ITEM 1. BUSINESS
OVERVIEW
Virage is a leading provider of software products and services that enable media and entertainment companies, corporate enterprises, educational institutions, and government agencies to publish, manage and distribute their video content over the Internet and intranets. Our Video Application Platform provides the necessary infrastructure for seamlessly integrating Internet-ready video into an internal or external website, transforming video into an effective online medium. Our platform includes our SmartEncode products, which encode and index video within a single automated process, and our server products, which enable the publishing and distribution of streaming video. Owners of video content can leverage our technology either by licensing our products or by employing our application services to outsource their needs. We currently have over 250 customers including media and entertainment corporations such as CNET, CNN, Disney and Warner Bros.; sports leagues such as Major League Baseball Advanced Media and the National Hockey League; global corporations such as Boeing, Cisco and Coca-Cola; educational institutions such as Harvard Business School, Princeton University and Stanford University Graduate School of Business; and government entities such as the FBI and the Library of Congress.
We were founded in April 1994 and incorporated in Delaware in March 1995. Our principal executive offices are located at 177 Bovet Road, Suite 520, San Mateo, California 94402 and our telephone number is (650) 573-3210.
INDUSTRY BACKGROUND
The emergence and rapid growth of broadband networks is enabling the use of streaming video across a variety of industry sectors. For many media and entertainment companies, video assets are central to their business. Conversion of those assets to digital formats is a requisite step to an increasingly digital future and offers both productivity as well as revenue enhancing potential. For example, conversion to digital video increases productivity by allowing staff to view and edit video on their corporate intranets, eliminating the need to find and handle videotapes. Digital video allows media companies to produce new content more quickly and to reuse existing content more effectively. In addition, video content can now be distributed directly to consumers with broadband access at work, in school, or in their homes, providing additional sources of revenue for content owners. For corporate enterprises, the value of web video distribution can be realized through more effective communication throughout the organization. The use of streaming video in the enterprise can also deliver increased productivity and significant cost savings. For example, a web-based video training course can substitute for expensive and time-consuming travel to a training site. Similarly, educational institutions can use video on their intranet or on the Internet to expand the reach of their courses or to enhance the research resources of their students.
According to a study released by Jupiter Media Metrix in April 2001, corporations will spend significantly higher amounts on streaming video technology in the next four years. Jupiter estimates that
spending will reach $2.8 billion in 2005, up from $140 million in 2000. The Federal Communications Commission also predicts that half of all Internet connections in the US will be broadband by 2004.
Even with significant improvements in networks and high-speed network access, further roadblocks inhibit the mass adoption of streaming video. First, the transformation to and management of digital video are complex and costly for the content owner. Second, current streaming media deployments and techniques result in an undesirable viewing experience for the end-user.
To effectively deliver video to the Internet or intranet, video must first be converted to a digital format such as RealVideo, QuickTime, Windows Media, or MPEG. This conversion process, known as encoding, produces digital video files that are stored in a wide variety of file storage systems or storage area networks. In order to reach the end-user or consumer, encoded video is distributed through hosting, caching, and backbone service providers either while it is encoded (live webcasting) or after the fact, when requested by the viewer (on-demand). Until recently, the only commercial products available for implementing streaming video were basic encoding tools and streaming servers. These basic tools were highly manual and ineffective for deploying and managing streaming video content at an enterprise scale. These techniques did not provide the content management capabilities necessary to deploy large video collections across multiple Internet or intranet sites in a timely and cost-effective manner.
To date, the end-user's streaming video viewing experience has been very poor. Although rapid improvements in networks and servers continue to improve the reliability and image quality of streaming video, most web video is lacking in other ways. First, streaming video is usually presented in a linear fashion, reflecting and inheriting the limitations of its technical predecessor, the television. Streaming video has also resided on the web in isolation because it lacks the data to interact properly with other textual or multimedia information. As the amount of video on the Internet or on a corporate intranet grows, the viewer's inability to locate the video they want, view just the segments they want, and retrieve or view related textual material will lead to an increasingly frustrating and time-consuming experience. To make matters worse, this frustrating user experience also results in inefficient and costly use of network bandwidth as users struggle to find the relevant information.
Content owners require an enterprise-class solution to deploy, manage and distribute video content over the Internet and intranets while enhancing the user's viewing experience.
THE VIRAGE SOLUTION
Virage provides a robust platform that supports enterprise-scale streaming media deployments. Our products allow customers to transform, manage and distribute their video in a way that is efficient, scalable, and of the highest quality. At the front end, Virage transforms video from an amorphous analog source into a structured digital video database quickly and efficiently. Our products eliminate much of the complexity, time, and effort required to encode and index video properly. In addition, our platform allows customers to administer and manage their collections of digital video content, integrating them dynamically throughout one or more Internet or intranet sites. Just as importantly, our products dramatically improve the end-users' experience by allowing them to quickly locate and view just the content that they want. As enterprises begin to deploy streaming media, Virage's solutions provide the content management capabilities required to scale these efforts successfully.
The Virage Internet Video Application Platform consists of several modules that can be implemented together or separately. Customers can employ these modules either by purchasing a license to our software or by outsourcing their needs to our Application Services division, which is powered by the same software we sell commercially.
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SMARTENCODE(TM) PRODUCTS
VideoLogger(R)
With a single pass of the video content, our VideoLogger application generates a rich information index and simultaneously encodes the video into the selected digital formats. The video index and digital video files are time synchronized, allowing the index data to reference particular moments in the video. The indexing process converts video into data that computers can recognize. The index, or video database, acts like an index found at the back of a book, allowing pinpoint access into video content. Indexing information can be derived from automated analysis of the video stream, from external sources of time-coded data, or from information entered by a user. Automatically extracted information includes a visual storyboard of scene changes, a transcription of spoken words (via speech recognition), audio classification, closed captioning or teletext, names of recognized faces and speakers, on-screen text, and time code. External sources of data could include an "edit decision list" from non-linear video editing software such as Avid, a transcript of words spoken, or a real-time statistics feed from a sports stadium. User entered information can include clip titles, clip descriptions, categories, clip in and out points, event dates, and other custom descriptions. The easy-to-use VideoLogger interface allows a customer to monitor video capture and indexing, control multiple encoders, and create clips on the fly. Once the index is produced, it can be integrated with a number of different back-end solutions, including the Virage Video Application Server. The Virage SmartEncode process is available either through the latest release of the award-winning Virage VideoLogger product or in an outsourced fashion through Virage application services.
Customers or third-party developers can enhance the SmartEncode process through the VideoLogger Software Developer Kit (SDK). The VideoLogger SDK provides developers and systems integrators access to the full range of VideoLogger functions through a programming interface. This enables reliable integration into a wide variety of automated workflows and allows developers to add additional indexing and encoding functionality to VideoLogger as necessary.
Virage ControlCenter(TM)
The Virage ControlCenter product is a powerful workflow application that remotely schedules, controls, and manages the SmartEncode process for multiple VideoLoggers from a central console. Capture of the source video signal is the starting point. Virage software can accept video from virtually any analog or digital source: camera, satellite feed, television, video tape, or digital file. Capture of multiple video
feeds can be automated and managed centrally via ControlCenter for greater efficiency. For outsourcing needs, Virage production facilities in the United States and Europe can capture content from over 500 satellite channels worldwide, from a range of professional satellites and fiber networks, and from all major tape formats.
SERVER PRODUCTS
Virage Video Application Server(TM)
The powerful XML-based Video Application Server product provides a comprehensive platform for publishing, managing and distributing Virage-enabled content on the web. The Video Application Server hosts the video index generated by the SmartEncode process. It is designed for high performance and can scale to enterprise-wide and Internet-wide deployments. The Video Application Server content management capabilities include account setup, deleting or inserting video assets from the databases, editing existing video assets, and managing multiple video collections.
The Video Application Server is used to publish and distribute content to video rich websites. With the Video Application Server, a customer can efficiently publish on demand video throughout a website, seamlessly integrated with the existing website look and feel. Sample web templates provide an easy "out of the box" experience, or customers can develop their own HTML templates to create search and results pages and player windows tailored to their specific needs. The Video Application Server supports all common streaming formats including RealVideo, Windows Media, QuickTime, and MPEG. It can also extend the viewing experience beyond the PC-based Internet to set top boxes, game consoles, handheld and wireless devices.
Other Server products include the following:
Video Application Server SDK
The Video Application Server Software Developer Kit (SDK) allows developers and systems integrators to build custom applications to suit any publishing environment.
Virage Syndication Manager(TM)
Our Syndication Manager application allows content owners to securely syndicate their streaming video content to a variety of web affiliates. Content owners can create discrete packages of video clips and assign rights to those packages to an array of affiliates. Content owners can set up business rules for each affiliate that will ensure that the video will be used only as contractually specified.
MediaSync(TM)
Our MediaSync product provides a fully integrated, end-to-end solution for rapidly assembling, synchronizing and publishing streaming video with PowerPoint slides to a website.
SERVICE OFFERINGS
Virage offers a wide variety of services to ensure our customers' success. Customers are encouraged to choose the combination of products and services that best meets their needs.
Software installation and training
License software customers increasingly are contracting with Virage for software installation and training support. These services ensure that customers can get up and running successfully with Virage software as quickly as possible. These services are typically billed on a daily or hourly basis.
Development and implementation services
Virage offers a variety of professional services aimed at helping customers to implement or customize our commercial software. The services typically consist of implementing our SmartEncode products in a unique production environment or building specialized plug-ins to our products. We can also build custom web templates for Video Application Server installations and help with website integration. We offer these services to customers regardless of whether they license software products, or opt for our outsourced, hosted solution. These services are typically billed on an hourly basis, though in some cases we offer a fixed fee project based upon the size of the project.
SmartEncode services
Instead of purchasing our SmartEncode products, customers can instead outsource their video processing needs to us. Using our own SmartEncode products, we process content from a variety of analog or digital sources and produce multiple formats and bit rates of high quality encoded video along with a rich video database. Editorial services include custom headlines, descriptions, keywords, and other useful information added by our expert content editors to suit a customer's requirements. We also can transcribe content to produce an exact text of the speech. We typically bill for such services as a charge per hour of video processed depending upon the level of services required. These services are provided out of our production facilities in the United States and Europe.
Application hosting services
Instead of purchasing our server products, customers can instead choose to have Virage host the Video Application Server and related applications on their behalf. Virage hosts the video information, also known as metadata, and surrounding application logic while one of our content distribution partners typically hosts the streaming video files. We provide daily, weekly, and monthly traffic reports to the content owner. We also provide a secure administration and publishing interface that provides our customers complete control of how and where their content gets published. We typically charge for application hosting services with both a fixed monthly minimum charge, and a variable component that increases based upon accesses to our video database. Virage has two datacenters that provide fault-tolerant arrays of servers, global load-balancing, and 24/7 monitoring to ensure reliable and scalable hosting.
BUSINESS STRATEGY
Our goal is to strengthen our position as a leading provider of products and application services that enable owners of content to publish, manage and distribute their video content over the Internet and intranets. To achieve this objective, our business strategy includes the following key components:
BECOME THE STANDARD FOR DEPLOYING, MANAGING AND DISTRIBUTING VIDEO CONTENT OVER THE INTERNET AND INTRANETS.
We intend to establish Virage as the standard for the deployment, management and distribution of video content over the Internet and intranets. To achieve this goal, we focus our direct and indirect selling and marketing activities on industry leaders in the media and entertainment, corporate enterprise, education, and government markets. Many major media companies, broadcast networks and large corporations already use Virage. We can grow our revenues through additional sales to our existing customers and sales to new customers. We believe that our penetration rate into most existing customers is low; most have done small pilot implementations which can lead to much larger sales opportunities. A small group of customers have made larger purchases, but even these larger customers offer significant new sales opportunities. For example, we have licensed our products to a number of larger broadcasters such as CNN primarily to automate their newsroom operations. We have recently obtained additional business from CNN for their video archives and from Turner Broadcasting Europe. We believe that there are additional archive opportunities with each of our broadcast customers, as well as opportunities to expand our software and services into additional newsrooms or affiliates. We also have a number of corporate customers who have made small initial purchases for either archives or for consumer focus groups. We believe we have opportunities in each of these corporations as they roll out additional streaming video initiatives such as corporate communications or training.
GENERATE INCREASING REVENUE STREAMS THROUGH NEW PRODUCTS AND SERVICES.
We intend to generate additional revenues by introducing new products and services. We have added, and will continue to add, to our licensed software product offering. For example, in the past fiscal year, we added several new applications including the Video Application Server, ControlCenter, and MediaSync products. We also introduced multi-byte support for Asian languages, along with new audio analysis support for Spanish, Italian, German, UK English, Brazilian Portuguese, Japanese, and Mandarin. In the fourth quarter of fiscal 2001, we also introduced a professional services offering to assist licensed software customers with implementation of our software products. We grew our applications services outsource solution in the fourth quarter of fiscal 2001 to over $1,000,000, a greater than three-fold increase over the same quarter of fiscal 2000. Virage expects to continue a significant investment in product development. Our development efforts will include both continued expansion of the base technology as well as development of specific applications to support customers in media and entertainment, sports, corporations, education, and government.
EMPOWER CONTENT PROVIDERS WITHOUT COMPETING AGAINST THEM.
Our licensed products and application services enable our customers to retain control over their video content and brands. We allow our customers to maintain a direct relationship with their user audience by distributing their video content directly from their own Internet sites, while extending the reach of their content through syndication. We do not aggregate our customers' video content on our own Internet site, and we do not depend on advertising and commerce revenue streams from our own Internet site to drive our business. We intend to maintain this business model, which supports content providers, as well as to enhance this model by providing products and application services that will drive more traffic to our customers' Internet sites.
ENHANCE AND LEVERAGE OUR TECHNICAL LEADERSHIP POSITION.
We combine the use of our proprietary technologies with proven third-party technologies to create technically advanced products and application services. Our internal technologies include our video indexing and management technologies, our configurable track architecture and an extensible software plug-in framework. We have filed 19 patent applications in the United States, six of which have resulted in issued patents. We will continue to aggressively develop and protect our intellectual property. We have designed our architecture and application programming interfaces to enable both rapid integration and easy interchangeability of proven third-party technologies into our products. We will continue to evaluate and integrate multiple third-party technologies into our products, selecting and substituting these technologies
based on technical superiority and favorable business economics. We have also designed our architecture and application programming interfaces to allow rapid integration of our products with the products of our value-added resellers and system integrators. As a result, our products are currently integrated with products from over 25 other vendors. We will continue to develop products that integrate easily with the products of other vendors in our markets.
EXPAND OUR INTERNATIONAL PRESENCE.
Potential customers for our products and services are located throughout the world. We intend to develop local sales, technical support and application services operations that can support these customers. We have an established subsidiary in London, England through which we have sold our products and services to a number of European customers including the BBC, Cable and Wireless, Ferrari Racing Team, Reuters, Schlumberger and Turner Broadcasting Europe. We also initiated sales operations in Latin America and Asia in fiscal 2001 and we plan to expand those operations in fiscal 2002.
PURSUE STRATEGIC RELATIONSHIPS.
We intend to pursue strategic relationships with, or acquisitions of, other companies to increase our customer base, expand our products and services, and strengthen our management team. By developing strategic relationships with leading technology providers, we believe we will be able to proliferate our products and services and improve our access to our target customer base. In addition, we may acquire companies to enhance our product and service offerings, to increase our workforce and to broaden our market opportunities.
CUSTOMERS
Our customers represent large media and entertainment corporations, other global corporations, educational institutions and government entities. For the year ended March 31, 2001, no customer accounted for more than 10% of our total revenues. For the year ended March 31, 2000, two customers each accounted for 13% and 10% of our total revenues. For the year ended March 31, 1999 three customers each accounted for 17%, 14% and 13% of our total revenues.
RESEARCH AND DEVELOPMENT
We believe that our future success will depend in part on our ability to continually develop new and enhance existing products and services. Accordingly, we invest a significant amount of our resources in research and product development activities. Our research and development expenses totaled $9,101,000, $4,182,000, and $2,325,000 for the years ended March 31, 2001, 2000 and 1999 respectively.
SALES AND MARKETING
SALES AND DISTRIBUTION STRATEGY
We sell our products and application services through a direct sales force and through indirect distribution channels. We currently target customers in several markets including media and entertainment, and enterprises such as corporations, government entities and universities. Our sales strategy is to pursue multiple opportunities for large-scale deployments within each customer account. Through our direct sales force in Boston, Chicago, London, Los Angeles, Munich, New York, San Francisco, Tampa/St. Petersburg, Atlanta, Houston, and Washington D.C., we focus on larger customers in North America, Europe, Latin America, and Asia. Our field representatives sell our products and services to customers who have been qualified by our telesales personnel. In addition, our direct sales force manages local relationships with key resellers. Our indirect distribution channels include major industry vendors, domestic and international distributors, system integrators and value-added resellers. Together, these distributors and value-added resellers accounted for approximately 33% of total revenues for the year ended March 31, 2001.
MARKETING ACTIVITIES
Since our inception, we have invested a substantial percentage of our revenues in a broad range of marketing activities to generate demand, gain corporate brand identity and educate the market about our products and services. These activities have focused primarily on direct marketing, direct mail and email, seminars, public relations, co-marketing and branding with our major customer accounts and strategic partners, targeted trade shows, conferences, speaking engagements, and product information through print collateral and our Internet site. In addition, we have an established developer relations function to encourage independent software developers to develop products and solutions that are compatible with our products and technologies.
COMPETITION
The Internet video marketplace is new, rapidly evolving and intensely competitive. As more companies begin to deploy searchable and interactive video on the Internet, we expect competition to intensify. We currently compete directly with other providers in the Internet video infrastructure marketplace including Convera Corporation. We may also compete indirectly with larger system integrators who embed or integrate these directly competing technologies into their product offerings. It is possible that we may work with these same larger companies on one customer bid and compete with them on another. In the future, we may compete with other video services vendors and searchable video portals. In addition, we may compete with our current and potential customers who may develop software or perform application services internally.
We believe that the principal competitive factors in our market are:
- video indexing management functionality;
- services experience and expertise;
- demonstrated video technology expertise;
- customer references;
- company reputation;
- ease of installation and use;
- real-time processing capability;
- software reliability and stability;
- scalability;
- pricing;
- 24-by-7 customer support; and
- adoption by other customers
We believe we compete favorably with our competitors based on these factors.
INTELLECTUAL PROPERTY
We depend on our ability to develop and maintain the proprietary aspects of our technology. To protect our proprietary technology, we rely primarily on a combination of patent, trademark and copyright laws, as well as confidentiality and license agreements with our employees and others. We actively seek patent protection for our intellectual property. We have filed 19 U.S. patent applications on our proprietary technology. Six patents have been issued and a seventh patent has been allowed by the Patent and Trademark Office. Our remaining twelve patent applications are currently pending. In 1997, we entered into a five-year patent cross-licensing agreement with IBM. The terms of this agreement include our nonexclusive license of IBM's multimedia software patents in return for an annual fee and a license to IBM of all of our current patents as described above and any patents that may be issued to us in the future.
We have seventeen trademarks, four of which are registered. We seek to avoid disclosure of our trade secrets by limiting access to our proprietary technology and restricting access to our source code. Despite these precautions, it may be possible for unauthorized third parties to copy particular portions of our technology or reverse engineer or obtain and use information that we regard as proprietary. In addition, the laws of some foreign countries do not protect proprietary rights to the same extent, as do the laws of the United States. Our means of protecting our proprietary rights in the United States or abroad may not be adequate and competing companies may independently develop similar technology.
EMPLOYEES
As of March 31, 2001, we had 199 employees and 18 full time contractors. Of our 217 total staff, 50 were employed in services, 76 were employed in engineering, 67 were employed in sales and marketing, and 24 were employed in general and administrative positions. None of our employees is subject to a collective bargaining agreement, and we have never experienced a work stoppage. We consider our relations with our employees to be good.
RISK FACTORS
The occurrence of any of the following risks could materially and adversely affect our business, financial condition and operating results. In this case, the trading price of our common stock could decline and you might lose all or part of your investment.
RISKS RELATED TO OUR BUSINESS
OUR REVENUE, COST OF SALES, AND EXPENSE FORECASTS WERE ONLY RECENTLY INTRODUCED TO THE PUBLIC AND THERE ARE A NUMBER OF RISKS THAT MAKE IT DIFFICULT FOR US TO FORESEE OR ACCURATELY EVALUATE FACTORS THAT MAY IMPACT SUCH FORECASTS.
We have limited visibility into future demand, and our limited operating history makes it difficult for us to foresee or accurately evaluate factors that may impact such future demand. Visibility over potential sales is typically limited to the current quarter. In order to provide a revenue forecast for the current quarter, we must make assumptions about conversion of these potential sales into current quarter revenues. Such assumptions may be materially incorrect due to competition for the customer order including pricing pressures, sales execution issues, customer selection criteria or length of the customer selection cycle, the failure of sales contracts to meet our revenue recognition criteria, our inability to hire and retain qualified personnel, our inability to develop new markets in Europe or Asia, and other factors that may be beyond our control. In addition, we are reliant on third party resellers for a significant portion of our license revenues and we have limited visibility into the status of orders from such third parties.
For quarters beyond the current quarter, we have very limited visibility into potential sales opportunities, and thus we have a lower confidence level in any revenue forecast or forward-looking guidance. In developing a revenue forecast for such quarters, we assess any customer indications about future demand, general industry trends, marketing lead development activities, productivity goals for the sales force and expected growth in sales personnel, and any demand for products that we may have.
Our cost of sales and expense forecasts are based upon our budgets and spending forecasts for each area of the Company. Circumstances we may not foresee could increase cost and expense levels beyond the levels forecasted. Such circumstances may include competitive threats in our markets which we may need to address with additional sales and marketing expenses, legal claims, employee turnover, additional royalty expenses should we lose a source of current technology, losses of key management personnel, unknown defects in our products, and other factors we cannot foresee.
BECAUSE WE HAVE ONLY RECENTLY INTRODUCED OUR VIDEO SOFTWARE PRODUCTS AND APPLICATION SERVICES, WE FACE A NUMBER OF RISKS WHICH MAY SERIOUSLY HARM OUR BUSINESS.
We incorporated in April 1994 and to date we have generated only limited revenues. We introduced our first video software products in December 1997, our application services in May 1999 and our professional services in March 2001. Because we have a limited operating history with our video software products, application services and professional services and because our revenue sources may continue to shift as our business develops, you must consider the risks and difficulties that we may encounter when making your investment decision. These risks include our ability to:
- expand our customer base;
- increase penetration into key customer accounts;
- maintain our pricing structure;
- develop new video products and application services; and
- adapt our products and services to meet changes in the Internet video infrastructure marketplace.
If we do not successfully address these risks, our business will be seriously harmed.
OUR BUSINESS MODEL IS UNPROVEN AND MAY FAIL, WHICH MAY SIGNIFICANTLY DECREASE THE MARKET PRICE OF OUR COMMON STOCK.
We do not know whether our business model and strategy will be successful. Our business model is based on the premise that content providers will use our licensed products and application services to catalog, manage, and distribute their video content over the Internet and intranets. Our potential customers may elect to rely on their internal resources or on lower priced products and services that do not offer the full range of functionality offered by our products and services. If the assumptions underlying our business model are not valid or if we are unable to implement our business plan, our business will suffer.
WE HAVE NOT BEEN PROFITABLE AND IF WE DO NOT ACHIEVE PROFITABILITY, OUR BUSINESS MAY FAIL.
We have experienced operating losses in each quarterly and annual period since we were formed and we expect to incur significant losses in the future. As of March 31, 2001, we had an accumulated deficit of $61,174,000. We expect to continue to incur increasing research and development, sales and marketing and general and administrative expenses. Accordingly, our failure to increase our revenues significantly or improve our gross margins will harm our business. In addition, our cash, cash equivalent and short-term investment resources (collectively, "cash resources") totaled $48,131,000 as of March 31, 2001 and we used $16,863,000 in our operating activities during the year ended March 31, 2001. We anticipate that our operating activities will use additional cash resources for at least the next 12 months. This may leave us with a deteriorated cash position in comparison to our cash position as of March 31, 2001 and this may affect our ability to transact future strategic operating and investing activities in a timely manner, which may harm our business and cause our stock price to fall. Even if we should achieve profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis in the future. If our revenues grow more slowly than we anticipate, if our gross margins do not improve, or if our operating expenses exceed our expectations, our operating results will suffer and our stock price may fall.
OUR QUARTERLY OPERATING RESULTS ARE VOLATILE AND DIFFICULT TO PREDICT. IF WE FAIL TO MEET THE EXPECTATIONS OF PUBLIC MARKET ANALYSTS OR INVESTORS, THE MARKET PRICE OF OUR COMMON STOCK MAY DECREASE SIGNIFICANTLY.
Our quarterly operating results have varied significantly in the past and are likely to vary significantly in the future. We believe that period-to-period comparisons of our results of operations are not meaningful and should not be relied upon as indicators of future performance. If securities analysts follow our stock, our operating results will likely fall below their expectations in some future quarter or quarters. Our failure to meet these expectations would likely cause the market price of our common stock to decline.
Our quarterly revenues depend on a number of factors, many of which are beyond our control and which makes it difficult for us to predict our revenues going forward. We plan to increase our operating expenses and if our revenues and gross margins do not increase, our business could be seriously harmed. We plan to increase our operating expenses to expand our sales and marketing operations, fund greater levels of research and development, expand our application and professional services and develop our internal organization. Many of these expenditures are planned or committed in advance in anticipation of future revenues, and if our revenues in a particular quarter are lower than we anticipate, we may be unable to reduce spending in that quarter. As a result, any shortfall in revenues or a failure to improve gross margins would likely hurt our quarterly operating results.
OUR REVENUES MAY BE HARMED IF GENERAL ECONOMIC CONDITIONS CONTINUE TO WORSEN.
Our revenues are dependent on the health of the economy and the growth of our customers and potential future customers. If the economy remains stagnant, our customers may continue to delay or reduce their spending on our software and service solutions. When economic conditions weaken, sales cycles for sales of software products and related services tend to lengthen and companies' information technology budgets tend to be reduced. If that happens, our revenues could suffer and our stock price may decline. Further, if the economic conditions in the United States worsen or if a wider or global economic slowdown occurs, we may experience a material adverse impact on our business, operating results, and financial condition.
OUR SERVICE REVENUES HAVE A SUBSTANTIALLY LOWER MARGIN THAN OUR LICENSE REVENUES, AND AN INCREASE IN SERVICE REVENUES RELATIVE TO LICENSE REVENUES COULD HARM OUR GROSS MARGINS.
Our service revenues, which includes fees for our application services as well as professional services such as consulting, implementation, maintenance and training, were 45% of our total revenues for the year ended March 31, 2001, 20% of our total revenues for the year ended March 31, 2000 and 8% of our total revenues for the year ended March 31, 1999. Our service revenues have substantially lower gross margins than our license revenues. Our cost of service revenues for the years ended March 31, 2001, 2000 and 1999 were 144%, 218% and 168%, respectively, of our service revenues. An increase in the percentage of total revenues represented by service revenues could adversely affect our overall gross margins.
Service revenues as a percentage of total revenues and cost of service revenues as a percentage of total revenues have varied significantly from quarter to quarter due to our relatively early stage of development. Historically, the relative amount of service revenues as compared to license revenues has varied based on customer demand for our application services revenues. However, we anticipate an increase in the percentage of license customers requesting professional services as a result of our introduction of professional services in the fourth quarter of fiscal 2001, which will also impact the relative amount of service revenues as compared to license revenues. We expect that the amount and profitability of our professional services will depend in large part on:
- the software solution which has been licensed;
- the complexity of the customers' information technology environments;
- the resources directed by customers to their implementation projects;
- the size and complexity of customer implementations; and
- the extent to which outside consulting organizations provide services directly to customers.
IF OUR INTERNAL PROFESSIONAL SERVICES ORGANIZATION DOES NOT PROVIDE IMPLEMENTATION SERVICES EFFECTIVELY AND ACCORDING TO SCHEDULE, OUR REVENUES AND PROFITABILITY WOULD BE HARMED.
Customers that license our products may require consulting, implementation, maintenance and training services and obtain them from our internal professional services, customer support and training organizations. When we provide these services, we may be required to recognize revenue from the licensing of our software products as the implementation services are performed. If our internal professional services organization does not effectively implement and support our products or if we are unable to expand our internal professional services organization as needed to meet our customers' needs, our ability to sell software, and accordingly our revenues, will be harmed.
THE FAILURE OF ANY SIGNIFICANT FUTURE CONTRACTS TO MEET OUR POLICIES FOR RECOGNIZING REVENUE MAY PREVENT US FROM ACHIEVING OUR REVENUE OBJECTIVES FOR A QUARTER OR A FISCAL YEAR, WHICH WOULD HURT OUR OPERATING RESULTS.
Our sales contracts are typically based upon standard agreements that meet our revenue recognition policies. However, our future sales may include site licenses, consulting services or other transactions with customers who may negotiate special terms and conditions that are not part of our standard sales contracts. If these special terms and conditions cause sales under these contracts to not qualify under our revenue recognition policies, we would defer revenues to future periods, which may hurt our reported operating results and cause our stock price to fall.
THE LENGTH OF OUR SALES AND DEPLOYMENT CYCLE IS UNCERTAIN, WHICH MAY CAUSE OUR REVENUES AND OPERATING RESULTS TO VARY SIGNIFICANTLY FROM QUARTER TO QUARTER.
During our sales cycle, we spend considerable time and expense providing information to prospective customers about the use and benefits of our products and services without generating corresponding revenue. Our expense levels are relatively fixed in the short term and based in part on our expectations of future revenues. Therefore, any delay in our sales cycle could cause significant variations in our operating results, particularly because a relatively small number of customer orders represent a large portion of our revenues.
Some of our largest sources of revenues are government entities and large corporations that often require long testing and approval processes before making a decision to license our products. In general, the process of entering into a licensing arrangement with a potential customer may involve lengthy negotiations. As a result, our sales cycle has been and may continue to be unpredictable. In the past, our sales cycle has ranged from one to 12 months. Our sales cycle is also subject to delays as a result of customer-specific factors over which we have little or no control, including budgetary constraints and internal approval procedures. In addition, because our technology must often be integrated with the products and services of other vendors, there may be a significant delay between the use of our software and services in a pilot system and our customers' volume deployment of our products and services.
IF OUR CUSTOMERS FAIL TO GENERATE TRAFFIC ON THE VIDEO-RELATED SECTIONS OF THEIR INTERNET SITES, OUR RECURRING REVENUES MAY DECREASE, WHICH MAY ADVERSELY AFFECT OUR BUSINESS AND FINANCIAL RESULTS.
Our ability to achieve recurring revenues from our application services is largely dependent upon the success of our customers in generating traffic on the video-related sections of their Internet sites. Generally, we generate recurring revenue from our application services whenever our customers add more hours of video to an existing project and with each additional video query on a customer's site. If our customers do not attract and maintain traffic on video-related sections of their sites, video queries may decrease and customers may decide not to add more hours of video to existing projects. This result would cause revenues from our application services to decrease, which will prevent us from growing our business.
IF WE FAIL TO INCREASE THE SIZE OF OUR CUSTOMER BASE OR INCREASE OUR REVENUES WITH OUR EXISTING CUSTOMERS, OUR BUSINESS WILL SUFFER.
Increasing the size of our customer base and increasing the revenues we generate from our customer base are critical to the success of our business. To expand our customer base and the revenues we generate from our customers we must:
- generate additional revenues from different organizations within our customers;
- conduct effective marketing and sales programs to acquire new customers; and
- establish and maintain distribution relationships with value added resellers and system integrators.
Our failure to achieve one or more of these objectives will hurt our business.
THE PRICES WE CHARGE FOR OUR PRODUCTS AND SERVICES MAY DECREASE, WHICH WOULD REDUCE OUR REVENUES AND HARM OUR BUSINESS.
The prices we charge for our products and services may decrease as a result of competitive pricing pressures, promotional programs and customers who negotiate price reductions. For example, some of our competitors have provided their services without charge in order to gain market share or new customers and key accounts. The prices at which we sell and license our products and services to our customers depend on many factors, including:
- purchase volumes;
- competitive pricing;
- the specific requirements of the order;
- the duration of the licensing arrangement; and
- the level of sales and service support.
If we are unable to sell our products or services at acceptable prices relative to our costs, or if we fail to develop and introduce on a timely basis new products and services from which we can derive additional revenues, our financial results will suffer.
WE RELY ON, AND EXPECT TO CONTINUE TO RELY ON, A LIMITED NUMBER OF CUSTOMERS FOR A SIGNIFICANT PORTION OF OUR REVENUES AND IF ANY OF THESE CUSTOMERS STOPS LICENSING OUR SOFTWARE OR PURCHASING OUR PRODUCTS AND SERVICES, OUR OPERATING RESULTS WILL SUFFER.
Historically, a limited number of customers has accounted for a significant portion of our revenues. We anticipate that our operating results in any given period will continue to depend to a significant extent upon revenues from a small number of customers. We cannot be certain that we will retain our current customers or that we will be able to recruit additional or replacement customers. If we were to lose one or more customers, our operating results could be significantly harmed.
ANY FAILURE OF OUR NETWORK COULD LEAD TO SIGNIFICANT DISRUPTIONS IN OUR APPLICATION SERVICES BUSINESS WHICH COULD DAMAGE OUR REPUTATION, REDUCE OUR REVENUES OR OTHERWISE HARM OUR BUSINESS.
Our application services business is dependent upon providing our customers with fast, efficient and reliable services. To meet our customers' requirements, we must protect our network against damage from, among other things:
- human error;
- physical or electronic security breaches;
- computer viruses;
- fire, earthquake, flood and other natural disasters;
- power loss;
- telecommunications failure; and
- sabotage and vandalism.
Our failure to protect our network against damage from any of these events will hurt our business.
WE DEPEND ON OUTSIDE THIRD PARTIES TO MAINTAIN OUR COMMUNICATIONS HARDWARE AND PERFORM MOST OF OUR COMPUTER HARDWARE OPERATIONS AND IF THESE THIRD PARTIES' HARDWARE AND OPERATIONS FAIL, OUR REPUTATION AND BUSINESS WILL SUFFER.
We have communications hardware and computer hardware operations located at Exodus Communications' facility in Santa Clara, California, at AboveNet Communications' facility in New York City, and at Phoenix Communications in New Jersey. We do not have complete backup systems for these operations. A problem with, or failure of, our communications hardware or operations could result in interruptions or increases in response times on the Internet sites of our customers. Furthermore, if these third party partners fail to adequately maintain or operate our communications hardware or do not perform our computer hardware operations adequately, our services to our customers may not be available. We have experienced system failures in the past. Other outages or system failures may occur. Any disruptions could damage our reputation, reduce our revenues or otherwise harm our business. Our insurance policies may not adequately compensate us for any losses that may occur due to any failures or interruptions in our systems.
POWER OUTAGES IN CALIFORNIA COULD ADVERSELY AFFECT US.
We have significant operations in the state of California and are dependent on a continuous power supply. California's energy crisis could substantially disrupt our operations and increase our expenses. California has recently implemented, and may in the future continue to implement, rolling blackouts throughout the state. Although state lawmakers are working to minimize the impact, if blackouts interrupt our power supply, we may be temporarily unable to continue operations at our California facilities. Any such interruption in our ability to continue operation at our facilities could delay the development of our products and services and disrupt communications with our customers or other third parties on which we rely, such as web hosting service providers. Future interruptions could damage our reputation and could result in lost revenue, either of which could substantially harm our business and results of operations. Furthermore, shortages in wholesale electricity supplies have caused power prices to increase. If energy prices continue to increase, our operating expenses will likely increase which could have a negative effect on our operating results, which in turn may cause our stock price to fall.
IF WE ARE UNABLE TO PERFORM OR SCALE OUR CAPACITY SUFFICIENTLY AS DEMAND FOR OUR SERVICES INCREASES, WE MAY LOSE CUSTOMERS WHICH WOULD BE DETRIMENTAL TO OUR BUSINESS.
We cannot be certain that if we increase our customers we will be able to correspondingly increase our personnel and to perform our application services at satisfactory levels. Certain customer contracts contain cash penalty provisions in the event that we do not perform our application services at satisfactory levels
and such penalty provisions will reduce our revenues and harm our business. In addition, our application services may need to accommodate an increasing volume of traffic. If we are not able to expand our internal operations to accommodate such an increase in traffic, our customers' Internet sites may in the future experience slower response times or outages. If we cannot adequately handle a significant increase in customers or customers' traffic, we may lose customers or fail to gain new ones, which may reduce our revenues and harm our business.
IF WE DO NOT SUCCESSFULLY DEVELOP NEW PRODUCTS AND SERVICES TO RESPOND TO RAPID MARKET CHANGES DUE TO CHANGING TECHNOLOGY AND EVOLVING INDUSTRY STANDARDS, OUR BUSINESS WILL BE HARMED.
The market for our products and services is characterized by rapidly changing technology, evolving industry standards, frequent new product and service introductions and changes in customer demands. The recent growth of video on the Internet and intense competition in our industry exacerbate these market characteristics. Our future success will depend to a substantial degree on our ability to offer products and services that incorporate leading technology, and respond to technological advances and emerging industry standards and practices on a timely and cost-effective basis. To succeed, we must anticipate and adapt to customer requirements in an effective and timely manner, and offer products and services that meet customer demands. If we fail to do so, our products and services will not achieve widespread market acceptance, and we may not generate significant revenues to offset our development costs, which will hurt our business.
The development of new or enhanced products and services is a complex and uncertain process that requires the accurate anticipation of technological and market trends. We may experience design, manufacturing, marketing and other technological difficulties that could delay our ability to respond to technological changes, evolving industry standards, competitive developments or customer requirements. You should additionally be aware that:
- our technology or systems may become obsolete upon the introduction of alternative technologies, such as products that better manage and search video content;
- we could incur substantial costs if we need to modify our products and services to respond to these alternative technologies;
- we may not have sufficient resources to develop or acquire new technologies or to introduce new products or services capable of competing with future technologies; and
- when introducing new or enhanced products or services, we may be unable to manage effectively the transition from older products and services and ensure that we can deliver products and services to meet anticipated customer demand.
WE DEPEND ON TECHNOLOGY LICENSED TO US BY THIRD PARTIES, AND THE LOSS OF OR OUR INABILITY TO MAINTAIN THESE LICENSES COULD RESULT IN INCREASED COSTS OR DELAY SALES OF OUR PRODUCTS.
We license technology from third parties, including software that is integrated with internally developed software and used in our products to perform key functions. We anticipate that we will continue to license technology from third parties in the future. This software may not continue to be available on commercially reasonable terms, if at all. Although we do not believe that we are substantially dependent on any licensed technology, some of the software we license from third parties could be difficult for us to replace. The loss of any of these technology licenses could result in delays in the licensing of our products until equivalent technology, if available, is developed or identified, licensed and integrated. The use of additional third-party software would require us to negotiate license agreements with other parties, which could result in higher royalty payments and a loss of product differentiation. In addition, the effective implementation of our products depends upon the successful operation of third-party licensed products in conjunction with our products, and therefore any undetected errors in these licensed products could prevent the implementation or impair the functionality of our products, delay new product introductions and/or damage our reputation.
IF WE ARE UNABLE TO RETAIN OUR KEY PERSONNEL, OUR BUSINESS MAY BE HARMED.
Our future success depends to a significant extent on the continued services of our senior management and other key personnel, and particularly Paul Lego, our Chief Executive Officer. The loss of either this individual or other key employees would likely have an adverse effect on our business. We do not have employment agreements with most of our senior management team. If one or more of our senior management team were to resign, the loss could result in loss of sales, delays in new product development and diversion of management resources.
OUR COMMON STOCK PRICE HAS DECLINED IN VALUE BELOW THE EXERCISE PRICE OF MANY EMPLOYEE STOCK OPTIONS AND, AS A RESULT, WE MAY EXPERIENCE DIFFICULTIES RETAINING EMPLOYEES.
Our common stock price has recently declined in value below the exercise price of many stock options granted to employees pursuant to our stock option plans. Thus, the intended benefit of the stock option, the creation of performance and retention incentives, may not be realized. As a result, we may lose employees whom we would prefer to retain which would harm our business. We may be required to create additional performance and retention incentives in order to retain these employees including the granting of additional stock options to these employees at current prices or issuing incentive cash bonuses. Such incentives may either dilute our existing stockholder base or result in unforeseen operating expenses, which may cause our stock price to fall.
BECAUSE COMPETITION FOR QUALIFIED PERSONNEL IS INTENSE, WE MAY NOT BE ABLE TO RECRUIT OR RETAIN PERSONNEL, WHICH COULD IMPACT THE DEVELOPMENT AND ACCEPTANCE OF OUR PRODUCTS AND SERVICES.
We expect that we will need to hire additional personnel in all functional areas in the foreseeable future. Competition for personnel throughout our industry is intense. We may be unable to attract or assimilate other highly qualified employees in the future. We have in the past experienced, and we expect to continue to experience, difficulty in hiring highly skilled employees with appropriate qualifications. In addition, new hires frequently require extensive training before they achieve desired levels of productivity. Some members of our existing management team have been employed at Virage for less than one year. We may fail to attract and retain qualified personnel, which could have a negative impact on our business.
FAILURE TO PROPERLY MANAGE OUR POTENTIAL GROWTH WOULD BE DETRIMENTAL TO OUR BUSINESS.
Any growth in our operations will place a significant strain on our resources. As part of this growth, we will have to implement new operational and financial systems, procedures and controls to expand, train and manage our employee base and to maintain close coordination among our technical, accounting, finance, marketing, sales and editorial staffs. We will also need to continue to attract, retain and integrate personnel in all aspects of our operations. To the extent we acquire other businesses, we will also need to integrate and assimilate new operations, technologies and personnel. Failure to manage our growth effectively could hurt our business.
WE HAVE LEASES FOR OUR FACILITIES THAT EXPIRE ON VARIOUS DATES THROUGH 2006 THAT WE MAY NOT BE ABLE TO FULLY UTILIZE AND THIS MAY CAUSE US TO INCUR LARGE ONE-TIME CHARGES FOR EXCESS CAPACITY.
Our principal administrative, research and development, sales, services and marketing activities are conducted on two leased properties in San Mateo, California: the first property consists of 21,000 square feet and expires in May 2002 and the second property consists of 48,000 square feet and expires in September 2006. In addition, we lease a property in New York City for services and sales under a lease that expires in March 2005, a property near Boston, Massachusetts where we perform research and development under a lease that expires in June 2003 and a property near London, England where we perform sales, services, marketing and administrative activities and that expires in February 2002.
During the year ended March 31, 2001, we were able to sublease our excess capacity at our facilities and received rental payments of $1,185,000. These sublease agreements will expire during the year ended March 31, 2002, and we may not be successful in renewing our arrangements with our current sublease tenants or finding new sublease tenants. If this should occur, we would be required to record a one-time charge at the end of the sublease agreement for a portion of the rental payments that we owe to our landlord relating to any excess capacity that exists at our facilities. Such a charge will harm our operating results and may cause our stock price to fall.
DEFECTS IN OUR SOFTWARE PRODUCTS COULD DIMINISH DEMAND FOR OUR PRODUCTS, WHICH MAY CAUSE OUR STOCK PRICE TO FALL.
Our software products are complex and may contain errors that may be detected at any point in the life of the product. We cannot assure you that, despite testing by us and our current and potential customers, errors will not be found in new products or releases after shipment, resulting in loss of revenues, delay in market acceptance and sales, diversion of development resources, injury to our reputation or increased service and warranty costs. If any of these were to occur, our business would be adversely affected and our stock price could fall.
Because our products are generally used in systems with other vendors' products, they must integrate successfully with these existing systems. System errors, whether caused by our products or those of another vendor, could adversely affect the market acceptance of our products, and any necessary revisions could cause us to incur significant expenses.
WE COULD BE SUBJECT TO LIABILITY CLAIMS AND NEGATIVE PUBLICITY IF OUR CUSTOMERS' SYSTEMS, INFORMATION OR VIDEO CONTENT IS DAMAGED THROUGH THE USE OF OUR PRODUCTS OR OUR APPLICATION SERVICES.
If our customers' systems, information or video content is damaged by software errors, product design defects or use of our application services, our business may be harmed. In addition, these errors or defects may cause severe customer service and public relations problems. Errors, bugs, viruses or misimplementation of our products or services may cause liability claims and negative publicity ultimately resulting in the loss of market acceptance of our products and services. Our agreements with customers that attempt to limit our exposure to liability claims may not be enforceable in jurisdictions where we operate.
OTHERS MAY BRING INFRINGEMENT CLAIMS AGAINST US WHICH COULD BE TIME CONSUMING AND EXPENSIVE FOR US TO DEFEND.
Other companies, including our competitors, may obtain patents or other proprietary rights that would prevent, limit or interfere with our ability to conduct our business. These companies could assert, and it may be found, that our technologies infringe their proprietary rights. We could incur substantial costs to defend any litigation, and intellectual property litigation could force us to do one or more of the following:
- cease using key aspects of our technology that incorporate the challenged intellectual property;
- obtain a license from the holder of the infringed intellectual property right; and
- redesign some or all of our products.
From time to time, we have received notices claiming that our technology infringes patents held by third parties. In the event any such a claim is successful and we are unable to license the infringed technology on commercially reasonable terms, our business and operating results would be significantly harmed.
IF THE PROTECTION OF OUR INTELLECTUAL PROPERTY IS INADEQUATE, OUR COMPETITORS MAY GAIN ACCESS TO OUR TECHNOLOGY, AND WE MAY LOSE CUSTOMERS.
We depend on our ability to develop and maintain the proprietary aspects of our technology. We seek to protect our software, documentation and other written materials under trade secret and copyright laws, which afford only limited protection. Our proprietary rights may not prove viable or of value in the future
since the validity, enforceability and type of protection of proprietary rights in Internet related industries are uncertain and still evolving.
Unauthorized parties may attempt to copy aspects of our products or to obtain and use information that we regard as proprietary. Policing unauthorized use of our products is difficult, and while we are unable to determine the extent to which piracy of our software or code exists, software piracy can be expected to be a persistent problem. We license our proprietary rights to third parties, and these licensees may not abide by our compliance and quality control guidelines or they may take actions that would materially adversely affect us. 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, and effective patent, copyright, trademark and trade secret protection may not be available in these foreign jurisdictions. To date, we have not sought patent protection of our proprietary rights in any foreign jurisdiction. Our efforts to protect our intellectual property rights through patent, copyright, trademark and trade secret laws may not be effective to prevent misappropriation of our technology, or may not prevent the development and design by others of products or technologies similar to or competitive with those developed by us. Our failure or inability to protect our proprietary rights could harm our business.
AS WE EXPAND OUR OPERATIONS INTERNATIONALLY, WE WILL FACE SIGNIFICANT RISKS IN DOING BUSINESS IN FOREIGN COUNTRIES.
As we expand our operations internationally, we will be subject to a number of risks associated with international business activities, including:
- costs of customizing our products and services for foreign countries, including localization, translation and conversion to international and other foreign technology standards;
- compliance with multiple, conflicting and changing governmental laws and regulations, including changes in regulatory requirements that may limit our ability to sell our products and services in particular countries;
- import and export restrictions, tariffs and greater difficulty in collecting accounts receivable; and
- foreign currency-related risks if a significant portion of our revenues become denominated in foreign currencies.
FAILURE TO INCREASE OUR BRAND AWARENESS AMONG CONTENT OWNERS COULD LIMIT OUR ABILITY TO COMPETE EFFECTIVELY.
We believe that establishing and maintaining a strong brand name is important to the success of our business. Competitive pressures may require us to increase our expenses to promote our brand name, and the benefits associated with brand creation may not outweigh the risks and costs associated with brand name establishment. Our failure to develop a strong brand name or the incurrence of excessive costs associated with establishing our brand name, may harm our business.
WE MAY NEED TO MAKE ACQUISITIONS OR FORM STRATEGIC ALLIANCES OR PARTNERSHIPS IN ORDER TO REMAIN COMPETITIVE IN OUR MARKET, AND POTENTIAL FUTURE ACQUISITIONS, STRATEGIC ALLIANCES OR PARTNERSHIPS COULD BE DIFFICULT TO INTEGRATE, DISRUPT OUR BUSINESS AND DILUTE STOCKHOLDER VALUE.
We may acquire or form strategic alliances or partnerships with other businesses in the future in order to remain competitive or to acquire new technologies. As a result of these acquisitions, strategic alliances or partnerships, we may need to integrate products, technologies, widely dispersed operations and distinct corporate cultures. The products, services or technologies of the acquired companies may need to be altered or redesigned in order to be made compatible with our software products and services, or the software architecture of our customers. These integration efforts may not succeed or may distract our management from operating our existing business. Our failure to successfully manage future acquisitions, strategic alliances or partnerships could seriously harm our operating results. In addition, our stockholders would be
diluted if we finance the acquisitions, strategic alliances or partnerships by incurring convertible debt or issuing equity securities.
WE HAVE ADOPTED CERTAIN ANTI-TAKEOVER MEASURES THAT MAY MAKE IT MORE DIFFICULT FOR A THIRD PARTY TO ACQUIRE US.
Our board of directors has the authority to issue up to 2,000,000 shares of preferred stock and to determine the price, rights, preferences and privileges of those shares without any further vote or action by the stockholders. The rights of the holders of common stock will be subject to, and may be adversely affected by, the rights of the holders of any preferred stock that may be issued in the future. The issuance of shares of preferred stock, while potentially providing desirable flexibility in connection with possible acquisitions and for other corporate purposes, could have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock. We have no present intention to issue shares of preferred stock. Further, on November 8, 2000, our board of directors adopted a preferred stock purchase rights plan intended to guard against certain takeover tactics. The adoption of this plan was not in response to any proposal to acquire us, and the board is not aware of any such effort. The existence of this plan could also have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock. In addition, certain provisions of our certificate of incorporation may have the effect of delaying or preventing a change of control, which could adversely affect the market price of our common stock.
RISKS RELATING TO THE INTERNET VIDEO INFRASTRUCTURE MARKETPLACE
COMPETITION AMONG INTERNET VIDEO INFRASTRUCTURE COMPANIES IS INTENSE. IF WE ARE UNABLE TO COMPETE SUCCESSFULLY, OUR BUSINESS WILL FAIL.
Competition among Internet video infrastructure companies seeking to attract new customers is intense and we expect this intensity of competition to increase in the future. Our competitors vary in size and in the scope and breadth of the products and services they offer and may have significantly greater financial, technical and marketing resources. Our direct competition in the marketplace comes primarily from Convera Corporation. We may also compete indirectly with system integrators to the extent they may embed or integrate competing technologies into their product offerings, and in the future we may compete with video service providers and searchable video portals. In addition, we may compete with our current and potential customers who may contemplate developing software or performing application services internally. Increased competition could result in price reductions, reduced margins or loss of market share, any of which will cause our business to suffer.
IF BROADBAND TECHNOLOGY IS NOT ADOPTED OR DEPLOYED AS QUICKLY AS WE EXPECT, DEMAND FOR OUR PRODUCTS AND SERVICES MAY NOT GROW AS QUICKLY AS ANTICIPATED.
Broadband technology such as digital subscriber lines, commonly referred to as DSL, and cable modems, which allows video content to be transmitted over the Internet more quickly than current technologies, has only recently been developed and is just beginning to be deployed. The growth of our business depends in part on the broad market acceptance of broadband technology. If the market does not adopt broadband technology, or adopts it more slowly than we anticipate, demand for our products and services may not grow as quickly as we anticipate, which will harm our business.
We depend on the efforts of third parties to develop and provide the technology for broadband transmission. Even if broadband access becomes widely available, heavy use of the Internet may negatively impact the quality of media delivered through broadband connections. If these third parties experience delays or difficulties establishing the technology to support widespread broadband transmission, or if heavy usage limits the broadband experience, the market may not accept our products and services.
Because the anticipated growth of our business depends in part on broadband transmission infrastructure, we are subject to a number of risks, including:
- changes in content delivery methods and protocols;
- the need for continued development by our customers of compelling content that takes advantage of broadband access and helps drive market acceptance of our products and services;
- the emergence of new competitors, including traditional broadcast and cable television companies, which have significant control over access to content, substantial resources and established relationships with media providers;
- the development of relationships by our competitors with companies that have significant access to or control over the broadband transmission technology or content; and
- the need to establish new relationships with non-PC based providers of broadband access, such as providers of television set-top boxes and cable television.
GOVERNMENT REGULATION OF THE INTERNET COULD LIMIT OUR GROWTH.
We are not currently subject to direct regulation by any government agency, other than laws and regulations generally applicable to businesses, although certain U.S. export controls and import controls of other countries may apply to our products. While there are currently few laws or regulations that specifically regulate communications or commerce on the Internet, due to the increasing popularity and use of the Internet, it is possible that a number of laws and regulations may be adopted in the U.S. and abroad in the near future with particular applicability to the Internet. It is possible that governments will enact legislation that may be applicable to us in areas such as content, network security, access charges and retransmission activities. Moreover, the applicability to the Internet of existing laws governing issues such as property ownership, content, taxation, defamation and personal privacy is uncertain. The adoption of new laws or the adaptation of existing laws to the Internet may decrease the growth in the use of the Internet, which could in turn decrease the demand for our services, increase the cost of doing business or otherwise hurt our business.
ITEM 2.
ITEM 2. PROPERTIES
Our principal administrative, research and development, sales, services and marketing activities are conducted on two leased properties in San Mateo, California: the first property consists of 21,000 square feet under a lease that expires in May 2002 and the second property consists of 48,000 square feet under a lease that expires in September 2006. In addition, we lease a property in New York City for services and sales under a lease that expires in March 2005, a property near Boston, Massachusetts where we perform research and development under a lease that expires in June 2003 and a property near London, England where we perform sales, services, marketing and administrative activities and that expires in February 2002. We have additional domestic sales offices located throughout the United States. We have foreign sales offices in various cities in Europe and Asia to support our worldwide sales organization.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
From time to time, we may become involved in litigation claims arising from our ordinary course of business. We believe that there are no claims or actions pending or threatened against us, the ultimate disposition of which would have a material adverse effect on us.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the fourth quarter of fiscal year 2001.
The following table sets forth certain information regarding our executive officers as of June 1, 2001:
Paul G. Lego, chairman of the board of directors, president and chief executive officer, joined Virage in January 1996. From January 1995 to January 1996, Mr. Lego was an associate at Sutter Hill Ventures, a venture capital firm. From June 1988 to December 1994, Mr. Lego was the chief operating officer at Digidesign, a manufacturer of digital audio recording and editing systems which was acquired by Avid Technology in January 1995. Mr. Lego has also held various marketing, manufacturing and engineering positions with Pyramid Technology Corporation, the General Electric Company and Digital Equipment Corporation. Mr. Lego holds a B.S. in electrical engineering from Cornell University and an M.B.A. from Harvard Business School.
Alfred J. Castino, chief financial officer, joined Virage in January 2000. From September 1999 to January 2000, Mr. Castino was the chief financial officer of RightPoint, a marketing software firm that was acquired by E.piphany. From September 1997 to August 1999, Mr. Castino was employed at PeopleSoft as vice president of finance and chief accounting officer, as senior vice president of finance and administration, and chief financial officer. From April 1996 to September 1997, Mr. Castino was vice president and corporate controller at Chiron Corporation, a biotechnology company. From August 1989 to March 1996, Mr. Castino held finance positions at Sun Microsystems, a computer hardware company, including finance director of United States operations, director of finance and planning for European operations, and assistant corporate controller. Mr. Castino's prior experience also includes seven years at Hewlett-Packard Company in various financial management positions. Mr. Castino is a certified public accountant. Mr. Castino holds a B.A. in economics from Holy Cross College and an M.B.A. from Stanford University.
David J. Girouard, vice president, services and strategy, joined Virage in May 1997. Prior to becoming our vice president and general manager, Virage Interactive, Mr. Girouard served as our director of product marketing from November 1997 to May 1999. From December 1994 to April 1997, Mr. Girouard was a product manager in the worldwide product marketing group at Apple Computer. Mr. Girouard holds a B.A. in engineering sciences and a B.E. from Dartmouth College. He also holds an M.B.A. from the University of Michigan.
Bradley J. Horowitz, chief technology officer, co-founded Virage in 1994. From 1989 to April 1993, Mr. Horowitz was a consultant for various companies, including Polaroid, TASC and Comtech Labs, in the area of digital image and video understanding. Mr. Horowitz received a B.S. in computer science from the University of Michigan and a M.S. in media science from the Media Lab at the Massachusetts Institute of Technology.
Joseph A. Hyrkin, vice president, strategic accounts and Asia Pacific sales, joined Virage in 1999. Prior to joining Virage, Mr. Hyrkin ran sales for Sina.com, a publicly listed company, that acts as the leading Chinese language portal and destination site. Before joining Sina.com, Mr. Hyrkin resided in Hong Kong and Beijing for seven years where he developed the China strategy for the British-based Economist Group. Mr. Hyrkin received a double B.A. in Chinese and Political Science from the State University of New York at Albany.
Andrew P. Langhoff, vice president, business development, joined Virage in January 2000. Prior to joining Virage, Mr. Langhoff held a number of positions within the online operations of the Walt Disney Company, most recently as vice president of broadband development for Go.com. From March 1998 to October 1999, Mr. Langhoff was vice president, business development for the Buena Vista Internet Group of Walt Disney Company where he was responsible for the strategic partnerships of ABCNEWS.com, ABC.com, ESPN.com and other Disney websites. From March 1997 to March 1998, Mr. Langhoff was vice president, business development for ABCNEWS Internet Ventures. From February 1996 to March 1997, Mr. Langhoff was vice president, business development for the ABC Multimedia Group. From 1992 to 1996, Mr. Langhoff was a general attorney at Capital Cities/ABC. Mr. Langhoff received a B.A. from Tufts University and a J.D. from the University of Virginia School of Law.
Michael H. Lock, vice president, worldwide sales, joined Virage in January 2001. Prior to joining Virage, Mr. Lock held various sales and marketing positions at Oracle Corporation, most recently as Vice President, Sales and Marketing, from 1996 to 2000. Mr. Lock also has served in a variety of sales, marketing and general management positions with IBM, Dun and Bradstreet Software and Drake International. Mr. Lock received a B.S. in Business Administration from Wilfrid Laurier University in Ontario, Canada.
Carlos O. Montalvo, vice president, marketing, joined Virage in May 1998. From March 1997 to April 1998, Mr. Montalvo served as vice president of marketing at Cinebase, a provider of media asset management software. From March 1987 to March 1997, Mr. Montalvo held various product and regional marketing positions and served as vice president of Apple Computer's interactive media group. Mr. Montalvo studied political science and bioengineering at the University of California at San Diego.
Frank H. Pao, vice president, business affairs and general counsel, joined Virage in April 1997. From September 1994 to March 1997, Mr. Pao specialized in intellectual property and licensing transactions at the law firm of Gray Cary Ware & Freidenrich. He has also held various engineering positions at Advanced Cardiovascular Systems and Lawrence Berkeley Laboratories. Mr. Pao holds a B.S. in bioengineering from the University of California at Berkeley and a J.D. from Boalt Hall School of Law at the University of California at Berkeley.
Mark K. Rattley, vice president and general manager, European operations, joined Virage as a full-time employee in March 2000. From November 1998 to March 2000, he held the position of vice president of Protege Software, a consulting firm, where he was responsible for developing our European operations. Previously, he spent six years as a director and general manager of Sun Microsystems UK where he was responsible for the enterprise and Internet software business in Europe. Prior to Sun Microsystems, Mr. Rattley held senior sales, product marketing, general management and director positions at Informix, Software Publishing Corporation, Rapid Recall and Technitron Systems. Mr. Rattley graduated in 1982 with a Higher National Certificate in advanced electronic engineering and a business administration diploma, studied at Reading College of Technology and Thames Valley University, England.
Gilbert C. Wai, vice president, engineering, joined Virage in July 1997. From October 1994 to June 1997, Mr. Wai was senior vice president of product development at Legato Systems, a publicly-held enterprise storage management software company. From September 1987 to September 1994, Mr. Wai held various marketing and engineering executive positions, most recently as vice president of product management and development, at Informix Software, a publicly-held database software company. Mr. Wai holds a B.S. in electrical engineering and computer science from the University of California at Berkeley.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
(a) Our common stock is listed on the Nasdaq National Market under the symbol "VRGE".
Following our initial public offering on June 29, 2000, the following high and low closing sales prices were reported by Nasdaq in each period indicated:
The reported last sale price of our common stock on the Nasdaq National Market on June 5, 2001 was $4.19. The approximate number of holders of record of the shares of our common stock was 279 as of June 5, 2001. This number does not include stockholders whose shares are held in trust by other entities. Because many of our shares of common stock are held by brokers and other institutions on behalf of stockholders, we are unable to estimate the total number of stockholders represented by these record holders.
We have not paid any cash dividends on our capital stock. We currently intend to retain future earnings, if any, to fund the development and growth of our business and, therefore, do not anticipate paying any cash dividends in the foreseeable future. See Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources."
(b) There has been no change to the disclosure contained in our report on Form 10-Q for the nine months ended December 31, 2000 regarding the use of proceeds generated by our initial public offering.
ITEM 6.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
SELECTED CONSOLIDATED FINANCIAL DATA
You should read the selected consolidated financial data set forth below in conjunction with Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and our Consolidated Financial Statements and the Notes thereto included elsewhere in this annual report. Historical results are not necessarily indicative of results that may be expected for any future period.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion of the financial condition and results of operations of Virage, Inc. should be read in conjunction with "Selected Consolidated Financial Data" and our consolidated financial statements and notes thereto.
OVERVIEW
Virage provides software products and application services that enable video for strategic online applications. Depending on their particular needs and resources, video content owners may elect either to license our software products or to subscribe to our application services. Our customers include media and entertainment companies, other corporations, government agencies and educational institutions.
REVENUE RECOGNITION
We enter into arrangements for the sale of licenses of software products and related maintenance contracts, application and professional services offerings and we also receive revenues under U.S. government agency research grants. Service revenues include revenues from maintenance contracts, application services and professional services. Other revenues are primarily U.S. government agency research grants.
Our revenue recognition policy is in accordance with the American Institute of Certified Public Accountants, or AICPA's, Statement of Position No. 97-2, or SOP 97-2, "Software Revenue Recognition," as amended by Statement of Position No. 98-4, "Deferral of the Effective Date of SOP 97-2, "Software Revenue Recognition," or SOP 98-4, and Statement of Position No. 98-9, "Modification of SOP No. 97-2 with Respect to Certain Transactions" or SOP 98-9. For each arrangement, we determine whether evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collection is probable. If any of these criteria are not met, revenue recognition is deferred until such time as all of the criteria are met. We consider all arrangements with payment terms extending beyond 12 months and other arrangements with payment terms longer than normal not to be fixed or determinable. If collectibility is not considered probable, revenue is recognized when the fee is collected provided all other criteria are met. No customer has the right of return.
Arrangements consisting of license and maintenance. For those contracts that consist solely of license and maintenance, we recognize license revenues based upon the residual method after all elements other than maintenance have been delivered as prescribed by SOP 98-9. We recognize maintenance revenues over the term of the maintenance contract as vendor specific objective evidence of fair value for maintenance exists. In accordance with paragraph 10 of SOP 97-2, vendor specific objective evidence of fair value of maintenance is determined by reference to the price the customer will be required to pay when it is sold separately (that is, the renewal rate). Each license agreement offers additional maintenance renewal periods at a stated price. Maintenance contracts are typically one year in duration. Revenue is recognized on a per copy basis for licensed software when each copy of the license requested by the customer is delivered. Revenue is recognized on licensed software on a per user or per server basis for a fixed fee when the product master is delivered to the customer. There is no right of return or price protection for sales to domestic and international distributors, system integrators, or value added resellers. In situations where the distributor, integrator or reseller has a purchase order from the end user that is immediately deliverable, we recognize revenue on shipment to the distributor, integrator or reseller, if other criteria in SOP 97-2 are met, since we have no risk of concessions. We defer revenues on shipments to distributors, integrators or resellers if the party does not have a purchase order from an end user that is immediately deliverable or other criteria in SOP 97-2 are not met. We recognize royalty revenues upon receipt of the quarterly reports from the vendors.
When licenses and maintenance are sold together with professional services such as consulting and implementation, license fees are recognized upon shipment, provided that (1) the criteria in the previous paragraph have been met, (2) the Company believes that the services are not essential to the other elements
of the arrangement and the Company has sufficient experience in providing the services, (3) the services do not involve a significant degree of risk or unique acceptance, (4) payment of the license fee is not dependent upon the performance of the services, (5) the services are available from other vendors, and (6) the services do not include significant alterations to the features and functionality of the software. In such an arrangement, the Company uses vendor specific objective evidence of fair value for the services and the maintenance to account for the arrangement using the residual method, regardless of any separate prices stated within the contract for each element. Vendor-specific objective evidence of fair value of services within a multiple element arrangement is based upon hourly or daily rates--the same rates used when the Company enters into stand-alone service contracts based upon time and materials. Through March 31, 2001, very few license and maintenance arrangements were sold together with professional services as the Company had not formally established a professional services organization until the end of fiscal 2001.
Should professional services be essential to the functionality of the licenses in a license arrangement which contains professional services or should an arrangement not meet the criteria mentioned previously in the above paragraph, both the license revenues and professional service revenues are recognized in accordance with the provisions of the AICPA's SOP 81-1, "Accounting for Performance of Construction Type and Certain Production Type Contracts" ("SOP 81-1"). When reliable estimates are available for the costs and efforts necessary to complete the implementation services and the implementation services do not include contractual milestones or other acceptance criteria, the Company accounts for the arrangements under the percentage of completion contract method pursuant to SOP 81-1 based upon input measures such as hours or days. When such estimates are not available, the completed contract method is utilized. When an arrangement includes contract milestones, the Company recognizes revenues as such milestones are achieved.
Application services. Our application services revenues consist of set-up fees, video processing fees and application hosting fees. Set-up fees are recognized ratably over the contract term, which is generally six to twelve months. We generate video processing fees for each hour of video that a customer deploys. Processing fees are recognized as encoding, indexing and editorial services are performed and are based upon hourly rates per hour of video content. We generate application hosting fees based on the number of video queries processed, subject in some cases to monthly minimums and maximums. We recognize revenues on transaction fees that are subject to monthly minimums based on the greater of actual transaction fees or the monthly minimum, and monthly maximums based on the lesser of actual transaction fees or the monthly maximum, since we have no further obligations, the payment terms are normal and each month is a separate measurement period.
Professional Services. The Company provides professional services such as consulting, implementation and training services to its customers. Revenues from such services, when not sold in conjunction with product licenses, are generally recognized as the services are performed. To date, revenues recognized from professional services have not been meaningful.
Other revenues. Other revenues consist primarily of U.S. government agency research grants that are best effort arrangements. The software-development arrangements are within the scope of the FASB's Statement of Financial Accounting Standards No. 68, "Research and Development Arrangements". As the financial risks associated with the software-development arrangement rests solely with the U.S. government agency, we are recognizing revenues as the services are performed. The cost of these services are included in cost of other revenues. Our contractual obligation is to provide the required level of effort (hours), technical reports, and funds and man-hour expenditure reports.
Cost of license revenues consist primarily of royalty fees for third-party software products integrated into our products. Our cost of service revenues includes personnel expenses, related overhead, communication expenses and capital depreciation costs for maintenance and support activities and application services. Our cost of other revenues includes engineering personnel expenses and related overhead for custom engineering and government projects.
We incurred net losses applicable to common stockholders of $28,874,000, $18,419,000 and $6,169,000 during the three years ended March 31, 2001, 2000 and 1999, respectively. As of March 31,
2001, we had an accumulated deficit of $61,174,000. We expect to continue to incur operating losses for the foreseeable future. In view of the rapidly changing nature of our market and our limited operating history, we believe that period-to-period comparisons of our revenues and other operating results are not necessarily meaningful and should not be relied upon as indications of future performance. Our historic revenue growth rates are not necessarily sustainable or indicative of our future growth.
RESULTS OF OPERATIONS
The following table sets forth consolidated financial data for the periods indicated, expressed as a percentage of total revenues.
FISCAL YEARS ENDED MARCH 31, 2001 AND 2000
Total Revenues. Total revenues increased to $11,401,000 in fiscal 2001 from $5,561,000 in fiscal 2000, an increase of $5,840,000. This increase was due to increases in license and service revenues, partially offset by a decrease in other revenues. International revenues increased to $3,341,000, or 29% of total revenues, in fiscal 2001 from $1,241,000, or 22% of total revenues, in fiscal 2000. There were no customers who accounted for more than 10% of total revenues in fiscal 2001. Sales to our two largest customers accounted for 13% and 10%, respectively, of total revenues in fiscal 2000. Sales to agencies of the U.S. government accounted for 10% of total revenues in fiscal 2001 and 12% of total revenues in fiscal 2000.
License revenues increased to $6,161,000 in fiscal 2001 from $4,188,000 in fiscal 2000, an increase of $1,973,000. The increase was primarily due to the introduction of new product lines, expansion of our domestic sales and marketing operations, and the opening of European sales offices.
Service revenues increased to $5,136,000 in fiscal 2001 from $1,102,000 in fiscal 2000, an increase of $4,034,000. Approximately 73% of this growth was due to revenue growth from our application services offering which was introduced in May 1999 and the remainder was due to an increase in the number of customers purchasing maintenance contracts.
Other revenues decreased to $104,000 in fiscal 2001 from $271,000 in fiscal 2000, a decrease of $167,000. This decrease was attributable to the level of engineering services performed for the federal government.
Total Cost of Revenues. Total cost of revenues increased to $8,253,000, or 72% of total revenues, in fiscal 2001 from $3,530,000, or 64% of total revenues, in fiscal 2000. This increase in total cost of revenues was due to increases in cost of license and service revenues, partially offset by a decrease in cost of other revenues.
Cost of license revenues decreased to $723,000, or 12% of license revenues, in fiscal 2001 from $870,000, or 21% of license revenues, in fiscal 2000. This decrease was due to an increase in the proportion of revenues from our products that are subject to fixed, rather than unit-based, license royalty payments in fiscal 2001.
Cost of service revenues increased to $7,381,000, or 144% of service revenues, in fiscal 2001 from $2,400,000, or 218% of service revenues in fiscal 2000. This increase was due almost entirely to larger expenditures to support the growth in our application services. We expect our cost of service revenues to increase for the foreseeable future as we expand our application services and worldwide support capabilities.
Cost of other revenues decreased to $149,000, or 143% of other revenues, in fiscal 2001 from $260,000, or 96% of other revenues, in fiscal 2000. This absolute dollar decrease was due to a reduction in other revenues.
Research and Development Expenses. Research and development expenses consist primarily of personnel and related costs for our development efforts. Research and development expenses increased to $9,101,000, or 80% of total revenues, in fiscal 2001 from $4,182,000, or 75% of total revenues, in fiscal 2000. The increase was primarily due to an increase in our research and development staff. We expect research and development expenses to increase substantially for the foreseeable future as we believe that significant product development expenditures are essential for us to maintain and enhance our market position. To date, we have not capitalized any software development costs as they have been insignificant after a working model.
Sales and Marketing Expenses. Sales and marketing expenses consist of personnel and related costs for our direct sales force, pre-sales support and marketing staff, and marketing programs including trade shows and seminars. Sales and marketing expenses increased to $17,129,000, or 150% of total revenues, in fiscal 2001 from $8,349,000, or 150% of total revenues, in fiscal 2000. Approximately half of this increase in absolute dollars was due to growth in our sales and marketing personnel while the remainder was due to increased expenses incurred in connection with trade shows and additional marketing programs. The increase in our sales and marketing staff related to the opening of new sales offices in the United States and Europe. We expect sales and marketing expenses to increase for the foreseeable future as we hire additional sales and marketing personnel, increase spending on advertising and marketing programs, and expand our operations in North America and internationally.
General and Administrative Expenses. General and administrative expenses consist primarily of personnel and related costs for general corporate functions, including finance, accounting, legal, human resources, facilities, costs of our external audit firm and costs of our outside legal counsel. General and administrative expenses increased to $5,298,000, or 47% of total revenues, in fiscal 2001 from $2,653,000 or 48% of total revenues, in fiscal 2000. The significant majority of this increase was due to an increase in headcount, with the remainder due to increased external legal and audit costs. We expect general and administrative expenses to increase for the foreseeable future as we hire additional general and administrative personnel and enhance our information systems.
Stock-Based Compensation Expense. Stock based compensation expense represents the amortization of deferred compensation (calculated as the difference between the exercise price of stock options granted to our employees and the then deemed fair value of our common stock) for stock options granted to our employees. We recognized stock-based compensation expense of $3,294,000 and $1,070,000 in fiscal 2001 and 2000, respectively, in connection with the granting of stock options to our employees.
Interest and Other Income, Net. Interest and other income, net, includes interest income from cash and cash equivalents offset by interest on capital leases and bank debt. Interest and other income, net, increased to $2,800,000 in fiscal 2001 from $384,000 in fiscal 2000, an increase of $2,416,000. The increase was due to interest income from increased cash balances, primarily due to the proceeds from our initial public offering in June 2000.
Provision for Income Taxes. We have not recorded a provision for fiscal 2001 income taxes. We recorded a provision for fiscal 2000 for current foreign and state income taxes of $36,000. We have experienced net losses since inception, which have resulted in deferred tax assets. We have recorded a valuation allowance for the entire deferred tax asset as a result of uncertainties regarding the realization of the asset balance through future taxable profits.
FISCAL YEARS ENDED MARCH 31, 2000 AND 1999
Total Revenues. Total revenues increased to $5,561,000 in fiscal 2000 from $3,350,000 in fiscal 1999, an increase of $2,211,000. This increase was due to increases in license and service revenues, partially offset by a decrease in other revenues. International revenues increased to $1,241,000, or 22% of total revenues, in fiscal 2000 from $358,000, or 11% of total revenues, in fiscal 1999. Sales to our two largest customers accounted for 13% and 10%, respectively, of total revenues in fiscal 2000. Sales to our largest customers accounted for 13% of total revenues in fiscal 1999. Sales to agencies of the U.S. government accounted for 12% of total revenues in fiscal 2000 and 40% of total revenues for the comparable period in fiscal 1999. Sales of licenses and services to agencies of the U.S. government, excluding other revenues, accounted for 27% of total revenues in fiscal 1999 (less than 10% of total revenues for the comparable period in 2000).
License revenues increased to $4,188,000 in fiscal 2000 from $1,956,000 in fiscal 1999, an increase of $2,232,000. The increase was primarily due to the introduction of new product lines, expansion of our domestic sales and marketing operations, and the opening of a European sales office in November 1998.
Service revenues increased to $1,102,000 in fiscal 2000 from $253,000 in fiscal 1999, an increase of $849,000. Approximately 46% of this growth was due to an increase in the number of customers purchasing maintenance contracts, while the remainder was due to the introduction of our application services offering in May 1999.
Other revenues decreased to $271,000 in fiscal 2000 from $1,141,000 in fiscal 1999, a decrease of $870,000. The majority of this decrease was attributable to the level of engineering services performed for the federal government with the remainder of the decrease being attributable to a lower amount of engineering services performed for customers.
Total Cost of Revenues. Total cost of revenues increased to $3,530,000, or 64% of total revenues, in fiscal 2000 from $1,682,000, or 51% of total revenues, in fiscal 1999. This increase in total cost of revenues was due to increases in cost of license and service revenues, partially offset by a decrease in cost of other revenues.
Cost of license revenues increased to $870,000, or 21% of license revenues, in fiscal 2000 from $397,000, or 20% of license revenues, in fiscal 1999. This increase in absolute dollars was due to royalty payments for new licensed technologies which first became payable by us during fiscal 2000.
Cost of service revenues increased to $2,400,000, or 218% of service revenues in fiscal 2000, from $426,000, or 168% of service revenues, in fiscal 1999. Over 95% of this increase was due to expenditures for our application services, while the remainder was due to increased support costs for a larger base of maintenance customers.
Cost of other revenues decreased to $260,000, or 96% of other revenues, in fiscal 2000 from $859,000, or 75% of other revenues, in fiscal 1999. This absolute dollar decrease was due to a reduction in other revenues.
Research and Development Expenses. Research and development expenses increased to $4,182,000, or 75% of total revenues, in fiscal 2000 from $2,325,000, or 69% of total revenues, in fiscal 1999. The increase was due to an increase in our research and development staff.
Sales and Marketing Expenses. Sales and marketing expenses increased to $8,349,000, or 150% of total revenues, in fiscal 2000 from $4,362,000, or 130% of total revenues, in fiscal 1999. Approximately half of this increase in absolute dollars was due to growth in our sales and marketing personnel while the remainder was due to increased expenses incurred in connection with trade shows and additional marketing programs. The increase in our sales and marketing staff related to the opening of new sales offices in the United States, a new sales office in Europe, and the launch of our application services offering in May 1999.
General and Administrative Expenses. General and administrative expenses increased to $2,653,000, or 48% of total revenues, in fiscal 2000 from $1,273,000, or 38% of total revenues, in fiscal 1999. The significant majority of this increase was due to an increase in headcount, with the remainder due to increased external legal and audit costs.
Stock-Based Compensation Expense. Stock based compensation expense represents the amortization of deferred compensation (calculated as the difference between the exercise price of stock options granted to our employees and the then deemed fair value of our common stock) for stock options granted to our employees. We recognized stock-based compensation expense of $1,070,000 in fiscal 2000 in connection with the granting of stock options to our employees. We did not recognize any stock-based compensation expense in fiscal 1999.
Interest and Other Income, Net. Interest and other income, net, includes interest income from cash, cash equivalents and short-term investments offset by interest on capital leases and bank debt. Interest and other income, net, increased to $384,000 in fiscal 2000 from $123,000 in fiscal 1999, an increase of $261,000. The increase was due to interest income from increased cash balances.
Provision for Income Taxes. We recorded a provision for current foreign and state income taxes for fiscal 2000 of $36,000. We have not recorded a provision for fiscal 1999 income taxes. We have experienced net losses since inception, which have resulted in deferred tax assets. We have recorded a valuation allowance for the entire deferred tax asset as a result of uncertainties regarding the realization of the asset balance through future taxable profits.
LIQUIDITY AND CAPITAL RESOURCES
As of March 31, 2001, we had cash, cash equivalents and short-term investments of $48,131,000, an increase of $38,024,000 from March 31, 2000 and our working capital, defined as current assets less current liabilities, was $40,588,000, an increase of $32,487,000 in working capital from March 31, 2000. The increase in our working capital is primarily attributable to cash generated from financing activities including our private placement, our initial public offering and exercise of our underwriters' over-allotment option ("IPO"), the exercise of warrants, and the issuance of stock under our employee stock plans, resulting in $61,447,000 of net proceeds to us during the year ended March 31,2001.
Our operating activities resulted in net cash outflows of $16,863,000, $12,331,000 and $5,999,000 for the years ended March 31, 2001, 2000 and 1999, respectively. The cash used in these periods was primarily attributable to net losses applicable to common stockholders of $28,874,000, $18,419,000 and $6,169,000 in the years ended March 31, 2001, 2000 and 1999, respectively.
Investing activities resulted in cash outflows of $34,770,000, $2,021,000 and $554,000 for the years ended March 31, 2001, 2000 and 1999, respectively. These expenditures were primarily for the purchase of short-term investments and for the purchases of computer hardware and software and furniture and fixtures. We expect that we will continue to invest in capital expenditures to the extent that such investments are required to support our headcount and expand our operations.
Financing activities provided net cash inflows of $61,206,000, $20,103,000 and $5,129,000 during the years ended March 31, 2001, 2000 and 1999, respectively, primarily as a result of sales of our preferred and common stock (including our IPO in fiscal 2001).
We anticipate that our current cash, cash equivalents and available credit facilities will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least the next 12 months. However, we may need to raise additional funds in future periods through public or private financings, or other sources, to fund our operations and potential acquisitions, if any, until we achieve profitability, if ever. We may not be able to obtain adequate or favorable financing when necessary to fund our business. Failure to raise capital when needed could harm our business. If we raise additional funds through the issuance of equity securities, the percentage of ownership of our stockholders would be reduced. Furthermore, these equity securities might have rights, preferences or privileges senior to our common stock.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Foreign Currency Exchange Rate Risk
We develop products in the United States. We license our products from the United States and from our subsidiary in the United Kingdom. Substantially all of our sales from the United States operation are denominated in U.S. dollars. Our subsidiary based in the United Kingdom incurs most of its expenses in pounds sterling and most of its sales are denominated in US dollars. We are unaware of any known trends or uncertainties that are reasonably expected to have a material impact on total revenues, expenses or loss from continuing operations related to the Euro conversion. We expect that future license and service revenues will continue to be derived from international markets and may be denominated in the currency of the applicable market. As a result, our financial results could be affected adversely by various factors, including foreign currency exchange rates or weak economic conditions in foreign markets. Although we will continue to monitor our exposure to currency fluctuations and, when appropriate, may use economic hedging techniques in the future to minimize the effect of these fluctuations, we cannot assure you that exchange rate fluctuations will not adversely affect our financial results in the future. Through March 31, 2001, the Company had not engaged in any foreign currency hedging activities.
Interest Rate Risk
Our exposure to financial market risk, including changes in interest rates, relates primarily to our investment portfolio. We typically do not attempt to reduce or eliminate our market exposure on our investment securities because a substantial majority of our investments are in fixed rate securities with maturities not exceeding 12 months. We do not invest in any derivative instruments. The fair value of our investment portfolio or related income would not be significantly impacted by either a 100 basis point increase or decrease in interest rates due mainly to the fixed-rate, and relatively short-term nature of our available-for-sale investment portfolio.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
VIRAGE, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Board of Directors and Stockholders Virage, Inc.
We have audited the accompanying consolidated balance sheets of Virage, Inc. as of March 31, 2001 and 2000, and the related consolidated statements of operations, redeemable convertible preferred stock and stockholders' equity (net capital deficiency), and cash flows for each of the three years in the period ended March 31, 2001. Our audits also included the financial statement schedule listed in the Index at item 14(a). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits 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 audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Virage, Inc. at March 31, 2001 and 2000, and the consolidated results of its operations and its cash flows for each of the three years in the period ended March 31, 2001, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects, the information set forth therein.
/s/ Ernst & Young LLP
San Jose, California April 13, 2001
VIRAGE, INC.
CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE DATA)
See accompanying notes.
VIRAGE, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE DATA)
(1) Excluding $301 and $98 in amortization of deferred stock-based compensation for the years ended March 31, 2001 and March 31, 2000, respectively.
(2) Excluding $536 and $199 in amortization of deferred stock-based compensation for the years ended March 31, 2001 and March 31, 2000, respectively.
(3) Excluding $983 and $394 in amortization of deferred stock-based compensation for the years ended March 31, 2001 and March 31, 2000, respectively.
(4) Excluding $1,474 and $379 in amortization of deferred stock-based compensation for the years ended March 31, 2001 and March 31, 2000, respectively.
See accompanying notes.
VIRAGE, INC.
CONSOLIDATED STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY (NET CAPITAL DEFICIENCY) (IN THOUSANDS, EXCEPT SHARE DATA)
See accompanying notes.
VIRAGE, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
See accompanying notes.
VIRAGE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
DESCRIPTION OF BUSINESS
Virage, Inc. ("Virage" or "the Company") is a provider of software products and application services that enable owners of video content to catalog, manage and distribute their video assets over the Internet and corporate intranets.
BASIS OF PRESENTATION
The consolidated financial statements include the accounts of the Company and its majority-owned subsidiary, Virage Europe, Ltd. All significant intercompany accounts and transactions have been eliminated in consolidation.
CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS
The Company invests its excess cash in money market accounts and debt instruments and considers all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents. Investments with an original maturity at the time of purchase of over three months are classified as short-term investments regardless of maturity date, as all such instruments are classified as available-for-sale and can be readily liquidated to meet current operational needs. At March 31, 2001, all of the Company's cash equivalents and short-term investments were classified as available-for-sale and consisted of obligations issued by U.S. government agencies and multinational corporations, maturing within one year.
Short-term investments at each year-end, including cash equivalents and short-term investments, were as follows (in thousands):
As of March 31, 2001 and 2000, the fair value approximated the amortized cost of available-for-sale securities. Realized gains and losses from sales of investments were insignificant for all periods presented.
PROPERTY AND EQUIPMENT
Property and equipment are carried at cost less accumulated depreciation. Property and equipment are depreciated for financial reporting purposes using the straight-line method over the estimated useful lives of generally three years or, in the case of property under capital leases and leasehold improvements, over the lesser of the useful life of the assets or lease term.
VIRAGE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
REVENUE RECOGNITION
The Company enters into arrangements for the sale of licenses of software products and related maintenance contracts, application services and professional services offerings; and also receives revenues under U.S. government agency research grants. Service revenues include revenues from maintenance contracts, application services, and professional services. Other revenues are primarily U.S. government agency research grants.
The Company's revenue recognition policy is in accordance with the American Institute of Certified Public Accountants' ("AICPA") Statement of Position No. 97-2 ("SOP 97-2"), "Software Revenue Recognition", as amended by Statement of Position No. 98-4, "Deferral of the Effective Date of SOP 97-2, "Software Revenue Recognition" ("SOP 98-4"), and Statement of Position No. 98-9, "Modification of SOP No. 97-2 with Respect to Certain Transactions" ("SOP 98-9"). For each arrangement, the Company determines whether evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collection is probable. If any of these criteria are not met, revenue recognition is deferred until such time as all criteria are met. The Company considers all arrangements with payment terms extending beyond twelve months and other arrangements with payment terms longer than normal not to be fixed or determinable. If collectibility is not considered probable, revenue is recognized when the fee is collected. No customer has the right of return.
Arrangements consisting of license and maintenance. For those contracts that consist solely of license and maintenance, the Company recognizes license revenues based upon the residual method after all elements other than maintenance have been delivered as prescribed by SOP 98-9. The Company recognizes maintenance revenues over the term of the maintenance contract as vendor specific objective evidence of fair value for maintenance exists. In accordance with paragraph 10 of SOP 97-2, vendor specific objective evidence of fair value of maintenance is determined by reference to the price the customer will be required to pay when it is sold separately (that is, the renewal rate). Each license agreement offers additional maintenance renewal periods at a stated price. Maintenance contracts are typically one year in duration. Revenue is recognized on a per copy basis for licensed software when each copy of the license requested by the customer is delivered. Revenue is recognized on licensed software on a per user or per server basis for a fixed fee when the product master is delivered to the customer. There is no right of return or price protection for sales to domestic and international distributors, system integrators, or value added resellers (collectively, "resellers"). In situations where the reseller has a purchase order from the end user that is immediately deliverable, the Company recognizes revenue on shipment to the reseller, if other criteria in SOP 97-2 are met, since the Company has no risk of concessions. The Company defers revenue on shipments to resellers if the reseller does not have a purchase order from an end user that is immediately deliverable or other criteria in SOP 97-2 are not met. The Company recognizes royalty revenues upon receipt of the quarterly reports from the vendors.
VIRAGE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
When licenses and maintenance are sold together with professional services such as consulting and implementation, license fees are recognized upon shipment, provided that (1) the criteria in the previous paragraph have been met, (2) the Company believes that the services are not essential to the other elements of the arrangement and the Company has sufficient experience in providing the services, (3) the services do not involve a significant degree of risk or unique acceptance, (4) payment of the license fee is not dependent upon the performance of the services, (5) the services are available from other vendors, and (6) the services do not include significant alterations to the features and functionality of the software. In such an arrangement, the Company uses vendor specific objective evidence of fair value for the services and the maintenance to account for the arrangement using the residual method, regardless of any separate prices stated within the contract for each element. Vendor-specific objective evidence of fair value of services within a multiple element arrangement is based upon hourly or daily rates--the same rates used when the Company enters into stand-alone service contracts based upon time and materials. Through March 31, 2001, very few license and maintenance arrangements were sold together with professional services as the Company had not formally established a professional services organization until the end of fiscal 2001.
Should professional services be essential to the functionality of the licenses in a license arrangement which contains professional services or should an arrangement not meet the criteria mentioned previously in the above paragraph, both the license revenues and professional service revenues are recognized in accordance with the provisions of the AICPA's SOP 81-1, "Accounting for Performance of Construction Type and Certain Production Type Contracts" ("SOP 81-1"). When reliable estimates are available for the costs and efforts necessary to complete the implementation services and the implementation services do not include contractual milestones or other acceptance criteria, the Company accounts for the arrangements under the percentage of completion contract method pursuant to SOP 81-1 based upon input measures such as hours or days. When such estimates are not available, the completed contract method is utilized. When an arrangement includes contract milestones, the Company recognizes revenues as such milestones are achieved.
Application services. Application services revenues consist of set-up fees, video processing fees and application hosting fees. Set-up fees are recognized ratably over the contract term, which is generally six to twelve months. The Company generates video processing fees for each hour of video that a customer deploys. Processing fees are recognized as encoding, indexing and editorial services are performed and are based upon hourly rates per hour of video content. Application hosting fees are generated based on the number of video queries processed, subject in some cases to monthly minimums and maximums. The Company recognizes revenues on transaction fees that are subject to monthly minimums based on the greater of actual transaction fees or the monthly minimum, and monthly maximums based on the lesser of actual transaction fees or the monthly maximum, since the Company has no further obligations, the payment terms are normal and each month is a separate measurement period.
Professional Services. The Company provides professional services such as consulting, implementation and training services to its customers. Revenues from such services, when not sold in conjunction with product licenses, is generally recognized as the services are performed.
Other revenues. Other revenues consist primarily of U.S. government agency research grants that are best effort arrangements. The software-development arrangements are within the scope of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 68, "Research and Development Arrangements." As the financial risks associated with the software-development arrangement rests solely with the U.S. government agency, the Company is recognizing revenues as the services are performed. The cost of these services are included in cost of other revenues. The Company's contractual obligation is to provide the required level of effort (hours), technical reports, and funds and man-hour expenditure reports.
VIRAGE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
CONCENTRATION OF REVENUES AND CREDIT RISK
The Company performs ongoing credit evaluations of its customers and maintains reserves for potential credit losses, and such losses have been within management's expectations. The Company generally requires no collateral from its customers.
Major customers (non-federal government agencies). For the year ended March 31, 2001, there were no customers that accounted for 10% or more of the Company's total revenues. For the year ended March 31, 2000, two customers each accounted for 13% and 10% of the Company's total revenues. For the year ended March 31, 1999, one customer accounted for 13% of the Company's total revenues.
European customers accounted for approximately 18% of the balance of accounts receivable as of March 31, 2001 and 2000.
Federal Government Agencies. For the years ended March 31, 2001, 2000, and 1999 direct and indirect revenues from federal government agencies accounted for 10%, 12%, and 40%, respectively, of total revenues. For the year ended March 31, 1999, two federal government agencies accounted for 17% and 14% of total revenues (no single federal government agency accounted for more than 10% of total revenues for the years ended March 31, 2001 or 2000).
RECLASSIFICATIONS
Certain prior year balances have been restated to conform with current year presentation.
ADVERTISING COSTS
Advertising costs are expensed as incurred. Advertising expense, including the amortization of the fair value of a warrant issued to an internet portal company in fiscal 2000 (see Note 4), totaled $697,000 and $256,000 for the years ended March 31, 2001 and March 31, 2000, respectively. Advertising expense was insignificant for the year ended March 31, 1999.
COMPREHENSIVE NET LOSS APPLICABLE TO COMMON STOCKHOLDERS
The Company has adopted the FASB's Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" ("FAS 130"). FAS 130 establishes standards for the reporting and display of comprehensive income (loss) and its components in a full set of general purpose financial statements. To date, the Company has had no other comprehensive income (loss), and consequently, net loss applicable to common stockholders equals total comprehensive net loss applicable to common stockholders.
USE OF ESTIMATES
The preparation of the Company's consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the Company's consolidated financial statements and accompanying notes. Actual results could differ materially from those estimates.
VIRAGE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
NET LOSS PER SHARE APPLICABLE TO COMMON STOCKHOLDERS
Basic and diluted net loss per share applicable to common stockholders are computed in conformity with the FASB's Statement of Financial Accounting Standards No. 128, "Earnings Per Share" ("FAS 128"), for all periods presented, using the weighted average number of common shares outstanding less shares subject to repurchase.
Pro forma basic and diluted net loss per share applicable to common stockholders have been computed as described above and also give effect, even if antidilutive, to common equivalent shares from preferred stock as if such conversion had occurred on April 1, 1998, or at the date of original issuance, if later.
The following table presents the computation of basic and diluted and pro forma basic and diluted net loss per share applicable to common stockholders (in thousands, except per share data):
The Company has excluded all outstanding stock options, warrants and shares subject to repurchase from the calculation of basic and diluted net loss per share applicable to common stockholders because these securities are antidilutive for all periods presented. Options and warrants to purchase 6,502,656, 3,779,990 and 2,013,690 shares of common stock and common stock equivalents were outstanding at March 31, 2001, 2000 and 1999, respectively. Such securities, had they been dilutive, would have been included in the computation of diluted net loss per share applicable to common stockholders using the treasury stock method.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The Company has evaluated the estimated fair value of financial instruments at March 31, 2001 and 2000. The amounts reported for cash and cash equivalents, short-term investments, accounts receivable, accounts payable, and equipment term loan obligations approximate their carrying values due to the short-term maturities of these instruments.
VIRAGE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
SEGMENT INFORMATION
The Company has adopted the FASB's Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information," which establishes standards for reporting information about operating segments. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker or group in deciding how to allocate resources and in assessing performance. The Company's segment information is presented in Note 8.
LONG-LIVED ASSETS
The Company has adopted the FASB's Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of," ("FAS 121") which requires impairment losses to be recorded for long-lived assets used in operations, such as property, equipment and improvements, and intangible assets, when indicators of impairment are present and the undiscounted cash flows estimated to be generated by those assets are less than the carrying amount of the assets. Through March 31, 2001, FAS 121 has had no impact on the Company's financial position or results of operations.
IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS
In December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements" ("SAB 101"). SAB 101 provides guidance on the recognition, presentation and disclosure of revenue in the financial statements of public companies. The Company has reviewed the guidance of SAB 101 and believes that its revenue recognition policy is (and has been) consistent with the guidance of SAB 101. Accordingly, the adoption of SAB 101 during the fourth quarter of the year ended March 31, 2001 did not have an impact on the Company's financial position or results of operations.
In March 2000, the Financial Accounting Standards Board issued FASB Interpretation No. 44 ("FIN 44"), "Accounting for Certain Transactions Involving Stock Compensation -- an Interpretation of APB Opinion No. 25". FIN 44 clarifies the application of APB Opinion No. 25 and, among other issues, clarifies the following: the definition of an employee for purposes of applying APB Opinion No. 25; the criteria for determining whether a plan qualifies as a noncompensatory plan; the accounting consequence of various modifications to the terms of the previously fixed stock options or awards; and the accounting for an exchange of stock compensation awards in a business combination. FIN 44 is effective July 1, 2000, but certain conclusions in FIN 44 cover specific events that occurred after either December 15, 1998 or January 12, 2000. The application of FIN 44 has not had a material impact on the Company's financial position or results of operations.
2. COMMITMENTS AND CONTINGENCIES
LEASES
The Company leases certain of its facilities under operating leases, some of which have options to extend the lease period. Rent expense was $2,714,000, $717,000, and $355,000 for the years ended March 31, 2001, 2000 and 1999, respectively.
VIRAGE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Future minimum lease payments under noncancelable operating leases at March 31, 2001 are as follows (in thousands):
The Company subleases portions of the space at its facility. Rental payments received that relate to the subleases were $1,185,000 for the year ended March 31, 2001 (none for the years ended March 31, 2000 and 1999). The sublease agreements, which will expire during the year ended March 31, 2002, provide for additional rental payments of $1,872,000 during fiscal 2002.
LITIGATION
The Company is subject to various claims that arise in the normal course of business. In the opinion of management, the ultimate disposition of these claims will not have a material adverse effect on the financial position, results of operations or cash flows of the Company.
3. REDEEMABLE CONVERTIBLE PREFERRED STOCK
The following is a summary of redeemable convertible preferred stock at March 31, 2000:
Below are the rights and preferences of the redeemable convertible preferred stock outstanding at March 31, 2000 before conversion to common stock upon the closing of the Company's initial public offering in July 2000.
VIRAGE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Convertible preferred stockholders and redeemable convertible preferred stockholders had the same voting rights as common stockholders. In addition, the Series A, B, B-1, C, D and E voted as a single class. In the event of any voluntary or involuntary liquidation of the Company, Series A, B, C, D and E stockholders were entitled to a per share liquidation preference of $1.50, $2.60, $2.68, $3.44, and $6.56 per share, respectively, plus accrued dividends, if any. The holders of Series A, B, C, D and E stock were entitled to per share noncumulative dividends of $0.12, $0.21, $0.21, $0.28 and $0.52 per annum, respectively, when and if declared by the Board of Directors. Should the vote of at least 67% of all redeemable preferred stockholders been obtained on or after October 9, 2006, Series A, B, C, D, and E preferred stock could have been redeemed at prices of $1.50, $2.60, $2.68, $3.44 and $6.56 per share, respectively, plus any and all declared but unpaid dividends.
In December 1999, the Company issued 684,343 additional shares of Series E redeemable convertible preferred stock at a price of $6.56 per share for a total purchase price of $4,489,000. The fair value of the shares at the time of issuance was estimated to be $13.20 per share. The difference between the fair value of $13.20 per share and issue price of $6.56 per share has been accounted for as a deemed dividend totaling $4,544,000.
4. STOCKHOLDERS' EQUITY
PREFERRED STOCK
During the year ended March 31, 2001, the Company's Certificate of Incorporation was amended to authorize 2,000,000 shares of preferred stock and the Board of Directors also adopted a preferred stock purchase right plan intended to guard the Company against certain takeover tactics. The Company's Board of Directors has the authority to fix or alter the designation, powers, preferences and rights of the shares of each preferred series and qualifications, limitations or restrictions to any unissued series of preferred stock.
INITIAL PUBLIC OFFERING
In July 2000, the Company completed its initial public offering and issued 3,500,000 shares of its common stock to the public at a price of $11.00 per share. The Company received net proceeds of $34,105,000 in cash after deducting the underwriters' commissions and approximately $1,700,000 of offering costs ($812,000 of which had been paid by the Company as of March 31, 2000). The Company's underwriters also exercised their over-allotment option to purchase an additional 525,000 shares of the Company's common stock at a price of $11.00 per share resulting in an additional $5,371,000 of net proceeds to the Company. All outstanding shares of redeemable convertible preferred stock were converted into an aggregate of 10,369,451 shares of common stock at the closing of the Company's public offering.
In addition, the Company's stockholders approved a 1-for-2 reverse stock split of the Company's preferred and common stock and also authorized an increase in the authorized number of common shares from 20,000,000 shares to 100,000,000 shares that became effective upon the consummation of the Company's initial public offering. All share data has been restated to reflect the reverse stock split.
COMMON STOCK PURCHASE AGREEMENT
In July 2000, the Company completed an $18,000,000 common stock purchase agreement with certain private investors issuing 1,636,361 common shares at $11.00 per share concurrent with its initial public offering.
VIRAGE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
WARRANTS
In September 1995 and October 1996, in connection with capital lease agreements, the Company issued warrants to purchase 23,332 shares of common stock at an exercise price of $0.75 per share, subject to certain adjustments. Interest expense related to the fair value of the warrants was insignificant. The fair value of the warrants was calculated using the Black-Scholes option pricing model assuming a fair value of common stock of $0.75, risk-free interest rate of 6.5%, volatility factor of 40%, and a life of 10 years. The warrants were exercised during the year ended March 31, 2001 pursuant to a net exercise provision in the warrant agreements resulting in the issuance of 22,221 common shares.
In May 1997, in connection with a credit facility agreement, Virage issued warrants to purchase 8,654 shares of Series B preferred stock at an exercise price of $2.60 per share. The warrants expire in May 2002 and as of March 31, 2001 remain outstanding. Interest expense related to the fair value of the warrants was insignificant. The fair value of the warrants was calculated using the Black-Scholes option pricing model assuming a fair value of Series B preferred stock of $2.60, risk-free interest rate of 6.5%, volatility factor of 40%, and a life of 5 years.
In November 1999, the Company entered into a software development and distribution agreement with SRI, International that provides the Company with a non-exclusive license from SRI, International to embed and distribute SRI's optical character recognition technology as a plug-in module to the Company's VideoLogger product. The Company is required to pay SRI, International cash royalty payments, subject to a minimum of $100,000 over the term of the agreement, based upon annual license copy volumes as are defined within the agreement. The Company also issued an immediately exercisable, nonforfeitable warrants to purchase 19,055 shares of Series E preferred stock at an exercise price of $6.56 per share, subject to certain adjustments. During the year ended March 31, 2001, the warrant was exercised resulting in $125,000 of proceeds to the Company. The Company determined the fair value of the warrants ($185,000) using the Black-Scholes valuation model assuming a fair value of the Series E preferred stock of $13.20, a risk-free interest rate of 5.9%, a volatility factor of 90%, and a life of 3 years. The fair value of the warrants has been recorded as a technology right and will be amortized to cost of goods sold over the life of the agreement, which expires on December 31, 2004. Amortization expense of $35,000 and $15,000 was recorded during the years ended March 31, 2001 and 2000, respectively.
In December 1999, the Company issued an immediately exercisable warrant to purchase 75,435 shares of Series E preferred stock at $6.56 per share in consideration for advertising provided by an Internet portal company. During the year ended March 31, 2001, the warrant was net exercised by the holder resulting in the issuance of 34,197 shares. The Company determined the fair value of the warrant using the Black-Scholes valuation model assuming a fair value of the Series E preferred stock of $13.20, risk-free interest rate of 6.1%, volatility factor of 90%, and a life of 4 years. The fair value of the warrant ($781,000) was recorded as deferred advertising costs and was amortized into sales and marketing expense on a straight-line basis over 12 months, the term of the advertising agreement, which commenced January 2000. Amortization expense of $586,000 and $195,000 was recorded during the years ended March 31, 2001 and 2000, respectively.
VIRAGE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
In February 2000, the Company entered into a six-year operating lease agreement on a new building. As part of the operating lease agreement, the Company issued a warrant to the landlord in June 2000 to purchase 181,818 shares of common stock at $11.00 per share which was exercised during the year ended March 31, 2001 resulting in proceeds of $2,000,000 to the Company. The warrant was issued concurrent with the pricing of the Company's IPO and if not exercised, the warrant would have expired at the end of the first day that the Company's stock began trading on NASDAQ. The Company estimated that the value of the warrant is $72,000 using a Black-Scholes model with the following assumptions: price of $11.00 as the deemed fair value, a risk-free interest rate of 6.1%, a volatility factor of 90%, and an expected life of one day (based upon the foregoing explanation of the warrant's short contractual life). The value of the warrant is being amortized as rent expense over the term of the six-year lease agreement and $6,000 was recorded during the year ended March 31, 2001.
In December 2000, the Company entered into a services agreement with a customer and issued an immediately exercisable, non-forfeitable warrant to purchase 200,000 shares of common stock at $5.50 per share. The warrant expires in December 2003 and remains unexercised as of March 31, 2001. The value of the warrant was estimated to be $648,000 and was based upon a Black-Scholes valuation model with the following assumptions: risk free interest rate of 7.0%, no dividend yield, volatility of 90%, expected life of three years, exercise price of $5.50 and fair value of $5.38. The non-cash amortization of the warrant's value will be recorded against revenues as revenues from services are recognized over the one-year services agreement. There was no amortization of the warrant's value during the year ended March 31, 2001 as revenues from the services agreement were insignificant through that date. The warrant's value will begin to be amortized in the first quarter of fiscal 2002 on a straight-line basis over the term of the agreement as services revenues are expected to be relatively consistent over the agreement term.
EMPLOYEE STOCK PLANS
In December 1997, the Company's stockholders agreed to terminate the Virage, Inc. 1995 Stock Option Plan (the 1995 Plan) and to introduce the Virage, Inc. 1997 Stock Option Plan (the 1997 Plan). All options issued under the 1995 Plan remained outstanding under that plan and did not become outstanding under the 1997 Plan. The 1997 Plan provides for the granting of incentive stock options and nonqualified stock options to employees, directors, and consultants. Under the 1997 Plan, the Board of Directors determines the term of each award and the award price. In the case of incentive stock options, the exercise price may be established at an amount not less than the fair market value at the date of grant, while nonstatutory options may have exercise prices not less than 85% of the fair market value as of the date of grant. Options granted to any person owning stock possessing more than 10% of the total combined voting power must have exercise prices of at least 110% of the fair market value at the date of grant. Options generally vest ratably over a four-year period commencing with the grant date and expire no later than ten years from the date of grant.
Options granted under the 1995 Plan are not exercisable until they are fully vested. Options granted under the 1997 Plan are immediately exercisable, but shares so purchased that are not yet vested may be repurchased by Virage upon termination of employment at the exercise price.
All shares subject to options outstanding under the 1995 Plan that expired or were terminated, canceled, or repurchased were added to the number of shares authorized and reserved for issuance under the 1997 Plan.
VIRAGE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Virage has elected to follow Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB Opinion No. 25"), and related interpretations in accounting for its employee stock options because, as discussed below, the alternative fair value accounting provided for under the FASB's Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("FAS 123"), requires use of option valuation models that were not developed for use in valuing employee stock options.
A summary of the Company's stock option activity and related information is set forth below:
As of March 31, 2001, there were 270,406 shares of common stock exercised pursuant to stock options that were not fully vested. These shares are subject to repurchase solely at the option of the Company at the original grant price upon an employee's termination.
Options canceled during the year ended March 31, 1999 of 358,625 included options issued under both the 1995 and 1997 Plans. Options canceled that were issued under the 1995 Plan of 138,270 were not returned to the 1997 Plan. Therefore, options made available for grant as a result of cancellations are less than options cancelled by 138,270 for the year ended March 31, 1999.
The following table summarizes information about stock options outstanding and exercisable at March 31, 2001:
VIRAGE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
In March 2000, the Company's Board of Directors approved the Virage, Inc. 2000 Employee Stock Purchase Plan (the "ESPP") which is designed to allow eligible employees of the Company to purchase shares of the Company's common stock at semiannual intervals through periodic payroll deductions. An aggregate of 1,100,000 shares of common stock has been reserved for the ESPP, and 53,171 shares have been issued through March 31, 2001. The ESPP is implemented in a series of successive offering periods, each with a maximum duration of 24 months. Eligible employees can have up to 10% of their base salary deducted that is to be used to purchase shares of the common stock on specific dates determined by the board of directors (up to a maximum of $25,000 per year based upon the fair market value of the shares). The price of common stock purchased under the ESPP will be equal to 85% of the lower of the fair market value of the common stock on the commencement date of each offering period or the specified purchase date.
Pro forma information regarding net loss is required by FAS 123, which also requires that the information be determined as if the Company had accounted for its employee stock plans under the fair value method. The fair value for these options was estimated at the date of grant using the minimum value method with the following weighted average assumptions for the years ended March 31, 2001, 2000 and 1999: risk-free interest rates of 6.5%, 5.8% and 5.7%, respectively, no dividend yield, a volatility factor of 90% and an expected life of the options of four years. The fair value of shares issued and to be issued pursuant to the Company's employee stock purchase plan were estimated using the following weighted average assumptions: risk-free interest rate of 6.5%, no dividend yield, a volatility factor of 90%, and an expected life of the option of six months.
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, including the expected price volatility. Because the Company's employee stock options and stock purchase plan shares have characteristics significantly different from those of traded options and because changes in the subjective input assumptions can materially affect the fair value estimate, in the Company's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options. The weighted-average fair value of options granted during the years ended March 31, 2001, 2000 and 1999 was $5.78, $4.28, and $0.06, respectively, and the weighted-average grant date fair value of ESPP shares was $2.07 during the year ended March 31, 2001.
For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. The pro forma net loss applicable to common stockholders would have been $35,043,000, $19,765,000 and $6,216,000 or $(2.28), $(8.65) and $(3.70) per share for the years ended March 31, 2001, 2000 and 1999, respectively.
DEFERRED COMPENSATION
During the years ended March 31, 2001, 2000 and 1999, the Company recorded aggregate deferred compensation of $71,000, $15,886,000 and $399,000, respectively, representing the difference between the exercise price of stock options granted and the then deemed fair value of the Company's common stock. The amortization of deferred compensation is charged to operations over the vesting period of the options using the straight-line method, which is typically four years. For the years ended March 31, 2001 and 2000, the Company amortized $4,165,000 and $1,689,000, respectively, of deferred compensation of which $3,294,000 and $1,070,000, respectively, related to stock options issued to employees (presented separately in the Company's statement of operations) and $871,000 and $619,000, respectively, related to stock options issued to consultants.
VIRAGE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
OPTIONS ISSUED TO CONSULTANTS
As of March 31, 2001, the Company had granted options to purchase 295,523 shares of common stock to consultants at exercise prices ranging from $1.00 to $12.00 per share. The options were granted in exchange for consulting services to be rendered and vest over periods ranging from immediately to four years. The Company valued these options at $2,846,000 being their fair value estimated using a Black-Scholes valuation model assuming fair values of common stock ranging from $1.52 to $11.00 per share, risk-free interest rates ranging from 4.75% to 6.13%, volatility factor of 90% and a life of four years. The Company recorded a charge to operations of $871,000 and $619,000 for the years ended March 31, 2001 and 2000, respectively, related to these options.
The options issued to consultants have been and will be marked-to-market using the estimate of fair value at the end of each accounting period pursuant to the FASB's Emerging Issues Task Force Issue No. 96-18, "Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring or in Conjunction with Selling, Goods or Services." During the year ended March 31, 2001, the Company recorded additional deferred compensation of $71,000 pursuant to this provision which will be amortized over the remaining vesting period.
5. SHARES RESERVED
At March 31, 2001, common stock reserved for future issuance was as follows:
6. SAVINGS PLAN
The Company maintains a savings plan under Section 401(k) of the Internal Revenue Code. Under the plan, employees may defer certain amounts of their pretax salaries but not more than statutory limits. The Company may make discretionary contributions to the plan as determined by the Board of Directors. The Company has not contributed to the plan through March 31, 2001.
7. INCOME TAXES
Due to operating losses and the Company's inability to recognize an income tax benefit from current losses, there is no provision for income taxes for the years ended March 31, 2001 or 1999. Provisions for income taxes for the year ended March 31, 2000 consisted primarily of current foreign taxes and state income taxes.
VIRAGE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
The difference between the provision for income taxes and the amount computed by applying the Federal statutory income tax rate to income before taxes is explained below (in thousands):
Significant components of the Company's deferred tax assets are as follows (in thousands):
FASB Statement No. 109, "Accounting for Income Taxes," provides for the recognition of deferred tax assets if realization of such assets is more likely than not. Based upon the weight of available evidence, which includes the Company's historical operating performance and the reported cumulative net losses in all prior years, the Company has provided a full valuation allowance against its net deferred tax assets.
The valuation allowance increased by $8,642,000 during the year ended March 31, 2001. Approximately $300,000 of the valuation allowance is related to stock options. The benefit of which will be credited to equity when realized.
As of March 31, 2001, the Company had federal and state net operating loss carryforwards of approximately $45,100,000 and $13,800,000, respectively. As of March 31, 2001, the Company also had federal and state research and development tax credit carryforwards of approximately $523,000 and $440,000, respectively. The net operating loss and tax credit carryforwards will expire at various dates beginning in 2003, if not utilized.
Utilization of the net operating loss and tax credit carryforwards may be subject to substantial annual limitations due to the ownership change limitations provided by the Internal Revenue Code and similar state provisions. The annual limitation may result in the expiration of net operating losses and tax credit carryforwards before utilization.
VIRAGE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
8. SEGMENT REPORTING
The Company has two reportable segments: the sale of software and related software support and professional services including revenues from U.S. government agencies ("software") and the sale of its application services which includes set-up fees, video processing fees, and application hosting fees ("application services"). The Company's Chief Operating Decision Maker ("CODM") is the Company's Chief Executive Officer who evaluates performance and allocates resources based upon total revenues and gross profit (loss). Discreet financial information for each segment's profit and loss and each segment's total assets is not provided to the Company's CODM, and is not tracked by the Company.
Information on the Company's reportable segments for the years ended March 31, 2001 and 2000 are as follows (in thousands):
Through March 31, 1999, the Company operated within one business segment - -- the sale of software and related software support services.
Total revenues to customers located outside the United States were approximately $3,341,000, $1,241,000 and $358,000 for the years ended March 31, 2001, 2000 and 1999, respectively. Virage Europe Ltd., the Company's European subsidiary, accounted for approximately $2,020,000, $1,137,000 and $140,000 of the Company's total revenues for the years ended March 31, 2001, 2000 and 1999, respectively.
9. QUARTERLY FINANCIAL DATA (UNAUDITED)
VIRAGE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
10. SUBSEQUENT EVENTS (UNAUDITED)
Subsequent to March 31, 2001, the Company's Board of Directors approved the adoption of an employee stock option plan and reserved up to 900,000 shares to be granted to non-director, non-officer employees of the Company.
In addition, the Company's 1997 stock option plan provides for the lesser of 1,000,000 shares or five percent of outstanding shares to increase the number of shares outstanding on an annual basis effective every April 1. Accordingly, 1,000,000 shares were authorized as additional shares to be granted under this plan in April 2001.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
There were no matters to be reported under this item.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
(a) Executive Officers
The information with respect to Executive Officers is included in Part I hereof after Item 4.
(b) Directors
The information required by this item is included in the section entitled "Election of Directors" in the Proxy Statement for the 2001 Annual Meeting of Stockholders ("Proxy Statement") and is incorporated by reference herein. The information regarding compliance with section 16(a) of the Exchange Act is included in the Proxy Statement and incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item is included in the section entitled "Executive Compensation" in the Proxy Statement and is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this item is included in the section entitled "Security Ownership of Certain Beneficial Owners and Management" in the Proxy Statement and is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item is included in the section entitled "Certain Transactions" in the Proxy Statement and is incorporated herein by reference.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a)(1) Financial Statements
The consolidated financial statements of Virage as set forth under Item 8 are filed as part of this Annual Report on Form 10-K.
(2) Financial Statement Schedule
VIRAGE, INC.
SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS
(IN THOUSANDS)
All other schedules are omitted because they are not applicable or the amounts are insignificant or the required information is presented in the Consolidated Financial Statements and Notes thereto in Item 8 above.
(3) Exhibits
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+ Incorporated by reference to the Registrant's Registration Statement on Form S-1 (Registration No. 333-96315).
++ Incorporated by reference to the Registrant's Quarterly Report filed on Form 10-Q on February 6, 2001.
(b) Reports on Form 8-K:
No reports on Form 8-K were filed during the fourth quarter ended March 31, 2001.
(c) See Item 14(a)(3) above.
(d) See Items 8 and 14(a)(2) above.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on June 20, 2001.
Virage, Inc.
By: /s/ Paul G. Lego ------------------------------------- Paul G. Lego Chairman of the Board of Directors, President and Chief Executive Officer
POWER OF ATTORNEY
Know all persons by these presents, that each person whose signature appears below constitutes and appoints Paul G. Lego and Alfred J. Castino, jointly and severally, his attorneys-in-fact, each with the power of substitution, for him in any and all capacities, to sign any amendments to this Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Index to Exhibits
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+ Incorporated by reference to the Registrant's Registration Statement on Form S-1 (Registration No. 333-96315).
++ Incorporated by reference to the Registrant's Quarterly Report filed on Form 10-Q on February 6, 2001.