used by the Company; (2) the
reliance on the efforts of vendors, customers, government agencies, and other
third parties beyond its control to achieve adequate compliance and avoid
disruption of its business in early 2000; and (3) the uncertainty of the
ultimate costs and consequences of any unanticipated disruption of its business
resulting from the failure of one of its applications or of a third party's
systems.
SOFTWARE REVENUE RECOGNITION
The American Institute of Certified Public Accountants issued Statement of
Position 97-2 ("SOP 97-2"), SOP 98-4, and SOP 98-9, to clarify guidance on
applying generally accepted accounting principles to software transactions and
to provide guidance on when revenue should be recognized and in what amounts for
licensing, selling, leasing, or otherwise marketing computer software. The
adoption of this guidance had no impact on the Company's methods of recognizing
revenue.
EARNINGS PER SHARE OF COMMON STOCK
In February 1997 the Financial Accounting Standards Board ("FASB") issued
Statement No. 128, Earnings Per Share ("Statement 128"), which establishes
standards for computing and presenting earnings per share ("EPS") for entities
with publicly held common stock or potential common stock. Statement 128
requires the presentation of basic and diluted EPS on the face of the income
statement for all entities with complex capital structures. The Company adopted
Statement 128 in 1997 and, in accordance with the requirements thereof, restated
its net loss per share for all prior periods. The effect of adoption was not
material to the accompanying consolidated financial statements. Net loss per
share of common stock is computed based on the weighted average number of shares
outstanding during each period.
COMPREHENSIVE INCOME
On January 1, 1998, the Company adopted Statement No. 130, Reporting
Comprehensive Income, Statement ("130"). The Company reported comprehensive loss
in its statement of changes in stockholders' equity. The adoption of Statement
130 resulted in revised and additional disclosures but had no effect on the
financial position, results of operations, or liquidity of the Company.
<PAGE>
BUSINESS SEGMENTS
In June 1997, the FASB also issued Statement No. 131, Disclosures about
Segments of an Enterprise and Related Information ("Statement 131"), which
establishes standards for the way public business enterprises report information
about operating segments in annual financial statements and requires that those
enterprises report selected information about operating segments in interim
financial reports issued to shareholders. Operating segments are components of
an enterprise about which separate financial information is available that is
evaluated regularly by the chief operating decision maker in deciding how to
allocate resources and in assessing performance. Statement 131 also establishes
standards for related disclosures about products and services, geographic areas,
and major customers. Statement 131 is effective for financial statements for
periods beginning after December 15, 1997. The Company has disclosed its
business segments in the footnotes to its financial statements. The adoption of
Statement 131 resulted in additional disclosures but had no effect on the
financial position, results of operations, or liquidity of the Company.
INFLATION
The effects of inflation on the Company's operations were not significant
during the periods presented in the consolidated financial statements, and the
effects thereof are not considered to be of significance in the future.
Generally, throughout the periods discussed above, the changes in revenue have
resulted primarily from fluctuations in sales levels, rather than price changes.
MARKET RISK
Financial instruments that potentially subject the Company to significant
concentrations of credit risk consist principally of short-term investments,
trade accounts receivable, and accounts payable.
The Company maintains cash and cash equivalents and certain other financial
instruments with various financial institutions. Company policy is designed to
limit exposure at any one institution. Certain investments are in excess of
Federal Deposit Insurance Corporation ("FDIC") guaranteed amounts. The Company
performs periodic evaluations of the relative credit standing of those financial
institutions that are considered in the Company's investment strategy.
The carrying amounts reported in the balance sheet for cash and cash
equivalents, short-term investments, accounts receivable, accounts payable, and
notes payable approximate their estimated fair values.
<PAGE>
CONSOLIDATED FINANCIAL STATEMENTS
ITERATED SYSTEMS, INC.
Years ended December 31, 1996, 1997, and 1998
with Report of Independent Auditors
<PAGE>
CONSOLIDATED FINANCIAL STATEMENTS
ITERATED SYSTEMS, INC.
Years ended December 31, 1996, 1997, and 1998
<TABLE>
<CAPTION>
CONTENTS
<S> <C>
Report of Independent Auditors.......................................... 16
Audited Consolidated Financial Statements
Consolidated Balance Sheets............................................. 17
Consolidated Statements of Operations................................... 18
Consolidated Statements of Shareholders' Equity and Comprehensive Loss.. 19
Consolidated Statements of Cash Flows................................... 20
Notes to Consolidated Financial Statements.............................. 21
</TABLE>
<PAGE>
REPORT OF INDEPENDENT AUDITORS
Board of Directors
Iterated Systems, Inc.
We have audited the accompanying consolidated balance sheets of Iterated
Systems, Inc. as of December 31, 1997 and 1998, and the related consolidated
statements of operations, shareholders' equity and comprehensive loss and cash
flows for each of the three years in the period ended December 31, 1998. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position of
Iterated Systems, Inc. at December 31, 1997 and 1998, and the consolidated
results of its operations and its cash flows for each of the three years in the
period ended December 31, 1998, in conformity with generally accepted accounting
principles.
/s/ Ernst & Young LLP
Atlanta, Georgia
January 15, 1999
<PAGE>
ITERATED SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
DECEMBER 31
1997 1998
------------------------------------------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 7,633,283 $ 3,706,070
Short-term investments 9,999,420 4,270,444
Accounts receivable, net of reserves for doubtful accounts
of $9,000 and $5,668, respectively 495,667 214,088
Inventory 8,275 -
Prepaid expenses and other assets 360,752 212,132
------------------------------------------
Total current assets 18,497,397 8,402,734
------------------------------------------
Property and equipment:
Computer equipment and purchased software 3,836,507 2,872,013
Furniture and equipment 366,084 390,158
Leasehold improvements 134,398 135,566
------------------------------------------
4,336,989 3,397,737
Accumulated depreciation and amortization (3,103,756) (2,761,119)
------------------------------------------
1,233,233 636,618
Other assets 44,464 44,699
------------------------------------------
Total assets $ 19,775,094 $ 9,084,051
==========================================
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 206,321 $ 153,670
Accrued expenses 639,461 353,086
Deferred revenue 5,126 5,126
Current maturities of long-term debt 80,784 -
Current portion of capitalized lease obligations 38,829 4,874
Other liabilities 34,572 34,572
------------------------------------------
Total current liabilities 1,005,093 551,328
Non-current liabilities:
Capitalized lease obligations 4,874 -
Other liabilities 48,977 14,405
Shareholders' equity:
Common stock, $.01 par value:
Authorized shares - 20,000,000
Issued and outstanding shares - 13,102,025
and 13,073,025, respectively 131,020 130,730
Additional paid-in capital 30,012,720 29,806,036
Accumulated deficit (11,436,434) (21,461,546)
Currency translation adjustments 8,844 43,098
------------------------------------------
Total shareholders' equity 18,716,150 8,518,318
------------------------------------------
Total liabilities and shareholders' equity $ 19,775,094 $ 9,084,051
==========================================
</TABLE>
See accompanying notes.
<PAGE>
ITERATED SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31
1996 1997 1998
---------------------------------------------------------
<S> <C> <C> <C>
Revenues:
Development and exclusive license fees $13,595,272 $ 9,088,972 $ 671,161
Software products 1,951,337 284,691 1,943
Other 11,650 97,500 80,000
---------------------------------------------------------
15,558,259 9,471,163 753,104
Costs and expenses:
Costs of product revenues 923,253 128,392 -
Sales and marketing 5,145,754 4,993,471 4,172,443
Research, development, and engineering 8,965,758 8,260,615 5,237,166
General and administrative 1,986,449 2,640,183 2,024,008
Inventory writedowns 238,000 - 8,275
---------------------------------------------------------
17,259,214 16,022,661 11,441,892
---------------------------------------------------------
Operating loss (1,700,955) (6,551,498) (10,688,788)
Other income (expense):
Interest income 191,266 395,927 714,555
Interest expense (86,129) (176,464) (16,287)
Foreign currency exchange gain (loss) (10,652) 2,986 (34,592)
---------------------------------------------------------
Net loss $(1,606,470) $(6,329,049) $(10,025,112)
=========================================================
Basic and diluted net loss per share of common
stock $(.15) $(.56) $(.77)
=========================================================
Weighted average number of shares of common stock
outstanding 10,563,500 11,319,600 13,083,954
=========================================================
</TABLE>
See accompanying notes.
<PAGE>
ITERATED SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY AND COMPREHENSIVE LOSS
<TABLE>
<CAPTION>
ACCUMULATED
ADDITIONAL OTHER
COMMON STOCK PAID-IN ACCUMULATED COMPREHENSIVE
------------------------
SHARES AMOUNT CAPITAL DEFICIT LOSS TOTAL
------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Balance at December 31, 1995 10,509,400 $105,094 $ 5,914,429 $ (3,500,915) $(4,625) $ 2,513,983
Comprehensive loss:
Net loss - - - (1,606,470) - (1,606,470)
Currency translation
adjustment - - - - 22,109 22,109
--------------
Comprehensive loss (1,584,361)
--------------
Issuance of common stock 200,000 2,000 1,996,634 - - 1,998,634
Exercise of stock options 5,200 52 4,605 - - 4,657
Compensation related to options
for 714,200 shares of common stock - - 278,316 - - 278,316
------------------------------------------------------------------------------------
Balance at December 31, 1996 10,714,600 107,146 8,193,984 (5,107,385) 17,484 3,211,229
Comprehensive loss:
Net loss - - - (6,329,049) - (6,329,049)
Currency translation
adjustment - - - - (8,640) (8,640)
--------------
Comprehensive loss (6,337,689)
--------------
Initial public offering of stock,
net of $1,821,000 of offering
costs 2,040,000 20,400 18,558,746 - - 18,579,146
Conversion of note payable to
stockholder to common stock 300,000 3,000 2,997,000 - - 3,000,000
Issuance of common stock 2,600 26 25,974 - - 26,000
Exercise of stock options 44,825 448 132,211 - - 132,659
Compensation related to options
for 570,200 shares of common stock - - 104,805 - - 104,805
------------------------------------------------------------------------------------
Balance at December 31, 1997 13,102,025 131,020 30,012,720 (11,436,434) 8,844 18,716,150
Comprehensive loss:
Net loss - - - (10,025,112) - (10,025,112)
Currency translation
adjustments - - - - 34,254 34,254
--------------
Comprehensive loss (9,990,858)
--------------
Issuance of warrants - - 31,597 - - 31,597
Exercise of stock options 7,200 72 2,221 - - 2,293
Purchase and retirement of common
stock (36,200) (362) (240,502) - - (240,864)
------------------------------------------------------------------------------------
Balance at December 31, 1998 13,073,025 $130,730 $29,806,036 $(21,461,546) $43,098 $ 8,518,318
====================================================================================
</TABLE>
See accompanying notes.
<PAGE>
ITERATED SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31
1996 1997 1998
---------------------------------------------------------
<S> <C> <C> <C>
OPERATING ACTIVITIES
Net loss $(1,606,470) $ (6,329,049) $(10,025,112)
Adjustments to reconcile net loss to net cash used
in operating activities:
Depreciation and amortization 1,285,317 1,468,109 863,782
Loss (gain) on sales of property and equipment 832 (180) (13,181)
Compensatory stock options 278,316 104,805 -
Issuance of warrants - - 31,597
Foreign currency transaction gain (loss) 10,652 (2,986) 34,592
Changes in operating assets and liabilities:
Accounts receivable 168,495 (84,561) 281,579
Inventory 249,480 15,789 8,275
Prepaid expenses and other assets (125,879) 240,418 148,385
Accounts payable (57,162) (102,219) (52,651)
Accrued expenses (338,959) (234,842) (286,375)
Deferred revenue (2,557,433) (2,552,000) -
Other liabilities (34,572) (34,572) (34,572)
---------------------------------------------------------
Net cash used in operating activities (2,727,383) (7,511,288) (9,043,681)
INVESTING ACTIVITIES
Purchases of property and equipment (1,158,042) (445,971) (294,037)
Proceeds from sale of property and equipment 15,797 400 39,574
(Purchases) sales of short-term investments - (9,999,420) 5,728,976
---------------------------------------------------------
Net cash (used in) provided by investing activities (1,142,245) (10,444,991) 5,474,513
FINANCING ACTIVITIES
Proceeds from note payable to stockholder - 3,000,000 -
Payments on note payable to bank (138,487) (138,487) (80,784)
Proceeds from capital leases 12,500 - -
Principal payments on capital lease obligations (138,191) (160,710) (38,829)
Net proceeds from initial public offering
of common stock - 18,579,146 -
Issuance of common stock 2,003,291 158,659 2,293
Repurchase of common stock - - (240,864)
---------------------------------------------------------
Net cash provided by (used in) financing activities 1,739,113 21,438,608 (358,184)
Effect of exchange rate fluctuation on cash 416 120 139
---------------------------------------------------------
Change in cash and cash equivalents (2,130,099) 3,482,449 (3,927,213)
Cash and cash equivalents at beginning of year 6,280,933 4,150,834 7,633,283
---------------------------------------------------------
Cash and cash equivalents at end of year $ 4,150,834 $ 7,633,283 $ 3,706,070
=========================================================
NON-CASH ITEMS
Conversion of proceeds on note payable to
stockholder to common stock $ - $ 3,000,000 $ -
=========================================================
</TABLE>
See accompanying notes.
<PAGE>
ITERATED SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998
1. DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
DESCRIPTION OF BUSINESS
Iterated Systems, Inc. (the "Company") develops and markets patented
digital image science technology based upon its Imaging Systems Architecture(TM)
to users of high quality digital image systems needing innovative, high
performance solutions that make workflows faster and more efficient. The
Company's patented technologies are based upon its research and development
expertise in digital image science and fractal-based mathematics that have
evolved over more than ten years experience.
During 1998 the Company has focused its efforts on products, including its
award-winning STiNG(TM) technology, which generate reusable, repurposable image
assets that can be converted to industry-standard formats for print and on-line
media at any resolution. The digital image systems industry in which the Company
operates is subject to rapid technological change.
As shown in the financial statements, the Company incurred a net loss of
$10,025,112 in 1998, and has an accumulated a deficit of $21,461,546 at December
31, 1998. The Company experienced negative cash flows from operations of
$9,043,681, and revenues decreased approximately 92% from the prior year. The
Company has a combined cash and short-term investment balance of $7,976,514 as
of December 31, 1998. These funds were generated by the proceeds of the
Company's September 1997 initial public stock offering and have enabled the
Company to meet obligations during 1998 despite negative cash flows. However,
the Company may not be able to depend solely on such funds to meet its planned
obligations during 1999. The Company is finalizing the development of its new
software products and expects initial revenues related thereto in the first
quarter of 1999. The Company may also seek to raise additional investment
capital in order to fund operations. The Company may also undertake certain cost
cutting measures that would slow down its research and development efforts. It
is not possible to predict the outcome of the Company's efforts and there is no
assurance that the Company will be successful in increasing revenues or
obtaining financing.
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of the Company
and its wholly-owned United Kingdom subsidiary, Iterated Systems Limited
("ISL"). Significant intercompany accounts and transactions have been eliminated
in consolidation.
USE OF ESTIMATES
The preparation of 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.
CASH EQUIVALENTS
The Company considers all highly-liquid investments with a maturity of
three months or less when purchased to be cash equivalents.
SHORT-TERM INVESTMENTS
The Company's short-term investments are classified as held-to-maturity and
are stated at cost. These investments mature within one year and the carrying
amounts reported in the balance sheets for these investments approximates their
fair values.
PROPERTY AND EQUIPMENT
Property and equipment are stated at cost. Depreciation and amortization
expense is calculated over the estimated useful lives of the related assets
(three to seven years) using the straight-line method for financial reporting
purposes. Amortization of assets recorded under capital leases is included with
depreciation and amortization expense.
ADVERTISING COSTS
Advertising costs are expensed in the period incurred. Such costs amounted
to $299,000, $132,000, and $23,000 during 1996, 1997, and 1998, respectively.
RESEARCH AND DEVELOPMENT
Research and development expenditures are expensed when incurred.
SOFTWARE REVENUE RECOGNITION
The American Institute of Certified Public Accountants issued Statement of
Position ("SOP") 97-2, SOP 98-4 and SOP 98-9 to clarify guidance on applying
generally accepted accounting principles to software transactions and to provide
guidance on when
<PAGE>
revenue should be recognized and in what amounts for licensing, selling,
leasing, or otherwise marketing computer software. The Company adopted this
guidance during 1997. The adoption of this guidance had no effect on the
Company's methods of recognizing revenue.
Development fees are recognized based on the Company's estimate of the
percentage of completion using actual costs incurred as a percentage of expected
total costs of individual development agreements or contracts. Exclusive license
fees are recognized over the exclusivity period, if applicable.
Revenues from the sale of hardware and packaged software products are
recognized upon the shipment of the products to the customers.
INCOME TAXES
Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for tax purposes. Such amounts are measured using
enacted tax rates and laws that are expected to be in effect when the
differences reverse.
FOREIGN CURRENCY TRANSLATION
ISL considers the British pound to be its functional currency. The Company
considers its functional currency to be the US dollar. ISL's assets and
liabilities are translated at year-end rates of exchange and its revenues and
expenses are translated at the average rates of exchange during the year.
Gains and losses resulting from currency translation are accumulated as
separate components of shareholders' equity and comprehensive loss. Gains and
losses resulting from foreign currency transactions are included in the
determination of net loss.
EMPLOYEE STOCK OPTIONS
In October 1995, the Financial Accounting Standards Board ("FASB") issued
Statement No. 123, Accounting for Stock-Based Compensation ("Statement 123").
Under Statement 123, the Company may continue following previously existing
accounting rules or adopt a new fair value method of valuing stock-based awards
to employees. The Company elected to continue following the existing accounting
rules under Accounting Principles Board Opinion No. 25, Accounting for Stock
Issued to Employees ("APB 25"), and related Interpretations in accounting for
its employee stock options. The pro forma effect on the accompanying
consolidated statements of operations of adopting Statement 123 is presented in
Note 9.
NET LOSS PER SHARE OF COMMON STOCK
In February 1997, the FASB issued Statement No. 128, Earnings Per Share
("Statement 128"), which establishes standards for computing and presenting
earnings per share ("EPS") for entities with publicly held common stock.
Statement 128 requires the presentation of basic and diluted EPS on the face of
the income statement for all entities with complex capital structures. The
Company adopted Statement 128 in 1997 and, in accordance with the requirements
thereof, restated its net loss per share for all prior periods. The effect of
adoption was not material to the accompanying consolidated financial statements.
Net loss per share of common stock is computed based on the weighted average
number of shares outstanding during the year. Stock options and warrants were
not included in the EPS calculation as they were antidilutive.
IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS
On January 1, 1998, the Company adopted Statement No. 130, Reporting
Comprehensive Income ("Statement 130"). The Company reported comprehensive
income in its statement of changes in stockholders' equity. The adoption of
Statement 130 resulted in revised and additional disclosures but had no effect
on the financial position, results of operations, or liquidity of the Company.
In June 1997, the FASB also issued Statement No. 131, Disclosures about
Segments of an Enterprise and Related Information ("Statement 131"), which
establishes standards for the way public business enterprises report information
about operating segments in annual financial statements and requires that those
enterprises report selected information about operating segments in interim
financial reports issued to shareholders. Operating segments are components of
an enterprise about which separate financial information is available which is
evaluated regularly by the chief operating decision maker in deciding how to
allocate resources and in assessing performance. Statement 131 also establishes
standards for related disclosures about products and services, geographic areas,
and major customers. The Company adopted Statement 131 in 1998, and the effect
of the adoption was not material to the consolidated financial statements (see
Note 10).
RECLASSIFICATIONS
Certain reclassifications were made to the 1996 and 1997 financial
statements to conform with the 1998 presentation.
2. FINANCIAL INSTRUMENTS
Financial instruments which potentially subject the Company to significant
concentrations of credit risk consist principally of short-term investments and
trade accounts receivable.
<PAGE>
The Company maintains cash and cash equivalents and certain other financial
instruments with various financial institutions. Company policy is designed to
limit exposure at any one institution. Certain investments are in excess of
Federal Deposit Insurance Corporation guaranteed amounts. The Company performs
periodic evaluations of the relative credit standing of those financial
institutions which are considered in the Company's investment strategy.
The carrying amounts reported in the balance sheet for cash and cash
equivalents, short-term investments, accounts receivable, accounts payable, and
notes payable approximate their estimated fair values.
3. INVENTORY
During 1995, the Company upgraded certain of its software products. The
upgraded software operates in such a way that, when used in conjunction with
recently available personal computer central processors and operating systems,
the Company's older hardware products became unnecessary for fully functional
operation. Accordingly, during 1996, the Company recorded reserves totaling
$238,000 to reduce the carrying value of certain inventory items and to reflect
inventory purchase commitments in excess of net realizable value. There is no
inventory balance as of December 31, 1998.
4. LONG-TERM DEBT AND CREDIT FACILITY
As of December 31, 1997, long-term debt consisted of a note payable to a
bank through July 1998 at approximately $12,000 per month, plus interest at
prime (8.5% at December 31, 1997), secured by certain computer equipment. The
note was repaid during 1998.
On May 31, 1996, (amended June 30, 1997), the Company entered into a Bridge
Financing Credit Facility (the "Credit Facility") with one of its shareholders
(the "Lender"). The Agreement allowed the Company to borrow up to $6,000,000
($3,000,000 at December 31, 1997) at prime plus 1% (9.5% at December 31, 1997)
from the Lender until June 30, 1998, without collateral. In addition, the Lender
received a warrant to purchase 100,000 shares of the Company's common stock at
$10 per share. The warrant expires on May 31, 1999.
On June 9, 1997, the Company borrowed $3,000,000 under the Credit Facility.
On October 31, 1997, the Lender exercised the option to convert those borrowings
into 300,000 shares of the Company's common stock at $10 per share. The Company
paid the Lender $112,000 in interest on the outstanding borrowings during 1997,
and commitment fees on amounts not borrowed of $26,000 and $9,400 for 1997 and
1998, respectively. No further borrowings occurred and the Credit Facility
expired on June 30, 1998.
5. CAPITALIZED LEASE OBLIGATIONS
Property and equipment includes the following amounts for leases that have been
capitalized:
<TABLE>
<CAPTION>
DECEMBER 31
1997 1998
----------------------------------
<S> <C> <C>
Telephone equipment $ 108,000 $
Computer equipment 340,000 13,000
----------------------------------
448,000 13,000
Less accumulated amortization (426,000) (10,000)
----------------------------------
$ 22,000 $ 3,000
==================================
</TABLE>
Amortization of leased assets is included in depreciation and amortization
expense. The computer equipment lease provides for a bargain purchase option at
the end of the lease. Amortization of leased assets is included in depreciation
and amortization expense.
Future minimum lease payments under capital leases consist of $5,300 for
1999, of which $500 relates to interest.
6. OPERATING LEASES
The Company leases certain office equipment and office space under
noncancellable agreements. The office equipment lease provides for an extension
of the lease term at fair rental value or a purchase option at fair market
value. One of the office space leases provides for a five year extension with
rent escalation clauses linked to the Consumer Price Index. Rent expense under
all operating leases approximated $727,000, $695,000, and $643,000 during 1996,
1997, and 1998, respectively.
<PAGE>
Future minimum lease payments under noncancellable operating leases, with
initial lease terms of at least one year at the time of inception, are as
follows at December 31, 1998:
<TABLE>
<S> <C>
1999........................................... $ 706,000
2000........................................... 439,000
2001........................................... 89,000
2002........................................... 89,000
2003 and after................................. 849,000
-----------
2,172,000
-----------
less: rental income from subleases............. (288,000)
-----------
$1,884,000
===========
</TABLE>
7. SIGNIFICANT CONTRACTS
In 1994, the Company entered into a Development and License Agreement (the
"1994 Agreement") with a major international telecommunications company (the
"Licensee") to provide for further development of certain advanced compression
technology for use in telecommunications applications. The Licensee supplied
significant funding for development and had certain exclusive rights until
September 1997 for specified modules in telecommunications markets. During 1996
and 1997, the Company recognized $10,873,000 and $5,752,000, respectively, in
development fee revenues and $1,800,000 and $1,350,000, respectively, in
exclusive license fee revenues under the contract. Except for certain
provisions, notably with respect to the continuing licensing of specific
technology components referred to above, the Agreement expired in September
1997.
The Company and Licensee entered into a new agreement on August 7, 1998,
that cancelled the 1994 Agreement and provides the Licensee with rights to
certain deliverables as defined in the agreement. Additionally, the Company
granted the Licensee warrants to purchase up to 1,452,570 shares of common
stock. The warrants expire four years from the issue date, are exercisable at $5
per share, and had an appraised value of $31,597 as of August 7, 1998. The
warrants have not been exercised as of December 31, 1998. In connection with
this issuance, the Company recorded a charge to earnings of $31,597 representing
the fair value of the warrant.
8. COMMON STOCK
INITIAL PUBLIC OFFERING
In September 1997, the Company sold 2,040,000 shares of common stock in an
initial public offering at $10.00 per share on the Oslo Stock Exchange.
STOCK SPLIT
On September 2, 1997, (a) the Company's Board of Directors agreed to effect
a 100 for 1 stock split in the form of a stock dividend and to increase the
number of authorized shares of common stock from 10,000,000 shares to 20,000,000
shares, effective September 3, 1997; and (b) the Company's shareholders approved
such Board actions. All share and per share amounts have been adjusted in the
accompanying consolidated financial statements to reflect such stock split.
OTHER
The Company has not registered any securities with the U.S. Securities and
Exchange Commission under the Securities Act of 1933, as amended, other than
pursuant to its registration statement on Form S-8 filed on December 9, 1998.
Securities of the Company may not be offered for sale or sold in the U.S., or to
or for the account or benefit of any "U.S. person" (as defined in the Securities
Act), unless the securities are registered under the Securities Act or an
exemption from such registration requirements is available.
9. STOCK OPTION PLANS
In 1992, the Company approved a stock option plan, which was amended by the
1994 Amended and Restated Stock Option Plan (the "Plan"). Options may be granted
to employees of the Company or key persons as defined by the Plan. The options
may be issued as incentive or nonqualified stock options. The terms and
conditions of options granted under the Plan, including the number of shares,
the exercise price and the time at which such options become exercisable are
determined by the Board of Directors. The terms of options granted under the
Plan may not exceed 10 years.
The Company granted options as to 311,000, 553,100, and 3,143,700 shares
under the Plan during 1996, 1997, and 1998, respectively, at exercise prices
ranging from $2 to $10. Options as to 707,700 shares granted in 1994 resulted in
$248,000 and $80,000 of compensation expense during 1996 and 1997, respectively.
This expense relates to the aggregate difference between the estimated fair
market values of the shares at the date of the grant and the exercise prices,
which was expensed over the vesting period.
<PAGE>
At December 31, 1998, options as to 189,675 shares are available for future
grants under the Plan and the Company has reserved 3,293,575 shares for further
issuance.
During 1994, the Company adopted a Directors Stock Option Plan for up to
180,000 shares of common stock for awards to non-employee directors. Options
granted under this plan vest over a three-year period. The Company granted
options as to 25,000 and 15,000 shares at exercise prices of $6 and $10 in 1996
and 1997, respectively. Grants issued under the plan resulted in $30,000 and
$25,000 of compensation expense during 1996 and 1997, respectively, which
relates to the aggregate difference between the estimated fair market values of
the shares at the dates of grant and the exercise prices, which is being
expensed over the vesting period. The Company has reserved 180,000 shares for
future issuance under this plan at December 31, 1998.
During 1998, options to purchase 1,758,200 shares of common stock were
canceled and reissued and options to purchase 40,000 shares of common stock were
repriced at lower prices.
A summary of stock option activity under both of the above-described plans
follows:
<TABLE>
<CAPTION>
PRICE WEIGHTED -
NUMBER OF SHARES PER SHARE AVERAGE PRICE
----------------------------------------------------------------
<S> <C> <C> <C>
Outstanding options at December 31, 1995 1,847,900
Options granted 326,000 $ 10.00 $10.00
Options exercised (5,200) 0.32 - 6.00 0.82
Options forfeited (39,500) 6.00 - 10.00 8.00
-------------------
Outstanding options at December 31, 1996 2,129,200 0.32 - 10.00 6.29
Options granted 553,100 7.40 - 10.00 9.42
Options exercised (44,825) 0.32 - 8.00 2.96
Options forfeited (634,725) 0.32 - 10.00 7.79
-------------------
Outstanding options at December 31, 1997 2,002,750 0.32 - 10.00 6.76
Options granted 3,143,700 2.00 - 7.48 5.12
Options exercised (7,200) 0.32 0.32
Options forfeited (177,150) 4.50 - 10.00 6.85
Options canceled (1,758,200) 4.50 - 10.00 7.77
-------------------
Outstanding options at December 31, 1998 3,203,900 0.32 - 8.00 4.40
===================
</TABLE>
The following table summarizes information concerning outstanding and
exercisable options at December 31, 1998:
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
------------------------------------------- -------------------------------------------
WEIGHTED AVERAGE
RANGE OF NUMBER REMAINING NUMBER WEIGHTED AVERAGE
EXERCISE PRICES OUTSTANDING CONTRACTUAL LIFE EXERCISABLE EXERCISE PRICE
- --------------- ------------------- ------------------- ------------------- -------------------
<S> <C> <C> <C> <C>
$ 0.32 4,700 4 4,700 $ 0.32
2.00 675,700 10 35,000 2.00
4.00-5.00 2,059,400 10 749,400 4.00-5.00
6.00-8.00 464,100 6 463,725 6.00-8.00
</TABLE>
The Company has elected to follow APB 25 and related Interpretations in
accounting for its employee stock options because, as discussed below, the
alternative fair value accounting provided for under Statement 123 requires use
of option valuation models that were not developed for use in valuing employee
stock options. Under APB 25, when the exercise price of the Company's stock
options equals or exceeds the market price of the underlying stock on the date
of grant, no compensation expense is recognized.
Pro forma information regarding net income is required by Statement 123,
which also requires that the information be determined as if the Company has
accounted for its employee stock options granted subsequent to December 31,
1994, under the fair value method. The fair values for these options were
estimated at the dates of grant using the minimum value method prior to the
Company's Initial Public Offering in September 1997 and the Black-Scholes method
thereafter, with the following weighted-average assumptions for 1996, 1997, and
1998; risk-free interest rates of 6.36%, 6.20%, and 5.07%, respectively; no
dividend yield; volatility
<PAGE>
of .01 prior to the effective date of the Company's Initial Public Offering in
September 1997, .421 for the remainder of 1997, and .740 in 1998; and a
weighted-average expected life of 6 years.
For purposes of pro forma disclosures, the estimated fair values of the
options are amortized to expense over the options' vesting periods. The
Company's pro forma net loss, assuming Statement 123 had been adopted, would
have been approximately $1,866,000, $6,755,000, and $11,232,000 during 1996,
1997, 1998, respectively. The Company's pro forma net loss per share, assuming
Statement 123 had been adopted, would have been, $0.18, $0.60, and $0.86 during
1996, 1997, 1998, respectively.
The weighted-average fair values of options granted for the years ended
December 31, 1996, 1997, and 1998 were $2.52, $2.90, and $2.01, respectively.
Because Statement 123 is applicable only to options granted subsequent to
December 31, 1994, its pro forma effect will not be fully reflected until 1999.
10. SEGMENT INFORMATION
In accordance with the requirements of Statement 131, the following
disclosure represents the information used by management when evaluating the
operating performance of its business units. The information reviewed by
management includes the operating revenue from external customers, net loss, and
identifiable assets for the Company's two geographic areas, the United States
and the United Kingdom. Both operating segments are involved in developing and
marketing patented digital image science technology.
The net assets of the foreign operations exclude intercompany accounts payable
to the Company (for which settlement is not planned or anticipated in the
foreseeable future).
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31
1996 1997 1998
---------------------------------------------------------
<S> <C> <C> <C>
OPERATING REVENUE
United States $15,462,000 $ 9,425,000 $ 750,000
United Kingdom 96,000 46,000 3,000
---------------------------------------------------------
Total $15,558,000 $ 9,471,000 $ 753,000
=========================================================
NET LOSS
United States $ 973,000 $ 5,511,000 $ 9,371,000
United Kingdom 633,000 818,000 654,000
---------------------------------------------------------
Total $ 1,606,000 $ 6,329,000 $10,025,000
=========================================================
IDENTIFIABLE ASSETS, NET
United States $ 3,144,000 $18,550,000 $ 8,621,000
United Kingdom 67,000 166,000 (103,000)
---------------------------------------------------------
Total $ 3,211,000 $18,716,000 $ 8,518,000
=========================================================
</TABLE>
MAJOR CUSTOMERS
Several customers of the domestic operating segment comprised a significant
portion of consolidated revenues in each period. During 1996, revenues of
$12,673,000 were recognized from a major international telecommunications
company (as discussed in Note 7), and $1,484,000 from product sales to a foreign
government. During 1997, $7,102,000 in revenues were recognized from a major
international telecommunications company, and $1,043,000 was recognized from a
foreign satellite transmission company. During 1998, revenues were derived from
sales to a government agency and from two different software development
companies, in the amount of $478,000, $105,000, and $72,000, respectively.
11. SIGNIFICANT EMPLOYMENT AGREEMENTS
In 1994, the Company entered into employment agreements of an indefinite
term with its two co-founders, who each serve as Executive Vice Presidents. The
agreements provide for: (a) a grant of stock options; (b) ongoing annual base
salaries; (c) salary continuation rights in the event of employment termination
under certain circumstances; and (d) possible performance-based cash bonuses
each year through 1996. There were no charges to expense for cash bonuses under
these agreements in 1996, 1997, and 1998.
In December 1997, the Company restated the employment agreement with the
President/Chief Executive Officer. The restated agreement acknowledges his
request to relinquish the President/Chief Executive Officer titles and to become
the Vice-Chairman of the Company's Board of Directors together with (a) a
reduction of base salary to reflect his advisory role; (b) an additional grant
of 124,100 stock options; and (c) a performance-based cash bonus in the amount
of $150,000, which was paid in 1997. The restated agreement also provides for
the immediate vesting of options as to 706,000 shares of common stock previously
granted and the forfeiture of options as to 218,300 shares of common stock
previously granted.
<PAGE>
In February 1998, the Company entered into an employment agreement with its
new President and Chief Executive Officer. The agreement provides for (a)
granting of immediate stock options; (b) granting of additional stock options
under certain circumstances; (c) granting of cash bonuses under certain
circumstances; and (d) salary continuation rights for 18 months in the event of
termination of employment under certain circumstances. There were no charges to
expense for bonuses or additional grants of stock options under this agreement
in 1998.
12. INCOME TAXES
The Company and ISL file income tax returns in the United States and the
United Kingdom, respectively.
At December 31, 1997, and December 31, 1998, the Company has net operating
loss carryforwards in the United States of $11,941,000 and $20,992,000,
respectively, which begin expiring in 2007. In addition, at December 31, 1997,
and December 31, 1998, the Company has $920,000 and $1,087,000, respectively, of
research and development credits available for offset against future United
States income taxes which also begin expiring in 2007. The utilization of net
operating loss carryforwards to offset future taxable income may be limited due
to any future changes in ownership of the Company.
At December 31, 1997, and December 31, 1998, ISL has net operating loss
carryforwards in the United Kingdom of (Pounds)1,600,000 ($2,633,000) and
(Pounds)2,052,000 ($3,405,000), respectively, which are available for offset
against future United Kingdom taxable income.
For financial reporting purposes, a valuation allowance has been recognized
to reduce the net deferred tax assets to zero due to uncertainties with respect
to the Company's ability to generate taxable income in the future sufficient to
realize the benefit of such deferred income tax assets.
The Company's deferred income tax liabilities and assets are as follows:
<TABLE>
<CAPTION>
DECEMBER 31
1997 1998
-----------------------------------------
<S> <C> <C>
Deferred income tax liabilities:
Prepaid insurance $ 19,000 $ 14,000
-----------------------------------------
Total deferred income tax liabilities 19,000 14,000
Deferred income tax assets:
Book over tax depreciation 158,000 255,000
Research and development credits 920,000 1,087,000
Allowance for bad debts 3,000 2,000
Net operating loss carryforwards-U.S. 4,538,000 7,965,000
Net operating loss carryforwards-U.K. 869,000 1,294,000
Contribution carryover - 5,000
Compensatory stock options 266,000 250,000
Deferred revenue 2,000 2,000
Alternative minimum tax credit 115,000 115,000
Bonuses 10,000 24,000
-----------------------------------------
Total deferred income tax assets 6,881,000 10,999,000
Valuation allowance for deferred income tax assets (6,862,000) (10,985,000)
-----------------------------------------
Net deferred income tax assets 19,000 14,000
-----------------------------------------
Net deferred income taxes $ - $ -
=========================================
</TABLE>
<PAGE>
A reconciliation of the provision for income taxes to the federal statutory rate
is as follows:
<TABLE>
<CAPTION>
1996 1997 1998
---------------------------------------------
<S> <S> <C> <C>
Tax at statutory rate $ (546,000) $(2,152,000) $(3,409,000)
State taxes, net of federal benefit (64,000) (253,000) (401,000)
Permanent differences and other (34,000) (79,000) (313,000)
Valuation allowance 644,000 2,484,000 4,123,000
---------------------------------------------
$ - $ - $ -
=============================================
</TABLE>
13. RETIREMENT PLAN
The Company maintains a defined contribution plan (the "401(k) Plan")
covering all employees. The Company makes matching contributions equal to 50% of
eligible employees' contributions, up to 4% of the employee's compensation,
increased to 6% effective June 1, 1998. The Company expensed $102,000, $102,000,
and $100,000 during 1996, 1997, and 1998, respectively, related to this plan.
<PAGE>
EXHIBIT 23.1
CONSENT OF INDEPENDENT AUDITORS
We consent to the incorporation by reference in this Annual Report on Form 10-K
of Iterated Systems, Inc. of our report dated January 15, 1999, included in the
1998 Annual Report to Stockholders of Iterated Systems, Inc.
Our audits also included the financial statement schedule of Iterated Systems,
Inc. listed in Item 14(a). This schedule is the responsibility of Iterated
Systems, Inc.'s management. Our responsibility is to express an opinion based
on our audits. In our opinion, the financial statement schedule referred to
above, when considered in relation to the basic financial statements taken as a
whole, presents fairly in all material respects the information set forth
therein.
We also consent to the incorporation by reference in the Registration Statement
(Form S-8 No. 333-68593) pertaining to the 1994 Amended and Restated Directors
Stock Option Plan and the 1994 Amended and Restated Stock Option Plan of
Iterated Systems, Inc. of our report dated January 15, 1999 with respect to the
consolidated financial statements of Iterated Systems, Inc. incorporated herein
by reference, and our report included in the preceding paragraph with respect to
the financial statement schedule included in this Annual Report on Form 10-K for
the year ended December 31, 1998.
/s/ Ernst & Young LLP
Atlanta, Georgia
March 25, 1999
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> DEC-31-1998
<CASH> 3,706,070
<SECURITIES> 4,270,444
<RECEIVABLES> 219,756
<ALLOWANCES> 5,668
<INVENTORY> 0
<CURRENT-ASSETS> 8,402,734
<PP&E> 3,397,737
<DEPRECIATION> 2,761,119
<TOTAL-ASSETS> 9,084,051
<CURRENT-LIABILITIES> 551,327
<BONDS> 0
0
0
<COMMON> 130,731
<OTHER-SE> 8,387,588
<TOTAL-LIABILITY-AND-EQUITY> 9,084,051
<SALES> 1,943
<TOTAL-REVENUES> 733,104
<CGS> 0
<TOTAL-COSTS> 5,237,166
<OTHER-EXPENSES> 6,204,726
<LOSS-PROVISION> 340
<INTEREST-EXPENSE> 16,287
<INCOME-PRETAX> (10,025,112)
<INCOME-TAX> 0
<INCOME-CONTINUING> (10,025,112)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (10,025,112)
<EPS-PRIMARY> (0.77)
<EPS-DILUTED> (0.77)
</TABLE>
