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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT of 1934
For the fiscal year ended December 31, 2001
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT of 1934
Commission File No. 1-11859
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PEGASYSTEMS INC.
(Exact name of Registrant as specified in its charter)
Massachusetts
(State or other jurisdiction of incorporation or organization)
(IRS Employer Identification No. 04-2787865)
101 Main Street
Cambridge, MA 02142-1590
(Address of principal executive offices) (zip code)
(617) 374-9600
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $.01 par value per share
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Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports) and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [_]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of the Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]
As of March 14, 2002, the aggregate market value of the Registrant's voting
stock held by non-affiliates of the Registrant was approximately $59 million.
There were 33,413,522 shares of the Registrant's common stock, $.01 par
value per share, outstanding on March 14, 2002.
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TABLE OF CONTENTS
PART 1
Item Page
---- ----
1 BUSINESS.......................... 3
2 PROPERTIES........................ 9
3 LEGAL PROCEEDINGS................. 9
4 SUBMISSION OF MATTERS TO A VOTE OF
SECURITY HOLDERS................ 11
EXECUTIVE OFFICERS OF THE
REGISTRANT...................... 11
PART II
5 MARKET FOR REGISTRANT'S COMMON
STOCK AND RELATED STOCKHOLDER
MATTERS........................... 13
6 SELECTED CONSOLIDATED FINANCIAL
DATA............................ 13
7 MANAGEMENT'S DISCUSSION AND
ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS......... 14
7A QUANTITATIVE AND QUALITATIVE
DISCLOSURE ABOUT MARKET RISK.... 23
8 FINANCIAL STATEMENTS AND
SUPPLEMENTARY DATA.............. 24
9 CHANGES IN AND DISAGREEMENTS WITH
ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.............. 24
PART III
DIRECTORS AND EXECUTIVE OFFICERS
10 OF THE REGISTRANT............... 25
11 EXECUTIVE COMPENSATION............ 26
12 SECURITY OWNERSHIP OF CERTAIN
BENEFICIAL OWNERS AND MANAGEMENT
AND RELATED STOCKHOLDER MATTERS... 29
13 CERTAIN RELATIONSHIPS AND RELATED
TRANSACTIONS.................... 30
PART IV
14 EXHIBITS, FINANCIAL STATEMENT 31
SCHEDULES, AND REPORTS ON FORM
8-K.............................
PART I
This Annual Report contains certain forward-looking statements. For this
purpose, any statements contained herein that are not statements of historical
fact may be deemed to be forward-looking statements. Without limiting the
generality of the foregoing, the words "believes", "anticipates", "plans",
"expects", and similar expressions are intended to identify forward-looking
statements. There are a number of important factors that could cause our actual
results to differ materially from those indicated by forward-looking statements
made in this Annual Report and presented elsewhere by management from time to
time. Some of the important risks and uncertainties that may cause our
operating results to differ materially or adversely are discussed in Item 7
Management's Discussion and Analysis of Financial Condition and Results of
Operations.
ITEM 1: BUSINESS
Overview
We provide software applications and software tools based on rules
technology. Our customers include some of the world's leading financial
services, healthcare and insurance companies. Our software allows organizations
to deliver high-quality, consistent customer service in multiple channels of
interaction, including traditional call centers and Internet self-service. Our
software can be used by thousands of concurrent users in transaction intensive
activity involving billions of dollars per day. Work processes initiated by our
systems are driven by a highly adaptive "rules base", which is a set of rules
defined by the user organization for its specific needs. The rules base leads
to a high level of consistency in customer interactions, but also drives
different processes depending on the customer profile or the nature of the
request. Pegasystems' rules technology enables business users to modify the
logic in applications to match their best practices and policies, and gives
users a high degree of control over work and flexibility in implementing
change. We provide implementation, consulting, training, and technical support
services to facilitate the use of our software. We maintain alliances with
third parties that offer complementary technology and systems integration
support to our customers. Our software runs on a broad range of computers.
Business Strategy
Our goal is to be a leader in the business rules management market. We build
rules based products that solve business problems and rules management tools
that accelerate and enhance the development efforts of others. Our business
strategy is to build on 18 years of experience and leadership in rules
technology, drive direct sales of industry specific applications, and maximize
the value of strategic partnerships.
. Rules technology leadership: We intend to continue investing in our
product offerings, incorporating advances in technology and driving the
evolution of our software applications and tools to maximize the benefits
of rules based technology for customers.
. Direct sales of industry specific applications: We intend to continue
direct sales of industry specific applications that streamline and enhance
work performance by applying process automation to key areas of customer
service and exceptions processing. Exceptions are transactions that are
identified as requiring additional information or follow up activity to be
completed. Our customers use our rules based products to automate
transaction and information processes, which might otherwise involve
complex and expensive manual processing.
. Strategic partnerships: We plan to continue developing and expanding
relationships with partners. Technology partners complement our software
with their technology. Systems integration partners deliver strategic
business planning, consulting, project management, and implementation
services to our customers. Our partners include Accenture, Sun
Microsystems, EDS, Systor and Misys, among others.
3
Pegasystems' Products
We offer two types of software products - Applications products, and Rules
management and process management tools.
Application products
Our application products are designed to reduce costs and increase
efficiency in completing important customer service and exception processing
transactions. The speed, quality and efficiency of completing such transactions
are significant factors in the effectiveness and results of our customers'
businesses. Our products enable our customers to use rules based process
automation to capture and complete transaction requests, which might otherwise
involve complex and expensive manual processing. Our applications software does
significantly more than collect customer data and track work--in addition, it
completes the work and guides customers or service representatives as they
proceed through interactions. With Pegasystems' products, organizations link
customer facing and back-office operations and integrate multiple
communications channels, such as the Web, contact center, phone, fax, and local
branch offices. Our products extend the reach of existing customer relationship
applications to achieve automation efficiencies by completing the often complex
and detailed follow up activities associated with customer interactions.
Our applications incorporate an advanced technical architecture that is
flexible, powerful and scalable. Our products consist of an industry specific
application template that provides a set of best practice rules and automation
flows for managing business transactions. These templates may be deployed "as
is" or further evolved using rules management and connectivity tools to produce
a highly automated and integrated business solution. Our application products
use business rules to capture an organization's unique business logic and apply
it consistently across multiple channels with personalization for individual
customers. All key aspects of Pegasystems' products are defined with business
rules, including presentation, processing logic, enforcement of quality
standards, reporting, and the management of customer service interactions.
Our applications support industry-standard hardware platforms, operating
systems and databases and provide a set of connectors to work with commonly
deployed business applications in target markets.
Rules management and process management tools
We have developed PegaRULES Process Commander, rules based software which
helps solve the enterprise workflow automation problem. The PegaRULES engine
provides an architecture that separates the strategic business logic from the
application and the underlying operating system. Just as business data, such as
customer, transaction history and accounting data, has evolved into a database
separate from the application, customers are demanding that rules regarding
business practices be located in a separate business "rules base" so that they
can maintain greater control over work and flexibility in implementing change.
PegaRULES Process Commander combines an enterprise rule base with application
tools used for developing, deploying, managing, and evolving enterprise-wide
business processes. PegaRULES Process Commander allows businesses to easily
manage, automate, integrate and rapidly evolve business processes across the
enterprise and its vendors, customers and partners. We made our first customer
delivery of PegaRULES Process Commander in the first quarter of 2002.
Markets and Representative Customers
We continue to focus on large, industry leading companies in the financial
services, healthcare, and insurance markets. In 2001, 2000, and 1999, one
financial services customer accounted for approximately 13.5%, 11.7%, and 12.5%
of our total revenue, respectively. Following is more detail on these markets
and a representative list of customers within those markets as of December 31,
2001.
Financial services
We provide software to financial services organizations that automates
transaction processing and customer sales and service across varied delivery
channels, such as Internet self-service, call centers, and branch networks.
Pegasystems' products improve the quality, accuracy, and efficiency of customer
interactions, and enhance the delivery of product and service offerings for the
following segments of the financial services industry:
4
. Corporate banking. Our software provides customer service capabilities
that automate the investigation and resolution of exceptions in corporate
actions, payments and securities settlement investigations, retail
brokerage, and wholesale clearing services.
. Retail financial services. We offer a rules driven process automation
solution for integrated customer service and support through call center,
branch platform, Web and e-mail channels.
. Check research and adjustment. Our software automates check research and
adjustment processing, streamlining check processing functions, reducing
manual work, and enabling the efficient access to check data stored on
microfilm and digital media.
Representative financial services customers of ours include First Data
Resources, BankOne Corporation, Bank of America, N.A., Barclays Bank PLC, JP
Morgan Chase & Co., Credit Lyonnais, Credit Suisse Group, Citibank, N.A.,
Fleet/Boston Financial Services, N.A., Franklin Templeton Corporate Services
Inc., The Hong Kong and Shanghai Banking Corporation Limited, National
Australia Bank Limited, Riggs Bank, N.A., Sears, Roebuck and Co., and Societe
Generale S.A.
Healthcare
Our healthcare applications provide health maintenance organizations and
health insurers with a set of products that supports their customer care
initiatives and helps them drive efficiency and lower costs.
. Member services. Our software automates the handling of many common
member inquiries, supporting contact management, account maintenance and
history, and sales inquiry. Our products also integrate with the
organization's legacy applications, building on their investments.
. Claims exceptions. Our software automates back office claims exceptions
processing, claims payment and exception research functions that
streamline operations by reducing the amount of manual work, error rates
and operational costs.
Representative healthcare customers of ours include Blue Cross Blue Shield
of Massachusetts, Blue Cross Blue Shield of Georgia, and HealthNOW New York.
Insurance
Our products for insurance companies support customer service in multiple
delivery channels and help resolve and complete policyholder requests. Our
products allow insurance companies to provide personalized customer service and
enhance their efforts to sell additional products to their customers.
Representative insurance customers of ours include American National
Insurance Company, The Guardian, The Hartford, and Northwestern Mutual Life.
Other markets
We continue to selectively pursue opportunities in markets such as
communications, retail, utilities and government, where our rules based
automation can drive significant efficiencies and cost reductions for those
industries.
Sales and Marketing
We market our software and services primarily through a direct sales force.
To support our sales force, we conduct marketing programs, including industry
trade shows, industry seminars, meetings with industry analysts, public
relations, partner co-marketing programs, direct marketing and telemarketing.
Our consulting staff, business partners, and other third parties also generate
sales leads. As of December 31, 2001, sales and marketing included 71 people
worldwide.
5
We have established joint marketing relationships with:
. Accenture, where Pegasystems is a preferred provider of rules based
applications products within their North American financial services
business;
. Misys, whose expertise in commercial banking with the Midas transaction
processing solution offers a high rate of straight through processing, and
combined with Pegasystems' Integrated Investigations provides high levels
of straight through processing and automation around exception conditions;
and
. Systor, whose strong presence in the commercial banking markets within
Switzerland and Germany helps us sell, implement and support German
speaking customers.
In addition, we distribute our products and technology through third
parties. For example, we have a strategic relationship with First Data
Resources Inc., or FDR, the largest credit card processor in the world. FDR
uses and re-licenses our software to the credit card market. First Data Evolve
is an integrated application for credit cards customer service and collections
designed to run on Pegasystems' rules technology. Also, PFPC, Inc., an
affiliate of PNC Bank Corp, incorporates Pegasystems' technology into a
comprehensive service solution for mutual fund institutions. In the future, we
may also market and sell our products through other value added resellers and
systems integrators. There can be no assurance, however, that we will be able
to attract and retain value added resellers, systems integrators, or other
parties that will be able to market and sell our products effectively.
In 2001, 2000, and 1999, sales to customers based outside of the United
States represented 23%, 26%, and 21%, respectively, of our total consolidated
revenue. During 2001, 2000, and 1999, we derived our operating revenue from the
following geographic areas:
2001 2000 1999
----------- ----------- -----------
(in $ thousands)
United States. $71,384 77% $59,699 74% $60,220 79%
United Kingdom 9,360 10% 6,826 8% 4,079 5%
Europe........ 8,747 10% 8,724 11% 6,802 9%
Other......... 2,796 3% 5,557 7% 5,528 7%
------- --- ------- --- ------- ---
$92,287 100% $80,806 100% $76,629 100%
See Note 1 of Notes to Consolidated Financial Statements.
Support and Professional Services
We offer support services through three groups: our Consulting Services
group shares market, business and technical knowledge with our customers
throughout the deployment of our applications; our Global Technology Services
group provides support and maintenance for our customers; and our Education
Services group offers training programs for our staff, customers and partners.
As of December 31, 2001, these professional services groups consisted of 164
people located in our 13 offices.
Consulting services
Our Consulting Services group helps companies implement and optimize our
software. These projects enable us to guide our customers through a disciplined
approach to deployment of our applications, and allow our workflow architects
and business process automation consultants to gain industry specific knowledge
that can be used in future projects and product development. Providing industry
specific business guidance throughout the deployment of our technology
generally improves our customers' satisfaction. Many of our customers choose to
engage our consulting services group to expand their use of our software to
additional business or product lines or add new functionality to their existing
solutions. In addition, through our alliances, systems integrators and
consulting firms also help our customers deploy our products.
6
Our implementation procedures, which we call Advanced Implementation
Methodology, or AIM, were developed through field experience and facilitate
implementation of our software through a disciplined approach to project
management that establishes standards for project activities and ensures
governance and accountability in adhering to those standards. By adopting a
phased approach to deployment, our customers can engage in smaller, more easily
managed projects that are more likely to result in a successful solution.
Global technology services
Our Global Technology Support, or GTS, group is primarily responsible for
support and maintenance of our customers. Our support offerings are available
at any time of day or night and GTS tailors services appropriately to meet the
unique support and project requirements of each customer. Support services
provided by GTS include automated problem tracking, prioritization and
escalation procedures, periodic preventative maintenance, documentation
updates, new software releases, and regularly scheduled meetings with our staff.
Our customers are granted access to ActionPlus, our Web-based self-service
extranet. The password-protected site offers a portal for information important
to the successful implementation and use of our products. ActionPlus is
available at any time of day or night and users may access the site to interact
with us at their convenience and to view product information, sales and
marketing support materials, Pegasystems news and event information. The site
also hosts discussion groups that enable customers to interact with each other
to share product knowledge and other special topics of interest.
Education services
We offer training programs for our staff, customers and partners. Training
programs are designed to meet the specific requirements of attendees' roles,
and are typically offered for workflow consultants, systems administrators,
developers, project managers, technical and business design managers. Training
programs are available on-site, through web-based training and computer-based
training programs, or in one of our regional training facilities in Cambridge,
Massachusetts, San Francisco, California and Reading, England.
Research and Development
Since our inception, we have made substantial investments in product
development. We believe that our future performance depends on our ability to
maintain and enhance our current products and develop new products. Our product
development priorities for application products include capabilities that
enhance the automation of customer relationship transactions to reduce costs
and increase business effectiveness for our customers. We intend to continue
design and development of industry specific applications that offer rapid
deployment and return on investment by pre-packaging key capabilities for
initial use and providing optional extensions for further evolution and power.
Our product development focus is to extend the power and breadth of
industry-specific application templates; maintain and extend support for
popular industry standard hardware platforms, operating systems, databases and
connectivity options to facilitate easy and rapid deployment in diverse
information technology infrastructures; develop industry standard interfaces
that allow other Customer Relationship Management, or CRM, and Customer Service
applications to inter-operate with our products which will allow our customers
to increase their return on their CRM investment; and enhance product quality,
platform stability, ease-of-use, and ease of installation. For PegaRULES,
product development is focused on building a robust system for the development,
deployment and execution of rules based process management applications,
primarily by third party developers.
We believe that maintaining future performance and visionary technology
leadership depends on our ability to anticipate changes, maintain and enhance
our current products, develop new products, and keep pace with the increasingly
sophisticated requirements of our current and prospective customers. We must
develop products that conform to our customers' information technology
standards, scale to meet the needs of large enterprises, operate globally, and
cost less than an internal development effort. Our development organization is
responsible for product architecture, core technology development, product
testing and quality assurance.
7
As of December 31, 2001, our development group consisted of 131 people. In
2001, 2000, and 1999, research and development expenses were approximately
$20.8 million, $15.1 million, and $19.8 million, respectively. We expect that
we will need to continue to commit significant resources to our product
research and development in the future.
If we are unable, for technical or other reasons, to develop and introduce
new products and services, or enhancements of existing products and services,
in a timely manner in response to changing market conditions or customer
requirements, or if new products and services do not achieve market acceptance,
our business, financial condition, and operating results will be materially
adversely affected.
Industry and Competitive Background
Industry
In addition to the expectations companies typically face, including
heightened pressure to lower operational costs, increase revenues, and deliver
value to their customers, companies now are frequently reacting to regulatory
changes and new competitive pressures. To be successful in this complex
environment, organizations must coordinate applications that support customers,
adopt a customer-centric approach to information and minimize manual work
efforts. Consequently, we believe an increasing number of companies are
implementing rules based solutions that help to deliver stronger financial
performance, a more productive workforce and superior customer satisfaction and
retention.
Competition
The application software market is intensely competitive and subject to
rapid change, as current competitors expand their product offerings and new
companies enter the market. Competitors vary in size and in the scope and
breadth of the products and services offered. We encounter competition from
. Potential and current customers' information technology departments, which
may seek to develop proprietary systems;
. Software application vendors, such as Siebel Systems, Onyx, and Chordiant,
whose products span multiple industries;
. Enterprise Application Vendors, such as Oracle, PeopleSoft Inc., IBM and
SAP;
. Companies that target specific markets such as financial services,
healthcare, and insurance such as Carreker, Sterling, Microbank and
Smartstream;
. Rules and business process automation vendors such as Blaze Software,
FileNet Inc., and ILog, who look to improve workflow capabilities and
business processes; and
. Professional services organizations that develop custom software in
conjunction with rendering consulting services.
We believe that the principal competitive factors within our market include:
. Proven success in delivering cost-saving and efficiency improvements;
. Product adaptability, scalability, functionality, and performance;
. Timely development and introduction of new products and product
enhancements;
. Establishment of a significant base of reference customers;
. Ability to integrate with other products and technologies;
. Customer service and support;
. Product price;
. Vendor reputation; and
. Relationships with systems integrators.
8
Although we believe our products compare favorably against the competition,
the market is constantly evolving and new competitors are emerging. There can
be no assurance that we can maintain our competitive position against current
and potential competitors. Many of our competitors can devote greater
managerial or financial resources to develop, promote, and distribute customer
relationship management software and provide related implementation,
consulting, training, and support services. Additionally, there can be no
assurance that current or future competitors will not develop products or
services which may be superior in one or more respects or which may gain
greater market acceptance. Current and future competitors have established or
may establish cooperative arrangements or strategic alliances among themselves
or with third parties, enhancing their abilities to compete. There can be no
assurance that we will be able to compete successfully against current or
future competitors or that the competitive pressures will not materially and
adversely affect our business, operating results, and financial condition.
We rely on system consulting and system integration firms for recommendation
and implementation of our products during the evaluation stage of the purchase
process. These third parties often have similar, and, in some cases, more
established, relationships with our competitors. There can be no assurance that
these third parties, many of which have significantly greater resources, will
not market competitive software products in the future or will not otherwise
reduce or discontinue their relationships with or support of us and our
products.
Employees
As of December 31, 2001, we had 476 employees, of whom approximately 373
were based in the United States, 10 were based in Canada, 78 were based in
Europe, 13 were based in Australia, and 2 were based in Singapore. Of the
total, approximately 71 were in sales and marketing, 164 performed consulting
and customer support, 131 performed research and development, and 110 were in
administration and finance.
Our future performance depends in significant part upon the continued
service of our key technical, sales and marketing, and senior management
personnel and our continuing ability to attract and retain highly qualified
technical, sales and marketing, and managerial personnel. Competition for such
personnel is intense and there can be no assurance that we will be successful
in attracting or retaining such personnel in the future. None of our employees
is represented by a labor union or is subject to a collective bargaining
agreement.
Backlog of License, Maintenance and Consulting Revenues
As of December 31, 2001, we had software license and maintenance agreements
and fixed fee professional services agreements with our customers expected to
result in approximately $32.5 million of revenue in 2002. Under such
agreements, we must fulfill certain conditions prior to recognizing revenue,
and there can be no assurance when, if ever, we will be able to satisfy all
such conditions in each instance. Our management does not believe that backlog,
as defined above, is a meaningful indicator of future financial performance.
ITEM 2: PROPERTIES
Our principal administrative, sales, marketing, support, and research and
development operations are located in an 85,228 square foot leased facility in
Cambridge, Massachusetts. The lease for this facility expires in 2003, subject
to our option to extend the term for up to eight additional years. We also
lease space for our other offices in the United States, Canada, Australia,
France, and the United Kingdom. These leases expire at various dates through
2006. We believe that additional or alternative space will be available as
needed in the future on commercially reasonable terms.
ITEM 3: LEGAL PROCEEDINGS
Pegasystems Inc. v. Carreker Corporation, C.A. No. 19043 (Del Ch.) On
August 7, 2001, the Company filed a Verified Complaint (the "Complaint")
against Carreker Corporation ("Carreker") in Delaware Chancery Court. The
Complaint alleged that Carreker breached the Product Development, Distribution
and Sublicensing Agreement (the "Agreement") that Pegasystems and Carreker
executed in May 1999. Through that Agreement,
9
Pegasystems and Carreker had committed to devote their efforts to jointly
develop backroom banking products employing Pegasystems' workflow products as
core components, and to refrain from other activities or alliances that would
create products within the exception management market. The Complaint alleged
that Carreker breached the Agreement when it acquired Check Solutions Company
and continued the development, marketing and sales of Check Solutions products;
that Carreker breached its covenant of good faith and fair dealing; and that
Carreker had engaged in unfair competition. The Complaint sought to enjoin
Carreker (including Check Solutions) from developing, marketing, licensing,
advertising, leasing or selling any products that compete with those jointly
developed by Pegasystems and Carreker under the Agreement, or any exception
management products or services other than those products jointly developed by
Carreker and Pegasystems under the Product Development, Distribution and
Sublicensing Agreement between the parties. Pegasystems moved for expedited
discovery (which the Court allowed), and for a preliminary injunction. On
August 20, 2001, the Company filed a verified Amended Complaint. On October 1,
2001, the Court issued a Memorandum Opinion dated September 28, 2001, granting
Pegasystems' motion and concluding that a preliminary injunction should issue.
The Court found that the undisputed facts preliminarily established that
Carreker's acquisition of Check Solutions violated several provisions of the
Agreement, including: the requirement that Carreker refrain from any
development activities or alliances which would create competing products; the
requirements that Carreker not assume any obligation or restriction that does
or would interfere or conflict with its performance under the Agreement; and
the requirement that Carreker exercise its best efforts to market and sell the
jointly-developed products in its exclusive territory. The Court further found
that none of the defenses set forth by Carreker had merit. On October 15, 2001,
the Court denied a motion by Carreker seeking reconsideration, and on October
17, 2001, the Court entered the Preliminary Injunction Order. On August 27,
2001, Carreker filed a Demand for Arbitration with the American Arbitration
Association (the "AAA"), and provided Pegasystems with notice purporting to
terminate the Agreement. Pegasystems opposed the filing of the Demand for
Arbitration, on the ground that Carreker had not exhausted the dispute
resolution procedures in the Agreement, and also argued that the purported
notice of termination was invalid. In the Court's September 28 Opinion, it
found that because the Agreement did not provide Carreker with a contractual
right to terminate, Carreker's notice of termination - sent only after the
litigation was commenced - had no legal force. On October 5, 2001, the AAA
agreed with the Company that Carreker's arbitration demand was premature, and
directed the parties to mediate their dispute. On November 5, 2001, the Company
announced that it had reached a settlement agreement with Carreker, resolving
both the Delaware and AAA proceedings, which have been dismissed and closed,
respectively.
In the Matter of the Arbitration Between Pegasystems Inc, et al., and Ernst
& Young, LLP, et al. On June 9, 2000, the Company and two of its officers
filed a complaint against Ernst & Young, LLP and Alan B. Levine (a former
partner of Ernst & Young) in Massachusetts state court. The Complaint alleges
that the defendants committed professional malpractice, breached contractual
and fiduciary duties owed to the Company, and issued false and misleading
public statements, in connection with advice that Ernst & Young rendered to the
Company to record $5 million in revenue in its financial statements for the
second fiscal quarter ended June 30, 1997 pursuant to a series of contracts
between the Company and First Data Resources, Inc. The complaint sought
compensatory damages, including contribution for losses and other costs
incurred in connection with certain class action securities litigation, which
has been settled. On April 5, 2001, the Court dismissed the Complaint, finding
that it was subject to the dispute resolution procedures set forth in an
engagement letter between the Company and Ernst & Young. The parties have
agreed to arbitrate this dispute. An arbitration hearing has tentatively been
scheduled for June 2002.
SEC Investigation. In May 1999, the Boston office of the SEC issued a
Formal Order of Private Investigation of the Company and certain individuals
currently or formerly associated with the Company concerning past accounting
matters, financial reports and other public disclosures and trading activity in
the Company's securities during 1997 and 1998. The Company continues to
cooperate fully with the investigation.
Qwest Arbitration. On January 17, 2002, the Company filed a demand for
arbitration with the American Arbitration Association in Denver, Colorado
against Qwest Corporation, successor in interest to US West
10
Business Resources, Inc. The Company is seeking monetary damages in the
arbitration relating to Qwest's termination of a software license and service
agreement between the parties. On February 8, 2002, Qwest filed a counterclaim
against the Company seeking monetary damages for alleged breach of that
agreement by the Company.
ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
During the fourth quarter of fiscal 2001, there were no matters submitted to
a vote of security holders.
EXECUTIVE OFFICERS OF THE REGISTRANT
The names of our executive officers and certain information about them are
set forth below as of December 31, 2001:
Name Age Position(s) and Office(s) Held
---- --- ------------------------------
Alan Trefler............ 45 Chief Executive Officer and Director
Richard H. Jones........ 50 President and Chief Operating Officer
Joseph J. Friscia....... 47 Executive Vice President of Sales and Service
Christopher J. Sullivan. 43 Senior Vice President, Chief Financial Officer and Treasurer
Kenneth Olson........... 52 Senior Vice President of Advanced Technology
Michael Pyle............ 47 Senior Vice President of Product Development
Our executive officers are elected by the Board of Directors on an annual
basis and serve until the next annual meeting of the Board of Directors and
until their successors have been duly elected and qualified. There are no
family relationships among any of our executive officers or directors.
Alan Trefler, a founder of Pegasystems, serves as Chief Executive Officer
and has been a Director since we organized in 1983. Prior thereto, he managed
an electronic funds transfer product for TMI Systems Corporation, a software
and services company. Mr. Trefler holds a B.A. degree in economics and computer
science from Dartmouth College.
Richard H. Jones joined Pegasystems in 1999 and was elected a Director of
Pegasystems in 2000. Prior to joining us, he served as Chief Asset Management
Executive and a member of the Operating Committee at Barnett Banks, Inc., which
at the time was among the nation's 25 largest banks, from 1995 to 1997. He
served as CEO of Fleet Investment Services, a brokerage and wealth management
organization, from 1991 to 1995. His prior experience also includes serving as
executive vice president with Fidelity Investments, an international provider
of financial services and investment resources and as a principal with the
consulting firm of Booz, Allen & Hamilton. Mr. Jones holds an undergraduate
degree from Duke University, with majors in both economics and management
science. He also holds an M.B.A. degree from the Wharton School of the
University of Pennsylvania.
Joseph J. Friscia joined Pegasystems in 1984 to establish our New York
office. Mr. Friscia has served as Executive Vice President of Sales and Service
since 1987, and has recently undertaken responsibility for delivery of
consulting and installation services. Prior to joining us, he worked as a money
transfer operations manager with Bankers Trust Company and J. Henry Schroder
Bank and Trust Company. Mr. Friscia holds a B.A. degree from Long Island
University and an M.B.A. degree from Adelphi University.
Christopher J. Sullivan joined Pegasystems in July 2001. In August 2001, he
was elected Senior Vice President, Chief Financial Officer and Treasurer. From
August 2000 to July 2001, he served as CFO at Event Zero, an IT consulting
company. From December 1998 to August 2000, he was the CFO and Executive Vice
11
President of AMS Holding Group, a software and information services provider to
the insurance industry. From 1997 to 1998, he served as Vice President of
Finance at Compaq Computer Corporation, a computer company. From 1996 to 1997,
he held an executive financial management position at Fisher Scientific
International, Inc., a distributor of clinical and scientific laboratory
equipment. He holds a B.S.B.A. degree and an M.B.A. degree from Babson College.
Kenneth Olson a founder of Pegasystems, joined Pegasystems in 1983 and
served as Vice President of Technical Development until 2000. Since 2000, he
has served as Senior Vice President of Advanced Technology, and holds primary
responsibility for new product development. Prior to Pegasystems, Mr. Olson
held positions at TMI Systems Corporation, where he was involved with the
development and installation of software solutions in European and Middle
Eastern markets. He holds a B.S. degree in the fields of Humanities and Science
from the Massachusetts Institute of Technology.
Michael Pyle joined Pegasystems in 1985 and has served as Senior Vice
president of Product Development since August 2000. Including his positions
with Pegasystems, Mr. Pyle's professional background encompasses almost thirty
years of software development and managerial experience throughout Europe and
the United States. Mr. Pyle completed his B.C.S. specializing in Computer
Science and Systems Programming at the C.S. College in London.
12
PART II
ITEM 5: MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER
MATTERS
The following table sets forth the range of high and low sales prices of our
common stock on the National Association of Security Dealers Automatic
Quotation ("Nasdaq") National Market System for 2001 and 2000. Our common stock
is traded under the Nasdaq Symbol "PEGA." As of February 1, 2002, we had
approximately 60 stockholders of record and approximately 4,500 beneficial
owners of our common stock. On February 1, 2002, the closing sale price of the
common stock was $5.55. We have never declared or paid any cash dividends on
our common stock. We intend to retain our earnings to finance future growth,
and therefore, do not anticipate paying any dividends in the foreseeable future.
High Low
----- -----
2001
First Quarter. $6.38 $2.75
Second Quarter $5.00 $2.07
Third Quarter. $4.43 $2.30
Fourth Quarter $4.60 $2.21
High Low
------ -----
2000
First Quarter. $25.81 $9.50
Second Quarter $11.63 $5.00
Third Quarter. $ 7.91 $3.92
Fourth Quarter $ 5.75 $2.03
ITEM 6: SELECTED CONSOLIDATED FINANCIAL DATA
The selected consolidated financial data presented below have been derived
from our consolidated financial statements. This data may not be indicative of
our future condition or results of operations and should be read in conjunction
with "Management's Discussion and Analysis of Financial Condition and Results
of Operations" and the consolidated financial statements and accompanying notes.
Years Ended December 31,
-----------------------------------------------
2001 2000 1999 1998 1997
-------- -------- -------- -------- --------
(in thousands, except per share data)
Consolidated Statements of Operations Data:
Total revenue........................................ $ 92,287 $ 80,806 $ 76,629 $ 61,769 $ 44,361
Income (loss) from operations........................ 6,534 (25,952) (5,920) (22,797) (3,388)
Net income (loss).................................... 12,534 (20,856) (2,410) (11,618) 1,085
Earnings (loss) per share:...........................
Basic............................................... $ 0.38 $ (0.71) $ (0.08) $ (0.41) $ 0.04
Diluted............................................. $ 0.37 $ (0.71) $ (0.08) $ (0.41) $ 0.04
Weighted average number of common shares outstanding:
Basic............................................... 32,677 29,206 28,947 28,604 28,284
Diluted............................................. 33,434 29,206 28,947 28,604 30,268
Years Ended December 31,
-----------------------------------------------
2001 2000 1999 1998 1997
-------- -------- -------- -------- --------
(in thousands)
Consolidated Balance Sheet Data:
Cash and cash equivalents............................ $ 33,017 $ 17,339 $ 30,004 $ 24,806 $ 52,005
Working capital...................................... 57,157 43,758 49,790 33,883 62,708
Long-term license installments, net.................. 43,155 37,401 36,744 49,000 36,403
Total assets......................................... 125,072 110,493 124,991 139,260 127,520
Long-term debt....................................... -- -- -- -- --
Stockholders' equity................................. 104,958 92,063 101,045 101,919 112,721
13
ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Significant accounting policies of which you should be aware in order to
understand the discussion which follows include our revenue recognition
policies, practices with respect to revenues and allowances, and litigation. A
discussion of our revenue recognition practices follows. The reader is referred
to the Notes to Consolidated Financial Statements for information on other
important accounting practices.
Historically, the timing of our revenue has been unpredictable. The timing
of license revenue recognition is generally related to the completion of
implementation services and acceptance of the licensed software by the
customer, the timing of which has proven difficult to predict accurately. Our
focus on closing large license transactions may cause volatility of our
quarterly operating results.
Our revenue is derived from two primary sources: software license fees and
service fees. Software license fees are generally payable on a monthly basis
under term license agreements, which generally have a five-year term and may be
renewed for additional years at the customer's option. The present value of
future license payments is generally recognized as revenue upon customer
acceptance and commitment to the contractual payment stream. A portion of the
fee from each arrangement is initially deferred and recognized as installment
receivable interest income over the license term. In addition, many of our
license agreements provide for license fee increases based on inflation. The
net present value of such increases is recognized as revenue when the values
are determinable. For purposes of the present value calculations, the discount
rates used are estimates of customers' borrowing rates, typically below prime
rate, and have varied between 3.5% and 8.00% for the three years ended December
31, 2001. As a result, revenue that we recognize relative to these types of
license arrangements can be impacted by changes in market interest rates. For
software license agreement renewals, license revenue is recognized upon
customer commitment to the new license terms.
Our service revenue is comprised of fees for software implementation,
consulting, maintenance, and training services. Our software implementation and
consulting agreements typically require us to provide a specified level of
implementation services for a specified fee, with additional consulting
services available at an hourly rate. Revenues for time and material projects
are recognized as fees are billed. Revenues for fixed price projects are
recognized once the fair value of services and any other elements to be
delivered under the arrangement can be determined. Costs associated with fixed
price contracts are expensed as incurred. Historically, we have had difficulty
developing accurate estimates of time and resources needed to complete fixed
price projects. As a result, determination of the fair value of the elements of
the contract has generally occurred later in the implementation process,
typically when implementation is complete and remaining services are no longer
significant to the project. Prior to the point at which the fair value of the
elements of a contract can be determined, revenue recognition for fixed price
projects is limited to amounts equal to costs incurred, resulting in no gross
profit. Once the fair values of the elements of a contract are apparent, profit
associated with the fixed price services elements will begin to be recognized.
Software license customers are offered the option to enter into a maintenance
contract, which requires the customer to pay a monthly maintenance fee over the
term of the maintenance agreement, typically renewable annually. Prepaid
maintenance fees are deferred and are recognized evenly over the term of the
maintenance agreement. We generally recognize training fees as the services are
provided. We reduce revenue for estimates of the fair value of potential
concessions during the period in which revenue is initially recorded, which are
in turn recognized as revenue when the related elements are completed and
provided to the customer.
International revenues were 23%, 26%, and 21% of total consolidated revenues
in 2001, 2000, and 1999, respectively. Our international revenues may fluctuate
in the future because such revenues generally result from a small number of
product acceptances during a given period. Historically, most of our contracts
have been denominated in U.S dollars. We expect, however, that in the future
more of our contracts may be denominated in foreign currencies thereby exposing
us to increased currency exchange risk.
14
Over the last several years, we have been involved in several lawsuits. In
2000, we recorded a charge of $14.8 million, representing the costs of settling
two shareholder class action suits. We generally record the estimated cost of
settling litigation when it is both probable that a settlement will be required
and the amount we expect to pay can be reasonably estimated. Legal defense
costs associated with these suits were expensed as incurred.
The following shows certain items reflected in our Statements of Operations
as a percentage of total revenue:
Year Ended December 31,
---------------------
2001 2000 1999
----- ----- -----
Software license revenue...................... 47.7% 41.8% 36.7%
Services revenue.............................. 52.3 58.2 63.3
----- ----- -----
Total revenue............................. 100.0 100.0 100.0
Cost of software license...................... 3.3 2.9 3.9
Cost of services.............................. 37.5 48.3 41.7
----- ----- -----
Total cost of revenue..................... 40.8 51.2 45.6
----- ----- -----
Gross profit..................................... 59.2 48.8 54.4
Research and development...................... 22.6 18.7 25.9
Selling and marketing......................... 19.0 29.9 24.9
General and administrative.................... 10.6 12.8 11.3
Litigation settlement and restructuring costs. -- 19.6 --
----- ----- -----
Total operating expenses......................... 52.2 81.0 62.1
----- ----- -----
Income (loss) from operations.................... 7.0 (32.2) (7.7)
Installment receivable interest income........... 6.7 5.0 4.9
Other interest income, net....................... 0.9 2.1 1.2
Other (expense) income, net...................... -- (0.4) 0.4
----- ----- -----
Income (loss) before provision for income taxes.. 14.6 (25.5) (1.2)
Provision for income taxes....................... 1.0 0.4 1.9
----- ----- -----
Net income (loss)................................ 13.6% (25.9)% (3.1)%
===== ===== =====
Year Ended December 31, 2001 Compared to Year Ended December 31, 2000
Revenue
Total revenue for 2001 increased 14% to $92.3 million from $80.8 million for
2000. The increase was primarily due to increased software license revenue.
Software license revenue for 2001 increased 30% to $44.1 million from $33.8
million for 2000. The increase was due primarily to software license
acceptances by existing customers and $2.3 million due to improved accounting
estimates relating to the revenue attributable to the inflation adjustment
provisions contained in our long-term software license agreements. A
significant portion of our software license revenue is from existing customers.
Software license revenue in the fourth quarter of 2001 increased to $13.9
million from $10.6 million in the third quarter, driven primarily by customer
acceptance of a significant installation and $1.1 million of revenue associated
with licenses sold to Carreker Corporation in connection with the resolution of
a dispute. New contract signings with customers slowed towards the latter part
of 2001, which is likely to negatively impact license revenue in the first half
of 2002.
Services revenue for 2001 increased 3% to $48.2 million from $47.0 million
for 2000. The increase was due primarily to higher maintenance revenue from a
larger installed base. Service revenue for the fourth quarter of 2001 decreased
to $9.6 million from $12.5 million in the third quarter, reflecting the impact
of current generally weak economic conditions and customers' delayed spending
and fewer new license contracts.
15
Deferred revenue at December 31, 2001 consisted primarily of billed fees
from arrangements for which acceptance of the software license or service
milestone had not occurred, the unearned portion of service revenue and advance
payment of maintenance fees. Deferred revenue balances increased to $6.2
million as of December 31, 2001 from $5.1 million as of December 31, 2000, due
to billings for software licenses in advance of customer acceptance and advance
payment of maintenance fees.
Cost of revenue
Cost of software license revenue for 2001 increased 28% to $3.0 million from
$2.4 million for 2000. Cost of software license includes the amortization
associated with a stock purchase warrant issued by us in September 1997, and
our acquisition of software for resale. The increase was due to software
acquired by us during 2000, which, after initially being amortized over three
years, was expensed in full in the second quarter of 2001 because the
productive use of this software was no longer anticipated. Cost of software
license as a percentage of license revenue for 2001 and 2000 was 7%.
Cost of services consists primarily of the costs of providing
implementation, consulting, maintenance, and training services.
Cost of services for 2001 decreased 11% to $34.6 million from $39.0 million
for 2000. Cost of services as a percentage of service revenue decreased to 72%
for 2001 from 83% for 2000. These decreases were primarily due to reduced staff
including compensation, travel and facilities expense, partially offset by
higher third party contracted consultant spending. The decrease as a percent of
service revenue was also partially due to higher service revenue.
Operating expenses
Research and development expenses for 2001 increased 38% to $20.8 million
from $15.1 million for 2000. As a percentage of total revenue, research and
development expenses increased to 23% for 2001 from 19% for 2000. These
increases were a result of growth in staffing costs including compensation and
benefits, the redeployment of internal resources and increased use of third
party consultants.
Selling and marketing expenses for 2001 decreased 27% to $17.5 million from
$24.1 million for 2000. As a percentage of total revenue, selling and marketing
expenses decreased to 19% for 2001 from 30% for 2000. The decreases were due to
reduced spending on infrastructure, marketing programs, and travel. The
decrease as a percent of revenue was also due to higher revenue.
General and administrative expenses for 2001 decreased 5% to $9.8 million
from $10.3 million for 2000. As a percentage of total revenue, general and
administrative expenses decreased to 11% for 2001 from 13% for 2000. These
decreases were due primarily to lower discretionary spending on infrastructure,
benefits and third party consulting, partially offset by higher compensation
costs, including incentive compensation.
Installment receivable interest income
Installment receivable interest income for 2001, which consists of the
portion of all license fees under long-term software license agreements that is
attributable to the time value of money, increased 53% to $6.2 million from
$4.0 million for 2000. The increase was due to improved accounting estimates
regarding the amount of interest income earned on license transactions recorded
in 2001, higher average discount rates, and the increased value of our
portfolio of customer licenses. A portion of the fee from each license lease
arrangement is initially deferred and recognized as installment receivable
interest income over the remaining term of the license lease. For purposes of
the present value calculations, the discount rates used are estimates of
customers' borrowing rates, typically below prime rate, and have varied between
3.5% and 8.00% for the three years ended December 31, 2001.
Other interest income, net
Interest income, net decreased 50% to $0.8 million for 2001 from $1.7
million for 2000. The decrease was due to lower yields on investments due to
declining interest rates.
16
Other income (expense), net
Other income (expense), net, which consists primarily of currency exchange
gains or losses and reseller development funds received from third-party
vendors of computer hardware products, was a $15 thousand gain for 2001 and a
$286 thousand expense for 2000. The increase was due to a lower currency
exchange loss, and increased reseller development funds.
Income (loss) before provision for income taxes
Income (loss) before provision for income taxes improved to $13.5 million in
2001 from a loss of $4.7 million in 2000, excluding litigation settlement and
restructuring costs of $15.8 million in 2000. Of this $18.2 million
improvement, $2.3 million is due to improved accounting estimates relating to
the revenue attributable to the inflation adjustment provisions contained in
our long-term software license agreements. Of the remaining $15.9 million
improvement, $7.3 million is from increased software license gross margin from
increased revenues, $5.7 million in improved service gross margin mostly due to
cost reductions, $1.4 million from reduced operating expenses and $1.5 million
of other improvements in interest income and other income and expense.
Provision for income taxes
The provision for income tax was $1.0 million in 2001, an increase from $0.3
million in 2000. The 2000 tax provision consisted of foreign subsidiary income
tax. The increase is related to minimum tax due on current year U.S. profits
and foreign subsidiary income. Minimal provisions for income taxes have been
made due to the availability of loss carry forwards to offset current period
income. See Note 8 of Notes to Consolidated Financial Statements.
Year Ended December 31, 2000 Compared to Year Ended December 31, 1999
Revenue
Total revenue for 2000 increased 5.5% to $80.8 million from $76.6 million
for 1999. An increase in license revenue was offset partially by a decrease in
services revenue.
Software license revenue for 2000 increased 20.2% to $33.8 million from
$28.1 million for 1999. The increase was due primarily to a rise in software
license acceptances by existing and new customers. License revenue recognized
in 2000 that had been deferred from prior year(s) decreased to $1.3 million in
2000 from $9.9 million in 1999.
Services revenue for 2000 decreased 3.1% to $47.0 million from $48.5 million
for 1999. The decrease was due primarily to a lower allocation of software
license revenue to services revenue under SOP 97-2 and 98-9. The decrease was
partially offset by a $1.4 million increase in maintenance revenue due to a
larger installed product base. Service revenue recognized in 2000 that had been
deferred from prior year(s) decreased to $3.4 million in 2000 from $4.7 million
in 1999.
Cost of revenue
Cost of software license revenue for 2000 decreased 21.0% to $2.4 million
from $3.0 million for 1999. In 1999, cost of software license included $0.5
million of purchased software that was resold and expensed. Cost of software
license relates to the amortization associated with a stock purchase warrant
issued by us in June 1997, and our acquisition of First Data Resources
Corporation's ESP software product. These costs are being amortized through
December 31, 2002. Amounts amortized prior to the sale of products
incorporating the related purchased software were treated as research and
development expenses. Product sales incorporating such software began in the
fourth quarter of 1998. Cost of software license as a percentage of license
revenue for 2000 decreased to 7.0% from 10.7% in 1999. The lower percentage was
due to the increase in license revenue, and reduction in cost of software
license.
17
Cost of services consists primarily of the costs of providing consulting,
maintenance, and training services. Cost of services for 2000 increased 22.2%
to $39.0 million from $31.9 million for 1999. Cost of services as a percentage
of services revenue increased to 83.0% for 2000 from 65.8% for 1999. These
increases were primarily due to a lower recovery rate on hours worked and costs
associated with increased staffing including compensation, benefits, travel,
and the allocation of facilities expense.
Operating expenses
Research and development expenses for 2000 decreased 23.9% to $15.1 million
from $19.8 million for 1999. As a percentage of total revenue, research and
development expenses decreased to 18.7% for 2000 from 25.9% for 1999. These
decreases were due to decreased staffing costs including compensation,
benefits, and travel.
Selling and marketing expenses for 2000 increased 26.3% to $24.1 million
from $19.1 million for 1999. As a percentage of total revenue, selling and
marketing expenses increased to 29.9% for 2000 from 24.9% for 1999. These
increases were due to additional costs associated with marketing programs such
as trade shows and additional employee related costs including compensation,
benefits, and travel.
General and administrative expenses for 2000 increased 19.0% to $10.3
million from $8.7 million for 1999. As a percentage of total revenue, general
and administrative expenses increased to 12.8% for 2000 from 11.3% for 1999.
These increased expenses were due to costs associated with increased staffing
including compensation, benefits, and travel. This increase in costs was
partially offset in the fourth quarter by a $0.7 million favorable recovery of
sales taxes accrued in prior years.
Litigation settlement and restructuring costs
We were involved in two lawsuits related to restatements of our financial
statements (the Chalverus Case and the Gelfer Case). We settled both cases and
recorded a charge of $14.8 million (net of insurance reimbursements of $4.3
million) in 2000, reflecting the cost of the settlements and legal costs. See
Note 10 of Notes to Consolidated Financial Statements.
During the three months ended December 31, 2000, we took a one-time
restructuring charge of $1.0 million for severance of 75 employees and leased
facilities costs. Approximately $0.2 million of depreciation expense was booked
due to reduced economic life of leased facilities under the restructuring plan.
As of December 31, 2000, $0.8 million of accrued severance remained.
Terminations were completed in January 2001.
Installment receivable interest income
Installment receivable interest income for 2000, which consists of the
portion of all license fees under long-term software license agreements that is
attributable to the time value of money, increased 6.4% to $4.0 million from
$3.8 million for 1999. This change was primarily due to the increase in our
installment receivable balance.
Other interest income, net
Interest income, net increased 85.2% to $1.7 million for 2000 from $0.9
million for 1999. The increase was due primarily to improved management of cash
funds with overnight investments in interest generating accounts and a larger
average balance of cash and cash equivalents.
Other income (expense), net
Other income (expense), net, which consists primarily of currency exchange
gains or losses and reseller development funds received from third-party
vendors of computer hardware products, was a $0.3 million loss for 2000 and
$0.3 million gain for 1999. The decrease was due primarily to larger currency
exchange losses.
Provision for income taxes
The provision for income tax was $0.3 million in 2000, a decrease from the
$1.5 million in 1999. The 2000 tax provision consists of foreign subsidiary
income tax. No benefit was provided for domestic losses incurred. See Note 8 of
Notes to Consolidated Financial Statements.
18
Liquidity and Capital Resources
We have funded our operations primarily from cash flow from operations and
the proceeds of our public stock offerings. At December 31, 2001, we had cash
and cash equivalents of $33.0 million and working capital of approximately
$57.2 million.
Net cash provided by (used in) operations for 2001 was $15.9 million
compared with ($11.2) million for 2000. Of the $27.1 million improvement, $17.6
million was due to improved profitability from on going operations. During
2000, cash used in operations included litigation settlement payments of $4.5
million, net of insurance recovery. The remaining improvement was due to
improved collections of accounts receivable and to net changes in deferred
revenues, accounts payable and accrued expenses.
Net cash used in investing activities for 2001 was $0.1 million compared
with $3.0 million for 2000. The decrease was primarily due to reduced purchases
of equipment and leasehold improvements, partially offset by the net changes in
other long-term assets and liabilities.
Net cash provided by financing activities for 2001 was $46 thousand compared
with $1.6 million for 2000. The decrease was primarily due to lower proceeds
from exercises of stock options and the employee stock purchase plan.
On February 6, 2002, we acquired substantially all of the assets of 1mind
Corporation (1mind) for initial consideration valued at $3.6 million,
consisting of 569,949 shares of our common stock and warrants to purchase for
nominal consideration 83,092 shares of our common stock. Depending upon the
achievement of specified milestones by the acquired business in 2002 and
validation of the negotiated value of 1mind, we will pay up to approximately $6
million in additional consideration substantially in the form of shares of our
common stock. The acquisition of 1mind will be accounted for as a purchase. We
have not yet completed the process of appraising the fair values of 1mind
assets, and accordingly have not yet allocated the purchase price.
We believe that current cash, cash equivalents, and cash flow from on going
operations will be sufficient to fund our operations until at least the end of
2002. We expect to receive cash during 2002 of $31.4 million for license
installments and $7.6 million for maintenance under existing contracts.
Material risks to additional cash flow from operations include, but are not
limited to, a decline in services revenues and delayed or reduced cash payments
accompanying sales of new licenses. There can be no assurance, however, that
changes in our plans or other events affecting our operations will not result
in materially accelerated or unexpected expenditures. In addition, there can be
no assurance that additional capital if needed will be available on reasonable
terms, if at all, at such time as we require. We have commitments under
non-cancelable leases, See Note 7 of Notes to Consolidated Financial Statements.
Our liquidity is affected by the manner in which we collect cash for certain
types of license transactions. Historically, our term licenses have provided
for monthly license payments, generally over five years. We expect to receive
the following amounts of cash over the next five years in connection with our
existing term license agreements:
License Installments
Years Ended December 31, (in thousands)
2002.......... $31,359
2003.......... 23,470
2004.......... 15,540
2005.......... 10,184
2006.......... 4,686
-------
$85,239
=======
19
Inflation
Inflation has not had a significant impact on our operating results to date,
and we do not expect it to have a significant impact in the future. Our
unbilled license and maintenance fees are typically subject to annual increases
based on recognized inflation indexes.
Significant Customers
In 2001, 2000 and 1999, we had one customer that accounted for 13.5%, 11.7%
and 12.5%, respectively, of our total consolidated revenue.
Forward-Looking Statements
This Annual Report contains certain forward-looking statements. For this
purpose, any statements contained herein that are not statements of historical
fact may be deemed to be forward-looking statements. Without limiting the
generality of the foregoing, the words "believes", "anticipates", "plans",
"expects", and similar expressions are intended to identify forward-looking
statements. There are a number of important factors that could cause our actual
results to differ materially from those indicated by forward-looking statements
made in this Annual Report and presented elsewhere by management from time to
time. Some of the important risks and uncertainties that may cause our
operating results to differ materially or adversely are discussed below.
We are being investigated by the Securities and Exchange Commission. In May
of 1999, the Boston office of the Securities and Exchange Commission ("SEC")
issued a Formal Order of Private Investigation of us and certain individuals,
currently or formerly associated with us, concerning past accounting matters,
financial reports and other public disclosures and trading activity in our
securities during 1997 and 1998. Such investigation may result in the SEC
imposing fines on us or taking other measures that may have a material adverse
impact on our financial position or results of operations. In addition,
regardless of the outcome of the investigation, it is likely that we will incur
substantial defense costs and that such investigation will cause a diversion of
management time and attention. Finally, the negative publicity resulting from
the investigation has made and may continue to make it more difficult for us to
close sales, which in turn could have a material adverse impact on our
financial position or results of operations.
Our stock price has been volatile. Quarterly results have fluctuated and
are likely to continue to fluctuate significantly. The market price of our
common stock has been and may continue to be highly volatile. Factors that are
difficult to predict, such as quarterly revenues and operating results,
statements and ratings by financial analysts, and overall market performance,
will have a significant effect on the price for shares of our common stock.
Revenues and operating results have varied considerably in the past from period
to period and are likely to vary considerably in the future. We plan product
development and other expenses based on anticipated future revenue. If revenue
falls below expectations, financial performance is likely to be adversely
affected because only small portions of expenses vary with revenue. As a
result, period-to-period comparisons of operating results are not necessarily
meaningful and should not be relied upon to predict future performance.
The timing of license revenues is related to the completion of
implementation services and product acceptance by the customer, the timing of
which has been difficult to predict accurately. There can be no assurance that
we will be profitable on an annual or quarterly basis or that earnings or
revenues will meet analysts' expectations. Fluctuations may be particularly
pronounced because a significant portion of revenues in any quarter is
attributable to product acceptance or license renewal by a relatively small
number of customers. Fluctuations also reflect a policy of recognizing revenue
upon product acceptance or license renewal in an amount equal to the present
value of the total committed payments due during the term. Customers generally
do not accept products until the end of a lengthy sales cycle and an
implementation period, typically ranging from one to six months but in some
cases significantly longer. In addition, we are more focused on closing larger
but fewer license transactions than in the past. This may increase the
volatility in our quarterly operating results. Risks over which we have little
or no control, including customers' budgets, staffing allocation, and internal
authorization reviews, can significantly affect the sales and acceptance
cycles. Changes dictated by customers may delay product implementation and
revenue recognition.
20
We will need to develop new products, evolve existing ones, and adapt to
technology change. Technical developments, customer requirements, programming
languages and industry standards change frequently in our markets. As a result,
success in current markets and new markets will depend upon our ability to
enhance current products, to develop and introduce new products that meet
customer needs, keep pace with technology changes, respond to competitive
products, and achieve market acceptance. Product development requires
substantial investments for research, refinement and testing. There can be no
assurance that we will have sufficient resources to make necessary product
development investments. We may experience difficulties that will delay or
prevent the successful development, introduction or implementation of new or
enhanced products. Inability to introduce or implement new or enhanced products
in a timely manner would adversely affect future financial performance. Our
products are complex and may contain errors. Errors in products will require us
to ship corrected products to customers. Errors in products could cause the
loss of or delay in market acceptance or sales and revenue, the diversion of
development resources, injury to our reputation, or increased service and
warranty costs which would have an adverse effect on financial performance.
We have historically sold to the financial services market. This market is
consolidating rapidly, and faces uncertainty due to many other factors. We have
historically derived a significant portion of our revenue from customers in the
financial services market, and our future growth depends, in part, upon
increased sales to this market. Competitive pressures, industry consolidation,
decreasing operating margins within this industry, currency fluctuations,
geographic expansion and deregulation affect the financial condition of our
customers and their willingness to pay. In addition, customers' purchasing
patterns are somewhat discretionary. As a result, some or all of the factors
listed above may adversely affect the demand by customers. The financial
services market is undergoing intense domestic and international consolidation.
In recent years, several customers have been merged or consolidated. Future
mergers or consolidations may cause a decline in revenues and adversely affect
our future financial performance.
If existing customers do not renew their licenses, our financial results may
suffer. A significant portion of total revenue has been attributable to
license renewals. While historically a majority of customers have renewed their
licenses, there can be no assurance that a majority of customers will continue
to renew expiring licenses. A decrease in license renewals absent offsetting
revenue from other sources would have a material adverse effect on future
financial performance. In addition, transition to prepaid perpetual licenses
may have a material adverse impact on the amount of license renewal revenues in
future periods.
We depend on certain key personnel, and must be able to attract and retain
qualified personnel in the future. The business is dependent on a number of
key, highly skilled technical, managerial, consulting, sales, and marketing
personnel, including Mr. Trefler, our Chief Executive Officer. The loss of key
personnel could adversely affect financial performance. We do not have any
significant key-man life insurance on any officers or employees and do not plan
to obtain any. Our success will depend in large part on the ability to hire and
retain qualified personnel. The number of potential employees who have the
extensive knowledge of computer hardware and operating systems needed to
develop, sell and maintain our products is limited, and competition for their
services is intense, and there can be no assurance that we will be able to
attract and retain such personnel. If we are unable to do so, our business,
operating results, and financial condition could be materially adversely
affected.
The market for our offerings is increasingly and intensely competitive,
rapidly changing, and highly fragmented. The market for customer relationship
management software and related implementation, consulting and training
services is intensely competitive and highly fragmented. We currently encounter
significant competition from internal information systems departments of
potential or existing customers that develop custom software. We also compete
with companies that target the customer interaction and workflow markets and
professional service organizations that develop custom software in conjunction
with rendering consulting services. Competition for market share and pressure
to reduce prices and make sales concessions are likely to increase. Many
competitors have far greater resources and may be able to respond more quickly
and efficiently to new or emerging technologies, programming languages or
standards or to changes in customer
21
requirements or preferences. Competitors may also be able to devote greater
managerial and financial resources to develop, promote and distribute products
and provide related consulting and training services. There can be no assurance
that we will be able to compete successfully against current or future
competitors or that the competitive pressures faced by us will not materially
adversely affect our business, operating results, and financial condition.
We must manage increased business complexity and growth effectively. Our
business has grown in size, geographic scope and complexity and we have
expanded our product offerings and customer base. This growth and expansion has
placed, and is expected to continue to place, a significant strain on
management, operations and capital needs. Continued growth will require us to
hire, train and retrain many employees in the United States and abroad,
particularly additional sales and financial personnel. We will also need to
enhance our financial and managerial controls and reporting systems. We cannot
assure that we will attract and retain the personnel necessary to meet our
business challenges. Failure to manage growth effectively may materially
adversely affect future financial performance.
We rely on certain third-party relationships. We have a number of
relationships with third parties that are significant to sales, marketing and
support activities and product development efforts. We rely on relational
database management system applications and development tool vendors, software
and hardware vendors, and consultants to provide marketing and sales
opportunities for the direct sales force and to strengthen our products through
the use of industry-standard tools and utilities. We also have relationships
with third parties that distribute our products. In particular, we rely on our
relationship with First Data Corporation for the distribution of products to
the credit card market and with PFPC Inc. for distribution of products to the
mutual fund market. There can be no assurance that these companies, most of
which have significantly greater financial and marketing resources, will not
develop or market products that compete with ours in the future or will not
otherwise end their relationships with or support of us.
We may face product liability and warranty claims. Our license agreements
typically contain provisions intended to limit the nature and extent of our
risk of product liability and warranty claims. There is a risk that a court
might interpret these terms in a limited way or could hold part or all of these
terms to be unenforceable. Also, there is a risk that these contract terms
might not bind a party other than the direct customer. Furthermore, some of our
licenses with our customers are governed by non-U.S. law, and there is a risk
that foreign law might give us less or different protection. Although we have
not experienced any material product liability claims to date, a product
liability suit or action claiming a breach of warranty, whether or not
meritorious, could result in substantial costs and a diversion of management's
attention and our resources.
We face risks from operations and customers based outside of the U.S. Sales
to customers headquartered outside of the United States represented
approximately 23%, 26% and 21% of our total revenue in 2001, 2000 and 1999,
respectively. We, in part through our wholly-owned subsidiaries based in the
United Kingdom, Singapore, and Australia, market products and render consulting
and training services to customers based in Canada, the United Kingdom, France,
Germany, the Netherlands, Belgium, Switzerland, Austria, Ireland, Sweden, South
Africa, Mexico, Australia, Hong Kong, and Singapore. We have established
offices in continental Europe and in Australia. We believe that our continued
growth will necessitate expanded international operations requiring a diversion
of managerial attention and financial resources. We anticipate hiring
additional personnel to accommodate international growth, and we may also enter
into agreements with local distributors, representatives, or resellers. If we
are unable to do one or more of these things in a timely manner, our growth, if
any, in our foreign operations will be restricted, and our business, operating
results, and financial condition could be materially and adversely affected.
In addition, there can be no assurance that we will be able to maintain or
increase international market demand for our products. Most of our
international sales are denominated in U.S. dollars. Accordingly, any
appreciation of the value of the U.S. dollar relative to the currencies of
those countries in which we distribute our products may place us at a
competitive disadvantage by effectively making our products more expensive as
22
compared to those of our competitors. Additional risks inherent in our
international business activities generally include unexpected changes in
regulatory requirements, increased tariffs and other trade barriers, the costs
of localizing products for local markets and complying with local business
customs, longer accounts receivable patterns and difficulties in collecting
foreign accounts receivable, difficulties in enforcing contractual and
intellectual property rights, heightened risks of political and economic
instability, the possibility of nationalization or expropriation of industries
or properties, difficulties in managing international operations, potentially
adverse tax consequences (including restrictions on repatriating earnings and
the threat of "double taxation"), enhanced accounting and internal control
expenses, and the burden of complying with a wide variety of foreign laws.
There can be no assurance that one or more of these factors will not have a
material adverse effect on our foreign operations, and, consequentially, our
business, operating results, and financial condition.
We face risks related to intellectual property claims or appropriation of
our intellectual property rights. We rely primarily on a combination of
copyright, trademark and trade secrets laws, as well as confidentiality
agreements to protect our proprietary rights. In October 1998, we were granted
a patent by the United States Patent and Trademark Office relating to the
architecture of our systems. We cannot assure that such patent will not be
invalidated or circumvented or that rights granted there under or the
description contained therein will provide competitive advantages to our
competitors or others. Moreover, despite our efforts to protect our proprietary
rights, unauthorized parties may attempt to copy aspects of our products or to
obtain the use of information that we regard as proprietary. In addition, the
laws of some foreign countries do not protect our proprietary rights to as
great an extent as do the laws of the United States. There can be no assurance
that our means of protecting our proprietary rights will be adequate or that
our competitors will not independently develop similar technology.
We are not aware that any of our products infringe the proprietary rights of
third parties. There can be no assurance, however, that third parties will not
claim infringement by us with respect to current or future products. We expect
that software product developers will increasingly be subject to infringement
claims as the number of products and competitors in our industry segment grows
and the functionality of products in different industry segments overlaps. Any
such claims, with or without merit, could be time-consuming, result in costly
litigation, cause product shipment delays, or require us to enter into royalty
or licensing agreements. Such royalty or licensing agreements, if required, may
not be available on terms acceptable to us or at all, which could have a
material adverse effect upon our business, operating results, and financial
condition.
We face risks related to the acquisition of 1mind. On February 6, 2002, we
acquired substantially all of the assets and specified liabilities of 1mind
Corporation and its wholly owned subsidiary (collectively, "1mind"). Following
the acquisition of 1mind, we intend to intensify our focus on marketing and
selling our products and services within the healthcare market. We face risks
in connection with integrating 1mind's technology and personnel into the
combined company. Additionally, we face risks involved with integrating and
retaining key former 1mind personnel. Overcoming these risks may result in
undue cost or delay and may require us to divert management time and attention
from our primary business operations. The result could be an adverse effect on
our financial results.
ITEM 7A: QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
Market risk represents the risk of loss that may affect us due to adverse
changes in financial market prices and rates. Our market risk exposure is
primarily fluctuations in foreign exchange rates and interest rates. We have
not entered into derivative or hedging transactions to manage risk in
connection with such fluctuations.
We derived approximately 23% of our total revenue in 2001 from sales to
customers based outside of the United States. Certain of our international
sales are denominated in foreign currencies. The price in dollars of products
sold outside the United States in foreign currencies will vary as the value of
the dollar fluctuates against such foreign currencies. Although our sales
denominated in foreign currencies in 2001 were not material, there can be no
assurance that such sales will not be material in the future and that there
will not be increases in the value of the dollar against such currencies that
will reduce the dollar return to us on the sale of our products in such foreign
currencies.
23
We believe that at current market interest rates, the fair value of license
installments receivable approximates carrying value as reported on our balance
sheets. However, there can be no assurance that the fair value will approximate
the carrying value in the future. Factors such as increasing interest rates can
reduce the fair value of the license installments receivable. The carrying
value reflects a weighted average of historic discount rates, and moves with
market rates as new license installment receivables are added to the portfolio,
which mitigates exposure to market interest rate risk.
ITEM 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Financial statement schedules are set forth in Item 14, "Exhibits, Financial
Statement Schedules, and Reports on Form 8-K" of this Form 10-K and are filed
herewith.
ITEM 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
24
PART III
ITEM 10: DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information relating to our executive officers is set forth in Part I,
immediately following Item 4, of this Report under the caption "Executive
Officers of the Registrant." The following information is furnished with
respect to each Director.
Alexander V. d'Arbeloff, 74, has been a Director of Pegasystems since August
2000. As of December 2000, he was also elected a member of our Compensation
Committee. In 1960, Mr. d'Arbeloff co-founded Teradyne, Inc., a leading
manufacturer of automatic test equipment and interconnection systems for the
electronics and telecommunications industries. Mr. d'Arbeloff served as
President and Chief Executive Officer of Teradyne until May 1997, and remained
Chairman of the Board until June 2000. Since 1989, Mr. d'Arbeloff has been a
member of the MIT Corporation, and was named its Chairman in July 1997. Mr.
d'Arbeloff also serves on the board of PRI Automation Inc. and on the boards of
several private companies.
Richard H. Jones, 50, joined Pegasystems in October 1999 and was elected a
Director of Pegasystems in November 2000. Prior to joining Pegasystems, he
served as Chief Asset Management Executive and a member of the Operating
Committee at Barnett Banks, Inc, which at the time was among the nation's 25
largest banks, from 1995 to 1997. He served as CEO of Fleet Investment
Services, a brokerage and wealth management organization from 1991 to 1995. His
prior experience also includes serving as executive vice president with
Fidelity Investments, an international provider of financial services and
investment resources and as a principal with the consulting firm of Booz, Allen
& Hamilton. Mr. Jones holds an undergraduate degree from Duke University, with
majors in both economics and management science. He also holds an M.B.A. degree
from the Wharton School of the University of Pennsylvania.
Steven F. Kaplan, 46, has served as a Director of Pegasystems since August
1999. As of December 2000 he was also elected a member of our Audit Committee.
He currently is Managing Director of The Audax Group, a private equity and
venture capital firm. From 1998 to 2000, Mr. Kaplan was affiliated with Texas
Pacific Group, a private equity firm, and he served as President, Chief
Operating Officer and Chief Financial Officer of Favorite Brands International
Holding Corp., a confectionery company controlled by Texas Pacific Group. From
1996 to 1997, Mr. Kaplan was Executive Vice President and Chief Financial
Officer of the Coleman Company, an international manufacturer of camping,
outdoor recreation and hardware equipment. From 1993 to 1996, Mr. Kaplan was a
financial and strategy consultant to venture capital and buy-out firms. During
1994, Mr. Kaplan served as Chief Financial Officer of Marcam Corporation, a
software developer. Prior to that, Mr. Kaplan served as Executive Vice
President and Chief Financial Officer of AM International, President of Harris
Graphics and Partner of Boston Consulting Group. Mr. Kaplan holds an MS in
Management, a BS in Electrical Engineering and Computer Science and a BS in
Management Science from the Massachusetts Institute of Technology.
William H. Keough, 64, has been a Director of Pegasystems and a member of
our Audit Committee since June 2000. He served as a director of Thermo Ecoteck
Corporation, an environmentally sound power plants and fuels public company,
from November 1999 until September 2000, when the company was spun back into
its parent, Thermo Electron. He also serves as chairman of the Board of
Trustees of the National Multiple Sclerosis Society's Central New England
chapter. He served as Senior Vice President and Chief Financial Officer of two
public companies from 1968 to 1999, most recently at the Pioneer Group, a
financial services business with $20 billion in assets, from 1986 to his
retirement in 1999. Mr. Keough holds a B.S./B.A. in Finance from Boston College
and an M.B.A. from Northeastern University.
Edward A. Maybury, 62, has been a Director of Pegasystems since our
organization in 1983. In December 2000, he was also elected a member of our
Compensation Committee. Since July 1992, he has served as a Director, and from
April 1992 through May 1993 was the President and Chief Executive Officer, of
Creative Systems, Inc., a software and services company. Prior thereto, Mr.
Maybury was the Chief Executive Officer of Data Architect Systems, Inc., a
software and services company.
25
James P. O'Halloran, 69, has been a Director of Pegasystems since 1999. From
April 1999 to August 2001, he was the Senior Vice President, Chief Financial
Officer, Treasurer, and Clerk of Pegasystems Inc From 1991 to 1999 he served as
President of G & J Associates, Ltd., a financial consulting firm. From 1956 to
1990, he was with the international accounting firm of Arthur Andersen LLP
serving as an audit partner from 1967 to his retirement in 1990. Mr. O'Halloran
also currently serves as a director of ASA International Ltd., a software firm
focusing on business applications for small and medium sized companies.
Edward B. Roberts, 66, has been a Director of Pegasystems since June 1996.
In December 2000, he was also elected a member of our Compensation Committee.
Since the early 1960s, he has been the David Sarnoff Professor of Management of
Technology at the Massachusetts Institute of Technology, where he founded and
chairs the MIT Entrepreneurship Center. Dr. Roberts co-founded and is a
Director of Medical Information Technology, Inc., a leading provider of
healthcare information systems. He is also a Director of Advanced Magnetics,
Inc., a specialty pharmaceutical company; NETsilicon, Inc., a semiconductor
producer that links equipment to the Internet; Inverness Medical Technology,
Inc., a manufacturer of medical diagnostics products; SOHU.com, Inc., an
internet portal, and several early-stage high-technology firms. Dr. Roberts
co-founded and served for 20 years as a general partner of the Zero Stage and
First Stage Capital group of venture capital funds.
Alan Trefler, 45, a founder of Pegasystems, served as President until
October 1999 and Clerk until June 1999 and has been Chief Executive Officer and
a Director since we organized in 1983. Prior to that, he managed an electronic
funds transfer product for TMI Systems Corporation, a software and services
company. Mr. Trefler holds a degree in economics and computer science from
Dartmouth College.
William W. Wyman, 64, has been a Director of Pegasystems since June 2000. In
December 2000, he was also elected a member of our Audit Committee. From 1984
through 1995, Mr. Wyman was a partner at Oliver, Wyman & Company, a management
consulting company which he co-founded. Mr. Wyman is also currently a director
of US Timberlands, a limited partnership consisting of the growing of trees and
the sale of logs and standing timber, and Predictive Systems, a network
consulting company focused on the design, performance, management and security
of complex computing networks.
Section 16(a) Beneficial Ownership Reporting Compliance
Section 16(a) of the Securities Exchange Act of 1934 (the "1934 Act")
requires our Directors and executive officers, and persons who own more than
ten percent of our Common Stock, to file reports with the Securities and
Exchange Commission (the "SEC") disclosing their ownership of our stock and
changes in such ownership of our stock. Copies of such reports are also
required to be furnished to us.
To our knowledge, based solely on review of copies of the above-mentioned
reports furnished to us and written representations that no other reports were
required during 2001, all such filing requirements were complied with in a
timely fashion.
ITEM 11: EXECUTIVE AND DIRECTOR COMPENSATION
Director Compensation
Each non-employee Director of Pegasystems receives $1,000 for every Board or
committee meeting attended. We also reimburse non-employee Directors for
expenses incurred in attending Board meetings. In addition, non-employee
Directors of Pegasystems are eligible to receive stock options under our 1996
Non-Employee Director Stock Option Plan and all Directors are eligible to
receive stock options and stock grants under our 1994 Long-Term Incentive Plan.
Currently, each non-employee Director is granted on an annual basis a fully
vested option to purchase 10,000 shares of common stock at a price equal to the
fair market value of the
26
common stock on the date of grant under the 1996 Non-Employee Director Stock
Option Plan. No other compensation is paid to Directors for attending Board or
committee meetings. Messrs. d'Arbeloff, Kaplan, Keough, Maybury, O'Halloran,
Roberts, and Wyman are currently the non-employee Directors of Pegasystems.
Executive Compensation
The following table sets forth all compensation awarded to, earned by or
paid for services rendered to us in all capacities during the years ended
December 31, 2001, 2000, and 1999 by (i) our Chief Executive Officer (ii) the
four most highly compensated other executive officers who were serving as
executive officers at December 31, 2001 and (iii) any individual who would have
been included in clause (ii) but for the fact that such individual was not
serving as an executive officer at December 31, 2001 (collectively, the "Named
Executive Officers"):
Summary Compensation Table
Long Term
Compensation
Annual Compensation(1) Awards
----------------------- ------------
Securities
Underlying All Other
Name and Principal Positions Year Salary($) Bonus($) Options(#) Compensation($)
---------------------------- ---- --------- -------- ------------ ---------------
Alan Trefler............................ 2001 $200,000 $ 70,000(7) -- --
Chairman and Chief Executive Officer... 2000 200,000 -- -- --
1999 200,000 -- -- --
Richard H. Jones........................ 2001 250,000 125,000(7) 100,000 $75,000(4)
President and Chief Operations Officer. 2000 250,000 -- -- 74,475
1999 46,556 -- 410,000 --
Joseph J. Friscia....................... 2001 255,000 80,000(7) 30,000 --
Executive Vice President of Sales and.. 2000 200,000 -- 50,000 60,554
Service................................ 1999 200,000 60,000(2) 100,000 86,869
Michael R. Pyle......................... 2001 177,500 70,000(7) 40,000 --
Senior Vice President of Product....... 2000 155,000 3,079(3) 50,000 1,644
Development............................ 1999 155,000 60,000(2) 35,000 30,734
James P. O'Halloran..................... 2001 160,000 -- 10,000 1,438(4)
Retired Senior Vice President and Chief 2000 240,000 50,000(5) 10,000 --
Financial Officer(6)................... 1999 150,728 -- 150,000 4,406
Kenneth Olson........................... 2001 155,000 50,000(7) 30,000 --
Senior Vice President of Advanced...... 2000 145,000 3,000(3) 40,000 11,457
Technology............................. 1999 145,000 40,000(2) 30,000 53,385
--------
(1) In accordance with the rules of the Securities and Exchange Commission,
other compensation in the form of perquisites and other personal benefits
has been omitted because the aggregate amount of such perquisites and other
personal benefits constituted less than the lesser of $50,000 or 10% of the
total of annual salary and bonuses for each of the Named Executive Officers
for 2001, 2000, and 1999.
(2) Represents bonuses earned in 1999 and paid in 2000.
(3) Represents payment for Y2K on-call coverage.
(4) Represents travel allowance.
(5) Represents bonus earned and paid in 2000.
(6) Mr. O'Halloran retired on August 31, 2001.
(7) Represents bonuses earned in 2001 and paid in 2002.
27
Option grants in fiscal year
The following table provides certain information concerning grants of
options to purchase our Common Stock made during the fiscal year ending
December 31, 2001, to each of the Named Executive Officers:
Option Grants in Fiscal 2001
Potential Realizable
Value at Assumed
Annual Rates of Stock
Price Appreciation for
Individual Grants Option Term (1)
--------------------- ----------------------
Percent of
Total
Options
Number of Granted
Shares to Exercise
Underlying Employees or Price
Options in Fiscal Base Expiration
Name Granted (#) Year ($/Share) Date 5%($) 10%($)
---- ----------- ---------- --------- ---------- ------- -------
Alan Trefler....... -- -- -- -- -- --
Richard H. Jones... 50,000(2) 2.2% $3.3450 6/5/11 105,183 266,553
50,000(2) 2.2% $2.3310 10/5/11 73,298 185,751
Joseph J. Friscia.. 30,000(2) 1.3% $4.3830 3/8/11 82,694 209,561
Michael R. Pyle.... 40,000(2) 1.8% $4.3830 3/8/11 110,258 279,415
James P. O'Halloran 10,000(3) 0.4% $3.3450 6/5/11 21,037 53,311
Kenneth Olson...... 30,000(2) 1.3% $4.3830 3/8/11 82,694 209,561
--------
(1) As required by the rules of the Securities and Exchange Commission,
potential values stated are based on the prescribed assumption that our
common stock will appreciate in value from the date of grant to the end of
the option term at rates (compounded annually) of 5% and 10%, respectively,
and therefore are not intended to forecast possible future appreciation, if
any, in the price of our common stock.
(2) These options vest in equal quarterly installments over four-years from the
date of grant, which was June 5, 2001 and October 5, 2001, respectively for
Richard H. Jones, and March 8, 2001 for Joseph J. Friscia, Michael R. Pyle,
and Kenneth Olson.
(3) These options were fully vested at the time of grant.
Year-End Option Table
The following table sets forth certain information concerning the number and
value of unexercised stock options held by each of the Named Executive Officers
as of December 31, 2001. None of the Named Executive Officers exercised options
during 2001.
Year-End Options Value
Number of Shares Value of Unexercised In-
Underlying Unexercised The-Money Options at
Options at Year-End Year-End($)
------------------------- -------------------------
Name Exercisable Unexercisable Exercisable Unexercisable
---- ----------- ------------- ----------- -------------
Alan Trefler....... -- -- -- --
Richard H. Jones... 216,250 293,750 $ 7,581 $144,919
Joseph J. Friscia.. 590,500 94,500 $1,179,757 --
Michael R. Pyle.... 282,350 111,750 $ 683,184 $ 1,706
James P. O'Halloran 170,000 -- $ 20,450 --
Kenneth Olson...... 88,875 86,125 $ 2,438 $ 1,463
Compensation Committee Interlocks and Insider Participation
During 2001, our Compensation Committee was composed of Alexander V.
d'Arbeloff, Edward A. Maybury, and Edward Roberts. None of our executive
officers has served as a director or member of the compensation committee (or
other committee serving an equivalent function) of any other entity, whose
executive officers served on our Board of Directors or Compensation Committee.
28
ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth certain information as of January 10, 2002,
with respect to the beneficial ownership of our common stock by (i) each person
known by us to be the beneficial owner of more than 5% of our outstanding
Common Stock (ii) each Director of Pegasystems, (iii) each of the Named
Executive Officer and (iv) all executive officers and Directors of Pegasystems
as a group. To our knowledge, based on information provided by such owners, all
persons listed below have sole voting and investment power with respect to
their shares of Common Stock, except to the extent authority is shared by
spouses under applicable law. The information provided below regarding persons
beneficially owning more than 5% of our Common Stock is based solely on public
filings made by such persons with the SEC through February 14, 2002.
Number of Percentage
Shares of Shares
Beneficially Beneficially
Name of Beneficial Owner Owned(1) Owned
------------------------ ------------ ------------
Alan Trefler(2)....................................................... 22,237,100 64.6%
Richard H. Jones(3)................................................... 1,298,500 3.8%
Joseph J. Friscia(4).................................................. 605,000 1.8%
James P. O'Halloran(5)................................................ 204,500 *
Steven F. Kaplan(4)................................................... 50,000 *
Edward A. Maybury(4).................................................. 68,500 *
Kenneth Olson(6)...................................................... 338,625 1.0%
Michael R. Pyle(4).................................................... 294,912 *
Christopher J. Sullivan(4)............................................ 9,375 *
Edward B. Roberts(7).................................................. 171,500 *
William H. Keough(8).................................................. 30,000 *
Alexander V. d'Arbeloff(8)............................................ 1,020,000 3.0%
William W. Wyman(4)................................................... 20,000 *
Wellington Management Company, LLP.................................... 1,796,900 5.5%
All executive officers, directors, and 5% beneficial owners as a group
(14 persons)(9)...................................................... 28,144,912 81.8%
--------
* Represents beneficial ownership of less than 1% of the outstanding Common
Stock.
(1) The number of shares of Common Stock deemed outstanding includes (i)
32,755,336 shares of Common Stock outstanding as of January 10, 2002 and
(ii) shares issuable pursuant to outstanding options held by the respective
person or group which are exercisable within 60 days of January 10, 2002,
as set forth below.
(2) Includes 375,000 shares held in trust with respect to which Mr. Trefler has
voting and dispositive power. Mr. Trefler disclaims beneficial interest.
(3) Includes 247,500 shares of Common Stock subject to stock options
exercisable within 60 days of
January 10, 2002.
(4) Consists solely of shares of Common Stock subject to stock options
exercisable within 60 days of
January 10, 2002.
(5) Includes 170,000 shares of Common Stock subject to stock options
exercisable within 60 days of
January 10, 2002.
(6) Includes 98,625 shares of Common Stock subject to stock options exercisable
within 60 days of
January 10, 2002.
(7) Includes 66,500 shares of Common Stock subject to stock options exercisable
within 60 days of
January 10, 2002.
(8) Includes 20,000 shares of Common Stock subject to stock options exercisable
within 60 days of
January 10, 2002.
(9) Includes 1,670,412 shares of Common Stock subject to stock options
exercisable within 60 days of
January 10, 2002 and the 375,000 shares of Common Stock described in
footnote (2) above.
29
ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
During 2001 there were no transactions involving more than $60,000, other
than executive compensation and benefits earned in the normal course of
business, nor are any proposed, between Pegasystems and any executive officer,
Director, 5% beneficial owner of our Common Stock or equivalents, or any
immediate family member of any of the foregoing, in which any such persons or
entities had or will have a direct or indirect material interest.
We have adopted a policy whereby transactions between Pegasystems and our
officers, Directors, principal stockholders and their affiliates must be on
terms no less favorable to us than could be obtained from unrelated third
parties and must be approved by a majority of the disinterested members of our
Board of Directors.
30
PART IV
ITEM 14: EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a)(1) Financial Statements
The following consolidated financial statements are required to be filed as
part of this report and are filed herewith:
Item
Report of Independent Auditors--Deloitte & Touche LLP
Report of Independent Public Accountants--Arthur Andersen LLP
Consolidated Balance Sheets at December 31, 2001 and 2000
Consolidated Statements of Operations for the years ended December 31,
2001, 2000, and 1999
Consolidated Statements of Stockholders' Equity and Other
Comprehensive Income for the years ended December 31, 2001, 2000, and
1999
Consolidated Statements of Cash Flows for the years ended December 31,
2001, 2000, and 1999
Notes to Consolidated Financial Statements
(2) Financial Statement Schedules
All financial statement schedules are omitted because the required
information is not present or not present in sufficient amounts to require
submission of the schedule or because the information is reflected in the
consolidated financial statements or notes thereto.
(3) Exhibits
The exhibits listed in the Exhibit Index immediately preceding such exhibits
are filed as part of this Annual Report on Form 10-K.
(b) Reports on Form 8-K
None.
31
SIGNATURES
Pursuant to the requirements to Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this Annual Report on Form
10-K to be signed on its behalf by the undersigned, thereunto duly authorized.
PEGASYSTEMS INC.
By: /S/ CHRISTOPHER SULLIVAN
-----------------------------
Christopher Sullivan
Senior Vice President, Chief
Financial Officer, and
Treasurer (principle
financial officer)
Date: March 27, 2002
Pursuant to the requirements of the Securities Exchange Act of 1934, this
Annual Report on Form 10-K has been signed below on March 27, 2002 by the
following persons on behalf of the Registrant and in the capacities indicated.
Signature Title
--------- -----
/S/ ALAN TREFLER Chief Executive Officer and Chairman (principle executive
----------------------------- officer)
Alan Trefler
/S/ RICHARD H. JONES
----------------------------- President, Chief Operating Officer and Director
Richard H. Jones
/S/ JAMES P. O'HALLORAN Director
-----------------------------
James P. O'Halloran
/S/ ALEXANDER V. D'ARBELOFF Director
-----------------------------
Alexander V. d'Arbeloff
/S/ STEVEN F. KAPLAN Director
-----------------------------
Steven F. Kaplan
/S/ WILLIAM H. KEOUGH Director
-----------------------------
William H. Keough
/S/ EDWARD A. MAYBURY Director
-----------------------------
Edward A. Maybury
/S/ EDWARD B. ROBERTS Director
-----------------------------
Edward B. Roberts
32
PEGASYSTEMS INC.
Exhibit Index
Exhibit No. Description
---------- -----------
3.3.* Restated Articles of Organization of the Registrant.
3.4.* Restated By-Laws of the Registrant.
4.1.* Specimen certificate representing the Common Stock.
10.1.** Amended and Restated 1994 Long-Term Incentive Plan.
10.2.** 1996 Non-Employee Director Stock Option Plan.
10.3.*** 1996 Employee Stock Purchase Plan.
10.13.* Lease Agreement dated February 26, 1993 between the Registrant and Riverside Office Park Joint
Venture.
10.14.* Amendment Number 1 to Lease Agreement dated August 7, 1994 between the Registrant and
Riverside Office Park Joint Venture.
10.15.+ Warrant Agreement dated June 27, 1997 by and between the Registrant and First Data Resources Inc.
10.16 ++ Employment Agreement dated May 10, 2001 between the Registrant and Joseph Friscia.
10.17 # Agreement and Release dated November 2, 2001 by and between the Registrant and Carreker
Corporation.
10.18+++ Asset Purchase Agreement dated January 29, 2002 by and among the Registrant and 1mind
Corporation, 1mind.com, LLC, and all of the Equity Holders of 1mind Corporation.
21.1**** Subsidiaries of the Registrant.
23.1. Independent Auditors' Consent--Deloitte & Touche LLP.
23.2. Independent Public Accountants' Consent--Arthur Andersen LLP.
99.1 Letter to Commission pursuant to temporary note 3T
--------
* Filed as an exhibit to the Registrant's Registration Statement on Form S-1
(Registration No. 333-03807) or an amendment thereto and incorporated
herein by reference to the same exhibit number.
+ Filed as exhibit 10.15 to the Registrant's 1997 Form 10-K and incorporated
herein by reference to the same exhibit number.
** Filed in the Registrant's Proxy Statement for its 1999 annual shareholders
meeting and incorporated herein by reference.
*** Filed in the Registrant's Proxy Statement for its 1998 annual shareholders
meeting and incorporated herein by reference
**** Filed as an exhibit to the Registrant's 1999 Form 10-K, filed with the
Commission on April 4, 2000 and incorporated herein by reference to the
same exhibit number.
++ Filed as exhibit 10.1 to the Registrant's June 30, 2001 Form 10-Q and
incorporated herein by reference.
+++ Filed as exhibit 2.0 to Registrant's February 6, 2002 Form 8-K.
# Confidential treatment requested as to certain portions.
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Stockholders of Pegasystems Inc.:
We have audited the accompanying consolidated balance sheets of Pegasystems
Inc. and subsidiaries as of December 31, 2001 and 2000 and the related
consolidated statements of operations, stockholders' equity and other
comprehensive income, and cash flows for each of the two years then ended.
These financial statements are the responsibility of the Company's management.
Our responsibility is to express an opinion on these consolidated financial
statements based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audits to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management as well as
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Pegasystems
Inc. and subsidiaries at December 31, 2001 and 2000 and the results of their
operations and their cash flows for each of the two years then ended in
conformity with accounting principles generally accepted in the United States
of America.
/S/ DELOITTE & TOUCHE LLP
Boston, Massachusetts
February 15, 2002
F-1
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors and Stockholders of Pegasystems Inc.:
We have audited the accompanying consolidated statements of operations,
stockholders' equity and cash flows of Pegasystems Inc. and its subsidiaries
for the year ended December 31, 1999. These consolidated financial statements
are the responsibility of Pegasystems Inc.'s management. Our responsibility is
to express an opinion on these consolidated financial statements based on our
audit.
We conducted our audit in accordance with auditing standards generally
accepted in the United States. 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 audit provides a
reasonable basis for our opinion.
As further discussed in Note 10, two class action lawsuits have been filed
by certain stockholders against the Company and certain of its current and
former officers and directors, the outcome of which is uncertain at this time.
Management believes that it is possible that the Company may be required to pay
substantial damages or settlement costs which could have a material adverse
effect on the Company's financial position or results of operations. In
addition, regardless of the outcome of any of these actions, it is likely that
the Company will incur substantial defense costs and that such actions will
cause a diversion of management's time and attention. The Company's delays in
SEC filings and adjustments made to previously published financial statements
have resulted in negative publicity for the Company. Such events and related
publicity have adversely affected demand for the Company's products and
services and may also have an adverse effect on the Company's financial
position or results of operations.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated results of
operations of Pegasystems Inc. and its subsidiaries and its cash flows for the
year ended December 31, 1999 in conformity with accounting principles generally
accepted in the United States.
/S/ ARTHUR ANDERSEN LLP
Boston, Massachusetts
March 27, 2000
F-2
PEGASYSTEMS INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except share-related data)
December 31,
------------------
2001 2000
-------- --------
ASSETS
------
Current assets:
Cash and cash equivalents........................................................... $ 33,017 $ 17,339
Trade accounts receivable, net of allowance for doubtful accounts of $1,034 in 2001
and $1,037 in 2000................................................................ 9,592 12,373
Short-term license installments, net................................................ 31,359 29,756
Prepaid expenses and other current assets........................................... 2,286 1,584
-------- --------
Total current assets............................................................ 76,254 61,052
Long-term license installments, net.................................................... 43,155 37,401
Equipment and improvements, net........................................................ 3,053 6,568
Purchased software and other, net...................................................... 2,610 5,472
-------- --------
Total assets.................................................................... $125,072 $110,493
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
Current liabilities:
Accounts payable and accrued expenses............................................... $ 12,840 $ 11,917
Deferred revenue.................................................................... 6,176 5,065
Current portion of capital lease obligations........................................ 81 312
-------- --------
Total current liabilities....................................................... 19,097 17,294
Deferred income taxes.................................................................. 1,000 1,000
Capital lease obligations, net of current portion...................................... -- 84
Other long-term liabilities............................................................ 17 52
-------- --------
Total liabilities............................................................... 20,114 18,430
-------- --------
Commitments and contingencies (Notes 7 and 9)
Stockholders' equity:
Preferred stock, $.01 par value, 1,000,000 shares authorized; no shares issued and
outstanding....................................................................... -- --
Common stock, $.01 par value, 45,000,000 shares authorized; 32,754,648 shares and
32,570,094 shares issued and outstanding in 2001 and 2000, respectively........... 328 326
Additional paid-in capital.......................................................... 101,318 100,886
Stock warrant....................................................................... 2,897 2,897
Retained earnings (accumulated deficit)............................................. 757 (11,777)
Accumulated other comprehensive loss................................................ (342) (269)
-------- --------
Total stockholders' equity...................................................... 104,958 92,063
-------- --------
Total liabilities and stockholders' equity...................................... $125,072 $110,493
======== ========
The accompanying notes are an integral part of these consolidated financial
statements.
F-3
PEGASYSTEMS INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
Years Ended December 31,
-------------------------
2001 2000 1999
------- -------- -------
Revenue:
Software license.......................................... $44,053 $ 33,806 $28,123
Services.................................................. 48,234 47,000 48,506
------- -------- -------
Total revenue......................................... 92,287 80,806 76,629
------- -------- -------
Cost of revenue:
Cost of software license.................................. 3,049 2,383 3,018
Cost of services.......................................... 34,572 39,005 31,928
------- -------- -------
Total cost of revenue................................. 37,621 41,388 34,946
------- -------- -------
Gross profit................................................. 54,666 39,418 41,683
------- -------- -------
Operating expenses:
Research and development.................................. 20,812 15,073 19,810
Selling and marketing..................................... 17,522 24,142 19,115
General and administrative................................ 9,798 10,334 8,678
Litigation settlement and restructuring (Note 10)......... -- 15,821 --
------- -------- -------
Total operating expenses.............................. 48,132 65,370 47,603
------- -------- -------
Income (loss) from operations................................ 6,534 (25,952) (5,920)
Installment receivable interest income....................... 6,159 4,015 3,772
Other interest income, net................................... 826 1,667 900
Other income (expense), net.................................. 15 (286) 338
------- -------- -------
Income (loss) before provision for income taxes.............. 13,534 (20,556) (910)
Provision for income taxes................................... 1,000 300 1,500
------- -------- -------
Net income (loss)..................................... $12,534 $(20,856) $(2,410)
======= ======== =======
Earnings (loss) per share, basic............................. $ 0.38 $ (0.71) $ (0.08)
======= ======== =======
Earnings (loss) per share, diluted........................... $ 0.37 $ (0.71) $ (0.08)
======= ======== =======
Weighted average number of common shares outstanding, basic.. 32,677 29,206 28,947
======= ======== =======
Weighted average number of common shares outstanding, diluted 33,434 29,206 28,947
======= ======== =======
The accompanying notes are an integral part of these consolidated financial
statements.
F-4
PEGASYSTEMS INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND OTHER COMPREHENSIVE INCOME
(in thousands)
Common Stock
------------
Retained Accumulated Total
Number Additional Earnings Other Stock-
of Paid-In Deferred Stock (Accumulated Comprehensive holders'
Shares Amount Capital Compensation Warrant Deficit ) Loss Equity
------ ------ ---------- ------------ ------- ------------ ------------- --------
Balance at December 31, 1998............ 28,683 $287 $ 87,757 $(36) $2,897 $ 11,489 $(475) $101,919
Exercise of stock options............... 222 2 664 -- -- -- -- 666
Issuance of stock under Employee Stock
Purchase Plan.......................... 91 1 434 -- -- -- -- 435
Issuance of compensatory stock option... -- -- 86 -- -- -- -- 86
Foreign currency translation adjustments -- -- -- -- -- -- 331 331
Amortization of deferred compensation... -- -- -- 18 -- -- -- 18
Net loss................................ -- -- -- -- -- (2,410) -- (2,410)
------ ---- -------- ---- ------ -------- ----- --------
Balance at December 31, 1999............ 28,996 290 88,941 (18) 2,897 9,079 (144) 101,045
Exercise of stock options............... 299 3 803 -- -- -- -- 806
Issuance of stock under Employee Stock
Purchase Plan.......................... 150 2 812 -- -- -- -- 814
Stock issued in settlement of litigation 3,125 31 10,330 -- -- -- -- 10,361
Foreign currency translation adjustments -- -- -- -- -- -- (125) (125)
Amortization of deferred compensation... -- -- -- 18 -- -- -- 18
Net loss................................ -- -- -- -- -- (20,856) -- (20,856)
------ ---- -------- ---- ------ -------- ----- --------
Balance at December 31, 2000............ 32,570 326 100,886 -- 2,897 (11,777) (269) 92,063
Exercise of stock options............... 68 1 59 -- -- -- -- 60
Issuance of stock under Employee Stock
Purchase Plan.......................... 117 1 300 -- -- -- -- 301
Issuance of compensatory stock option... -- -- 73 -- -- -- -- 73
Foreign currency translation adjustments -- -- -- -- -- -- (73) (73)
Net income.............................. -- -- -- -- -- 12,534 -- 12,534
------ ---- -------- ---- ------ -------- ----- --------
Balance at December 31, 2001............ 32,755 $328 $101,318 $ -- $2,897 $ 757 $(342) $104,958
====== ==== ======== ==== ====== ======== ===== ========
Comprehensive
(Loss) Income
-------------
Balance at December 31, 1998............
Exercise of stock options...............
Issuance of stock under Employee Stock
Purchase Plan..........................
Issuance of compensatory stock option...
Foreign currency translation adjustments $ 331
Amortization of deferred compensation...
Net loss................................ (2,410)
--------
Balance at December 31, 1999............ (2,079)
========
Exercise of stock options...............
Issuance of stock under Employee Stock
Purchase Plan..........................
Stock issued in settlement of litigation
Foreign currency translation adjustments $ (125)
Amortization of deferred compensation...
Net loss................................ (20,856)
--------
Balance at December 31, 2000............ (20,981)
========
Exercise of stock options...............
Issuance of stock under Employee Stock
Purchase Plan..........................
Issuance of compensatory stock option...
Foreign currency translation adjustments $ (73)
Net income.............................. 12,534
--------
Balance at December 31, 2001............ $ 12,461
========
The accompanying notes are an integral part of these consolidated financial
statements.
F-5
PEGASYSTEMS INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
Years Ended December 31,
---------------------------
2001 2000 1999
------- -------- --------
Cash flows from operating activities:
Net income (loss).................................................... $12,534 $(20,856) $ (2,410)
Adjustments to reconcile net loss to net cash provided by (used in)
operating activities:
Provision for deferred income taxes................................ -- -- 250
Depreciation and amortization...................................... 6,228 6,631 6,833
Reduction in provision for doubtful accounts....................... -- -- (727)
Issuance of compensatory stock option.............................. 73 -- 86
Stock issued in settlement of litigation........................... -- 10,361 --
Loss on disposal of fixed assets................................... 153 -- --
Change in operating assets and liabilities:
Trade accounts receivable and license installments............. (4,581) (1,358) 15,745
Prepaid expenses and other current assets...................... (714) (678) 278
Accounts payable and accrued expenses.......................... 1,089 (1,601) (1,165)
Deferred revenue............................................... 1,111 (3,700) (12,659)
------- -------- --------
Net cash provided by (used in) operating activities......... 15,893 (11,201) 6,231
Cash flows from investing activities:
Purchase of equipment and improvements............................. (561) (2,626) (2,766)
Other long term assets and liabilities............................. 475 (354) 175
------- -------- --------
Net cash used in investing activities....................... (86) (2,980) (2,591)
Cash flows from financing activities:
Payments net of proceeds under capital lease obligations........... (315) (54) 126
Exercise of stock options.......................................... 60 806 666
Proceeds from sale of stock under Employee Stock Purchase Plan..... 301 814 435
------- -------- --------
Net cash provided by financing activities................... 46 1,566 1,227
Effect of exchange rate on cash and cash equivalents.................. (175) (50) 331
------- -------- --------
Net increase (decrease) in cash and cash equivalents........ 15,678 (12,665) 5,198
Cash and cash equivalents, beginning of year.......................... 17,339 30,004 24,806
------- -------- --------
Cash and cash equivalents, end of year................................ $33,017 $ 17,339 $ 30,004
======= ======== ========
Supplemental disclosures of cash flow information:
Cash paid during the year for:
Interest....................................................... $ 36 $ 88 $ 32
------- -------- --------
Income taxes................................................... $ 1,191 $ 834 $ 28
------- -------- --------
Non-cash financing activity:
Equipment acquired under capital lease............................. $ -- $ 292 $ 280
------- -------- --------
Stock issued in settlement of litigation........................... $ -- $ 10,361 $ --
======= ======== ========
The accompanying notes are an integral part of these consolidated financial
statements.
F-6
PEGASYSTEMS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2001, 2000 and 1999
1. SIGNIFICANT ACCOUNTING POLICIES
(a) Business
Pegasystems Inc. and subsidiaries (the "Company") develops, markets,
licenses and supports software that enables transaction intensive-organizations
to manage a broad array of customer interactions. The Company also offers
consulting, training, and maintenance and support services to facilitate the
installation and use of its products.
(b) Management Estimates and Reporting
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America 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 periods presented. Actual results could differ from
those estimates. Significant assets and liabilities with reported amounts based
on estimates include trade and installment accounts receivable, long term
license installments and deferred revenue.
During 2001, the Company continued to improve its accounting systems and was
able to develop more accurate estimates of revenues attributable to inflation
adjustments contained in the Company's long-term software license agreements.
These improved estimates of the determinable amount of additional license fees
earned had the effect of increasing license revenue by approximately $2.3
million in 2001.
(c) Principles of Consolidation
The consolidated financial statements include the accounts of the Company
and its wholly-owned subsidiaries, Pegasystems Limited (a United Kingdom
company), Pegasystems Company (a Canadian company), Pegasystems Worldwide Inc.
(a United States corporation), GDOO AB (a Swedish company), and Pegasystems Pty
Ltd. (an Australian company), Pegasystems Investments Inc. (a United States
corporation) and Pegasystems Private Limited (a Singapore company). All
intercompany accounts and transactions have been eliminated in consolidation.
To be consistent with current year presentation, which shows short-term license
installments separate from trade accounts receivable, certain amounts in the
2000 consolidated balance sheet have been reclassified.
(d) Foreign Currency Translation
The translation of assets and liabilities of the Company's foreign
subsidiaries is made at year-end exchange rates, while revenue and expense
accounts are translated at the average exchange rates during the period
transactions occurred. The resulting translation adjustments are reflected as a
separate component of accumulated other comprehensive loss. Realized and
unrealized exchange gains or losses from transactions and adjustments are
reflected in other income, net, in the accompanying consolidated statements of
operations.
(e) Revenue Recognition
The Company's revenue is derived from two sources: software license fees and
service fees. Software license fees are generally payable on a monthly basis
under license lease agreements, which generally have a five-year term and may
be renewed for additional years at the customer's option. The present value of
future license payments is generally recognized as revenue upon customer
acceptance and lease renewal. A portion of the fee from each arrangement is
initially deferred and recognized as installment receivable interest income
over the rest of the license term. In addition, many of the Company's contracts
contain provisions allowing for
F-7
PEGASYSTEMS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
increases in amounts billed to reflect inflation, the net present value of such
increases is recognized as revenue when the values are determinable. For
purposes of the present value calculations, the discount rates used are
estimates of customers' borrowing rates, typically below prime rate, and have
varied between 3.5% and 8.00% for the three years ended December 31, 2001. As a
result, revenue that the Company recognizes relative to these types of license
arrangements can be impacted by changes in market interest rates. For software
license agreement renewals, license revenue is recognized upon customer
commitment to the new license terms.
The Company's services revenue is comprised of fees for software
implementation, consulting, maintenance, and training services. The Company's
software implementation and consulting agreements typically require the Company
to provide a specified level of implementation services for a specified fee,
with additional consulting services available at an hourly rate. Revenues for
time and material projects are recognized as fees are billed. Revenues for
fixed price projects are recognized once the fair value of services and any
other elements to be delivered under the arrangement can be determined. Costs
associated with fixed price contracts are expensed as incurred. Historically,
the Company has had difficulty developing accurate estimates of time and
resources needed to complete fixed price projects. As a result, determination
of the fair value of the elements of the contract has generally occurred later
in the implementation process, typically when implementation is complete and
remaining services are no longer significant to the project. Prior to the point
at which the fair value of the elements of a contract can be determined,
revenue recognition for fixed price projects is limited to amounts equal to
costs incurred, resulting in no gross profit. Once the fair values of the
elements of a contract are apparent, profit associated with the fixed price
services elements will begin to be recognized. Software license customers are
offered the option to enter into a maintenance contract, which requires the
customer to pay a monthly maintenance fee over the term of the maintenance
agreement, typically renewable annually. Prepaid maintenance fees are deferred
and are recognized evenly over the term of the maintenance agreement. The
Company generally recognizes training fees as the services are provided. The
Company reduces revenue for the fair value of potential concessions during the
period in which revenue is initially recorded, which are in turn recognized in
revenue when the related elements are completed and provided to the customer.
(f) Concentration of Credit Risk
Financial instruments that potentially subject the Company to a
concentration of credit risk consist of short term cash investments, trade
accounts receivable and long-term license installments receivable. The Company
records long-term license installments in accordance with its revenue
recognition policy, which results in receivables from customers (due in periods
exceeding one year from the reporting date, primarily from large organizations
with strong credit ratings). The Company grants credit to customers who are
located throughout the world. The Company performs credit evaluations of its
customers and generally does not request collateral from its customers. Amounts
due under long-term license installments are expected to be received as follows:
F-8
PEGASYSTEMS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
License
Installments
Years Ended December 31, (in thousands)
------------------------ --------------
2002................................. $ 31,359
2003................................. 23,470
2004................................. 15,540
2005................................. 10,184
2006................................. 4,686
--------------
85,239
Deferred license interest income..... (10,725)
--------------
Total license installments receivable $ 74,514
==============
(g) Cash and Cash Equivalents
The Company considers all highly liquid investments with remaining
maturities of three months or less at the date of purchase to be cash
equivalents.
(h) Equipment and Improvements
Equipment and improvements are recorded at cost. Depreciation is computed
using the straight-line method over the estimated useful lives of the assets,
which are three years for equipment and five years for furniture and fixtures.
Leasehold improvements and equipment under capital lease are amortized over the
lesser of the life of the lease or the useful life of the asset. Repairs and
maintenance costs are expensed as incurred.
(i) Impairment of Long-Lived Assets
The Company evaluates its long lived assets for impairment whenever events
or changes in circumstances indicate that the carrying amount of such assets
may not be recoverable. If such assets are considered to be impaired, the
impairment to be recognized is measured by the amount by which the carrying
amount of the asset exceeds the fair value of the asset.
(j) Research and Development and Software Costs
Research and development costs, other than certain software related costs,
are expensed as incurred. Capitalization of software costs begins upon the
establishment of technical feasibility, generally demonstrated by a working
model or an operative version of the computer software product that is
completed in the same language and is capable of running on all of the
platforms as the product to be ultimately marketed. Such costs have not been
material to date, and as a result, no internal costs were capitalized during
2001, 2000 or 1999. See Note 6 for discussion of the capitalized purchased
software in connection with the Company's Software License and Support and
Warrant Agreements with First Data Resources, Inc.
Software costs are included in cost of software license revenue. No
amortization expense for internally developed capitalized software costs was
charged to cost of software license revenue in 2001, 2000, and 1999.
(k) Net Earnings (Loss) Per Share
Basic earnings (loss) per share is computed based on the weighted average
number of common shares outstanding during the period. Diluted earnings (loss)
per share includes, to the extent inclusion of such shares would be dilutive to
earnings per share, the effect of outstanding options and warrants, computed
using the treasury stock method.
F-9
PEGASYSTEMS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Years Ended December 31,
-------------------------
2001 2000 1999
------- -------- -------
(in thousands,
except per share data)
Basic
Net income (loss)........................................................ $12,534 $(20,856) $(2,410)
======= ======== =======
Weighted average common shares outstanding............................... 32,677 29,206 28,947
Basic earnings (loss) per share.......................................... $ 0.38 $ (0.71) $ (0.08)
Diluted
Net income (loss)........................................................ $12,534 $(20,856) $(2,410)
======= ======== =======
Weighted average common shares outstanding............................... 32,677 29,206 28,947
Effect of assumed exercise of stock options.............................. 757 -- --
------- -------- -------
Weighted average common shares outstanding, assuming dilution............ 33,434 29,206 28,947
Diluted earnings (loss) per share........................................ $ 0.37 $ (0.71) $ (0.08)
Outstanding options and warrant excluded as impact would be anti-dilutive 7,618 4,326 5,400
(l) Segment Reporting
The Company currently operates in one operating segment, customer service
software. The Company derives substantially all of its operating revenue from
the sale and support of one group of similar products and services.
Substantially all of the Company's assets are located within the United States.
During 2001, 2000, and
1999, the Company derived its operating revenue from the following countries,
principally through export from the United States of America:
2001 2000 1999
----------- ----------- -----------
(in $ thousands)
United States. $71,384 77% $59,699 74% $60,220 79%
United Kingdom 9,360 10% 6,826 8% 4,079 5%
Europe........ 8,747 10% 8,724 11% 6,802 9%
Other......... 2,796 3% 5,557 7% 5,528 7%
------- --- ------- --- ------- ---
$92,287 100% $80,806 100% $76,629 100%
======= === ======= === ======= ===
In 2001, 2000, and 1999, one customer accounted for approximately 13.5%,
11.7%, and 12.5% of the Company's total revenue, respectively. At December 31,
2001, one customer represented 16.4% of outstanding accounts receivable and one
customer represented 15.7% of long and short-term license installments.
(m) Stock Options
The Company periodically grants stock options for a fixed number of shares
to employees and directors with an exercise price equal to the fair market
value of the shares at the date of the grant. The Company accounts for such
stock option grants using the intrinsic value method in accordance with APB
Opinion No. 25, "Accounting for Stock Issued to Employees", and intends to
continue to do so. Stock options granted to non-employee contractors are
accounted for using the fair value method in accordance with SFAS No. 123,
"Accounting for Stock-Based Compensation". The Company has adopted the
disclosure provisions of SFAS No. 123, "Accounting for Stock-Based
Compensation," relative to the impact of the fair value method.
F-10
PEGASYSTEMS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(n) Fair Value of Financial Instruments
The principal financial instruments held by the Company consist of cash and
equivalents, accounts receivable and payable, capital lease obligations, and
license installment receivables arising from license transactions. The carrying
values of cash and equivalents, accounts receivable, accounts payable, and
capital lease obligations approximates their fair value due to the short-term
nature of the accounts. Using current market rates, the fair value of license
installment receivables approximates carrying value at December 31, 2001 and
2000.
(o) Legal Costs
Costs incurred in connection with various litigation in which the Company is
involved are expensed as incurred.
(p) New Accounting Standards
In June 2001, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 141, "Business
Combinations," and SFAS No. 142, "Goodwill and Other Intangible Assets." These
pronouncements provide guidance on how to account for the acquisition of
businesses and intangible assets, including goodwill, which arise from such
activities. SFAS No.141 affirms that only one method of accounting may be
applied to a business combination, the purchase method. SFAS No. 141 also
provides guidance on the allocation of purchase price to the assets acquired.
SFAS No. 142 provides that goodwill resulting from business combinations no
longer be amortized to expense, but rather requires an annual assessment of
impairment and, if necessary, adjustments to the carrying value of goodwill.
Adoption of these pronouncements would not have a significant effect on the
Company's consolidated financial statements.
In July 2001, the FASB issued SFAS No. 143, "Accounting for Obligations
Associated with the Retirement of Long-Lived Assets and SFAS No. 144
"Accounting for the Impairment of Disposal of Long-Lived Assets. SFAS No.143
establishes accounting standards for the recognition and measurement of an
asset retirement obligation and its associated asset retirement cost. It also
provides guidance for legal obligations associated with the retirement of
tangible long-lived assets. SFAS No. 144 establishes a single accounting model
for the impairment or disposal of long-lived assets, including discontinued
operations. Adoption of these pronouncements is not expected to have a
significant effect on the Company's consolidated financial statements.
2. VALUATION AND QUALIFYING ACCOUNTS -- ALLOWANCE FOR DOUBTFUL ACCOUNTS
The Company's allowance for doubtful accounts was $1.0 million at December
31, 2001 and 2000. For the years ended December 31, 2001 and 2000, no provision
for doubtful accounts was recorded. For the year ended December 31, 1999, the
provision for doubtful accounts was a credit of $0.7 million. The following is
a roll forward of the allowance for doubtful accounts:
Additions
Balance (Deductions)
at Charged to Charged Balance
Beginning Costs and to Other at End
Description of Year Expenses Account Write-offs of Year
----------- --------- ------------ -------- ---------- -------
(in thousands)
Allowance for doubtful accounts:
Year ended December 31, 2001. $1,037 -- 3 -- $1,034
Year ended December 31, 2000. $1,026 -- 11 -- $1,037
Year ended December 31, 1999. $2,753 (727) -- (1,000) $1,026
F-11
PEGASYSTEMS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
3. EQUIPMENT AND IMPROVEMENTS
The cost and accumulated depreciation of equipment and improvements consist
of the following:
December 31,
------------------
2001 2000
-------- --------
(in thousands)
Computer equipment and purchased software...... $ 8,535 $ 15,157
Furniture and fixtures......................... 2,990 3,511
Leasehold improvements......................... 3,133 3,367
Equipment under capital leases................. 914 914
-------- --------
15,572 22,949
Less: accumulated depreciation and amortization (12,519) (16,381)
-------- --------
Equipment and improvements, net................ $ 3,053 $ 6,568
======== ========
Depreciation expense was approximately $3.9 million, $4.3 million, and $4.5
million for the years ended December 31, 2001, 2000, and 1999, respectively.
During the year ended December 31, 2001, the Company recorded disposals of
approximately $7.9 million of furniture and fixtures, and leasehold
improvements, resulting in a loss on disposal of $153 thousand.
4. ACCOUNTS PAYABLE AND ACCRUED EXPENSES
Accounts payable and accrued expenses consist of the following:
December 31,
---------------
2001 2000
------- -------
(in thousands)
Trade accounts payable........................... $ 881 $ 1,502
Employee compensation and benefits............... 7,940 3,874
Accrued taxes.................................... 758 1,096
Other accrued expenses........................... 3,261 4,627
Accrued restructuring and severance (See Note 10) -- 818
------- -------
$12,840 $11,917
======= =======
5. STOCKHOLDERS' EQUITY
(a) Common Stock
The Company has 45,000,000 authorized shares of common stock $.01 par value,
of which 32,754,648 shares were issued and outstanding at December 31, 2001.
(b) Preferred Stock
The Company has authorized 1,000,000 shares of Preferred Stock, which may be
issued from time to time in one or more series. The Company's Board of
Directors has authority to issue the shares of Preferred Stock in one or more
series, to establish the number of shares to be included in each series and to
fix the designation, powers, preferences and rights of the shares of each
series and the qualifications, limitations or restrictions thereof, without any
further vote or action by the stockholders. The issuance of Preferred Stock
could decrease the amount of earnings and assets available for distribution to
holders of Common Stock, and may have the effect of delaying, deferring or
preventing a change in control of the Company. The Company had not issued any
shares of preferred stock as of December 31, 2001.
F-12
PEGASYSTEMS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(c) Long-Term Incentive Plan
In 1994, the Company adopted a Long Term Incentive Plan as amended, (the
"1994 Plan") to provide employees, directors and consultants with opportunities
to purchase stock through incentive stock options and non-qualified stock
options.
In addition to options, eligible participants under the 1994 Plan may be
granted stock appreciation rights, restricted stock and long-term performance
awards. As of December 31, 2001, a total of 11.5 million shares of common stock
were reserved for issuance under the 1994 Plan. At December 31, 2001,
approximately 1.6 million shares were available for issuance.
The option price per share is determined at the date of grant. For incentive
stock options, the option price may not be less than 100% of the fair market
value of the Company's common stock at the grant date. Incentive stock options
granted to a person having greater than 10% of the voting power of all classes
of stock must have an exercise price of at least 110% of fair market value of
the Company's common stock. Options granted under the 1994 Plan generally vest
over five years and expire no later than ten years from the date of grant.
(d) 1996 Non-Employee Director Stock Option Plan
The Director Plan was originally adopted by the Board of Directors on May
13, 1996 and approved by the stockholders on June 26, 1996. An amendment and
restatement of the Director Plan was adopted by the Board of Directors on
November 23, 1999. As amended and restated, the Director Plan provides for the
grant to each new non-employee Director of the Company on the date he or she
first becomes a Director of an option to purchase 30,000 shares of Common Stock
at a price per share equal to the fair market value thereof on the date of
grant, such option to vest in equal annual installments over three years. It
also provides for the grant to each non-employee Director at the time of the
regular meeting of Directors following the annual stockholders meeting
(commencing in 2000) of a fully vested option to purchase 10,000 shares of
Common Stock at a price per share equal to the fair market value thereof on the
date of grant. Prior to amendment and restatement, the Director Plan provided
for the grant to each new non-employee Director of the Company on the date he
or she first became a Director of the Company an option to purchase 30,000
shares of Common Stock at a price per share equal to the fair market value
thereof on the date of grant, such options to vest in equal annual installments
over five years. At December 31, 2001, 10,000 shares were available for grant
under the Director Plan. There are 130,000 shares reserved for issuance upon
exercise of options granted under the Director Plan. The Director Plan is
administered by the Company's Compensation Committee.
(e) 1996 Employee Stock Purchase Plan
The 1996 Employee Stock Purchase Plan (the "Stock Purchase Plan") was
adopted by the Board of Directors on May 13, 1996 and approved by the
stockholders on June 26, 1996. An aggregate of 500,000 shares of common stock
are reserved for issuance pursuant to this plan. To date, there have been four
stock issuances under the Stock Purchase Plan of approximately 375,000 shares.
Under the terms of the Stock Purchase Plan, employees are entitled to purchase
shares at 85% of the fair market value of the Company's common stock on either
the commencement date or completion date for offerings under the plan,
whichever is less. The Stock Purchase Plan is tax qualified and no compensation
expense has been recognized in the financial statements for the completed
offerings.
F-13
PEGASYSTEMS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Stock Options Summary
For pro forma compensation expense relating to the Employee Stock Purchase
Plan, the weighted average fair value of shares sold in 2001, 2000, and 1999
was $1.74, $7.27, and $2.79
The following table presents the combined activity for the 1994 Plan and the
Director Plan for the years ended December 31:
2001 2000 1999
---------------- ---------------- ----------------
Weighted Weighted Weighted
Number Average Number Average Number Average
of Exercise of Exercise of Exercise
Options Price Options Price Options Price
------- -------- ------- -------- ------- --------
(in thousands, except per share amounts)
Outstanding options at beginning of year: 7,537 $8.83 6,262 $ 6.02 5,532 $7.61
Granted................................... 2,300 4.10 2,962 17.41 2,834 5.23
Exercised................................. (68) 0.50 (299) 2.69 (222) 3.01
Cancelled................................. (1,152) 8.91 (1,388) 9.66 (1,882) 9.69
------ ----- ------ ------ ------ -----
Outstanding options at end of year............ 8,617 7.56 7,537 8.92 6,262 6.02
====== ===== ====== ====== ====== =====
Exercisable options at end of year............ 4,415 7.46 3,165 6.79 2,058 4.33
------ ----- ------ ------ ------ -----
Weighted average fair value of options granted
during the year.............................. 2.87 11.69 3.97
===== ====== =====
The following table presents weighted average price and life information
about significant option groups outstanding and exercisable at December 31,
2001:
Options Outstanding Options Exercisable
---------------------------------------------- -----------------------------
Weighted
Average
Number Remaining Weighted Number Weighted
Range of Outstanding Contractual Life Average Exercisable Average
Exercise Prices (in thousands) (years) Exercise Price (in thousands) Exercise Price
--------------- -------------- ---------------- -------------- -------------- --------------
$ 0.33-- 4.22 2,536 6.69 $ 2.80 1,634 $ 2.36
4.34-- 7.38 2,164 8.93 4.76 504 5.26
7.63-- 8.95 2,157 7.11 7.80 1,308 7.80
9.23--25.75 1,760 969
----- 7.52 17.58 ----- 16.76
8,617 4,415
===== =====
The following are the pro forma net loss and loss per share, as if the
compensation expense for the option plans had been determined based on the fair
value at the grant consistent with the provisions of SFAS No. 123:
2001 2000 1999
--------------- ------------------ ----------------
As Pro As Pro As Pro
Reported Forma Reported Forma Reported Forma
-------- ------ -------- -------- -------- -------
Net income (loss) (in thousands) $12,534 $ (390) $(20,856) $(34,570) $(2,410) $(7,776)
Basic loss per share............ $ 0.38 $(0.01) $ (0.71) $ (1.18) $ (0.08) $ (0.27)
Diluted loss per share.......... $ 0.37 $(0.01) $ (0.71) $ (1.18) $ (0.08) $ (0.27)
F-14
PEGASYSTEMS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The fair value of options at the date of grant were estimated using the
Black-Scholes option pricing model with the following weighted-average
assumptions:
2001 2000 1999
---- ---- ----
Volatility.................. 100% 200% 97%
Expected option life (years) 5.0 5.0 5.0
Interest rate (risk free)... 4.4% 6.00% 5.54%
Dividends................... None None None
The effects on 2001, 2000, and 1999 pro forma net loss and loss per share of
the estimated fair value of stock options and shares are not necessarily
representative of the effects on the results of operations in the future. In
addition, the estimates made utilize a pricing model developed for traded
options with relatively short lives; the Company's option grants typically have
a life of up to ten years and are not transferable. Therefore, the actual fair
value of a stock option grant may be different from the Company's estimates.
The Company believes that its estimates incorporate all relevant information
and represent a reasonable approximation in light of the difficulties involved
in valuing non-traded stock options.
6. SOFTWARE LICENSE AND SUPPORT AND WARRANT AGREEMENTS
On June 27, 1997, the Company entered into Software License and Support and
Warrant Agreements with First Data Resources, Inc. ("FDR").
The provisions of the Software License and Support Agreement give FDR the
right to use the Company's software in connection with new products and also
the exclusive right to market, distribute and sublicense the Company's software
and new products to FDR customers and prospects. In addition to the granting of
a license to use its software, the Company will also provide services to FDR in
connection with the new products. For the right to the license and the
services, FDR is expected to pay the Company a base fee of $49.25 million with
additional fees possible based on successful resale of the products. FDR paid
$39.9 million through December 31, 2001 of which $9.2 million was paid in 2001
and remaining fees are expected to be paid on a monthly basis over the term of
the agreement. The initial term of this agreement commenced on June 27, 1997
and runs through December 31, 2002.
In accordance with the Software License and Support Agreement, the Company
was granted a license for access to and the use of the designs, specifications
and code of FDR's ESP product. As consideration for this right, the Company
paid FDR $10.0 million. This amount was recorded as purchased software on the
accompanying balance sheets.
In connection with the Software License and Support Agreement, the Company
committed to provide a warrant to FDR. Pursuant to the Warrant Agreement, the
Company gave FDR the right to purchase 284,876 shares of the Company's common
stock at a purchase price of $28.25 per share which represented the fair market
value of the common stock on the date of the agreement. The warrant became
exercisable on June 27, 1998 and will expire on June 27, 2002. The warrant was
valued at $2.9 million and the corresponding deferred asset was capitalized and
included in "purchased software and other" on the accompanying balance sheets.
The Company has been recognizing the base fee revenue and also amortizing
the value of the purchased software and the warrant on a pro rata basis over
the initial 5 1/2 year term of the agreement. During the years ended December
31, 2001, 2000 and 1999, the Company recognized base fee revenue of
approximately $8.9 million per year, related to the Software License and
Support Agreement and recorded amortization expense of approximately $2.3
million per year, related to the ESP software and warrant.
F-15
PEGASYSTEMS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
7. LEASES
The Company leases certain equipment and office space under non-cancelable
capital and operating leases. Future minimum rental payments required under the
capital and operating leases with non-cancelable terms in excess of one year at
December 31, 2001 are as follows:
Years Ending December 31, Capital Leases Operating Leases
------------------------- -------------- ----------------
(in thousands)
2002.......................................... $ 83 $4,263
2003.......................................... -- 2,142
2004.......................................... -- 704
2005.......................................... -- 647
2006.......................................... -- 49
2007 and thereafter........................... -- --
----- ------
$ 83 $7,805
Less: amounts representing interest.............. (2)
-----
Present value of minimum lease payments..........
Less: current portion............................ (81)
-----
Capital lease obligations, net of current portion $ --
=====
Total rent expense under operating leases was approximately $4.5 million,
$4.9 million, and $5.2 million, for the years ended December 31, 2001, 2000,
and 1999, respectively.
8. INCOME TAXES
The components of income/(loss) before provision (benefit) for income taxes
are as follows:
2001 2000 1999
------- -------- -------
(in thousands)
Domestic. $12,214 $(21,538) $(2,451)
Foreign.. 1,320 982 1,541
------- -------- -------
Total. $13,534 $(20,556) $ (910)
------- -------- -------
The components of the provision for income taxes for the years ended
December 31, 2001, 2000, and 1999 consists of the following:
2001 2000 1999
------ ---- ------
(in thousands)
Current:
Federal................ $ 146 $ -- $ --
State.................. -- -- --
Foreign................ 854 300 1,250
------ ---- ------
Total current...... $1,000 $300 $1,250
Deferred:
Federal................ -- -- 1,139
State.................. -- -- (139)
Foreign................ -- -- (750)
------ ---- ------
Total deferred..... -- -- $ 250
------ ---- ------
Total provision........ $1,000 $300 $1,500
====== ==== ======
F-16
PEGASYSTEMS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The effective income tax rate differed from the statutory federal income tax
rate due to the following:
2001 2000 1999
----- ----- ------
Statutory federal income tax rate......................... 35.0% (35.0)% (35.0)%
State income taxes, net of federal benefit and tax credits -- -- (9.9)
Permanent differences..................................... 1.5 1.4 66.5
Tax credits............................................... -- -- (170.4)
Tax effective on foreign activities....................... 2.1 (0.2) (4.3)
Increases in (reductions of) valuation allowance.......... (31.2) 35.3 317.9
----- ----- ------
Effective income tax rate................................. 7.4% 1.5% 164.8%
===== ===== ======
Deferred income taxes at December 31, 2001 and 2000, reflect the net tax
effects of net operating loss and tax credit carry forward and temporary
differences between the carrying amounts of assets and liabilities for
financial statement purposes and the amounts used for tax purposes. The
components of the Company's net deferred tax assets (liabilities) as of
December 31, 2001 and 2000 are as follows:
December 31,
------------------
2001 2000
-------- --------
(in thousands)
Software revenue................ $(25,982) $(22,677)
Depreciation.................... (84) (895)
Vacation accrual................ 236 189
Receivable and other reserves... 900 2,073
Net operating loss carry forward 32,592 33,711
Tax credits..................... 5,078 3,515
-------- --------
Net deferred tax assets......... 12,740 15,916
Less valuation allowances....... 13,740 16,916
-------- --------
$ (1,000) $ (1,000)
======== ========
A valuation allowance has been provided for deferred tax assets since it is
uncertain if the Company will realize the entire benefit of the assets. The
decrease in the valuation allowance during the year resulted from the
generation of additional future taxable temporary differences and the
utilization of U.S. net operating tax losses. Of the valuation allowance at
December 31, 2001, approximately $ 1.1 million is related to tax benefits
generated on exercise of stock options, which will be recorded directly to
equity when realized.
At December 31, 2001, the Company had alternative minimum tax ("AMT"), and
research and experimentation ("R&E") credit carry forwards for federal and
state purposes of approximately $5.9 million, available to offset future
taxable income. The carry forward period for the AMT credit is unlimited. The
R&E credit carry forwards generally expire from 2002 to 2021.
As of December 31, 2001, the Company has available U.S. net operating loss
carry forwards of approximately $82.4 million. The operating loss carry
forwards expire from 2012 to 2020. These carry forwards may be used to offset
future income taxes payable at the federal and state levels, if any, and are
subject to review by the U.S. Internal Revenue Service and various state taxing
authorities.
A provision has not been made for the U.S. or additional foreign taxes on
$1.8 million of undistributed earnings of foreign subsidiaries that could be
subject to taxation if remitted to the U.S., because the Company plans to keep
these amounts permanently reinvested overseas.
F-17
PEGASYSTEMS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
9. COMMITMENTS AND CONTINGENCIES
Company Litigation
Pegasystems Inc. v. Carreker Corporation, C.A. No. 19043 (Del Ch.) On August
7, 2001, the Company filed a Verified Complaint (the "Complaint") against
Carreker Corporation ("Carreker") in Delaware Chancery Court. The Complaint
alleged that Carreker breached the Product Development, Distribution and
Sublicensing Agreement (the "Agreement") that Pegasystems and Carreker executed
in May 1999. Through that Agreement, Pegasystems and Carreker had committed to
devote their efforts to jointly develop backroom banking products employing
Pegasystems' workflow products as core components, and to refrain from other
activities or alliances that would create products within the exception
management market. The Complaint alleged that Carreker breached the Agreement
when it acquired Check Solutions Company and continued the development,
marketing and sales of Check Solutions products; that Carreker breached its
covenant of good faith and fair dealing; and that Carreker had engaged in
unfair competition. The Complaint sought to enjoin Carreker (including Check
Solutions) from developing, marketing, licensing, advertising, leasing or
selling any products that compete with those jointly developed by Pegasystems
and Carreker under the Agreement, or any exception management products or
services other than those products jointly developed by Carreker and
Pegasystems under the Product Development, Distribution and Sublicensing
Agreement between the parties. Pegasystems moved for expedited discovery (which
the Court allowed), and for a preliminary injunction. On August 20, 2001, the
Company filed a verified Amended Complaint. On October 1, 2001, the Court
issued a Memorandum Opinion dated September 28, 2001, granting Pegasystems'
motion and concluding that a preliminary injunction should issue. The Court
found that the undisputed facts preliminarily established that Carreker's
acquisition of Check Solutions violated several provisions of the Agreement,
including: the requirement that Carreker refrain from any development
activities or alliances which would create competing products; the requirements
that Carreker not assume any obligation or restriction that does or would
interfere or conflict with its performance under the Agreement; and the
requirement that Carreker exercise its best efforts to market and sell the
jointly-developed products in its exclusive territory. The Court further found
that none of the defenses set forth by Carreker had merit. On October 15, 2001,
the Court denied a motion by Carreker seeking reconsideration, and on October
17, 2001, the Court entered the Preliminary Injunction Order. On August 27,
2001, Carreker filed a Demand for Arbitration with the American Arbitration
Association (the "AAA"), and provided Pegasystems with notice purporting to
terminate the Agreement. Pegasystems opposed the filing of the Demand for
Arbitration, on the ground that Carreker had not exhausted the dispute
resolution procedures in the Agreement, and also argued that the purported
notice of termination was invalid. In the Court's September 28 Opinion, it
found that because the Agreement did not provide Carreker with a contractual
right to terminate, Carreker's notice of termination - sent only after the
litigation was commenced - had no legal force. On October 5, 2001, the AAA
agreed with the Company that Carreker's arbitration demand was premature, and
directed the parties to mediate their dispute. On November 5, 2001, the Company
announced that it had reached a settlement agreement with Carreker, resolving
both the Delaware and AAA proceedings, which have been dismissed and closed,
respectively.
In the Matter of the Arbitration Between Pegasystems Inc, et al., and Ernst
& Young, LLP, et al. On June 9, 2000, the Company and two of its officers filed
a complaint against Ernst & Young, LLP and Alan B. Levine (a former partner of
Ernst & Young) in Massachusetts state court. The Complaint alleges that the
defendants committed professional malpractice, breached contractual and
fiduciary duties owed to the Company, and issued false and misleading public
statements, in connection with advice that Ernst & Young rendered to the
Company to record $5 million in revenue in its financial statements for the
second fiscal quarter ended June 30, 1997 pursuant to a series of contracts
between the Company and First Data Resources, Inc. The complaint sought
compensatory damages, including contribution for losses and other costs
incurred in connection with certain class action securities litigation, which
has been settled. On April 5, 2001, the Court dismissed the Complaint, finding
that it was subject to the dispute resolution procedures set forth in an
engagement letter between the Company and Ernst & Young. The parties have
agreed to arbitrate this dispute. An arbitration hearing has tentatively been
scheduled for June 2002.
F-18
PEGASYSTEMS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
SEC Investigation. In May 1999, the Boston office of the SEC issued a
Formal Order of Private Investigation of the Company and certain individuals
currently or formerly associated with the Company concerning past accounting
matters, financial reports and other public disclosures and trading activity in
the Company's securities during 1997 and 1998. The Company continues to
cooperate fully with the investigation.
Qwest Arbitration. On January 17, 2002, the Company filed a demand for
arbitration with the American Arbitration Association in Denver, Colorado
against Qwest Corporation, successor in interest to US West Business Resources,
Inc. The Company is seeking monetary damages in the arbitration relating to
Qwest's termination of a software license and service agreement between the
parties. On February 8, 2002, Qwest filed a counterclaim against the Company
seeking monetary damages for alleged breach of that agreement by the Company.
10. LITIGATION SETTLEMENT AND RESTRUCTURING
The Company had been involved in two lawsuits related to restatements of its
financial statements (the Chalverus case and the Gelfer Case). The Company has
settled both cases and recorded a charge of $14.8 million, net of insurance
reimbursement of $4.3 million, during 2000, reflecting the cost of settlements
and legal costs.
During the year ended December 31, 2000, the Company recorded a
restructuring charge of $1.0 million for severance of 75 employees in various
locations and certain costs associated with leased facilities. Approximately
$0.2 million of additional depreciation expense was recorded due to reduced
economic life of the leased facilities to be closed or idled under the
restructuring plan. Terminations were completed in January 2001. There are no
accruals remaining relating to these charges as of December 31, 2001.
11. SELECTED QUARTERLY INFORMATION (UNAUDITED)
2001
----------------------------------------------
1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
----------- ----------- ----------- -----------
(in thousands, except per share data)
Revenue...................... $22,817 $ 22,856 $23,107 $23,507
Gross profit................. 12,713 12,384 14,009 15,560
(Loss) income from operations (177) 1,052 2,244 3,415
Net income................... 1,094 2,652 3,884 4,904
Earnings per share--Basic.... $ 0.03 $ 0.08 $ 0.12 $ 0.15
Earnings per share--Diluted.. $ 0.03 $ 0.08 $ 0.12 $ 0.15
2000
----------------------------------------------
1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
----------- ----------- ----------- -----------
(in thousands, except per share data)
Revenue...................... $18,006 $ 21,280 $ 22,664 $18,856
Gross profit................. 8,839 12,338 10,952 7,289
Loss from operations......... (2,728) (14,850) (1,497) (6,877)
Net loss..................... (1,377) (13,699) (246) (5,534)
Loss per share--Basic........ $ (0.05) $ (0.47) $ (0.01) $ (0.18)
Loss per share--Diluted...... $ (0.05) $ (0.47) $ (0.01) $ (0.18)
F-19
PEGASYSTEMS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
12. SUBSEQUENT EVENT (UNAUDITED)
On February 6, 2002, the Company acquired substantially all of the assets of
1mind Corporation (1mind) for initial consideration valued at $3.4 million,
consisting of 569,949 shares of the Company's common stock and warrants to
purchase for nominal consideration 83,092 shares of the Company's common stock.
Depending upon the achievement of specified milestones by the acquired business
in 2002 and validation of the negotiated value of 1mind, the Company will pay
up to approximately $6 million in additional consideration substantially in the
form of shares of the Company's common stock. The acquisition of 1mind will be
accounted for as a purchase. The Company has not yet completed the process of
appraising the fair values of 1mind assets, and accordingly has not yet
allocated the purchase price.
F-20