U. S. Securities and Exchange Commission
Washington, D.C. 20549
FORM 10-KSB
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1999.
[ ] TRANSITION REPORT UNDER SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from _________ to _________.
Commission File Number: 1-14896
NETWORK-1 SECURITY SOLUTIONS, INC.
(Name of small business issuer in its Charter)
Delaware 11-3027591
(State or other jurisdiction (IRS Employer
of incorporation) Identification Number)
1601 Trapelo Road, Reservoir Place
Waltham, Massachusetts 02451
(Address of Principal Executive Offices)
Issuer's telephone number : (781) 522-3400
Securities registered under Section 12(b) of the Exchange Act:
Title of each class Name of each exchange
Common Stock, $.01 par value on which registered
Boston Stock Exchange
Securities registered under Section 12(g) of the Exchange Act:
None
Check whether the issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 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 [ ]
Check if there is no disclosure of delinquent filers in response to
Item 405 of Regulation S-B contained in this form, and no disclosure will 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-KSB
or any amendment to this Form 10-KSB. [X]
The issuer's revenues for its most recent fiscal year: $394,000.
The aggregate market value of the Common Stock of the registrant held
by non-affiliates as of February 28, 2000 was approximately $38,744,000 based on
the average bid and asked prices for such Common Stock as reported on the Nasdaq
SmallCap Market.
The number of shares of Common Stock outstanding as of February 28,
2000 was 5,350,753.
Documents Incorporated by Reference: None
Transitional Small Business Disclosure Format (Check One):
Yes [ ] No [X]
PART I
THIS ANNUAL REPORT ON FORM 10-KSB CONTAINS CERTAIN STATEMENTS WHICH ARE
FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF THE SAFE HARBOR PROVISIONS OF
SECTION 27A OF THE SECURITIES ACT OF 1933, AS AMENDED, AND SECTION 21E OF THE
SECURITIES EXCHANGE ACT OF 1934, AS AMENDED. ACTUAL RESULTS, EVENTS AND
CIRCUMSTANCES (INCLUDING FUTURE PERFORMANCE, RESULTS AND TRENDS) COULD DIFFER
MATERIALLY FROM THOSE SET FORTH IN SUCH STATEMENTS DUE TO VARIOUS RISKS AND
UNCERTAINTIES, INCLUDING BUT NOT LIMITED TO, THOSE DISCUSSED IN THE SECTION
ENTITLED "RISK FACTORS THAT MAY AFFECT FUTURE RESULTS" IN ITEM 1 OF THIS REPORT
AS WELL AS THOSE RISKS DISCUSSED ELSEWHERE IN THIS REPORT.
ITEM 1. DESCRIPTION OF BUSINESS
GENERAL
Network-1 Security Solutions, Inc. (the "Company") develops, markets,
licenses and supports a family of network security software products designed to
provide comprehensive security to computer networks, including Internet based
systems and internal networks and computing resources. The Company's
CYBERWALLPLUS(TM) family of security software products enables an organization
to protect its computer networks from internal and external attacks and to
secure organizational communications over such internal networks and the
Internet. The Company's CYBERWALLPLUS suite of products was first introduced in
January 1999 and evolved from its prior FIREWALL/PLUS suite of security software
products. The Company also offered its customers a full range of consulting
services in network security and network design within its professional services
group prior to its sale to Exodus Communications, Inc. (NASDAQ; EXDS) in
February 2000.
The CYBERWALLPLUS family of security solutions is designed to protect
against Internet and Intranet based security threats and to address security
needs that arise from within internal networks that often utilize other network
transport protocols besides TCP/IP (the Internet network transport protocol)
including, among others, Novell's IPX, Digital Equipment's DECnet and IBM's SNA.
The Company's CYBERWALLPLUS family of network security products operates on the
Microsoft Windows NT and Windows 2000 operating system platforms. The filter
engine software technology of CYBERWALLPLUS, with its unique ability to handle
and filter all commonly used network transport protocols, provides organizations
with a highly secure and flexible security solution. Additionally, unlike most
firewall solutions which focus on an enterprise's connection to the Internet,
the CYBERWALLPLUS solution can be deployed throughout the enterprise; at the
perimeter to control access to and from the Internet, between internal networks
and on application servers and desktop PCs.
Every day, more and more companies are turning to E-Business and
extranets as a way to obtain a competitive edge and broaden their markets. The
E-Business revolution is helping companies reduce costs, increase responsiveness
and provide empowerment through immediate knowledge. However, by tying together
previous separate company networks and by inviting
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customers, partners and suppliers onto their networks, companies have found that
what were once closed and secure enterprise networks are now becoming open
networks.
Within these new open networks, the traditional perimeters and network
boundaries have disappeared. The Company does not believe traditional perimeter
security devices such as firewalls can effectively secure all of a network's
resources which have embraced E-Business. The Company's CYBERWALLPLUS family of
products is designed to solve this problem by protecting data where it resides -
between the internal network segments and inside the server itself - finally
allowing organizations to leverage the promise of electronic business, while
ensuring the safety of strategic data assets.
The Company is currently pursuing an aggressive growth strategy
focusing its efforts on marketing its CYBERWALLPLUS family of network security
products. Key elements of the Company's strategy are to:
o Focus on securing e-Business networks by replacing perimeter
"chokepoint" firewalls with web server embedded firewalls and intrusion
prevention software from the Company (CyberwallPLUS - SV);
o Emphasize the need for internal network security to secure e-Business
networks. Internal network security is an important element of an
effective multi-layer defense strategy to protect against external
attacks, as the CSI/FBI 1999 Computer Security study indicates that
approximately 30% of the organizations with perimeter firewalls were
breached by outsiders. In addition, Internal network security is
critical to protect enterprise resources from unwelcomed "insider"
access. The same CSI/FBI 1999 study found that 56% of all breaches were
from those with "insider" access;
o Implement a marketing plan specifically targeted to create product
interest and demand among security, network and system administrators
in organizations of all sizes. Elements of the plan include
co-marketing agreements with major complementary suppliers, such as
Entrust Technologies, Inc., RSA Security, Inc., Oracle Corporation and
Citrix Systems, Inc., targeted email distribution, newsletter
sponsorships, trade shows and VAR recruiting activities; and
o Implement a sales plan which includes a multi-channel distribution
strategy, emphasizing selling direct to end customers and establishing
and maintaining third-party resale relationships with OEMs, systems
integrators and VARs in the United States and internationally.
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The Company was incorporated under the laws of the State of Delaware in
July 1990. The Company's executive offices are located at 1601 Trapelo Road,
Reservoir Place, Waltham, Massachusetts 02451 and its telephone number is (781)
522-3400. The Company's web site can be found at http://www.network-1.com.
INDUSTRY BACKGROUND
NETWORK SECURITY
A critical resource of every organization is its information and its
ability to distribute and access information throughout the enterprise. Although
open computing environments have many business advantages, their accessibility
makes an organization's critical software applications and electronically stored
data vulnerable to security threats. Open computing environments are inherently
complex, typically involving a variety of hardware, operating systems, network
transport protocols and applications supplied by a multitude of vendors, making
these networks difficult to manage, monitor and protect from unauthorized access
or attack. The security risk associated with network computing is complicated by
the increasing popularity of the Internet, Intranets and Extranets (Intranets
which allow access to one or more users outside of the internal network). By
connecting an internal private network to the Internet, unauthorized third
parties are given a new means by which to access an organization's private
network. The combination of TCP/IP with other commonly used network transport
protocols within internal networks, increases the network security challenge
because of the various avenues of attack available to both internal and external
attackers.
As a result of the explosive growth in network computing and Internet
use, as well as use of Intranets and Extranets, protection of an organization's
network and data has become a significant economic concern for businesses. The
recently reported malicious attacks on various major online businesses were
estimated by Forrester Research to have cost the industry more than $1 billion.
The heightened awareness to the potential threats of network infrastructure
attacks have caused President Clinton and Attorney General Reno as well as
multiple US government and industry institutions to initiate active steps and
programs aimed at enhancing network security and pursuit of hackers by the
authorities. According to FBI estimates, U.S. companies suffer estimated losses
of over $10 billion per year as a result of unauthorized access to information
and data. According to the 1999 Computer Security Institute/FBI Computer Crime
and Security Survey, 30% of the respondent organizations with perimeter
firewalls indicated break-ins by outsiders - reflecting the insufficient
protection provided by the single layer of defense that perimeter firewalls
present. Additionally, 56% of the respondents reported unauthorized access by
insiders as a major source of breaches. The Company believes that securely
segmenting internal network areas and computing resources from unauthorized
access will become paramount to providing overall information security by
presenting multiple layers of defense against outsider threats and adding the
ability to protect from threats by insiders.
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FIREWALLS - CYBERWALLS
A firewall is a security solution that enables an organization to
protect its computer resources from unauthorized access by internal and external
network users. Firewalls enforce access control security policies between a
trusted network and an untrusted network. Only authorized traffic as defined by
security policies is allowed access through the firewall. Firewalls are
predominantly utilized today to provide security for a network's perimeter by
preventing external breaches of the internal network (trusted network) from
untrusted external sources (the public network).
Due to the significant growth in Internet connections, a number of
companies have introduced firewall products ("IP Firewalls") designed primarily
to protect an internal network using TCP/IP as the network transport protocol
from Internet based security threats or threats from within Intranets. IP
Firewalls can also filter other network transport protocols used specifically
with the IP routing protocol (such as UDP and ICMP). In addition, a limited
number of IP Firewalls have limited filtering capabilities for a small number of
non-IP based network transport protocols.
Firewalls may also serve to provide access control between individual
sub-networks on an internal network or to control access between an internal
network and a selected outside party authorized to have access to the internal
network for limited purposes. IP Firewalls can accomplish this task to the
extent that TCP/IP is the network transport protocol being used within an
internal network as is the case with Intranets and Extranets. To the extent
other network transport protocols are utilized within such an internal network,
IP Firewalls will disallow all data utilizing any such network transport
protocol from passing through the firewall, thereby denying access entirely to a
party which is intended to have such access. This reduces the effectiveness of
IP Firewalls in a multi-protocol networked environment.
In January 1999, the Company introduced a new suite of advanced
firewalls or "cyberwalls" which are specifically designed for use throughout an
organization's network - on servers and in multi-protocol Internet, Intranet and
Extranet environments. The term "cyberwalls" was introduced in an Aberdeen Group
report, issued in January 1999, entitled "Cyberwalls: Network Security for an
Interconnected World". Cyberwalls, based on an expansion of firewall security
model, are a response to the increasing need for internal as well as external
network security. Unlike IP firewalls, which typically operate as IP routers
that reside at an organization's perimeter and filter the IP protocol,
cyberwalls operate as a transparent bridge that can reside anywhere on the
enterprise network, filter all commonly used network transport protocols (IP and
non-IP).
The Company's CYBERWALLPLUS family of security solutions is designed to
address security needs that arise from within internal networks utilizing
non-TCP/IP network transport protocols, including Novell's IPX, Digital
Equipment Corporation's DECnet and IBM's SNA, as well as to protect against
TCP/IP based Internet and Intranet security threats addressed by IP Firewalls.
The Company's CYBERWALLPLUS suite of products consists of a cyberwall designed
to control access to an organization's internal network from the public networks
(the "CYBERWALLPLUS - IP EDITION"), a cyberwall controlling access between
internal networks (the "CYBERWALLPLUS - AP EDITION"), a cyberwall controlling
access between the network and a trusted server (the "CYBERWALLPLUS - SV
EDITION"), and a cyberwall management application enabling the control and
monitoring of many cyberwalls (the "CYBERWALLPLUS - CENTRAL").
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CYBERWALLPLUS TECHNOLOGY
The Company's network security solutions are based upon its proprietary
CyberwallPLUS technology which provides organizations enterprise-wide security
to protect against unauthorized access from the Internet as well as security for
internal sources of intrusion and breach. The following are key elements of the
Company's CYBERWALLPLUS solution:
Enterprise-Wide Deployment. Unlike most firewall solutions which focus
on an enterprise's connection to the Internet, the CYBERWALLPLUS solution, as a
result of its unique architecture, may be used throughout the enterprise; at the
perimeter to control access to and from the Internet, between internal networks
and on application servers, including web servers, and desktop PCs to protect
data residing on such servers and PCs. While firewall solutions must be
installed on dedicated computers, CYBERWALLPLUS can operate on Windows NT and
Windows 2000 workstations and servers without interfering with the normal
operation of such desktop computers or servers. As a result, the CYBERWALLPLUS
security solution can be installed on existing strategic computing resources
within the enterprise without incurring the expense of additional computing
hardware. CYBERWALLPLUS does not utilize significant server resources and may
therefore co-exist with other application software running on the host WINDOWS
NT/2000 system.
Advance Filtering System. The architecture of WINDOWS NT/2000 includes
two operating modes, the "user" system itself and "kernel" modes. The
CYBERWALLPLUS Filter Engine is implemented in kernel mode to maximize
performance and to provide maximum security from network intrusion to the host
operating system environment. Using proprietary kernel-level software code
developed by the Company, CYBERWALLPLUS Interceptor Shim and Filter Engine
introduce a security layer between the network hardware drivers and the Windows
NT operating system. CYBERWALLPLUS filters all network packet traffic before it
reaches the host system. Incoming data packets enter the host through the
network interface card and its associated hardware driver and are immediately
passed to the CYBERWALLPLUS Interceptor Shim, which redirects them to the Filter
Engine. The Filter Engine, using a proprietary high-speed, real-time security
policy enforcement language, checks the packet content and its context against a
user defined security policy rule database to determine whether the packet
should be allowed to enter (or exit) the system. Packets permitted access are
then re-inspected against an integrated database of intrusion signatures that
fend off a variety of denial-of-service and surveillance attacks used by
hackers.
Multi-Layer Security. The Company's CYBERWALLPLUS family of products
employs stateful inspection and filtering technology provides advanced security
for TCP/IP related network transport protocols and applications. Stateful
filtering involves the knowledge of states of protocols at specific transaction
intervals during the network connection between two communicating applications
between specific systems. Transaction states occur at Link, Network, Transport
and Application layers of the communications over a computer network, and
CYBERWALLPLUS can detect conditions that violate the required or expected state
of one or a simultaneous series of protocols. CYBERWALLPLUS incorporates frame,
packet, byte stream and stateful inspection capabilities in the security
management of network connections. The Company believes that CYBERWALLPLUS'S
multi-layer approach to security greatly strengthens the security of trusted
network resources and the host WINDOWS NT/2000 system itself.
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Multi-Protocol Capability. A unique aspect of CYBERWALLPLUS is its
ability to provide multi-protocol filtering not available from network security
products offered by other firewall vendors. CYBERWALLPLUS has the advantage of
filtering not only TCP/IP, but also a multitude of other network transport
protocols. The Company believes that the ability of CYBERWALLPLUS to filter
multiple network transport protocols offers significant advantages as a security
product for internal networks where multiple network transport protocols are
common. In a PC-based environment, multiple network transport protocols often
co-exist, as WINDOWS NT/2000 itself comes pre-equipped with TCP/IP, IPX
(Novell), NetBEUI (LAN Manager) and AppleTalk. In addition, certain applications
require the use of non-TCP/IP protocols to operate between sub-networks on an
enterprise network. The multi-protocol filtering capability of CYBERWALLPLUS is
effective in securing web systems that access information via non-IP protocols.
While some commercially available routers allow basic packet filtering for
multiple network transport protocols, the Company believes its multi-protocol
advanced filtering capabilities offer superior features to router based
solutions, such as a graphical user interface, extensive logging, reporting and
alarming and security policy time management.
Transparency. CYBERWALLPLUS may be operated in a transparent
("stealth") mode. In this mode, CYBERWALLPLUS has no network address (i.e. it is
not visible on the network) and therefore can not be identified for attack. The
Company believes that this feature provides additional security to the host
system because when a firewall has a network address, it can be located and is
more susceptible to attack. CYBERWALLPLUS provides full firewall protection
while operating in transparent mode, except that remote management is not
permitted.
Centralized Management. Through its CYBERWALLPLUS - CENTRAL product,
the CYBERWALLPLUS suite permits centralized management and monitoring that
allows a network manager to manage and monitor multiple cyberwalls from a local
or remote location. Accordingly, large and geographically dispersed cyberwall
networks may be managed from a single location.
Customized Security Policies. CYBERWALLPLUS also allows customized
security policies for individual departments, applications and individual
systems and personnel within the network. Network managers may apply security
rules to any edition of the CYBERWALLPLUS products so that individual systems,
protocols, applications, frames and many other network entities are either
explicitly denied or authorized access to specific applications and other
network entities.
Ease of Use. CYBERWALLPLUS was designed to be easily installed,
configured and managed by a network or system manager with minimal or no
security skills. CYBERWALLPLUS may be installed and configured by use of the
graphical user interface (GUI) by simply pointing and clicking the mouse. To
facilitate implementation, CYBERWALLPLUS comes pre-programmed with a wide
variety of frequently used default security policies (templates) which require
the customer to simply select one of the rule-bases and save the selection.
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PRODUCTS
In January 1999, the Company introduced a family of CYBERWALLPLUS
products for WINDOWS NT which offers a broad range of network security
solutions. The CYBERWALLPLUS family of products includes the CYBERWALLPLUS - IP
EDITION, CYBERWALLPLUS - SV EDITION, CYBERWALLPLUS - AP EDITION and
CYBERWALLPLUS - CENTRAL. All products are currently shipping. Through the first
quarter of 1999, the Company's main product was CYBERWALLPLUS'S predecessor
product line, FIREWALL/PLUS. The Company first introduced the FIREWALL/PLUS
ENTERPRISE EDITION for Windows NT in January 1997. As of December 31, 1999, the
Company had licensed one or more of its FIREWALL/PLUS or CYBERWALLPLUS family of
software products to over 250 customers. License revenue from these products
accounted for 61% and 63% of the Company's revenues for the years ended December
31, 1999 and 1998, respectively.
The Company announced in February 2000 that all of its products will
ship for use with Microsoft's new Windows 2000 platform, in the second quarter
of 2000.
CYBERWALLPLUS - IP. This product is an IP network firewall, for
perimeter Internet and internal Intranet applications. The product operates on a
WINDOWS NT/2000 host, running on Intel - Pentium or Compaq platforms and
provides high performance, ease-of-use and support for "stealth" operations. A
fully functional 14-day evaluation copy of the product may be downloaded from
the Company's web site. Depending on configuration, pricing for the IP product
starts at U.S. $1,995.
CYBERWALLPLUS - SV. While WINDOWS NT/2000 provides many useful and
important security features, the operating system does not specifically include
firewall-class packet filtering features for network security. Industry concern
over limitations in WINDOWS NT/2000 network security is well documented. Systems
and network administrators have been required to work around the limited network
security controls within WINDOWS NT/2000 by placing the computer systems behind
external firewalls, thereby increasing exposure to network attack and cost.
Because the server-based CYBERWALLPLUS - SV operates in the kernel of the host's
operating system, WINDOWS NT/2000 administrators have an easy-to-use, flexible
tool to implement powerful network access controls and intrusion detection
facilities not featured in WINDOWS NT/2000. CYBERWALLPLUS - SV adds a range of
robust security capabilities not currently provided within WINDOWS NT/2000,
including stateful packet inspection, protocol and address filtering for any
protocol (including IP, IPX, AppleTalk, and NetBEUI that ship with Windows NT),
built-in network intrusion detection and prevention, and comprehensive audit
logging. These powerful features not only protect servers from unauthorized
network access, but also detect and prevent malicious "denial of service" and
surveillance scanning. The product is priced starting at U.S. $995.
CYBERWALLPLUS - AP. Using CYBERWALLPLUS - AP (Any Protocol),
departmental networks and other internal network domains may be securely
interconnected by an organization's multi-protocol backbone network. The AP
EDITION of CYBERWALLPLUS supports over 4,500 protocols, including proprietary
protocols that may exist in financial, manufacturing, power utility or airline
networks. The Company's unique filter engine in CYBERWALLPLUS allows for the
easy addition of additional IP and non-IP protocols to the cyberwall's security
rules and policies. The AP product operates on a WINDOWS NT/2000 host running on
Intel - Pentium or Compaq platforms. Prices depend on configuration and start at
U.S. list $6,995.
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CYBERWALLPLUS - CENTRAL. Rounding out the CYBERWALLPLUS offering is the
central management application used to configure and monitor multiple remote
cyberwalls. The software was released in December 1999 and is key to the
adoption of CYBERWALLPLUS by large enterprise customers and OEM's. The product
can run on WINDOWS NT/2000 and Windows 98. It is currently offered free of
charge with any purchase of one of CYBERWALLPLUS products.
CUSTOMERS
The Company's customers represent a wide range of industries and
institutions, both commercial and government, which consider networked-data
resources to be among the most important assets within their organizations. As
of December 31, 1999, the Company had licensed one or more of its network
security products to over 250 customers. Customers for FIREWALL/PLUS and
CYBERWALLPLUS products have included The Sabre Group Inc., ("Sabre"), Electronic
Data Systems Corporation ("EDS"), TRW, Inc., National Semiconductor Corp.,
Fairchild Semiconductor, Atlantic Richfield Company and related entities
("ARCO"), GTE, Inc., and Continental Airlines. During the year ended December
31, 1998, license revenues from EDS and Sabre accounted for 16% and 11% of the
Company's revenues, respectively.
During the years ended December 31, 1999 and 1998, license revenue from
international customers (licenses to foreign end users and international
distributors) accounted for 12% and 3% of the Company's revenues, respectively.
All of the Company's revenues from international licenses were denominated in
U.S. dollars.
SALES AND MARKETING
The Company is currently implementing a sales and marketing plan which
consists of a multi-channel distribution strategy and a promotion strategy to
create consumer awareness of the Company and its CYBERWALLPLUS products and to
educate the market about the need to implement network security products and of
the capabilities and benefits of the Company's CYBERWALLPLUS solutions.
MULTI-CHANNEL DISTRIBUTION
IN-HOUSE SALES AND MARKETING TEAM. The Company's internal sales and
marketing team consists of eleven (11) persons, consisting of a Vice President
of Sales and Marketing, a Director of Marketing, a Director of Public Relations,
a Director of Channel Programs, four sales representatives, two sales engineers
and one marketing support personnel. The Company's sales representatives and
sales engineers are responsible for soliciting potential customers and providing
pre-sale technical support to customers, as well as supporting third-party
distribution channels..
The Company intends to hire additional sales and marketing personnel in
connection with the expansion of the Company's sales efforts. Although the
Company's in-house sales force will continue to solicit potential customers, its
primary responsibility is expected to evolve to supporting third-party
distribution channels.
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THIRD-PARTY DISTRIBUTION CHANNELS. A key element of the Company's
distribution strategy is to establish and maintain relationships with
third-party distributors within the United States and internationally. By
engaging such third-party distributors, the Company is able to utilize the
end-user sales and support infrastructure of these channels.
The Company currently has relationships with six (6) national, regional
and local systems integrators, VARs and resellers in North America, including
EDS, EnerNet Associates, Inc. and Studon Business Solutions, Inc. The Company
currently has relationships with international system integrators, VARs,
resellers and distributors in the following 15 countries: Japan, Canada, United
Kingdom, Israel, Republic of China, the Netherlands, Hong Kong, Russia,
Argentina, Peru, Ecuador, Paraguay, Colombia, Switzerland and South Africa.
The Company's agreements with resellers generally grant the reseller
the right to market the Company's products in specified territories on a
non-exclusive basis, are terminable on short notice and do not prohibit the
reseller from selling products that are competitive with the Company's products.
The Company intends to continue to seek to establish relationships with
additional third-party distributors, large system integrators and VARs with the
necessary resources to successfully distribute the Company's CYBERWALLPLUS
products.
The Company also seeks to enter into OEM or licensing arrangements
whereby the Company grants to an OEM or other third party the right to
incorporate and/or bundle a specific technology of the Company with the OEM's or
other third-party's products. The Company believes that arrangements with
third-party distributors and OEMs will account for an increased percentage of
its revenues in the future.
ADVERTISING AND PROMOTION
The Company is implementing an advertising and promotion strategy to
create consumer awareness of the Company and its CYBERWALLPLUS products and to
educate the market about network security threats and the ability of
CYBERWALLPLUS to address customer needs. The Company advertises and promotes its
products through print advertising, Internet web site advertising, direct
marketing efforts and participation in trade shows and seminars which target
organization security and management information system administrators and
network system integrators.
The Company's web site, http://www.network-1.com, includes a
description of the Company's CYBERWALLPLUS family of products and enables
visitors to the site to download a fully functional CYBERWALLPLUS for a 14-day
trial. The Company continues to add content to the web site, such as product
information, including a user guide, network security industry information and
additional content specific to distributors and end users, improved download
capabilities for the trial version and continuous updates and announcements from
the Company - including press releases and new marketing materials.
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PROFESSIONAL SERVICES
The Company has designed, planned, audited and implemented numerous
networks worldwide for a broad spectrum of clients, including Fortune 500
companies, small companies with modest requirements, federal, state and foreign
governments and utilities, as well as education and research institutions.
On February 9, 2000, the Company entered into an Asset Purchase
Agreement with Exodus Communications, Inc. ("Exodus") pursuant to which its
professional services business was sold for an aggregate consideration of $4.0
million in cash, of which $1.3 million is held in escrow subject to certain
conditions described below. The Company has reclassified all of its consulting
service revenues and related expenses as revenue and expenses from discontinued
operations. See Note L to Financial Statements. In connection with this sale,
all seven (7) employees of the Company's professional services business agreed
to become employees of Exodus. Such employees include Dr. William Hancock, the
Company's former Chief Technology Officer and Robert Russo, the Company's former
Vice President of Professional Services. Dr. Hancock will continue to serve on
the Company's Board of Directors. Effective upon the closing of the sale, the
Company granted stock options to the seven employees for the purchase of 104,063
shares at $2.91 per share. In connection therewith, the Company incurred a
compensation charge of $525,000 based upon the intrinsic value of the portion of
the options vesting at such date. The balance of the options vest one year after
the closing provided that the employees are still employed by Exodus. An
additional charge of $863,000 will be incurred at such date assuming all the
options vest. The $1.3 million of the purchase price held in escrow includes (i)
$300,000 conditioned upon Exodus securing a minimum of $300,000 of purchase
orders or commitments for consulting services from certain customers within
ninety (90) days of the closing, and (ii) $1,000,000 conditioned upon the
Company's former employees remaining employed by Exodus for at least one (1)
year from the closing of the sale. In connection with such sale, the Company has
agreed not to offer any professional or consulting services competitive with
those services offered by Exodus for a period of two years from the closing
date. The Company has agreed to pay an aggregate of 14% of the $1.0 million of
the escrow proceeds to the former employees provided that they remain with
Exodus for at least one year.
The decision of the Board of Directors of the Company in November 1999
to sell the Company's Professional Services Group resulted in the classification
of the results of operations and net assets of this group as discontinued
operations in the Company's financial statements. Consulting services generated
77% and 62% of the Company's revenues for the years ended 1999 and 1998,
respectively. Consulting revenues for ARINC, Delphi Automotive, Inc. and R.W.
Johnston Pharmaceutical Research Institute accounted for 26%, 19% and 11% of the
Company's revenues for 1999, respectively. Consulting revenues from the City of
Hope and Flour Daniel accounted for 29% and 22% of the Company's revenues for
1998, respectively.
CUSTOMER SERVICE AND SUPPORT
The Company believes that customer service and support is critical to
retaining customers and attracting prospective customers. The Company provides
customer service and support through its internal technical support staff
located at its Waltham, MA office. To date, the Company has not incurred any
material warranty expense. Customers receive telephone and email presale
support. Customers are required to purchase the Company's annual maintenance
11
program at an average annual cost of 15% of the then current purchase price
which includes technical assistance and product updates. Technical support is
available 24 hours a day, 7 days a week, by telephone and electronic mail. In
addition, the Company provides customers with fee-based on-site installation,
support and training. The Company provides its resellers with sales and
technical support.
PRODUCT DEVELOPMENT
The Company believes that development of new products and enhancements
to existing products are essential for the Company to effectively compete in the
network security market. The Company's product development efforts are directed
toward enhancing its CYBERWALLPLUS family of security products, developing new
products and responding to emerging industry standards and other technological
changes. The Company intends to introduce new application products for the
network security market. The Company's new product development efforts are
focused on enhancements to the Company's current suite of products and new
network security products, including products that support Windows 2000 and
other operating systems. While the Company expects that certain of its new
products will be developed internally, the Company may, based on timing and cost
considerations, expand its product offerings through acquisitions. In addition,
the Company has relied on external development resources for the development of
certain of its products and components.
The Company currently has fourteen (14) employees in its engineering
organization - who perform research, development, quality assurance and
after-sale support. Historically, a substantial portion of the Company's
research and development activities have been undertaken by engaging third-party
consultants and independent contractors. Currently all development activities
are being done by employees. During the years ended December 31, 1999 and 1998,
the Company's total product development costs, including the costs capitalized,
were $1,828,000, and $864,000, respectively.
The Company intends to hire additional software engineers and
developers on a full-time basis during 2000.
COMPETITION
The network security market in general, and the firewall-cyberwall
product market in particular, is characterized by intense competition and
rapidly changing business conditions, customer requirements and technologies.
The Company believes that the principal competitive factors affecting the market
for network security products include security effectiveness, name recognition,
scope of product offerings, product features, distribution channels, price, ease
of use and customer service and support. Currently, the Company's principal
competitors include Axent Technologies Inc., Check Point Software Technologies,
Ltd., Cisco Systems, Inc., NetGuard, Ltd., Network Associates, Inc. NetworkICE,
SonicWall, Inc. and WatchGuard Technologies, Inc. Due to the rapid expansion of
the network security market, the Company may face competition from new entrants.
Most of the Company's current and potential competitors have longer
operating histories, greater name recognition, larger installed customer bases
and possess substantially greater
12
financial, technical and marketing and other competitive resources than the
Company. As a result, the Company's competitors may be able to adapt more
quickly to new or emerging technologies and changes in customer requirements or
devote greater resources to the promotion and sale of their products than the
Company. While the Company believes that its CYBERWALLPLUS products do not
compete against manufacturers of other types of security products (such as
encryption and authentication products), potential customers may perceive the
products of such other companies as substitutes for the Company's products. In
addition, certain of the Company's competitors may determine for strategic
reasons to consolidate, to substantially lower the price of their network
security products or to bundle their products with other products, such as
hardware or other enterprise software products. Accordingly, it is possible that
new competitors and alliances among competitors may emerge and rapidly acquire
significant market share. The Company's current and potential competitors may
develop products that may be more effective than the Company's current or future
products, or the Company's products may be rendered obsolete or less marketable
by evolving technologies or changing consumer demands, or the Company may
otherwise be unable to compete successfully. Increased competition for firewall
and CyBERWALLPLUS products may result in price reductions, reduced gross margins
and may adversely effect the Company's ability to gain market share, any of
which would adversely effect the Company's business, operating results and
financial condition.
PROPRIETARY RIGHTS
The Company's success is substantially dependent on its proprietary
technologies. The Company does not hold any patents and relies on copyright and
trade secret laws, non-disclosure agreements with employees, distributors and
customers, including "shrink wrap" license agreements that are not signed by the
customer, and technical measures to protect the ideas, concepts and
documentation of its proprietary technologies and know-how to protect its
intellectual property rights. Such methods may not afford complete protection,
and there can be no assurance that third parties will not independently develop
substantially equivalent or superior technologies or obtain access to the
Company's technologies, ideas, concepts and documentation. In addition,
confidentiality agreements between the Company and its employees, distributors
or customers may not provide meaningful protection for the Company's proprietary
information in the event of any unauthorized use or disclosure. Any inability to
protect its proprietary technologies could have a material adverse effect on the
Company. Furthermore, the Company may be subject to additional risk as it enters
into transactions in countries where intellectual property laws are not well
developed or are poorly enforced. Legal protection of the Company's rights may
be ineffective in such countries.
The Company has applied for a U.S. trademark registration for the
CYBERWALLPLUS. Although the Company is not aware of any challenges to the
Company's rights to use this trademark, there can be no assurance that the use
of this mark would be upheld if challenged.
Although the Company believes that its technologies and products have
been developed independently and do not infringe upon the proprietary rights of
others, there can be no assurance that the Company's technologies and products
do not infringe and that third parties will not assert infringement claims
against the Company in the future. The Company is not aware of any patent
infringement charge or any violation of other proprietary rights claimed by any
third party relating to the Company or the Company's products.
13
As the number of security products being offered continues to increase,
the functionality of such products may further overlap, which could result in
increased infringement claims by software developers, including infringement
claims against the Company with respect to future products. The Company may not
be able to modify its products or obtain a license in a timely manner, upon
acceptable terms and conditions. In addition, the Company may not have the
financial or other resources necessary to defend a patent infringement or other
proprietary rights infringement action. Failure to do any of the foregoing could
have a material adverse effect on the Company, including possibly requiring the
Company to cease marketing its products.
EMPLOYEES
As of March 10, 2000, the Company had 30 full time employees, including
11 in sales and marketing, 12 in product research and development, 2 in
technical support and 5 in administration and finance. None of the Company's
employees are represented by a labor union or are subject to a collective
bargaining agreement. The Company has not experienced any work stoppages and
considers its relationship with its employees to be good.
Competition with respect to the recruitment of highly qualified
personnel in the software industry is intense and many of the Company's
competitors have significantly greater resources than the Company. The Company's
ability to attract and assimilate new personnel will be critical to the
Company's performance and there can be no assurance that the Company will be
successful in attracting or retaining the personnel it requires to enhance its
products, develop new products and conduct its operations successfully.
RISK FACTORS THAT MAY AFFECT FUTURE RESULTS
The Company operates in a rapidly changing and, highly competitive
environment that involves a number of risks, some of which are beyond the
Company's control. The following discussion highlights the most material of the
risks.
WE HAVE A HISTORY OF LOSSES AND IF WE DO NOT ACHIEVE PROFITABILITY, WE
MAY NOT BE ABLE TO CONTINUE OUR BUSINESS IN THE FUTURE.
We have incurred substantial operating losses since our inception,
which has resulted in an accumulated deficit of $21,693,000 as of December 31,
1999. For the fiscal years ended December 31, 1999 and 1998, we incurred net
losses of $6,946,000 and $5,777,000, respectively. We have financed our
operations primarily through the sales of equity and debt securities. Our
expense levels are high and our revenues are difficult to predict. We anticipate
incurring additional losses until we increase our client base and revenues. We
may never achieve or sustain significant revenues or profitability. If we are
unable to achieve increased revenues, we will continue to have losses and may
not be able to continue our operations.
14
WE COULD BE REQUIRED TO CUT BACK OR STOP OPERATIONS IF WE ARE UNABLE TO
RAISE OR OBTAIN NEEDED FUNDING.
Our ability to continue operations will depend on our positive cash
flow, if any, from future operations or our ability to raise additional funds
through equity or debt financing. In December 1999, we consummated a private
financing of $3.0 million of equity and debt in order to obtain the working
capital necessary to continue to finance our operations and execute our business
plan. Although we anticipate that future revenues and our current cash balance
will be sufficient to fund our operations and capital requirements until
approximately January 2001, we cannot give you any assurance that we will not
need additional funds before such time. We have no current arrangements for
additional financing and we may not be able to obtain additional financing on
commercially reasonable terms, if at all. We could be required to cut back or
stop operations if we are unable to raise or obtain funds when needed.
WE HAVE HAD A LIMITED OPERATING HISTORY AS A SOFTWARE PRODUCT COMPANY
AND LACK ANY SUBSTANTIAL REVENUE.
We have a limited operating history as a software product company and
have made only limited sales of our products. Our total revenues for software
licenses for the years ended December 31, 1999 and 1998 were $260,000 and
$569,000, respectively.
THE RECENT SALE OF OUR PROFESSIONAL SERVICES BUSINESS WILL HAVE AN
ADVERSE EFFECT ON CASH FLOW AND REVENUES.
In February 2000, we sold our professional services business to Exodus
Communications Inc. for $4.0 million in cash, of which $1.3 million is held in
escrow subject to certain conditions. As part of the transaction with Exodus, we
agreed not to offer any professional or consulting services for two (2) years
following the closing. The professional services business accounted for 77% and
62% of our total revenues during the fiscal years ended December 31, 1999 and
1998, respectively. Accordingly, our future cash flow from operations is likely
to be materially adversely effected from the sale of our professional services
business until, if ever, we generate sufficient revenue from the licensing of
our software products.
OUR REVENUES DEPEND ON SALES OF OUR CYBERWALLPLUS PRODUCTS AND WE ARE
UNCERTAIN WHETHER THERE WILL BE BROAD MARKET ACCEPTANCE OF THESE PRODUCTS.
Our revenue growth for the foreseeable future is dependent upon
increased sales of our CYBERWALLPLUS family of software products. Since the
introduction of our predecessor line of security products (FIREWALL/PLUS) in
June 1995 through December 31, 1999, license revenue from all software products
has been $2,922,000 including a non-refundable pre-paid royalty of $500,000 in
1997. Since the introduction of our CYBERWALLPLUS suite of products in January
1999 through December 31, 1999, license revenue from our CYBERWALLPLUS products
was only $195,000. Our future financial performance will depend upon the
successful introduction and customer acceptance of our CYBERWALLPLUS products as
well as the development of new and enhanced versions of this product. Revenue
from products such as CYBERWALLPLUS depend on a number of factors, including the
influence of market competition, technological changes in the network
15
security market, our ability to design, develop and introduce enhancements on a
timely basis and our ability to successfully establish and maintain distribution
channels. If we fail to achieve broad market acceptance of our CYBERWALLPLUS
products, it would have a material adverse effect on our business, operating
results and financial condition.
INABILITY TO ENTER INTO STRATEGIC RELATIONSHIPS WITH INDIRECT CHANNEL
PARTNERS COULD HAVE A MATERIAL ADVERSE EFFECT ON US.
As part of our sales and marketing efforts, we are seeking to develop
strategic relationships with indirect channel partners, such as original
equipment manufacturers and resellers. We have limited financial, personnel and
other resources to undertake extensive marketing activities ourselves.
Therefore, our prospects will depend on our ability to develop and maintain
strategic marketing relationships with indirect channel partners and their
ability to market and distribute our products. If we are unable to enter into
and maintain such arrangements or if such arrangements do not result in the
successful commercialization of our products, then this could have a material
adverse effect on our business, operating results and financial condition.
WE MAY NOT BE ABLE TO SUCCESSFULLY COMPETE IN THE NETWORK SECURITY
MARKET.
The network security market is characterized by intense competition and
rapidly changing business conditions, customer requirements and technologies.
The principal competitive factors affecting the market for network security
products include security effectiveness, scope of product offerings, name
recognition, product features, distribution channels, price, ease of use and
customer service and support. Most of our current and potential competitors have
longer operating histories, greater name recognition, larger installed customer
bases and possess substantially greater financial, technical and marketing and
other competitive resources than us. As a result, our competitors may be able to
adapt more quickly to new or emerging technologies and changes in customer
requirements or to devote greater resources to the promotion and sale of their
products than we may. In addition, certain of our competitors may determine for
strategic reasons to consolidate, to substantially lower the price of their
network security products or to bundle their products with other products, such
as hardware or other enterprise software products. Our current and potential
competitors may develop products that may be more effective than our current or
future products or that render our products obsolete or less marketable.
Increased competition for network security products may result in price
reductions and reduced gross margins and may adversely effect our ability to
gain market share, any of which would adversely affect the Company's business,
operating results and financial condition.
OUR OPERATING RESULTS MAY FLUCTUATE QUARTERLY AND IF THEY WERE BELOW
THE EXPECTATIONS OF INVESTORS AND ANALYSTS, THE PRICE OF OUR STOCK WOULD LIKELY
BE ADVERSELY EFFECTED.
We anticipate significant quarterly fluctuations in our operations in
the future, since our results are dependent on the volume and timing of orders,
which are difficult to predict. Customers' purchasing patterns and budgeting
cycles, as well as the introduction of new products, may also cause our
operating results to fluctuate. Therefore, comparing quarterly operating results
may not be meaningful and should not be relied on. Also, our operating results
16
may be below analysts' and investors' expectations in some future quarters,
which would likely have a material adverse effect on our common stock's price.
WE ARE DEPENDENT ON A FEW KEY PERSONNEL AND WE NEED TO ATTRACT AND
RETAIN HIGHLY QUALIFIED TECHNICAL, SALES, MARKETING, DEVELOPMENT AND MANAGEMENT
PERSONNEL.
Our success is largely dependent on the continued service of key
technical and senior management personnel. The loss of the services of one or
more of our key employees, in particular Avi A. Fogel, our President and Chief
Executive Officer, or Robert P. Olsen, our Vice President of Marketing and
Sales, could have a material adverse effect on our business, operating results
and financial condition. We have employment agreements with Messrs. Fogel and
Olsen that expire in May 2002 and May 2001, respectively.
Our success will also depend on our ability to attract, train and
retain highly qualified technical, sales, marketing, development and managerial
personnel. There is considerable and often intense competition for the services
of such personnel. We may not be able either to retain our existing personnel or
acquire additional qualified personnel as and when needed. If we are unable to
hire and retain such personnel, our business, operating results and financial
condition could be materially adversely affected.
WE MAY NOT BE ABLE TO ADEQUATELY PROTECT OUR PROPRIETARY TECHNOLOGY,
WHICH COULD RESULT IN LOWER REVENUES AND/OR PROFITS.
We do not hold any patents and rely on copyright and trade secret laws,
non-disclosure agreements and contractual provisions to protect our proprietary
technology. These methods afford only limited protection. Despite the
precautions we take, unauthorized parties may attempt to copy or otherwise
obtain and use our proprietary technologies, ideas, know-how and other
proprietary information without authorization or may independently develop
technologies similar or superior to our technologies. Policing unauthorized use
of our products may be difficult and costly. Also, the laws of some foreign
countries do not protect our proprietary rights as much as the laws of the
United States. We are unable to predict whether our means of protecting our
proprietary rights will be adequate.
We believe that our technologies have been developed independent of
others. Nevertheless, third parties may assert infringement claims against us
and our technologies may be determined to infringe on the intellectual property
rights of others. We could become liable for damages, be required to modify our
technologies or obtain a license if our technologies are determined to infringe
upon the intellectual property rights of others. We may not be able to modify
our technologies or obtain a license in a timely manner, if required, or have
the financial or other resources necessary to defend an infringement action. We
would be materially adversely effected if we fail to do any of the foregoing.
17
WE CAN BE EXPOSED TO NUMEROUS POTENTIAL LIABILITY CLAIMS FOR DAMAGES
AND, IF OUR INSURANCE DOESN'T ADEQUATELY COVER LOSSES, THIS COULD HAVE A
MATERIAL ADVERSE EFFECT ON US.
Since our products are used to prevent unauthorized access to and
attacks on critical enterprise information, we may be exposed to potential
liability claims for damage caused as a result of an actual or alleged failure
of an installed product. We cannot assure you that the provisions in our license
agreements designed to limit our exposure will be enforceable. Our personnel
often gain access to confidential and proprietary client information. Any
unauthorized use or disclosure of such information could result in a claim for
substantial damages. We can give no assurances that our insurance policies will
be sufficient to cover potential claims or that adequate levels of coverage will
be available in the future at a reasonable cost.
POSSIBLE DELISTING OF OUR SECURITIES FROM NASDAQ SYSTEM; RISKS RELATING
TO LOW-PRICED STOCKS.
Our common stock is listed on the Nasdaq SmallCap Market under the
symbol "NSSI." In order to continue to be listed on Nasdaq, however, we must
comply with certain maintenance standards. In the event of a delisting, an
investor could find it more difficult to dispose of or to obtain accurate
quotations as to the market value of our common stock.
In addition, if our common stock were to become delisted from trading
on Nasdaq and the trading price of the common stock were to fall below $5.00 per
share, our common stock could be considered a penny stock. SEC regulations
generally define a penny stock to be an equity security that is not listed on
Nasdaq or a national securities exchange and that has a market value of less
than $5.00 per share, subject to certain exceptions. The SEC regulations would
require broker-dealers to deliver to a purchaser of our common stock a
disclosure schedule explaining the penny stock market and the risks associated
with it. Various sales practice requirements are also imposed on broker-dealers
who sell penny stocks to persons other than established customers and accredited
investors (generally institutions). Broker-dealers must also provide the
customer with current bid and offer quotations for the penny stock, the
compensation of the broker-dealer and monthly account statements disclosing
recent price information for the penny stock held in the customer's account. If
our common stock is no longer traded on Nasdaq and becomes subject to the
regulations applicable to penny stocks, investors may find it more difficult to
obtain timely and accurate quotes and execute trades in our common stock.
THE SIGNIFICANT NUMBER OF OPTIONS, WARRANTS AND CONVERTIBLE SECURITIES
OUTSTANDING MAY ADVERSELY AFFECT THE MARKET PRICE FOR OUR COMMON STOCK.
As of February 28, 2000, there are outstanding (i) options and warrants
to purchase an aggregate of 2,338,255 shares of our common stock at exercise
prices ranging from $1.50 to $10.00, (ii) 491,803 shares of Series D Convertible
Preferred Stock which are convertible at any time into an equal number of shares
of our common stock and (iii) debt in the principal amount of $1,500,000 which,
subject to stockholder approval, can be converted into 491,803 shares of our
18
Series D Preferred Stock (up to 570,492 shares if you include potential interest
through the maturity of promissory notes) and warrants to purchase 491,803
shares of our common stock (up to 570,492 shares if you include potential
interest through the maturity of the promissory notes) at an exercise price of
$3.00 per share, subject to adjustment depending upon product revenue achieved
during the three (3) month period ended March 31, 2000. To the extent that
outstanding options, warrants or convertible debt are exercised or converted,
your percentage ownership will be diluted and any sales in the public market of
the common stock underlying such options, warrants or convertible debt may
adversely affect prevailing market prices for our common stock.
WE HAVE A SIGNIFICANT AMOUNT OF AUTHORIZED BUT UNISSUED PREFERRED
STOCK, WHICH MAY AFFECT THE LIKELIHOOD OF A CHANGE OF CONTROL IN OUR COMPANY.
As of the date of this prospectus, our Board of Directors has the
authority, without further action by the stockholders, to issue 5,000,000 shares
of preferred stock (of which only 491,803 shares of Series D Preferred Stock are
outstanding as of the date hereof) on such terms and with such rights,
preferences and designations as the Board may determine. Such terms may include
restricting dividends on our common stock, dilution of the voting power of our
common stock or impairing the liquidation rights of the holders of our common
stock. Issuance of such preferred stock, depending on the rights, preferences
and designations thereof, may have the effect of delaying, deterring or
preventing a change in control. In addition, certain "anti-takeover" provisions
in Delaware law may restrict the ability of out stockholders to authorize a
merger, business combination or change of control.
ITEM 2. DESCRIPTION OF PROPERTY
The Company currently subleases approximately 9,000 square feet of
office space in Waltham, Massachusetts, for its principal executive offices. The
lease expires August 31, 2001, and requires the Company to make payments of
approximately $20,000 per month over the term of the lease.
ITEM 3. LEGAL PROCEEDINGS
None
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
19
PART II
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
MARKET INFORMATION. The Common Stock has traded since November 12, 1998
on the NASDAQ SmallCap Market under the symbol "NSSI." The following table sets
forth, for the periods indicated, the range of the high and low bid prices for
the Common Stock as reported on NASDAQ. Such prices reflect inter-dealer
quotations, without retail mark-up, mark-down or commission and may not
necessarily represent actual transactions.
YEAR ENDED DECEMBER 31, 1999 HIGH LOW
--------- ---------
Fourth Quarter $ 10.8125 $ 1.50
Third Quarter $ 6.625 $ 1.625
Second Quarter $ 6.875 $ 3.75
First Quarter $ 8.125 $ 6.00
YEAR ENDED DECEMBER 31, 1998
Fourth Quarter $ 7.25 $ 6.50
(commencing November 12, 1998)
On March 2, 2000, the last sale price for the Common Stock as reported
on NASDAQ was $17.50 per share. The number of record holders of the Company's
Common Stock was 63 as of March 7, 2000. The Company believes that there are in
excess of 2,300 beneficial owners of its Common Stock.
DIVIDEND POLICY. The Company has never declared or paid any cash
dividends on its Common Stock and does not intend to declare or pay cash or
other dividends in the foreseeable future. The Board of Directors currently
expects to retain any future earnings for use in the operation and expansion of
its business. The declaration and payment of any future dividends will be at the
discretion of the Board of Directors and will depend upon a variety of factors,
including future earnings, if any, operations, capital requirements, the general
financial condition of the Company, the preferences of any series of Preferred
Stock which may be designated in the future, the general business conditions and
future contractual restrictions on payment of dividends, if any.
RECENT SALES OF UNREGISTERED SECURITIES. On December 22, 1999, the
Company consummated a $3.0 million private offering of preferred stock, warrants
and notes purchased by thirty-nine (39) investors including principals and
affiliates of Wheatley Partners II, L.P., the Company's largest stockholder,
Corey M. Horowitz, a principal stockholder and Chairman of the Board of
Directors of the Company, Avi A. Fogel, President, Chief Executive Officer and a
director of the Company, and Emanuel R. Pearlman, a director of the Company. In
accordance with the terms of the Securities Purchase Agreement, an aggregate of
491,803 shares of Series D Preferred Stock were issued to investors at a price
of $3.05 per share (equal to a 20% discount of the average thirty (30) closing
price for the Company's Common Stock through December 6, 1999) together with
five-year warrants to purchase the same number of shares of Common Stock at an
exercise price of $3.00 per share. The exercise price of the warrants is subject
to
20
adjustment depending on the product revenue achieved by the Company during the
three-month period ended March 31, 2000 so that beginning at a product revenue
level of less than $500,000, the exercise price shall be adjusted to $1.00 per
share and increasing $.25 for each $250,000 increase in product revenue above
$500,000 (except for product revenue between $2,250,000 and $3,249,999 for which
the exercise price shall remain at $3.00 per share), up to a maximum $4.00 per
share exercise price for product revenue equal to or greater than $4.0 million.
Each share of Series D Preferred Stock is convertible into one share of Common
Stock, subject to adjustment. The conversion price of the preferred stock
($1,500,000) was less than the aggregate market price ($2,551,000) of the common
stock obtainable on conversion on the date of the private placement. In
addition, the exercise price of the warrants ($1,475,000) was less than the
aggregate market price ($2,551,000) of the Common Stock obtainable on exercise
on the date of the private placement. Accordingly, the value of the warrants and
the beneficial conversion feature of the preferred stock, limited to the
$1,500,000 proceeds received on the issuance, was accounted for as an imputed
dividend on the preferred stock at the date of issuance. In addition, the
Company issued to investors promissory notes in the aggregate principal amount
of $1.5 million at an interest rate of 8% per annum. The promissory notes will
be convertible into Series D Preferred Stock and warrants (upon the same terms
described above) subject to stockholder approval. In the event the conversion of
the notes is not approved by a majority vote of the stockholders of the Company,
holders have no right to convert the notes, however the interest rate on the
notes shall increase to 12% per annum. The conversion price of the Series D
preferred stock ($1,500,000) and the exercise price of the warrants ($1,475,000)
was less than the aggregate market price ($5,102,000) of the Common Stock
obtainable upon conversion and exercise on the date of the private placement.
Accordingly, in the event of approval of the conversion by the stockholders, the
beneficial conversion feature of the preferred stock, limited to the $1,500,000
proceeds received on the issuance of the notes, will be accounted for as
interest expense. The Company has filed with the Securities and Exchange
Commission a Form S-3 Registration Statement to register among other securities
the Common Stock underlying the Series D Preferred Stock, warrants and notes
(assuming conversion of the Series D Preferred Stock and warrants underlying the
notes).
USE OF PROCEEDS. On November 12, 1998, the Company's registration
statement on Form SB-2, as amended (file number 333-59617), relating to its
initial public offering (the "IPO") was declared effective by the Securities and
Exchange Commission. Whale Securities Co., L.P. acted as the underwriter in
connection with the IPO which was consummated on November 17, 1998. In
connection with the IPO, the Company registered, issued and sold 1,700,000
shares of Common Stock, at an initial public offering price of $6.00 per share
resulting in net proceeds of $7,931,000, after payment of underwriting discounts
and commissions and offering expenses of $2,269,000. Additionally, the Company
registered 170,000 shares of Common Stock underlying warrants to purchase Common
Stock sold by the Company to the underwriter for $100. The warrants are
exercisable for a four-year period commencing on November 12, 1999 at a price of
$9.30 per share. Since November 17, 1998 (the date of consummation of the
Offering) through December 31, 1999, the Company used the net proceeds of the
IPO as follows: $3,034,000 for sales and marketing, $1,586,000 for software
development, $546,000 for payment of past due trade payables, $585,000 for
repayment of outstanding indebtedness (including $132,000 for repayment of
indebtedness to officers, directors and 10% or more stockholders and affiliates)
$200,000 for purchase of computer equipment, $158,000 for the relocation of its
corporate offices and $1,822,000 for working capital and general corporate
purposes.
21
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION
THE FOLLOWING DISCUSSION AND ANALYSIS SHOULD BE READ IN CONJUNCTION
WITH THE COMPANY'S FINANCIAL STATEMENTS, INCLUDING THE NOTES THERETO, INCLUDED
ELSEWHERE IN THIS FORM 10-KSB. EXCEPT FOR THE HISTORICAL INFORMATION CONTAINED
HEREIN, THIS DISCUSSION CONTAINS FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS
AND UNCERTAINTIES, INCLUDING, BUT NOT LIMITED TO, THOSE DISCUSSED IN THE SECTION
ABOVE ENTITLED "RISK FACTORS WHICH MAY AFFECT FUTURE RESULTS" IN ITEM 1 OF THIS
REPORT AS WELL AS THOSE RISKS DISCUSSED IN THIS SECTION AND ELSEWHERE IN THIS
REPORT. BECAUSE SUCH STATEMENTS INVOLVE RISKS AND UNCERTAINTIES, ACTUAL RESULTS
MAY DIFFER MATERIALLY FROM THOSE EXPRESSED OR IMPLIED BY SUCH FORWARD-LOOKING
STATEMENTS.
OVERVIEW
The Company develops, markets, licenses and supports a family of
network security software products designed to provide comprehensive security to
computer networks, including Internet based systems and internal networks and
computing resources. From inception (July 1990) through December 31, 1994, the
Company was primarily engaged in providing consulting and training services. In
1995, the Company began to shift its focus from consulting and training to the
development and marketing of network security software products. The Company
introduced its first network software product (FIREWALL/PLUS) in June 1995. In
January 1999, the Company introduced its CYBERWALLPLUS family of network
security products. Accordingly, the Company has a limited relevant operating
history as a software developer and has made only limited sales of its
CyberwallPLUS product, upon which an evaluation of its prospects and future
performance can be made. Such prospects must be considered in light of the
risks, expenses and difficulties frequently encountered in the operation and
expansion of a new business and the shift from research and product development
to commercialization of products based on rapidly changing technologies in a
highly specialized and emerging market. The Company will be required to
significantly expand its product and development capabilities, introduce new
products, introduce enhanced features to existing products, expand its in-house
sales force, establish and maintain distribution channels through third-party
vendors, increase marketing expenditures, and attract additional qualified
personnel. In addition, the Company must adapt to the demands of an emerging and
rapidly changing computer network security market, intense competition and
rapidly changing technology and industry standards. The Company may not be able
to successfully address such risks, and the failure to do so would have a
material adverse effect on the Company's business, results of operations and
financial condition.
To date, the Company has incurred significant losses and, at December
31, 1999, had an accumulated deficit of $ 21,693,000. In addition, since
December 31, 1999, the Company has continued to incur significant operating
losses. The Company expects to incur substantial operating expenses in the
future to support its product development activities, as well as continue to
expand its domestic and international sales activities and marketing
capabilities.
22
In February 2000, the Company completed the sale of its professional
services business for a sales price of $4.0 million which included $1.3 million
held in escrow subject to certain former employees of the Company remaining
employed by the purchaser for at least one year and the purchaser securing
certain minimum purchase orders within ninety (90) days of the closing. In
connection with the sale, the Company agreed not to offer any professional
consulting services competitive with the purchaser until the second anniversary
of the closing. Effective upon the sale, the Company granted options to acquire
104,063 shares of Common Stock at $2.91 per share to certain employees of the
professional services business. In connection therewith, the Company incurred a
compensation charge of $525,000 based upon the intrinsic value of the portion of
the options vesting at such date. The balance of the options vest one year after
the closing provided that the employees are still employed by Exodus. An
additional charge of $863,000 will be incurred at such date assuming all the
options vest. The sale has been accounted for by the Company as a sale of a
discontinued operation and the Company will record a gain on the sale of
approximately $1.9 million in the first quarter of 2000.
The Company's software products have not yet achieved market
acceptance. The future success of the Company is largely dependent upon market
acceptance of its CYBERWALLPLUS family of software products. While the Company
believes that its family of software products offer advantages over competing
products for network security, license revenue from network security software
products since the introduction of FIREWALL/PLUS (June 1995), a predecessor
product line, through December 31, 1999 has only been $2,922,000, including a
non-refundable pre-paid royalty of $500,000 in 1997. From January 1999 through
December 31, 1999, license revenue from CYBERWALLPLUS has only been $195,000. In
addition, during 1999 license revenues from software products have decreased as
compared to 1998. CYBERWALLPLUS may not achieve significant market acceptance.
Revenue from such commercial products depend on a number of factors, including
the influence of market competition, technological changes in the network
security market, the Company's ability to design, develop and introduce
enhancements on a timely basis, and the ability of the Company to successfully
establish and maintain distribution channels. The failure of CYBERWALLPLUS to
achieve significant market acceptance as a result of competition, technological
change or other factors, would have a material adverse effect on the Company's
business, operating results and financial condition.
The Company has committed significant product and development resources
to its CYBERWALLPLUS family of products. The Company's anticipated levels of
expenditures for product development are based on its plans for product
enhancements and new product development. The Company capitalizes and amortizes
software development costs in accordance with Statement of Financial Accounting
Standards No. 86. These costs consist of salaries, consulting fees and
applicable overhead. The Company will use a portion of the proceeds from its
private offering, the sale of its professional services business and proceeds
from option exercises during the first quarter of 2000 to significantly increase
its product development expenditures.
23
RESULTS OF OPERATIONS
YEAR ENDED DECEMBER 31, 1999 COMPARED TO YEAR ENDED DECEMBER 31, 1998
Revenues decreased by $305,000 or 44%, from $699,000 for the year ended
December 31, 1998 ("1998") to $394,000 for the year ended December 31, 1999
("1999"). License revenues decreased by $309,000 or 54%, from $569,000 for 1998
to $260,000 for 1999, as a result of the introduction of its new CyberwallPLUS
line of products which was first shipped in March 1999. In addition, management
believes that license revenues in 1999 were adversely impacted by concerns over
Y2K by certain customers. Service revenues from maintenance increased by $4,000
or 3% from $130,000 in 1998 to $134,000 in 1999. The Company's revenues from
customers in the United States represented 96% of its revenues in 1998 and 87%
of its revenues in 1999.
Cost of licenses decreased $71,000 or 43%, from $166,000 for 1998 to
$95,000 for 1999, representing 29% and 37% of license revenues, respectively.
The decrease in the cost of licenses resulted primarily from lower hardware
costs associated with decreased license sales of FIREWALL/PLUS PREMIER VERSION
and decreased royalties on third party product sales. The increase in cost of
licenses as a percentage of license revenues was due to the remaining balance of
a minimum royalty due on a product no longer sold. Amortization of software
development costs increased by $292,000 or 55%, from $533,000 for 1998 to
$825,000 for 1999, representing 94% and 317% of license revenues, respectively.
The increase in amortization of software development costs was due to the
write-off of the unamortized capitalized software costs associated with the
Company's predecessor product line, FIREWALL/PLUS, and other technology
discontinued.
Cost of services increased by $93,000 or 137%, from $68,000 for 1998 to
$161,000 for 1999, representing 52% and 120% of service revenues, respectively.
The increase in cost of services in dollar amount and as a percentage of service
revenues was due primarily to the increase of personnel costs.
Gross loss increased from ($68,000) for 1998 to ($687,000) for 1999,
representing (10%) and (174%) of revenues, respectively. The increase in gross
loss was primarily due to decreased license revenue of $309,000, and the
increase in amortization of capitalized software of $292,000.
Product development expenses increased by $764,000 or 115%, from
$664,000 for 1998 to $1,428,000 for 1999, representing 95% and 362% of revenues,
respectively. The increase in product development costs was due primarily to
increased personnel costs of $857,000 which was a result of the development team
being established in Massachusetts and the technology being transferred from the
prior development team in the Texas office which was closed during 1999. The use
of outside consultants was discontinued which decreased outside consulting costs
by $68,000. During 1998 and 1999, the Company capitalized $200,000 and $400,000,
respectively, of additional software development costs associated with the
development and enhancement of its CYBERWALLPLUS family of products. Overall
development costs increased from $864,000 in 1998 to $1,828,000 in 1999 due to
the hiring of the development team which included some duplication of cost as
the technology was transferred to the new team.
24
Sales and marketing expenses increased by $1,526,000 or 134%, from
$1,141,000 for 1998 to $2,667,000 for 1999, representing 163% and 677% of
revenues, respectively. The dollar amount increase in sales and marketing
expenses were due primarily to increases in personnel costs of $418,000,
increases in advertising, public relations, direct marketing, and other
marketing cost totaling $901,000, and increases in sales costs of $196,000. The
increase in sales and marketing expenses as a percentage of sales was due to the
compounding effect of an increase in sales and marketing expenditures and the
decrease in the Company's revenues.
General and administrative expenses decreased by $564,000 or 23%, from
$2,485,000 for 1998 to $1,921,000 for 1999, representing 356% and 488% of
revenues for 1998 and 1999, respectively. The decrease in general and
administrative expenses in dollar amount was due primarily to a decrease of
$306,000 related to accounting recognition of compensation expense related to
options issued to the Company's President and Chief Executive Officer in May
1998, a decrease of $246,000 for the use of outside consultants which was
partially offset by increases in investor relations of $121,000, an increase in
rent and general office expenses of $210,000, professional fees of $32,000 and
an increase in insurance costs of $59,000. The increase in general and
administrative expense as a percent of revenue was due to the decrease in the
Company's revenues.
Write-off of in-process research and development costs was $469,000 in
1998 and $0 in 1999, representing 67% and 0% of revenue for 1998 and 1999,
respectively. The decrease in in-process research and development costs in
dollar amount and as a percentage of revenue in 1999 was due to costs
written-off associated with the CommHome acquisition in 1998.
Interest income (net of interest expense of $3,000) for 1999 was
$142,000 compared with interest expense (net of interest income of $35,000) for
1998 of $1,154,000, representing 36% and 165% of revenue for 1999 and 1998,
respectively. The decrease in interest expense was due primarily to the fact
that all debt incurred prior to the IPO and related debt discount and interest
was either satisfied or converted into shares of Series C Preferred Stock upon
consummation of the Company's public offering in November 1998 (the "IPO") which
accelerated all the unamortized debt discount to be expensed in 1998. The
Company completed a Series D Preferred Stock, warrant and note financing on
December 22, 1999 which resulted in a small interest charge in 1999. If the
conversion feature of the notes included as part of the December financing is
approved by the stockholders of the Company at its next annual meeting scheduled
for April 28, 2000, the Company will incur an interest charge of $1,500,000 upon
such approval related to the excess of the market value of the common stock (on
the closing date of the December financing) issuable upon conversion of the
preferred stock and exercise of the warrants issuable upon conversion of the
notes.
Loss from discontinued operations was $385,000 in 1999 compared with a
gain of $204,000 in 1998. Revenues from discontinued operations increased by
$152,000, or 13%, in 1999 from $1,132,000 in 1998 to $1,284,000 in 1999. The
total cost of discontinued operations increased $741,000 in 1999 from $928,000
in 1998 to $1,669,000 in 1999 which includes sales, marketing and related
general and administrative costs. The loss in 1999 was attributed to an increase
in personnel and travel-related costs for the professional services division
that was sold in February 2000.
25
No provision for or benefit from federal, state or foreign income taxes
was recorded for 1998 or 1999 because the Company incurred net operating losses
for each year and fully reserved its deferred tax assets as their future
realization could not be determined.
As a result of the foregoing, the net loss increased by $1,169,000 or
20%, from $5,777,000 for 1998 to $6,946,000 for 1999.
LIQUIDITY AND CAPITAL RESOURCES
The Company's capital requirements have been and will continue to be
significant. At December 31, 1999, the Company had $3,023,000 of cash and cash
equivalents and working capital of $2,407,000. The Company has financed its
operations primarily through private sales of equity and debt securities and
consummation of its IPO on November 17, 1998. Net cash used in operating
activities was $2,531,000 during 1998 and $5,504,000 during 1999, respectively.
Net cash used in operating activities for 1998 was primarily attributable to a
net loss from continuing operations of $5,981,000 and a decrease in accounts
payable, accrued expenses and other current liabilities of $187,000, which was
partially offset by non-cash expenses including amortization of debt discount of
$1,031,000, issuance of Common Stock and warrants for services rendered of
$917,000 and depreciation and amortization of $696,000. Net cash used in
operating activities in 1999 was primarily attributable to a net loss from
continuing operations of $6,946,000, which was partially offset by decreases in
accounts payable, accrued expenses and other current liabilities of $104,000,
and non-cash expenses including issuance of Common Stock and warrants for
services rendered of $410,000 and depreciation and amortization of $1,123,000.
The Company's operating activities during 1998 and 1999 were financed
primarily with $1,750,000 of net proceeds from the issuance of $1,750,000
principal amount of notes and warrants to purchase 325,919 shares of Common
Stock in 1998 and an IPO consummated on November 17, 1998 which resulted in
$7,931,000 of net proceeds. In December 1999, the Company consummated a $3.0
million private financing of preferred stock, warrants and notes. In addition,
in February 2000, the Company sold its professional services business and
received proceeds of $2.7 million. The Company also received $2.2 million from
the exercise of stock options in February 2000. The Company does not currently
have a line of credit from a commercial bank or other institution.
The Company anticipates, based on currently proposed plans and
assumptions relating to the implementation of its business plan (including the
timetable of, costs and expenses associated with, and success of, its marketing
efforts), that the proceeds from the December 1999 financing, the sale of its
professional services business and the exercises of stock options through March
1, 2000, together with projected revenues from operations, will be sufficient to
satisfy the Company's operations and capital requirements for the next ten (10)
months from the date of this report (through January 2001). There can be no
assurance, however, that such funds will not be expended prior thereto due to
unanticipated changes in economic conditions or other unforeseen circumstances.
In the event the Company's plans change, or its assumptions change, or prove to
be inaccurate (due to unanticipated expenses, difficulties, delays or
otherwise), or the projected revenues otherwise prove to be insufficient to fund
the implementation of the Company's business plan or working capital
requirements, the Company could be required to seek additional financing sooner
than currently anticipated. The Company has no current arrangements with
26
respect to any additional financing. Consequently, additional financing may not
be available to the Company when needed, on commercially reasonable terms or at
all. Any inability to obtain additional financing when needed would have a
material adverse effect on the Company, requiring it to curtail and possibly
cease its operations. In addition, any additional equity financing may involve
substantial dilution to the interests of the Company's then existing
stockholders.
FLUCTUATIONS IN OPERATING RESULTS
The Company anticipates significant quarterly fluctuations in its
operating results in the future. The Company generally ships orders for
commercial products as they are received and, as a result, does not have any
material backlog. As a result, quarterly revenues and operating results depend
on the volume and timing of orders received during the quarter, which are
difficult to forecast. Operating results may fluctuate on a quarterly basis due
to factors such as the demand for the Company's products, purchasing patterns
and budgeting cycles of customers, the introduction of new products and product
enhancements by the Company or its competitors, market acceptance of new
products introduced by the Company or its competitors and the size, timing,
cancellation or delay of customer orders, including cancellation or delay in
anticipation of new product introduction or enhancement. Therefore, comparisons
of quarterly operating results may not be meaningful and should not be relied
upon, nor will they necessarily reflect the Company's future performance.
Because of the foregoing factors, it is likely that in some future quarters the
Company's operating results will be below the expectations of public market
analysts and investors. In such event, the price of the Common Stock would
likely be materially adversely affected.
The sales cycle for the Company's products can be lengthy and generally
commences at the time a prospective customer demonstrates an interest in
licensing a CYBERWALLPLUS solution, typically includes a 14-day free evaluation
period and ends upon execution of a purchase order by the customer. The length
of the sales cycle varies depending on the type and sophistication of the
customer and the complexity of the operating system.
YEAR 2000 ISSUE
The Company did not incur material costs with respect to potential
software issues associated with the Year 2000.
ITEM 7. FINANCIAL STATEMENTS
The financial statements required hereby are located on pages F-1
through F-16 which follow Part III.
ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
None.
27
PART III
ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS, AND CONTROL PERSONS;
COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT.
The information required by this item is incorporated by reference from
the Company's definitive proxy statement to be filed not later than April 30,
2000 pursuant to Regulation 14A of the General Rules and Regulations under the
Securities Exchange Act of 1934 ("Regulation 14A").
ITEM 10. EXECUTIVE COMPENSATION
The information required by this item is incorporated by reference from
the Company's definitive proxy statement to be filed not later than April 30,
2000 pursuant to Regulation 14A.
ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this item is incorporated by reference from
the Company's definitive proxy statement to be filed not later than April 30,
2000 pursuant to Regulation 14A.
ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item is incorporated by reference from
the Company's definitive proxy statement to be filed not later than April 30,
2000 pursuant to Regulation 14A.
ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits.
Number Description of Exhibit
------ ----------------------
2.1 Merger Agreement, dated September 11, 1998, between the Company and
CommHome Systems Corporation (1)
3.1 Certificate of Incorporation of the Company, as amended (includes
form of Certificate of Designation of Series C Preferred Stock and
Series D Preferred Stock) (2)
3.2 By-laws of the Company, as amended (1)
4.1 Form of Common Stock Certificate (1)
4.2 Company's Stock Option Plan, as amended (1)
28
Number Description of Exhibit
------ ----------------------
10.1 Employment Agreement, dated May 18, 1998, between the Company and
Avi A. Fogel, and amendment, dated May 30, 1998 (1)
10.2 Employment Agreement, dated May 18, 1998, between the Company and
Robert P. Olsen (1)
10.3 Employment Agreement, dated May 19, 1998, between the Company and
Murray P. Fish (1)
10.4 Employment Agreement, dated June 30, 1998, between the Company and
William Hancock (1)
10.5 Employment Agreement, dated April 4, 1994, between the Company and
Robert Russo, and amendments, dated February 16, 1996 and September
10, 1998 (1)
10.6 Waiver, dated June 30, 1998, of salary increases by William Hancock
and Robert Russo (1)
10.7 Lease and Service Agreement, dated June 5, 1998, between the
Company and Alliance Wellesley L.P. (1)
10.8 Lease, dated June 29, 1994, between the Company and Greenview
Limited Partnership (1)
10.9 Agreement, dated August 30, 1996, between the Company and CMH
Capital Management Corp. ("CMH"), with respect to advisory
services, and amendments, dated January 15, 1997, and January 30,
1997 (1)
10.10 Agreement, dated May 14, 1998, between the Company, CMH and
Applewood Associates, L.P. with respect to advisory services (1)
10.11 Master Software License Agreement, dated November 10, 1997, between
the Company and Electronic Data System Corporation, and amendment,
dated May 29, 1998 (1)
10.12 Software Distribution Agreement, dated June 5, 1997, between the
Company and Trusted Information Systems, Inc. (1)
10.13 Software Distribution Agreement, dated September 26, 1997, between
the Company and Trusted Information Systems, Inc. (1)
10.14 Reseller Agreement, dated April 17, 1998, between the Company and
Aventail Software Corporation (1)
10.15 Agreement, dated January 31, 1997, among the Company, Robert Russo
and William Hancock, in 10.15 which Messrs. Russo and Hancock
surrendered shares of Common Stock (1)
29
Number Description of Exhibit
------ ----------------------
10.16 Agreement, dated September 26, 1997, between the Company, Robert
Russo, William Hancock, and Kenneth Conquest, in which Messrs.
Russo, Hancock, and Conquest surrendered shares of Common Stock (1)
10.17 Agreement, dated May 14, 1998, among the Company, Robert Russo and
William Hancock, in which Messrs. Russo and Hancock surrendered
shares of Common Stock (1)
10.18 Agreement, dated May 14, 1998, between the Company and CMH, in
connection with the issuance of shares for advisory fees (1)
10.19 Exchange Agreement, dated July 8, 1998, between the Company and
certain of its holders of outstanding warrants and options (1)
10.20 Employment Agreement, dated July 31, 1998, between the Company and
Joseph A. Donohue (1)
10.21 Employment Agreement, dated August 24, 1998, between the Company
and Joseph D. Harris (1)
10.22 Agreement, dated October 1, 1998, between the Company and CMH, with
respect to advisory services (1)
10.23 Agreement, dated October 20, 1998, between the Company and certain
of its holders of promissory notes (1)
10.24 Employment Agreement, dated December 12, 1998, between the Company
and Lance Westbrook (2)
10.25 Agreement of Sublease, dated December 24, 1998, between PAREXEL
International Corporation and the Company and Consent to Sublease,
dated January 14, 1999, between Boston Properties Limited
Partnership, PAREXEL International Corporation and the Company. (2)
10.26 Agreement, dated January 13, 1999, between the Company and Robert
Russo relating to deferred salary. (2)
10.27 Agreement, dated March 10, 1999, between the Company and William
Hancock and Pledge and Escrow Agreement, dated March 10, 1999,
relating to $100,000 loan. (2)
10.28 Employment Agreement dated May 15, 1999, between the Company and
Robert Russo (3)
10.29 Securities Purchase Agreement, dated February 22, 1999 between the
Company and the investors including form of Certificate of
Designation of Series D Preferred Stock (Exhibit A), form of
Warrant (Exhibit 4B) and form of Promissory Note (Exhibit D). (4)
10.30 Asset Purchase Agreement, dated February 9, 2000, between the
Company and Exodus Communications, Inc. including all exhibits and
schedules (5)
30
Number Description of Exhibit
------ ----------------------
10.31 Termination Agreement, dated February 9, 2000 between the Company
and William Hancock *
10.32 Termination Agreement, dated February 7, 2000 between the Company
and Robert Russo *
21.1 List of Subsidiaries of the Company. (1)
23.1 Consent of Richard A. Eisner & Company, LLP *
27.1 Financial Data Schedule. *
- ----------------------
* Filed herewith.
1 Incorporated by reference to the same numbered exhibit to the Registrant's
Registration Statement on Form SB-2 (File Number 333-59617).
2 Incorporated by reference to the same numbered exhibit to Registrant's
Annual Report on Form 10-KSB.
3 Incorporated by reference to the same numbered exhibit to Registrant's
Quarterly Report on Form 10-QSB for the quarterly period ended June 30, 1999.
4 Incorporated by reference to Exhibit 10.28 to Registrant's Form 8-K filed on
January 4, 2000.
5 Incorporated by reference to Exhibit 10.29 to Registrant's Form 8-K filed on
February 15, 2000.
(b) Reports on Form 8-K
No reports on Form 8-K were filed during the last quarter of the period
covered by this Report.
31
NETWORK-1 SECURITY SOLUTIONS, INC.
CONTENTS
PAGE
----
INDEX TO FINANCIAL STATEMENTS
Independent auditors' report F-2
Balance sheets as of December 31, 1999 and 1998 F-3
Statements of operations for the years
ended December 31, 1999 and 1998 F-4
Statements of stockholders' equity (deficiency) for
the years ended December 31, 1999 and 1998 F-5
Statements of cash flows for the years ended
December 31, 1999 and 1998 F-6
Notes to financial statements F-7
F-1
INDEPENDENT AUDITORS' REPORT
Board of Directors and Stockholders
Network-1 Security Solutions, Inc.
Waltham, Massachusetts
We have audited the accompanying balance sheets of Network-1 Security Solutions,
Inc. (the "Company") as of December 31, 1999 and 1998 and the related statements
of operations, stockholders' equity and cash flows for each of the years then
ended. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements enumerated above present fairly, in all
material respects, the financial position of Network-1 Security Solutions, Inc.
as of December 31, 1999 and 1998 and the results of its operations and its cash
flows for each of the years then ended in conformity with generally accepted
accounting principles.
Richard A. Eisner & Company, LLP
New York, New York
January 28, 2000
With respect to Note L
February 9, 2000
With respect to Note M
February 29, 2000
With respect to Note C
March 14, 2000
F-2
NETWORK-1 SECURITY SOLUTIONS, INC.
BALANCE SHEETS
DECEMBER 31,
----------------------------
1999 1998
------------ ------------
ASSETS
Current assets:
Cash and cash equivalents $ 3,023,000 $ 6,423,000
Accounts receivable - net of allowance for doubtful
accounts of $40,000 and $111,000, respectively 65,000 77,000
Prepaid expenses and other current assets 155,000 119,000
Due from officer 88,000
------------ ------------
Total current assets 3,331,000 6,619,000
Equipment and fixtures - net 425,000 394,000
Capitalized software costs - net 500,000 925,000
Security deposits 82,000 37,000
Net assets of discontinued operations 258,000 105,000
------------ ------------
$ 4,596,000 $ 8,080,000
============ ============
LIABILITIES
Current liabilities:
Accounts payable $ 320,000 $ 420,000
Accrued expenses and other current liabilities 546,000 342,000
Deferred revenue 58,000 79,000
------------ ------------
Total current liabilities 924,000 841,000
Notes payable - related parties 525,000
Notes payable - others 975,000
Interest payable - related parties 1,000
Interest payable - others 2,000
------------ ------------
2,427,000 841,000
------------ ------------
Commitments and contingencies
STOCKHOLDERS' EQUITY
Preferred stock - $.01 par value; 5,000,000 shares authorized;
Series A - 10% cumulative, none issued and outstanding
Series B - none issued and outstanding
Series C - 562,836 shares issued and outstanding - December 31, 1998 6,000
Series D - 491,803 shares issued and outstanding - December 31, 1999 5,000
Common stock - $.01 par value; 25,000,000 shares authorized;
4,935,211 and 4,366,520 shares issued and outstanding 50,000 44,000
Additional paid-in capital 23,941,000 20,819,000
Accumulated deficit (21,693,000) (13,247,000)
Unearned portion of compensatory stock options (134,000) (383,000)
------------ ------------
2,169,000 7,239,000
------------ ------------
$ 4,596,000 $ 8,080,000
============ ============
SEE NOTES TO FINANCIAL STATEMENTS
F-3
NETWORK-1 SECURITY SOLUTIONS, INC.
STATEMENTS OF OPERATIONS
YEAR ENDED
DECEMBER 31,
----------------------------
1999 1998
------------ ------------
Revenues:
Licenses $ 260,000 $ 569,000
Services 134,000 130,000
------------ ------------
394,000 699,000
------------ ------------
Cost of revenues:
Amortization of software development costs 825,000 533,000
Cost of licenses 95,000 166,000
Cost of services 161,000 68,000
------------ ------------
1,081,000 767,000
------------ ------------
Gross loss (687,000) (68,000)
------------ ------------
Operating expenses:
Product development costs 1,428,000 664,000
Selling and marketing 2,667,000 1,141,000
General and administrative 1,921,000 2,485,000
Write-off of in-process research and development 469,000
------------ ------------
6,016,000 4,759,000
------------ ------------
Loss from continuing operations before interest costs (6,703,000) (4,827,000)
Interest income (expense) - net 142,000 (1,154,000)
------------ ------------
Loss from continuing operations (6,561,000) (5,981,000)
(Loss) income from discontinued operations (385,000) 204,000
------------ ------------
NET LOSS (6,946,000) (5,777,000)
Imputed dividend on preferred stock (1,500,000)
------------ ------------
NET LOSS APPLICABLE TO COMMON STOCK $ (8,446,000) $ (5,777,000)
============ ============
PER COMMON SHARE - BASIC AND DILUTED:
Loss from continuing operations $ (1.83) $ (2.65)
(Loss) income from discontinued operations (0.09) 0.09
------------ ------------
Net loss $ (1.92) $ (2.56)
============ ============
WEIGHTED AVERAGE NUMBER OF COMMON SHARES OUTSTANDING - BASIC AND DILUTED 4,394,178 2,257,920
============ ============
SEE NOTES TO FINANCIAL STATEMENTS
F-4
NETWORK-1 SECURITY SOLUTIONS, INC.
STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIENCY)
PREFERRED STOCK COMMON STOCK
---------------------------- ----------------------------
SHARES AMOUNT SHARES AMOUNT
------------ ------------ ------------ ------------
BALANCE - DECEMBER 31, 1997 500,000 $ 5,000 1,706,037 $ 17,000
Common stock options issued to Chief Executive Officer
Amortization of compensatory stock options
Issuance of Series C preferred stock 562,836 6,000
Issuance of common stock, warrants and options for
services rendered and payment of liability 51,256 1,000
Warrants issued in connection with debt financing
Repurchase and retirement of common shares (62,080)
Conversion of warrants to stock at discount as part of
debt refinancing 596,741 6,000
Conversion of Series B preferred stock (500,000) (5,000) 310,399 3,000
Acquisition of CommHome 64,167
Issuance of common stock for cash-initial public offering 1,700,000 17,000
Net loss
------------ ------------ ------------ ------------
BALANCE - DECEMBER 31, 1998 562,836 6,000 4,366,520 44,000
Amortization of compensatory stock options
Issuance of common stock and options for services
rendered and payment of liability 5,855
Conversion of Series C preferred stock (562,836) (6,000) 562,836 6,000
Issuance of Series D preferred stock and warrants,
net of expenses of $34,000 491,803 5,000
Beneficial conversion feature of Series D preferred stock
and related imputed dividend
Net loss
------------ ------------ ------------ ------------
BALANCE - DECEMBER 31, 1999 491,803 $ 5,000 4,935,211 $ 50,000
============ ============ ============ ============
UNEARNED
ADDITIONAL PORTION OF
PAID-IN ACCUMULATED COMPENSATORY
CAPITAL DEFICIT STOCK OPTIONS TOTAL
------------ ------------ ------------ ------------
BALANCE - DECEMBER 31, 1997 7,373,000 $ (7,470,000) $ (75,000)
Common stock options issued to Chief Executive Officer 938,000 $ (938,000) 0
Amortization of compensatory stock options 555,000 555,000
Issuance of Series C preferred stock 2,949,000 2,955,000
Issuance of common stock, warrants and options for
services rendered and payment of liability 499,000 500,000
Warrants issued in connection with debt financing 766,000 766,000
Repurchase and retirement of common shares (1,000) (1,000)
Conversion of warrants to stock at discount as part of
debt refinancing (6,000) 0
Conversion of Series B preferred stock 2,000 0
Acquisition of CommHome 385,000 385,000
Issuance of common stock for cash-initial public offering 7,914,000 7,931,000
Net loss (5,777,000) (5,777,000)
------------ ------------ ------------ ------------
BALANCE - DECEMBER 31, 1998 20,819,000 (13,247,000) (383,000) 7,239,000
Amortization of compensatory stock options 249,000 249,000
Issuance of common stock and options for services
rendered and payment of liability 161,000 161,000
Conversion of Series C preferred stock 0
Issuance of Series D preferred stock and warrants,
net of expenses of $34,000 1,461,000 1,466,000
Beneficial conversion feature of Series D preferred stock
and related imputed dividend 1,500,000 (1,500,000) 0
Net loss (6,946,000) (6,946,000)
------------ ------------ ------------ ------------
BALANCE - DECEMBER 31, 1999 $ 23,941,000 $(21,693,000) $ (134,000) $ 2,169,000
============ ============ ============ ============
SEE NOTES TO FINANCIAL STATEMENTS
F-5
NETWORK-1 SECURITY SOLUTIONS, INC.
STATEMENTS OF CASH FLOWS
YEAR ENDED
DECEMBER 31,
--------------------------
1999 1998
----------- -----------
CASH FLOWS FROM OPERATING ACTIVITIES:
Loss from continuing operations $(6,561,000) $(5,981,000)
Adjustments to reconcile loss from continuing operations to net cash
(used in) operating activities:
Amortization of debt discount 1,031,000
Issuance of common stock and warrants for services rendered 410,000 917,000
Issuance of preferred stock for payment of interest 147,000
Provision for doubtful accounts (71,000) 66,000
Depreciation and amortization 1,123,000 696,000
Write-off of purchased research and development 469,000
Changes in:
Accounts receivable 83,000 84,000
Prepaid expenses and other current assets (36,000) (89,000)
Accounts payable, accrued expenses and other current liabilities 104,000 (187,000)
Interest payable 3,000
Deferred revenue (21,000) 40,000
----------- -----------
Net cash used in continuing operations (4,966,000) (2,807,000)
Cash (used in) provided by discontinued operations (538,000) 276,000
----------- -----------
Net cash used in operating activities (5,504,000) (2,531,000)
----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Acquisitions of equipment and fixtures (363,000) (178,000)
Capitalized software costs (400,000) (200,000)
Investment in CommHome (84,000)
Security deposits (45,000) 94,000
Loan to officer (88,000)
----------- -----------
Net cash used in investing activities (896,000) (368,000)
----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of notes payable and warrants 1,500,000 1,825,000
Proceeds from issuance of preferred stock and warrants 1,500,000
Repayment of notes payable (575,000)
Net proceeds from IPO 8,021,000
Repayment of capital lease obligations (8,000)
Purchase of treasury shares (1,000)
----------- -----------
Net cash provided by financing activities 3,000,000 9,262,000
----------- -----------
NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS (3,400,000) 6,363,000
Cash and cash equivalents - beginning of year 6,423,000 60,000
----------- -----------
CASH AND CASH EQUIVALENTS - END OF YEAR $ 3,023,000 $ 6,423,000
=========== ===========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid during the year for interest $ 10,000
Noncash transactions:
Issuance of preferred stock in connection with repayment of debt $ 2,955,000
Issuance of common stock in connection with acquisition of subsidiary $ 385,000
Issuance of common stock in connection with payment of deferred salary $ 32,000
SEE NOTES TO FINANCIAL STATEMENTS
F-6
NETWORK-1 SECURITY SOLUTIONS, INC.
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1999 AND 1998
NOTE A - THE COMPANY
Network-1 Security Solutions, Inc. (the "Company") develops, markets, licenses
and supports its proprietary network security software products designed to
provide comprehensive security to computer networks. The Company also provides
maintenance and training services. The Company also provided consulting services
in network security and network design through its Professional Services Group
which was sold in February 2000 and is being accounted for as a discontinued
operation (see Note L).
NOTE B - SIGNIFICANT ACCOUNTING POLICIES
[1] CASH EQUIVALENTS:
The Company considers all highly liquid short-term investments purchased
with a maturity of three months or less to be cash equivalents.
[2] REVENUE RECOGNITION:
License revenue is recognized upon delivery of software or delivery of a
required software key. Service revenues consist of maintenance and
training services. Annual renewable maintenance fees are a separate
component of each contract, and are recognized ratably over the contract
term. Training revenues are recognized as such services are performed.
[3] EQUIPMENT AND FIXTURES:
Equipment and fixtures are stated at cost and are depreciated using the
straight-line method over their estimated useful lives of five years.
[4] SOFTWARE DEVELOPMENT COSTS:
Costs to maintain developed programs and development costs incurred to
establish the technological feasibility of computer software are expensed
as incurred. The Company capitalizes costs incurred in producing computer
software after technological feasibility of the software has been
established through the date that the software is ready for general
release to customers. Such costs are amortized based on current and
estimated future revenue of each product with an annual minimum equal to
the straight-line amortization over the remaining estimated economic life
of the product. The Company estimates the economic life of its software to
be three years. At each balance sheet date, the unamortized capitalized
software costs of each product are compared with the net realizable value
of that product and any excess capitalized costs are written off.
[5] INCOME TAXES:
The Company utilizes the liability method of accounting for income taxes.
Under such method, deferred tax assets and liabilities are recognized for
the future tax consequences attributable to differences between the
financial statement carrying amounts of existing assets and liabilities
and their respective tax bases. Deferred tax assets and liabilities are
measured using enacted tax rates in effect at the balance sheet date. The
resulting asset or liability is adjusted to reflect enacted changes in tax
law.
F-7
NETWORK-1 SECURITY SOLUTIONS, INC.
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1999 AND 1998
NOTE B - SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
[6] PER SHARE DATA:
Basic loss per share is calculated based on the weighted average number of
outstanding common shares during the year. Diluted per share data includes
the dilutive effects of options, warrants and convertible securities. As
all potential common shares are anti-dilutive, they are not included in
the calculation of diluted loss per share. For the year ended December 31,
1999, in computing loss per share, the loss from continuing operations and
net loss is increased by $1,500,000, representing an imputed preferred
stock dividend equivalent to the value of the beneficial conversion
feature on the Series D Preferred Stock (see Note G[1]).
[7] 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 reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the
financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those
estimates.
[8] FINANCIAL INSTRUMENTS:
The carrying amounts of accounts receivable, accounts payable and accrued
expenses approximate their fair value due to the short period to maturity
of these instruments.
[9] STOCK-BASED COMPENSATION:
The Company has elected to continue to account for its employee
stock-based compensation plans using the intrinsic value method prescribed
by Accounting Principles Board Opinion No. 25 ("APB No. 25"), "Accounting
for Stock Issued to Employees" and to disclose the pro forma effect on net
loss per share had the fair value of options been expensed. Under the
provisions of APB No. 25, compensation cost for stock options is measured
as the excess, if any, of the market value of the Company's common stock
at the date of the grant over the amount an employee must pay to acquire
the stock.
NOTE C - DUE FROM OFFICER
On March 10, 1999, the Company entered into an agreement with one of its
officers who is also a director, pursuant to which the Company agreed to loan
the officer up to $100,000, at an interest rate of 6.5% per annum, to be used by
the officer to satisfy certain outstanding personal tax obligations. The loan
was repayable on December 31, 1999. In consideration for such loan, the officer
pledged 50,000 shares of common stock of the Company as collateral for the
repayment of the loan. As of December 31, 1999, the Company was owed
approximately $88,000 pursuant to the agreement. On March 14, 2000, the loan
with the officer was paid in full.
F-8
NETWORK-1 SECURITY SOLUTIONS, INC.
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1999 AND 1998
NOTE D - EQUIPMENT AND FIXTURES
Equipment and fixtures are summarized as follows:
DECEMBER 31,
-------------------------
1999 1998
----------- -----------
Office and computer equipment $ 416,000 $ 808,000
Furniture and fixtures 90,000 59,000
Leasehold improvements 5,000
----------- -----------
506,000 872,000
Less accumulated depreciation (81,000) (478,000)
----------- -----------
$ 425,000 $ 394,000
=========== ===========
NOTE E - CAPITALIZED SOFTWARE COSTS
YEAR ENDED
DECEMBER 31,
-------------------------
1999 1998
----------- -----------
Balance, beginning of year (net of
accumulated amortization) $ 925,000 $ 1,258,000
Additions 400,000 200,000
Amortization (825,000)(A) (533,000)
----------- -----------
Balance, end of year (net of
accumulated amortization) $ 500,000 $ 925,000
=========== ===========
(a) Includes write off of $213,000 associated with a predecessor
product line and other technology which was discontinued.
NOTE F - NOTES PAYABLE
Pursuant to a private placement in December 1999, the Company issued $1,500,000
of convertible promissory notes ($525,000 of which was payable to related
parties) bearing interest at 8% which mature in December 2001. Subject to
approval by a majority vote of the stockholders of the Company, the notes may be
converted into 491,803 shares of Series D convertible preferred stock of the
Company (570,492 shares if interest through the maturity of the notes is
considered) and an equal number of five-year warrants to purchase 491,803 shares
of Common Stock (570,492 shares if interest through the maturity of the notes is
considered) at an exercise price of $3.00 per share, subject to certain
adjustments (see Note G[1]). In the event the conversion of the notes is not
approved by a majority vote of the stockholders of the Company, holders have no
right to convert the notes, however the interest rate on the notes shall
increase to 12% per annum. The conversion price of the Series D preferred stock
($1,500,000) and the exercise price of the warrants ($1,475,000) was less than
the aggregate market price ($5,102,000) of the common stock obtainable upon
conversion and exercise on the date of the private placement. Accordingly, in
the event of approval of the conversion by the shareholders, the beneficial
conversion feature of the preferred stock, limited to the $1,500,000 proceeds
received on the issuance of the notes, will be accounted for as interest
expense.
Effective with the Company's initial public offering in November 1998, the
Company issued 562,836 shares of Series C preferred stock in exchange for
cancellation of certain promissory notes then outstanding which, with accrued
interest, aggregated $2,955,000. In addition, the Company repaid the $509,000
balance owed on the remaining notes from the proceeds of the initial public
offering. In December 1999, such Series C preferred stock was converted into an
equal number of shares of common stock.
F-9
NETWORK-1 SECURITY SOLUTIONS, INC.
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1999 AND 1998
NOTE F - NOTES PAYABLE (CONTINUED)
The notes which were cancelled or repaid consisted of the following:
(1) 1998 borrowings in the aggregate of $1,750,000 bearing interest at 8%
($1,400,000 of which was payable to related parties).
(2) 1997 borrowings in the aggregate of $1,500,000 at interest rates
between 6% - 8% including $750,000 owed to related parties.
(3) $100,000 note payable to a corporation wholly-owned by the Chairman
of the Board and a principal stockholder of the Company.
In connection with the 1998 borrowings referred to above, the Company
issued ten-year warrants valued at $766,000 to purchase 325,919
shares of the Company's common stock at an exercise price of $4.83
per share, increasing the effective interest rate to 92%. During
1998, the Company also borrowed $75,000 at an interest rate of 10%.
Interest expense for the years ended December 31, 1999 and 1998
includes $3,000 and $928,000, respectively, of interest and
amortization of debt discount on notes to related parties.
NOTE G - STOCKHOLDERS' EQUITY
[1] PREFERRED STOCK:
Pursuant to a private placement in December 1999, the Company issued
491,803 shares of Series D convertible preferred stock for proceeds of
$1,500,000. Such stock is convertible on a share for share basis into
common stock at an initial conversion price of $3.05 per share, has
identical voting rights as the Company's common stock and is entitled to
equivalent dividend and distribution rights as those paid on shares of
common stock obtainable on conversion. In connection therewith, the
Company also issued five-year warrants to purchase 491,803 shares of
common stock at an exercise price of $3.00 per share. The exercise price
of the warrants is subject to adjustment depending on the product revenue
achieved by the Company during the three month period ending March 31,
2000. The exercise price shall be adjusted to $1.00, if product revenues
are less than $500,000, increasing $.25 for each $250,000 increase in
product revenue above $500,000 (except for product revenue between
$2,250,000 and $3,250,000 for which the exercise price shall remain at
$3.00) up to a maximum $4.00 exercise price for product revenue equal to
or greater than $4.0 million. The holders of the Series D convertible
preferred stock are entitled to a liquidation preference of $3.05 per
share plus any declared but unpaid dividends before any payments are made
to holders of common stock, in the event of liquidation, dissolution or
winding up of the Company. The conversion price of the preferred stock
($1,500,000) was less than the aggregate market price ($2,551,000) of the
common stock obtainable on conversion on the date of the private
placement. In addition, the exercise price of the warrants ($1,475,000)
was less than the aggregate market price ($2,551,000) of the common stock
obtainable on exercise on the date of the private placement. Accordingly,
the value of the warrants and the beneficial conversion feature of the
preferred stock, limited to the $1,500,000 proceeds received on the
issuance, was accounted for as an imputed dividend on the preferred stock
at the date of issuance.
In December 1999, 562,836 shares of Series C convertible preferred stock
were converted into 562,836 shares of common stock.
F-10
NETWORK-1 SECURITY SOLUTIONS, INC.
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1999 AND 1998
NOTE G - STOCKHOLDERS' EQUITY (CONTINUED)
[2] STOCK OPTIONS AND WARRANTS:
During 1996, the Board of Directors and stockholders approved the adoption
of the 1996 Stock Option Plan (the "1996 Plan"). The 1996 Plan, as
amended, provides for the granting of both incentive and non-qualified
options to purchase up to 1,800,000 shares of common stock of the Company.
The term of options granted under the 1996 Plan may not exceed ten years
(five years in the case of an incentive stock option granted to an
optionee owning more than 10% of the voting stock of the Company). The
option price for incentive stock options can not be less than 100% of the
fair market value of the shares of common stock at the time the option is
granted (110% for a 10% stockholder). The exercise price for non-qualified
options is set by the Compensation Committee in its discretion.
The following table summarizes the activity under the 1996 Plan:
YEAR ENDED DECEMBER 31,
-----------------------------------------------------------
1999 1998
---------------------------- ----------------------------
WEIGHTED WEIGHTED
AVERAGE AVERAGE
EXERCISE EXERCISE
OPTIONS PRICE OPTIONS PRICE
------------ ------------ ------------ ------------
Options outstanding at beginning of year 905,947 $5.85 184,687 $5.72
Granted 747,630 3.34 1,186,140 6.13
Cancelled (306,532) 5.09 (464,880) 6.50
------------ ------------
Options outstanding at end of year 1,347,045 4.54 905,947 5.85
============ ============
Options exercisable at end of year 693,858 5.06 372,621 5.70
============ ============
The following table presents information relating to stock options
pursuant to the 1996 Plan outstanding and exercisable at December 31,
1999:
WEIGHTED WEIGHTED WEIGHTED
RANGE OF AVERAGE AVERAGE AVERAGE
EXERCISE OPTIONS EXERCISE OPTIONS EXERCISE REMAINING
PRICES EXERCISABLE PRICE OUTSTANDING PRICE LIFE IN YEARS
------------- ------------- ------------- ------------- ------------- -------------
$1.50 57,386 $1.50 239,237 $1.50 9.75
$2.91 - $4.25 152,362 3.63 362,143 3.59 9.62
$4.83 - $6.50 484,110 5.93 745,665 5.97 8.78
------------- -------------
693,858 5.06 1,347,045 4.54 9.18
============= =============
F-11
NETWORK-1 SECURITY SOLUTIONS, INC.
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1999 AND 1998
NOTE G - STOCKHOLDERS' EQUITY (CONTINUED)
[2] STOCK OPTIONS AND WARRANTS: (CONTINUED)
The weighted average fair value at date of grant for options granted
during the year ended December 31, 1999 and 1998, were $2.45 and $2.89 per
option, respectively. The fair value of options at date of grant was
estimated using the Black-Scholes option pricing model utilizing the
following weighted average assumptions:
DECEMBER 31,
----------------------
1999 1998
--------- ---------
Risk-free interest rates 5.99% 5.04%
Expected option life in years 6 6
Expected stock price volatility 90% 40%
Expected dividend yield 0% 0%
Had the Company elected to recognize compensation cost based on the fair
value of the options at the date of grant as prescribed by Statement of
Financial Accounting Standards No. 123 "Accounting for Stock-Based
Compensation", net loss for the years ended December 31, 1999 and 1998
would have been $(9,557,000) and $(6,749,000) or $(2.17) per share and
$(2.99) per share, respectively.
[3] On July 8, 1998, the Company entered into an agreement with certain of
its option and warrant holders pursuant to which the Company issued
596,741 shares of its common stock in exchange for cancellation of
outstanding warrants to purchase 789,521 shares of the Company's common
stock.
As of December 31, 1999, the Company has the following outstanding
warrants and options to purchase shares of common stock in addition to
the outstanding options under the 1996 Plan.
NUMBER OF
WARRANTS EXERCISE
AND OPTIONS PRICE EXPIRATION DATE
----------- ----- ---------------------------
62,080 $1.61 October 11, 2003 - January 15, 2004
357,735 2.42 May 18, 2003 - April 4, 2004
491,803 3.00 December 22, 2004
6,207 6.04 February 17, 2002
111,744 6.44 March 14, 2006 - February 24, 2007
170,000 9.30 November 12, 2003
93,120 9.66 March 14, 2006
----------
1,292,689
==========
[4] INITIAL PUBLIC OFFERING:
On November 12, 1998 the Company issued 1,700,000 shares of its common
stock in an initial public offering and received net proceeds therefrom
aggregating $7,931,000.
F-12
NETWORK-1 SECURITY SOLUTIONS, INC.
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1999 AND 1998
NOTE H - COMMITMENTS AND CONTINGENCIES
[1] OPERATING LEASES:
The Company subleases an office facility in Massachusetts under an
operating lease which expires in 2001. As at December 31, 1999, rental
commitments for the remaining term of the sublease is as follows:
YEAR ENDING
DECEMBER 31,
-----------
2000 $ 243,000
2001 162,000
-----------
$ 405,000
===========
Rental expense for the years December 31, 1999 and 1998 aggregated
$268,000 and $125,000, respectively.
[2] SOFTWARE DISTRIBUTION AGREEMENTS:
(a) In September 1997, the Company entered into a software distribution
agreement, pursuant to which the Company had the right to
incorporate certain technology into its software. The Company is
required to make certain royalty payments based on unit sales as
defined. The Company is obligated to pay a minimum of $100,000 in
royalties pursuant to the agreement for the period September 1997 to
March 30, 1999. As of December 31, 1999 and 1998, accrued royalty
payable was approximately $120,000 and $90,000, respectively.
(b) In July 1996, the Company entered into an agreement pursuant to
which certain technology was developed for the Company. The Company
is required to make certain royalty payments based on unit sales as
defined, up to a maximum royalty payment of $100,000. For the years
ended December 31, 1999 and 1998, royalties owed pursuant to such
agreement were not significant.
[3] EMPLOYMENT AGREEMENTS:
In May 1998, the Company entered into an employment agreement with its
President and Chief Executive Officer which provides for a base salary of
$150,000, subject to annual increases of up to 20% by the Board of
Directors at its discretion. The agreement also provides for an annual
bonus of up to $50,000 as determined by the Board of Directors in its
discretion. The agreement expires in May 2002. In connection therewith,
the Company granted the President a five-year option to purchase 294,879
shares of the Company's common stock at an exercise price of $2.42 per
share. The option vests 34% immediately and then 22% per year thereafter.
As the estimated fair value of the Company's common stock at the date of
grant of the option ($5.60 per share) was in excess of the exercise price,
the Company will incur aggregate compensation expense of $938,000 over the
service period of which $555,000 and $249,000 has been charged to expense
in 1998 and 1999, respectively.
As at December 31, 1999, aggregate salary commitments pursuant to
employment agreements with the President and other officers amounted to
$510,000, $310,000 and $56,000, for 2000, 2001 and 2002, respectively.
F-13
NETWORK-1 SECURITY SOLUTIONS, INC.
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1999 AND 1998
NOTE H - COMMITMENTS AND CONTINGENCIES (CONTINUED)
[4] SAVINGS AND INVESTMENT PLAN:
The Company has a Savings and Investment Plan which allows participants to
make contributions by salary reduction pursuant to Section 401(k) of the
Internal Revenue Code of 1986. The Company also may make discretionary
annual matching contributions in amounts determined by the Board of
Directors, subject to statutory limits. The Company did not make any
contributions to the 401(k) Plan during the years ended December 31, 1999
and 1998.
[5] FINANCIAL ADVISORY AGREEMENT:
The Company had a financial advisory agreement with a corporation owned by
the Chairman of the Board and a principal stockholder, which expired in
August 1998. Pursuant to such agreement, monthly fees of $12,500 were to
be paid to such corporation, and the Company issued two 7-year warrants,
each to purchase up to 31,040 shares of common stock at an exercise price
of $6.44 and $8.05, respectively. Such exercise prices were subsequently
reduced to an exercise price of $1.61 per share. The Company also agreed
to pay such corporation and another corporation, which is a principal
stockholder of the Company, a cash fee equal to 3% of the total proceeds
or other consideration received in connection with a merger or sale of
substantially all of the Company's assets completed by January 2001.
Expenses under the agreement, including amortization of the value ascribed
to the warrants, included in general and administrative expenses, for the
year ended December 31, 1998 amounted to $125,000.
On May 14, 1998, the Company issued 31,250 shares of common stock to this
entity in satisfaction of amounts owed pursuant to the financial advisory
agreement.
In October 1998, the Company entered into a financial advisory agreement
with the corporation referred to above, which expired in January 1999.
Pursuant to such agreement, the Company issued 10,000 shares of common
stock to this entity in full satisfaction of its obligations pursuant to
the financial advisory agreement.
NOTE I - INCOME TAXES
The principal components of deferred tax assets and valuation allowance are as
follows:
YEAR ENDED
DECEMBER 31,
--------------------------
1999 1998
----------- -----------
Deferred tax assets:
Net operating loss carryforwards $ 6,400,000 $ 4,038,000
Compensatory warrants and options not yet
deducted for tax purposes 421,000
Other 57,000
----------- -----------
6,400,000 4,516,000
Valuation allowance (6,400,000) (4,516,000)
----------- -----------
Net deferred tax asset $ 0 $ 0
=========== ===========
F-14
NETWORK-1 SECURITY SOLUTIONS, INC.
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1999 AND 1998
NOTE I - INCOME TAXES (CONTINUED)
The Company has recorded a valuation allowance for the full amount of its
deferred tax assets as the likelihood of its future realization cannot be
presently determined. The valuation allowance was increased by $1,884,000 in
1999 and $1,608,000 in 1998.
The difference between the tax benefit and the amount computed by applying the
statutory federal income tax rate to loss from continuing operations is
attributable to the following:
YEAR ENDED
DECEMBER 31,
--------------------
1999 1998
-------- --------
Income tax benefit - statutory rate (34.0)% (34.0)%
Increase in valuation allowance on deferred tax assets 34.0 34.0
-------- --------
Income tax benefit-statement of operations 0.0% 0.0%
======== ========
At December 31, 1999, the Company has available net operating loss carryforwards
to reduce future federal taxable income of approximately $17,000,000 for tax
reporting purposes, which expire from 2009 through 2019. Pursuant to Section 382
of the Internal Revenue Code, future utilization of these past losses is subject
to certain limitations based on changes in the ownership of the Company's stock
that have occurred.
NOTE J - OTHER MATTERS
[1] For the year ended December 31, 1998, revenues from continuing operations
of approximately $159,000 (23%) and $86,000 (12%) were from two
customers. For the year ended December 31, 1999, approximately $48,000
(12%) of revenues from continuing operations were from the first customer
referred to above.
[2] For the years ended December 31, 1999 and 1998, export sales of the
Company's products amounted to approximately $52,000 and $28,000,
respectively.
[3] For the years ended December 31, 1999 and 1998, advertising expense was
$261,000 and $24,000, respectively.
NOTE K - COMMHOME ACQUISITION
In November 1998, the Company acquired all of the outstanding common stock of
CommHome Systems Corp. ("CommHome") for 46,667 shares of common stock and the
assumption of liabilities of approximately $185,000 effective upon consummation
of the initial public offering. The Company's President was also the President
of CommHome and owned 51% of its outstanding common stock. Of the assumed
liabilities, $105,000 was owed to two officers of the Company and was satisfied
by the issuance of 17,500 shares of common stock. The Company incurred a charge
of approximately $469,000 for purchased research and development upon the
acquisition. CommHome is a development stage company and has had no revenues.
The principal activity has been the design of residential networking solutions.
F-15
NETWORK-1 SECURITY SOLUTIONS, INC.
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1999 AND 1998
NOTE L - DISCONTINUED OPERATIONS
On February 9, 2000, the Company completed the sale of its Professional Services
Group (PSG) to Exodus Communications, Inc. ("Exodus") for $4.0 million in cash,
of which $1.3 million will be held in escrow subject to certain conditions.
Release to the Company of cash held in escrow is conditioned upon (i) as to
$1,000,000, certain PSG employees remaining employed by Exodus for at least one
year and (ii) as to $300,000, Exodus securing a minimum of $300,000 of purchase
orders or commitments for consulting services from certain customers within 90
days of the closing. PSG provided consulting services in network security and
network design. Effective upon the sale, the Company granted options to acquire
104,063 shares of common stock at $2.91 per share to certain employees of PSG.
In connection therewith, the Company incurred a compensation charge of $525,000
based upon the intrinsic value of the portion of the options vesting at such
date. The balance of the options vest one year after the closing provided that
the employees are still employed by Exodus. An additional charge of $863,000
will be incurred at such date assuming all the options vest. In addition, the
Company has agreed to pay an aggregate of 14% of the $1,000,000 of escrow
proceeds to the former employees provided that they remain with Exodus for at
least one year.
In February 2000 upon completion of the sale, the Company recognized gain of
approximately $1,900,000, net of the compensation charge. Upon satisfaction of
the conditions, additional net gain of up to approximately $300,000 will be
recognized.
The results of PSG have been reported separately as discontinued operations in
the consolidated statement of operations and net assets of PSG have been
segregated in the accompanying balance sheets. Prior year consolidated financial
statements have been restated to present PSG as a discontinued operation.
Components of amounts reflected in the statement of operations and balance
sheets are presented below.
YEAR ENDED
DECEMBER 31,
-------------------------
1999 1998
--------- ---------
Accounts receivable $ 317,000 $ 172,000
Fixed assets 52,000 21,000
Accrued expenses (66,000) (64,000)
Deferred revenue (45,000) (24,000)
--------- ---------
$ 258,000 $ 105,000
========= =========
YEAR ENDED
DECEMBER 31,
---------------------------
1999 1998
----------- -----------
Revenue $ 1,284,000 $ 1,132,000
Cost of revenue (1,353,000) (722,000)
Operating expenses (316,000) (206,000)
----------- -----------
Net income (loss) $ (385,000) $ 204,000
=========== ===========
NOTE M - SUBSEQUENT EXERCISE OF OPTIONS
The Company received $2,200,000 in aggregate proceeds upon the exercise of
options to purchase 452,192 shares of common stock from February 15, 2000 to
February 29, 2000.
F-16
SIGNATURES
In accordance with the requirements of Section 13 or 15(d) of the
Securities Exchange Act of 1934, the registrant caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized, in the City of
Waltham, Commonwealth of Massachusetts, on the 21st day of March 2000.
NETWORK-1 SECURITY SOLUTIONS, INC.
By: /s/ AVI A. FOGEL
---------------------------
Avi A. Fogel, President and
Chief Executive Officer
In accordance with the requirements of Section 13 or 15(d) of the
Securities Exchange Act of 1934, the registrant caused this report to be signed
on its behalf by the following persons in the capacities and on the dates
indicated:
NAME TITLE DATE
---- ----- ----
/s/ AVI A. FOGEL President, Chief Executive Officer and March 21, 2000
- ----------------------------- Director (principal executive officer)
Avi A. Fogel
/s/ MURRAY P. FISH Chief Financial Officer (principal March 21, 2000
- ----------------------------- financial officer and principal
Murray P. Fish accounting officer)
/s/ COREY M. HOROWITZ Chairman of the Board of Directors March 21, 2000
- -----------------------------
Corey M. Horowitz
/s/ WILLIAM H. HANCOCK Director March 21, 2000
- -----------------------------
William H. Hancock
EXHIBIT INDEX
Number Description of Exhibit
------ ----------------------
2.1 Merger Agreement, dated September 11, 1998, between the Company and
CommHome Systems Corporation (1)
3.1 Certificate of Incorporation of the Company, as amended (includes
form of Certificate of Designation of Series C Preferred Stock and
Series D Preferred Stock) (2)
3.2 By-laws of the Company, as amended (1)
4.1 Form of Common Stock Certificate (1)
4.2 Company's Stock Option Plan, as amended (1)
10.1 Employment Agreement, dated May 18, 1998, between the Company and
Avi A. Fogel, and amendment, dated May 30, 1998 (1)
10.2 Employment Agreement, dated May 18, 1998, between the Company and
Robert P. Olsen (1)
10.3 Employment Agreement, dated May 19, 1998, between the Company and
Murray P. Fish (1)
10.4 Employment Agreement, dated June 30, 1998, between the Company and
William Hancock (1)
10.5 Employment Agreement, dated April 4, 1994, between the Company and
Robert Russo, and amendments, dated February 16, 1996 and September
10, 1998 (1)
10.6 Waiver, dated June 30, 1998, of salary increases by William Hancock
and Robert Russo (1)
10.7 Lease and Service Agreement, dated June 5, 1998, between the
Company and Alliance Wellesley L.P. (1)
10.8 Lease, dated June 29, 1994, between the Company and Greenview
Limited Partnership (1)
10.9 Agreement, dated August 30, 1996, between the Company and CMH
Capital Management Corp. ("CMH"), with respect to advisory
services, and amendments, dated January 15, 1997, and January 30,
1997 (1)
10.10 Agreement, dated May 14, 1998, between the Company, CMH and
Applewood Associates, L.P. with respect to advisory services (1)
10.11 Master Software License Agreement, dated November 10, 1997, between
the Company and Electronic Data System Corporation, and amendment,
dated May 29, 1998 (1)
10.12 Software Distribution Agreement, dated June 5, 1997, between the
Company and Trusted Information Systems, Inc. (1)
Number Description of Exhibit
------ ----------------------
10.13 Software Distribution Agreement, dated September 26, 1997, between
the Company and Trusted Information Systems, Inc. (1)
10.14 Reseller Agreement, dated April 17, 1998, between the Company and
Aventail Software Corporation (1)
10.15 Agreement, dated January 31, 1997, among the Company, Robert Russo
and William Hancock, in 10.15 which Messrs. Russo and Hancock
surrendered shares of Common Stock (1)
10.16 Agreement, dated September 26, 1997, between the Company, Robert
Russo, William Hancock, and Kenneth Conquest, in which Messrs.
Russo, Hancock, and Conquest surrendered shares of Common Stock (1)
10.17 Agreement, dated May 14, 1998, among the Company, Robert Russo and
William Hancock, in which Messrs. Russo and Hancock surrendered
shares of Common Stock (1)
10.18 Agreement, dated May 14, 1998, between the Company and CMH, in
connection with the issuance of shares for advisory fees (1)
10.19 Exchange Agreement, dated July 8, 1998, between the Company and
certain of its holders of outstanding warrants and options (1)
10.20 Employment Agreement, dated July 31, 1998, between the Company and
Joseph A. Donohue (1)
10.21 Employment Agreement, dated August 24, 1998, between the Company
and Joseph D. Harris (1)
10.22 Agreement, dated October 1, 1998, between the Company and CMH, with
respect to advisory services (1)
10.23 Agreement, dated October 20, 1998, between the Company and certain
of its holders of promissory notes (1)
10.24 Employment Agreement, dated December 12, 1998, between the Company
and Lance Westbrook (2)
10.25 Agreement of Sublease, dated December 24, 1998, between PAREXEL
International Corporation and the Company and Consent to Sublease,
dated January 14, 1999, between Boston Properties Limited
Partnership, PAREXEL International Corporation and the Company. (2)
10.26 Agreement, dated January 13, 1999, between the Company and Robert
Russo relating to deferred salary. (2)
10.27 Agreement, dated March 10, 1999, between the Company and William
Hancock and Pledge and Escrow Agreement, dated March 10, 1999,
relating to $100,000 loan. (2)
Number Description of Exhibit
------ ----------------------
10.28 Employment Agreement dated May 15, 1999, between the Company and
Robert Russo (3)
10.29 Securities Purchase Agreement, dated February 22, 1999 between the
Company and the investors including form of Certificate of
Designation of Series D Preferred Stock (Exhibit A), form of
Warrant (Exhibit 4B) and form of Promissory Note (Exhibit D). (4)
10.30 Asset Purchase Agreement, dated February 9, 2000, between the
Company and Exodus Communications, Inc. including all exhibits and
schedules (5)
10.31 Termination Agreement, dated February 9, 2000 between the Company
and William Hancock *
10.32 Termination Agreement, dated February 7, 2000 between the Company
and Robert Russo *
21.1 List of Subsidiaries of the Company. (1)
23.1 Consent of Richard A. Eisner & Company, LLP *
27.1 Financial Data Schedule. *
- ----------------------
* Filed herewith.
1 Incorporated by reference to the same numbered exhibit to the Registrant's
Registration Statement on Form SB-2 (File Number 333-59617).
2 Incorporated by reference to the same numbered exhibit to Registrant's
Annual Report on Form 10-KSB.
3 Incorporated by reference to the same numbered exhibit to Registrant's
Quarterly Report on Form 10-QSB for the quarterly period ended June 30, 1999.
4 Incorporated by reference to Exhibit 10.28 to Registrant's Form 8-K filed on
January 4, 2000.
5 Incorporated by reference to Exhibit 10.29 to Registrant's Form 8-K filed on
February 15, 2000.