ITEM 1. BUSINESS.
Forward-Looking Statements
This Annual Report on Form 10-K contains forward-looking statements and information relating to us and our subsidiaries, which are based on management’s beliefs, as well as assumptions made by our management and information currently available to us. These statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. When used in this Annual Report, words such as “anticipate”, “believe”, “estimate”, ‘expect”, “intend” and similar expressions, as they relate to us or our management identify forward-looking statements. Such statements reflect our current views with respect to future events and are subject to certain risks, uncertainties and assumptions, including but not limited to those factors set forth below in Item 1A
ITEM 1A. RISK FACTORS.
The following important factors, among others, could cause our actual operating results to differ materially from those indicated or suggested by forward-looking statements made in this Form 10-K or presented elsewhere by management from time to time.
The restatement of our consolidated financial statements and the matters relating to the investigations by the Audit Committee and by the Special Committee of the Board of Directors may result in additional litigation and governmental enforcement actions.
On July 19, 2006, we announced that our Audit Committee had undertaken a detailed review of the revenue recognition accounting for software license and service agreement transactions entered into during fiscal 2004 and 2005. The Audit Committee notified our independent public accounting firm and engaged its own legal advisors and forensic accountants to assist it with its investigation. Also in July 2006, our Audit Committee concluded, in consultant and upon the recommendation of management in consultation with and upon the recommendation of management, that our previously issued financial statements included in our Annual Reports on Form 10-K for the fiscal years ended December 31, 2004 and 2005 and in our Quarterly Reports on Form 10-Q for the interim fiscal periods ended March 31, June 30 and September 30, 2005 and March 31, 2006, and all of our earnings releases and similar communications relating to those fiscal periods, should no longer be relied upon.
We conducted a review and investigation of several accounting issues with the assistance of outside legal counsel and outside accounting specialists. The review and investigation included a review of our revenue recognition accounting for certain software license and service agreement transactions, stock option practices and related stock-based compensation expense and other accounting adjustments, including foreign tax filing errors and accounting timing adjustments. These review and investigations, and related activities, have required us to incur substantial expenses for legal, accounting, tax and other professional services, and have diverted management’s attention from our business.
As a result of the review and investigation of our accounting practices, we restated previously released financial statements for 2000 through the first quarter of 2006. We also recorded cumulative effect adjustments for fiscal years 2000 through 2003, the effects of which are indicated as adjustments to our financial statements as of December 31, 2003. For more information on these matters, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 2 to our Consolidated Financial Statements.
While we believe we have made appropriate judgments in our reviews and resulting restatement as presented and described in this Annual Report on Form 10-K, the SEC may disagree with the manner in which we have accounted for and reported the financial impact. Accordingly, there is a risk we may have to further restate our prior financial statements, amend prior filings with the SEC, or take other actions not currently contemplated.
We may also become the subject of, or otherwise required to incur legal fees and costs in connection with, private litigation, regulatory proceedings, or government enforcement actions. No assurance can be given regarding the outcomes from such activities. The resolution of these matters will be time consuming, expensive, and will distract management from the conduct of our business. Our available directors’ and officers’ liability insurance may not be sufficient to cover our legal expenses or those of persons we are obligated to indemnify. If we are subject to adverse findings in litigation, regulatory proceedings or government enforcement actions, we could be required to pay damages or penalties or have other remedies imposed, which could have a material adverse effect on our business, financial condition, results of operations and cash flows. Furthermore, the restatements of our financial results and any resulting litigation or SEC investigation could impact our relationships with customers and our ability to generate revenue.
We have identified material weaknesses in our disclosure controls and procedures and our internal control over financial reporting as of December 31, 2006 that, if not remedied effectively, could result in material misstatements in our financial statements in future periods.
Our management is responsible for establishing and maintaining adequate internal control over our financial reporting, as defined in Rule 13a-15(f) or 15d-15(f) promulgated under the Securities Exchange Act of 1934, as amended. Our management assessed the effectiveness of our internal control over financial reporting as of December 31, 2006, and identified material weaknesses. Our management also evaluated the effectiveness of our disclosure controls and procedures and, due to these material weaknesses, our disclosure controls and procedures were not effective as of December 31, 2006.
A material weakness is defined as a control deficiency, or combination of significant control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. A control deficiency exists when the design or operation of a control does not allow management or employees, in the normal course of performing their assigned functions, to prevent or detect misstatements on a timely basis.
We identified the following material weaknesses as of December 31, 2006:
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inappropriate level of responsibility for contract review and approval, as well as revenue recognition decisions;
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insufficient flow of documentation and information between operations and finance personnel;
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inappropriate responsibility of vice president of operations in overseeing the performance of the sales force and approving contracts;
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insufficient review of contracts by the operations personnel to ensure proper data entry of standard and non-standard terms;
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insufficient tracking of the issuance and return of license key codes;
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insufficient tracking of inventory maintained by resellers; and
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insufficient processes for approving, issuing, documenting and accounting for stock option grants.
For further information about these material weaknesses, please see Item 9A - “Controls and Procedures” included elsewhere in this Annual Report on Form 10-K. Because of these material weaknesses, management concluded that, as of December 31, 2006, our internal control over financial reporting was not effective.
We have implemented and continue to implement a number of remedial measures designed to address the material weaknesses identified as of December 31, 2006. If these remedial initiatives are insufficient to address the identified material weaknesses, or if additional material weaknesses or significant deficiencies in our internal control are discovered in the future, we may fail to meet our future reporting obligations on a timely basis, our financial statements may contain material misstatements, our operating results may be harmed, we may fail to meet our future reporting obligations on a timely basis, we may be subject to litigation. Any failure to address the identified material weaknesses or any additional material weaknesses or significant deficiencies in our internal control could also adversely affect the results of future management evaluations regarding the effectiveness of our “internal control over financial reporting” that are required under Section 404 of the Sarbanes-Oxley Act of 2002. Internal control deficiencies could also cause investors to lose confidence in our reported financial information.
We can give no assurance that the measures we have taken to date or any future measures we may take will remediate the material weaknesses identified or that any additional material weaknesses will not arise in the future due to a failure to implement and maintain adequate internal control over financial reporting or circumvention of these controls. In addition, even if we are successful in strengthening our controls and procedures, those controls and procedures may not be adequate to prevent or identify irregularities or facilitate the fair presentation of our financial statements or our periodic reports filed with the SEC.
Failure or circumvention of our internal controls and procedures could seriously harm our business.
Our internal controls and procedures have been circumvented in the past and may be circumvented in the future. We are making significant changes in our internal control over financial reporting and our disclosure controls and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, and not absolute, assurances that the objectives of the system are met. The failure or circumvention of our controls, policies and procedures could have a material adverse effect on our business, results of operations and financial condition.
Our financial statements have been impacted, and could be impacted again, by revenue recognition errors.
We restated previously released financial statements for 2000 through the first quarter of 2006, which was in part due to revenue recognition errors in the accounting for certain software license and service agreements. Our financial statements could be adversely impacted by improper or erroneous application of revenue recognition policies and accounting rules. For instance, revenue recognition depends on, among other criteria, when: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred (generally FOB shipping point or electronic distribution); (3) the fee is deemed fixed or determinable; and (4) collection is probable. Our personnel may misrepresent an contract and consent to undocumented terms with a customer, imply delivery that has not occurred, make promises of future concessions or misrepresent a customer’s credit rating. We have implemented policies and procedures we hope will prevent and discourage such improper application of revenue recognition policies and accounting rules, but there can be no assurance that such policies will be followed. In addition, depending on when we learn of improper application of revenue recognition policies, we may have to restate our financial statements for a previously reported period, which would seriously harm our business, operating results and financial condition.
We have a history of operating losses, and we may not be profitable.
We incurred operating losses in 2006 and for three of the five years ended December 31, 2005. In August 2006 we announced a strategic restructuring of our company in response to our recent losses and our renewed focus on core products and services that included a 20% reduction in workforce and the closing of two sales offices. We were profitable for the second and fourth quarters of 2006, but operating losses for the first and third quarters of 2006, caused us to incur an operating loss for 2006. As of December 31, 2006, our accumulated deficit was $22.0 million. Our ability to achieve and maintain profitability is dependent on continued revenues from new and existing customers and expense control. There can be no assurance that we will return to profitability and even if we achieve profitability, we cannot assure that we can sustain profitability on a quarterly or annual basis.
If we are not current in our filings with the SEC, we will face several adverse consequences.
We are not current with our financial filings and until we are current and if we are unable to remain current in our financial filings, we will not be able to have a registration statement under the Securities Act of 1933, covering a public offering of securities, declared effective by the SEC, and we will not be able to make offerings pursuant to existing registration statements or pursuant to certain “private placement” rules of the SEC under Regulation D, to any purchasers not qualifying as “accredited investors.” These restrictions may impair our ability to raise funds in the public markets, should we desire to do so, and to attract and retain key employees.
We are reliant on fees from maintenance contracts and renewals. If we fail to retain our maintenance customers, our revenues may be adversely affected.
We rely on maintenance contract renewals for a significant percentage of our revenue, as software maintenance fees have represented 40%, 41% and 41% of our total revenues in the years ended December 31, 2006, 2005 and 2004, respectively. While a maintenance contract on our products is mandatory for the first year after purchase, subsequent renewals of the maintenance contract are at the discretion of our customers. Accordingly, our failure to retain maintenance customers or a significant decline in the rate of maintenance contract renewals could have a material adverse effect on our business, results of operations, cash flows, and financial position.
We rely heavily on indirect distribution channels and strategic partner relationships for the sales of our products. If these relationships are disrupted, our revenues may be adversely affected.
We sell our products in part through value-added resellers, systems integrators, original equipment manufacturers and distributors, which are not under our control. Sales of our products by such channel partners represented 67%, 60% and 49% of our product revenues in years ended December 31, 2006, 2005 and 2004, respectively. We rely heavily on our indirect sales partners for sales of our expert operations management products to new customers. The loss of major original equipment manufacturers or resellers of our products, a significant decline in their sales, or difficulty on the part of such third-party developers or resellers in developing successful G2-based applications could have a material adverse effect on our business, results of operations, cash flows and financial position. There can be no assurance that we will be able to attract or retain additional qualified third-party resellers, or that third-party resellers will be able to effectively sell and implement our products. In addition, we rely on third-party resellers to provide post-sales service and support to our customers, and any deficiencies in such service and support could adversely affect our business, results of operations, cash flows, and financial position.
We depend heavily on our sales and marketing force.
Our future success in the expert operations management marketplace will depend, in part, upon the productivity of our sales and marketing personnel, our ability to continue to attract, integrate, train, motivate and retain new sales and marketing personnel, and our ability to manage sales and channel partners. There can be no assurance that our investment in sales and marketing will ultimately prove to be successful. In addition, there can be no assurance that our sales and marketing personnel will be able to compete successfully against the significantly more extensive and better funded sales and marketing operations of many of our current and potential competitors. Our inability to manage our sales and marketing personnel effectively could have a material adverse effect on our business, results of operations, cash flows, or financial position.
Our quarterly operating results may vary, leading to fluctuations in trading prices for our common stock and possible liquidity problems.
We have experienced, and may experience in the future, significant quarter-to-quarter fluctuations in our operating results. There can be no assurance that revenue growth or profitable operations can be attained on a quarterly or annual basis in the future. Our sales cycle typically ranges from 6 to 12 months, and the cost of acquiring our software, building and deploying applications, and training users represents a significant expenditure for customers. Our relatively long sales cycle and high license fees, together with fixed short-term expenses, can cause significant variations in operating results from quarter to quarter, based on a relatively small variation in the timing of major orders. Factors such as the timing of new product introductions and upgrades and the timing of significant orders could contribute to this quarterly variability. In addition, we ship software products within a short period after receipt of an order and typically do not have a material backlog of unfilled orders of software products. Therefore, revenues from software licenses in any quarter are substantially dependent on orders booked in that quarter. Historically, a majority of each quarter’s revenues from software licenses has come from license contracts that have been executed in the final weeks of that quarter. The revenues for a quarter may include some large orders. If the timing of any of these large orders is delayed, it could result in a substantial reduction in revenues for that quarter. Our expense levels are based in part on expectations of future revenue levels. A shortfall in expected revenues could therefore result in a disproportionate decrease in our results of operations and cash flows, which may impact our ability to continue as an independent concern.
Our business may suffer if we fail to remain competitive with other companies offering similar products and services.
A number of companies offer products that offer rule engine capabilities or that perform certain functions of G2 for specific applications. In all of our markets, there is competition from “point solutions,” real-time and rule engine products, and internally developed software. There are commercially available software development tools that software application developers or potential customers could use to build software that has functionality similar to our products.
In addition, we believe that end users in our markets are increasingly seeking application-specific products and components as well as complete solutions, rather than general software tools to develop application-specific functionality and solutions. Meeting this demand has required us to modify our sales approach. We are increasingly reliant on indirect channel partners, including original equipment manufacturers, value-added resellers, and systems integrators, to satisfy market requirements. A number of software companies offer products that compete in specific application areas addressed by these partners, such as cement kiln control, manufacturing execution systems, logistics systems, and network management, and they could be successful in supplying alternatives to products based on our software.
Companies offering competitive rule engine products include Fair Isaac, ILOG, and Computer Associates. Certain companies, such as Micromuse and Aspen Technology, sell “point solutions” that compete with operations management applications based on G2 with respect to specific applications or uses. Several companies, including ILOG, Pavilion, and System Management Arts, offer operations management products with limited real-time, expert system, or fault isolation capabilities, but at lower price points than those provided by us. Certain competitors in this category have greater financial and other resources than we do and might introduce new or improved products to compete with G2, possibly at lower prices.
Many of our customers have significant investments in their existing solutions and have the resources necessary to enhance existing products and to develop future products. These customers may develop and incorporate competing technologies into their systems or may outsource responsibility for such systems to others who do not use our products. There is no assurance that we can successfully persuade development personnel within these customers’ organizations to use G2-based products that can cost-effectively compete with their internally developed products. Thus there could be a reduction in the need for our products and services that may limit our future opportunities.
We believe that continued investment in research and development and sales and marketing will be required to maintain our competitive position. There can be no assurance that competitors will not develop products or provide services that are superior to our products or services or achieve greater market acceptance. Competitive pressures faced by us could force us to reduce our prices, which could result in reduced profitability. There can be no assurance that we will be able to compete successfully against current and future sources of competition or that such competition will not have a material adverse effect on our business, results of operations, cash flows, or financial position.
Our business may suffer if we fail to address the challenges associated with international operations.
Our international revenues represented 49%, 53%, and 51% of our total revenues for years ended December 31, 2006, 2005, and 2004, respectively. We categorize our revenues according to product shipment destination, which therefore does not necessarily reflect the ultimate country of installation. Our international operations require significant management attention and financial resources.
There are certain risks inherent in our international business activities including:
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changes in foreign currency exchange rates;
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unexpected changes in politics and regulatory requirements;
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tariffs and other trade barriers;
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costs of localizing products for foreign countries;
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lack of acceptance of products in foreign countries;
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longer accounts receivable payment cycles;
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difficulties in building and managing international operations;
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tax issues, including restrictions on repatriating earnings;
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weaker intellectual property protection in other countries;
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economic weakness or currency related crises that may arise in different countries or geographic regions; and
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the burden of complying with a wide variety of foreign laws.
These factors may have a material adverse effect on our future international sales and, consequently, on our business, results of operations, cash flows, or financial position
We rely heavily on revenues from our G2 and G2-based products. If demand for the G2 product declines, our revenues may be adversely affected.
Substantially all of our license revenues are derived from G2, a customizable object-oriented development and deployment platform for building expert operations management systems, and from software application products based on G2 and other core technologies. Accordingly, our business and financial results are substantially dependent upon the continued customer acceptance and deployment of G2 and our other products. The timing of major G2 releases may affect the timing of purchases of our products. We have introduced several G2-based products for building applications and may develop others. We believe that market acceptance of these products will be important to our future growth. There can be no assurance that such products will achieve market acceptance or that new products will be successfully developed.
In addition, we rely on many of our distribution partners to develop G2-based products for specialized markets. Accordingly, our business and financial results are also linked to the continued successful product development by our partners and market acceptance of such G2-based products. Any decline in the demand for G2 and our other products, whether as a result of competitive products, price competition, the lack of success of our partners, technological change, the shift in customer demand toward complete solutions, or other factors, could have a material adverse effect on our business, results of operations, cash flows, or financial position.
Our software is complex and may contain undetected errors. Such errors could cause costly delays in product introduction or require costly software design modifications.
Complex software products such as those that we offer may contain unintended errors or failures commonly referred to as “bugs.” There can be no assurance that, despite significant testing by us and by current and potential customers, errors will not be found in new products after commencement of commercial shipments. Although we have not experienced material adverse effects resulting from any such errors or defects to date, there can be no assurance that errors or defects will not be discovered in the future that could cause delays in product introduction and shipments or require design modifications that could adversely affect our business, results of operations, cash flows, or financial position.
Sales of our products are highly dependent on our customers’ capital expenditure budgets. If an economic downturn causes our customers to reduce their capital expenditures, our revenues may be adversely affected.
Because capital expenditures are often viewed as discretionary by organizations, sales of our products for capital budget projects are subject to general economic conditions. Future recessionary conditions in the industries that use our products may adversely affect our business, results of operations, cash flows, or financial position.
Our business may be adversely affected if we fail to develop new products and respond to changes in technology.
The market for our products is characterized by rapid technological change, evolving industry standards, changes in end-user requirements, and frequent new product introductions and enhancements. Our future success will depend in part upon our ability to enhance our existing products, to introduce new products and features to meet changing customer requirements and emerging industry standards, and to manage transitions from one product release to the next. We have from time to time experienced delays in introducing new products and product enhancements. There can be no assurance that we will not experience difficulties that could delay or prevent the successful development, introduction and marketing of these new products and product enhancements. There also can be no assurance that we will successfully complete the development of new or enhanced products, that we will successfully manage the transition to future versions of G2, or to successor technology, or that our future products will achieve market acceptance. In addition, the introduction of products embodying new technologies and the emergence of new industry standards could render our existing products and products currently under development obsolete and unmarketable. From time to time, new products, capabilities, or technologies may be announced that have the potential to replace or shorten the life cycle of our existing product offerings. There can be no assurance that announcements of currently planned or other new product offerings will not cause customers to defer purchasing our existing products.
Our research and development in new reasoning technologies may not lead to profitable commercialization.
We developed a pre-release version of a new software reasoning platform, TrueManage, designed for handheld computing devices and targeted at application markets not currently addressed by our G2 and G2-based products. We have also prototyped a TrueManage application product called LifeVisor, a cell phone device for self-management of chronic conditions such as diabetes and obesity. Development of TrueManage and LifeVisor is complex, requiring specialized technical expertise. The targeted handheld computing markets experiences rapid advancements in related technologies and applications. Our strategy was to distribute these products, particularly LifeVisor, through other companies that have significantly larger presence and scale in the targeted markets than we do. We found that it would require significant funding to develop, launch, and build distribution channels for TrueManage and LifeVisor and have therefore suspended development. There can be no assurance that we will be able to successfully complete the development of TrueManage and LifeVisor in the future. Our ability to use the is technology and realize a return on this investment may be limited.
Our stock price may be volatile and an investment in our common stock could suffer a decline in value.
The market price for our common stock may fluctuate significantly in response to a number of factors, some of which are beyond our control. These factors include:
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actual or anticipated fluctuations in our operating results;
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developments or disputes concerning proprietary rights;
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the loss of key management or technical personnel;
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technological innovations or new products;
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governmental regulatory action;
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fluctuations in currency exchange rates;
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general conditions in the software industry;
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broad market fluctuations; and
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economic conditions in the United States or abroad.
The stock market has recently experienced price and volume fluctuations. These fluctuations have particularly affected the market price of many software companies, often without regard to their operating performance.
Compliance with changing regulation of corporate governance and public disclosure may result in additional risks and expenses.
Changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations and NASDAQ rules, are creating uncertainty for companies such as ours. These new or changed laws, regulations and standards are subject to varying interpretations in many cases and, as a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies, which could result in continuing uncertainty regarding compliance matters and higher costs necessitated by ongoing revisions to disclosure and governance practices. We are committed to maintaining high standards of corporate governance and public disclosure. As a result, our efforts to comply with evolving laws, regulations and standards have resulted in, and are likely to continue to result in, increased general and administrative expenses and management time and attention. In particular, our efforts to comply with Section 404 of Sarbanes-Oxley and the related regulations regarding our required assessment of our internal controls over financial reporting and our external auditors’ audit of that assessment has required the commitment of significant financial and managerial resources, and we expect our compliance efforts to require the continued commitment of significant resources. Additionally, if our efforts to comply with new or changed laws, regulations and standards differ from the activities intended by regulatory or governing bodies, our reputation may be harmed, and we might be subject to sanctions or investigation by regulatory authorities, such as the SEC. Any such action could adversely affect our business and the market price of our stock.
Our common stock is quoted on the Pink Sheets, which limits the liquidity and could negatively affect the value of our common stock.
Our common stock is quoted on the Pink Sheets, which provides significantly less liquidity than a securities exchange, such as the New York Stock Exchange, the American Stock Exchange, or the NASDAQ Global Market.
Purchasers of shares of our common stock may find it difficult to resell their shares at prices quoted in the market or at all. There is currently a limited volume of trading in our common stock, and on some days there has been no trading activity at all. We cannot predict when or whether investor interest in our common stock might lead to an increase in its market price or the development of a more active trading market or how liquid that market might become.
Additionally, because our common stock is listed on the Pink Sheets, the liquidity of our common stock is impaired, not only in the number of shares that are bought and sold, but also through delays in the timing of transactions, and limited coverage by security analysts and the news media, if any, of our company. As a result, prices for shares of our common stock may be lower than might otherwise prevail if our common stock was traded on a national securities exchange, like the New York Stock Exchange, the American Stock Exchange or the NASDAQ Global Market.
Because we rely heavily upon proprietary technology, our business could be adversely affected if we are unable to protect our proprietary technology or if third parties successfully assert infringement claims against us.
Our success is heavily dependent upon our proprietary technology. We rely upon a combination of trade secret, contract, copyright, patent, and trademark law to protect our proprietary rights in our products and technology. We enter into confidentiality and/or license agreements with our employees, contractors, third-party resellers, and end users and limit
access to and distribution of our software, documentation, and other proprietary information. In addition, we have placed technical inhibitors in our software that prevent such software from running on unauthorized computers. However, effective patent, copyright, and trade secret protection may not be available in every country in which our products are distributed. There can be no assurance that the steps taken by us to protect our proprietary technology will be adequate to prevent misappropriation of our technology by third parties, or that third parties will not be able to develop similar technology independently. In addition, there can be no assurance that third parties will not assert infringement claims in the future or that such claims will not be successful.
Provisions in our corporate documents and Delaware law could delay or prevent a change of control of the company, even if that change would be beneficial to our stockholders.
Our certificate of incorporation and bylaws contain provisions that may make a change of control of the company difficult, even if it would be beneficial to our stockholders, including provisions governing the classification, nomination and removal of directors, prohibiting stockholder action by written consent, regulating the ability of our stockholders to bring matters for action before annual stockholder meetings, and the authorization given to our board of directors to issue and set the terms of preferred stock. In addition, Section 203 of the Delaware General Corporation Law would impose restrictions on mergers and other business combinations between us and any holder of 15 percent or more of our outstanding common stock.
ITEM 2.
ITEM 2. PROPERTIES.
At December 31, 2006, our headquarters and principal operations were located in a leased facility with 16,928 square feet in Burlington, Massachusetts. The lease on the Burlington facility expires on March 31, 2011. In addition to rental expenses, we must also pay an allocated portion of operating expenses and taxes each year. We also lease sales office space in the metropolitan areas of several cities throughout the United States, as well as France, Italy, and The Netherlands. We believe that our existing facilities are adequate for our current needs and that suitable additional space will be available as required.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
We are involved in various lawsuits, claims and inquiries, most of which are routine to the nature of our business. In the opinion of our management, the resolution of these matters will not have a material adverse effect on our financial position, results of operations or cash flows.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II.
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES
Our common stock, $0.01 par value per share, was traded on the OTC Bulletin Board through September 25, 2006 and has traded since on the Pink Sheets. Our common stock is currently quoted on the Pink Sheets under the symbol “GNSM”. The following table sets forth the high and low closing prices per share of our common stock for the quarterly periods indicated on the Pink Sheets. Prices for common stock are the closing sales prices on the OTC Bulletin Board through September 25, 2006 and the closing sales prices on the Pink Sheets after that date. Due to the low trading volume in our common stock, the reported trading prices may not be indicative of the value of our common stock.
We have never declared or paid cash dividends on our capital stock. We do not anticipate paying any cash dividends in the foreseeable future. Payment of future dividends, if any, will be at the discretion of our board of directors after taking into account various factors, including our financial condition, operating results, current and anticipated cash needs and plans for expansion.
There were approximately 114 holders of record of our common stock as of May 25, 2007. This number does not include stockholders for whom shares are held in a “nominee” or “street” name.
We have not sold any unregistered securities in the past three years.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA.
You should read the data set forth below in conjunction with Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, Item 7A, “Quantitative and Qualitative Disclosures About Market Risk” and our consolidated financial statements and related notes appearing elsewhere in this Annual Report on Form 10-K. As discussed in Note 2 to the Consolidated Financial Statements, the financial statements for 2005, 2004, 2003, 2002, 2001 and 2000 and for the fiscal quarters therein, along with the first quarters of 2006, have been restated. The restated financial statements for years 2001 and 2000 are not presented and are unaudited. The restated financial data for 2002 and 2003 presented below are unaudited. The selected consolidated statement of operations data set forth below for the years ended December 31, 2006, 2005 and 2004 and the consolidated balance sheet data as of December 31, 2006 and 2005 are derived from our audited consolidated financial statements that are included elsewhere in this Annual Report on Form 10-K.
(1) See Note 2, “Restatement of Previously Issued Financial Statements” to the Consolidated Financial Statements included in Item 8
(2) See Note 9, “Accrued Expenses” of Notes to the Consolidated Financial Statements included in Item 8.
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
You should read the following discussion and analysis together with our consolidated financial statements and related notes and other financial information appearing elsewhere in this Annual Report on Form 10-K.
The following discussion and analysis gives effect to the restatement described in Note 2 to the Consolidated Financial Statements. For this reason, the data set forth in this section may not be comparable to discussions and data in our previously filed annual and quarterly reports.
Business Overview
We were incorporated in Delaware in 1986 to develop and sell software products for operations management applications that are based on rule-driven, real-time logic. Our flagship product has been and continues to be, G2, which applies the rule-based knowledge of human experts to support and automate decisions that optimize operations and that detect, diagnose and resolve costly problems. We have also developed a number of market-specific products using G2 as a platform. Since our inception, we have sold over 18,000 licenses to customers in a variety of industries.
Over the years we have developed and improved G2 and its related products on a regular basis, in terms of performance, functionality and ability to integrate with a wide variety of industry-standard products and protocols. We released a major version of G2, version 8.0, in June 2004, which constituted a generational advance in our product. During 2005 we released G2 version 8.1 and G2 version 8.2, which both significantly expanded upon the capabilities introduced with G2 version 8.0. During 2006, we continued the development of major enhancements to G2 by introducing an Alpha version of G2 version 8.3 in October 2006. We completed the Beta program for version 8.3 in March 2007. In addition to G2 version 8.3, we also enhanced all of our G2 based application products based on G2 version 8.3 and we plan to release these products along with G2 version 8.3 in mid 2007. These products include G2 ReThink version 5.1, G2 e-SCOR version 5.1, G2 Optegrity version 5.1, G2 NeurOn-Line version 5.1 and G2 Integrity version 5.0.
In 2006, we continued to focus our sales force on the generation of new business through indirect channels. We also continued to support the current and future needs of our existing end user customers. As part of the execution of our indirect channel strategy, we have introduced new indirect channel programs designed to improve our ability to attract new partners and to support existing partners, who pursue new business based on our products across all of the vertical and horizontal markets that we serve.
To assist our end users and partners in developing applications, we offer professional services in the U.S., Europe and the Middle East. Most of these services are billed on a time and materials basis. Occasionally, we enter into fixed price arrangements, which are usually accounted for using a proportional performance model.
We conduct our business in North and South America, Europe, the Middle East, Africa and the Asia-Pacific region. In 2006, approximately 33% of our revenues were generated from license sales, 27% from consulting and training and 40% from customer support services. Prices for our products are generally denominated in U.S. dollars or Euros, although we conduct some business in other local currencies. The U.S. Government, particularly the Department of Defense and the Department of Energy, is a major customer. We have several significant OEM partners; among them are Siemens, Ericsson, and Motorola.
Detailed domain knowledge and expertise are critical elements for the success of our product implementations. Therefore, we frequently work closely with partners who are able to provide such expertise and are familiar with particular markets and applications. Our partners are value-added resellers, original equipment manufacturers, and system integrators. Partners account for 67% of our product revenues in 2006.
Critical Accounting Policies
The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, and expenses, as well as related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to bad debts, income taxes, and contingencies. We base our
estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
We believe the following accounting policies are critical to an understanding of our consolidated financial statements and involve the more significant judgments and estimates used in the preparation of our consolidated financial statements.
Revenue Recognition
We derive revenues from two primary sources: (1) product licenses and (2) services revenues, which include maintenance, consulting, and education revenues. While the basis for software revenue recognition is substantially governed by the provisions of Statement of Position No. 97-2, Software Revenue Recognition (SOP 97-2), and Statement of Position No. 98-9, Modification of SOP 97-2, Software Revenue Recognition with Respect to Certain Transactions, (SOP 98-9), Statement of Position No. 81-1, Accounting for Construction-type and Certain Production-type Contracts (SOP 81-1), as issued by the American Institute of Certified Public Accountants, and SEC Staff Accounting Bulletin 104, Revenue Recognition (SAB 104), we exercise judgment and use estimates in connection with the determination of the amount of software license and services revenues to be recognized in each accounting period.
For software license arrangements that do not require significant modification or customization of the underlying software, we recognize license revenue when: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred (generally FOB shipping point or electronic distribution); (3) the fee is deemed fixed or determinable; and (4) collection is probable. A significant majority of our license revenues are recognized in this manner. For term licenses that include the right to use software bundled with maintenance for the duration of the term, we recognize revenue ratably over such term.
We assess whether fees are fixed or determinable and free of contingencies or significant uncertainties at the time of sale and recognize revenue if all other revenue recognition criteria are met. If the fee is not fixed or determinable, revenue is recognized as payments become due from the customer.
Our license arrangements generally do not include acceptance provisions. However, if an arrangement includes an acceptance provision, revenue is recognized upon the earlier of receipt of a written customer acceptance or expiration of the acceptance period.
Our software is distributed directly through our sales force and indirectly through alliances with resellers. Revenue arrangements with resellers are recognized upon delivery of the software to the reseller provided all other revenue recognition criteria, as specified above, have been satisfied. For resellers with rights of return, we recognize revenue upon delivery of the software to the end user.
We account for software license revenues included in multiple element arrangements using the residual method prescribed in SOP 98-9. Under the residual method, the fair value of the undelivered elements, such as maintenance, consulting, and education services, based on vendor specific objective evidence is deferred and the remaining portion of the arrangement fee is allocated to the delivered elements, generally, the software licenses. If evidence of the fair value of one or more of the undelivered services does not exist, revenues are deferred and recognized when delivery of those services occurs or fair value can be established. We determine vendor specific objective evidence of fair value for services revenues based upon our current pricing for those services when sold separately and vendor specific objective evidence of fair value for maintenance services is measured by substantive renewal rates. Our current pricing practices are influenced primarily by product type, purchase volume, maintenance term, and customer location.
Our software arrangements may include consulting services sold separately under consulting engagement contracts that generally include implementation. These services may also be provided completely or partially by independent third-parties experienced in providing such consulting and implementation in coordination with dedicated customer personnel. Revenues from these arrangements are generally accounted for separately from the license revenue because they meet the criteria for separate accounting, as defined in SOP 97-2. The more significant factors considered in determining whether the revenue should be accounted for separately include the nature of services, such as consideration of whether the services are essential to the functionality of the licensed product, degree of risk, availability of services from other vendors, timing of payments and impact of milestones or acceptance criteria on the realizability of the software license fee.
For projects that require customization and development of the software, we account for the software and services as prescribed in SOP 81-1. Under this method, the software license revenue is recognized ratably over the term of the consulting engagement or at the time of delivery of contractual milestones.
Maintenance services generally include rights to unspecified upgrades, when and if available, telephone support, updates, and bug fixes. Maintenance revenue is recognized ratably over the term of the maintenance contract on a straight-line basis when all the revenue recognition requirements are met. Historically we have not offered any specified upgrade rights to an existing product.
Consulting services that are sold separately from license revenue are generally recognized as the services are performed on a time and materials basis. Consulting revenues for fixed-price contracts are recognized using a proportional performance model. If there is a significant uncertainty about the project completion or receipt of payment for the consulting services, revenue is deferred until the uncertainty is sufficiently resolved.
Education revenues are recognized as the related training services are provided.
Stock Based Compensation
In December 2004, the Financial Accounting Standards Board, or FASB issued SFAS No. 123(R), Share Based Payment. This statement is a revision of SFAS No. 123, Accounting for Stock-Based Compensation and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees and related interpretations. SFAS 123(R) establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods and services or incurs a liability in exchange for goods and services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of those equity instruments. It requires an entity to measure the costs of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award and recognize that cost over the service period. We adopted SFAS 123(R) during 2006 using the modified prospective method, which requires that we record compensation expense for all unvested stock option and restricted stock awards as required by SFAS 123(R) beginning January 1, 2006. Our assessment of the estimated stock-based compensation expense is affected by our stock price as well as assumptions regarding a number of complex variables including, but not limited to, our stock price, volatility, and employee stock option exercise behaviors and the related tax impact. We will recognize stock-based compensation expense on all awards on a straight-line basis over the requisite service period.
Accounts Receivable and Allowance for Doubtful Accounts
We make estimates of the collectability of our accounts receivable. Management specifically analyzes accounts receivable and analyzes historical bad debts, customer concentrations, customer credit-worthiness, current economic trends and changes in our customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. Uncertainties affecting our estimates include future industry and economic trends and the related impact of the financial condition of our customers, as well as the ability of our customers to generate cash flows sufficient to pay us amounts due. If circumstances change, such as higher than expected defaults or an unexpected material adverse change in a customer’s ability to meet its financial obligations to us, our estimates of the recoverability of amounts due us could be reduced by a material amount which may have a material effect on our financial position, results of operations or cash flows.
Foreign Currency Translation
Our contracts with our customers are generally denominated in U.S dollars or Euros. We transact business in various countries and thus have exposure to fluctuations in foreign currency exchange rates. Foreign currency exchange gains and loses on our trade accounts receivable are recorded as a component of other income (expense).
In 2004 we evaluated our intercompany balances and based upon our determination that settlement of such balances would not be planned or anticipated for the foreseeable future, we entered into formal long-term note agreements with our subsidiaries. As a result, we account for such notes as part of our net investment in these subsidiaries and accordingly record foreign currency changes related to these balances as a component of accumulated other comprehensive income.
In addition, we have certain cash balances held in currencies other than our functional currency or the functional currency of our subsidiaries. These amounts are translated at each month end to the functional currency in each country, and any resulting gain or loss is recorded in the appropriate statements of operations.
To date, we have not used financial instruments to hedge operating activities denominated in foreign currencies. We assess the need to utilize financial instruments to hedge currency exposures on an ongoing basis.
Our international business is subject to risks typical of an international business, including, but not limited to, differing economic conditions, changes in political climate, differing tax structures, other regulations and restrictions and foreign exchange rate volatility. Accordingly, our future results could be materially and adversely affected by changes in these or other factors.
Accounting for Income Taxes
As part of the process of preparing our consolidated financial statements we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves us estimating our actual current tax liabilities together with assessing temporary differences resulting from differing treatment of items, such as deferred revenue, for tax and accounting purposes as well as net operating losses. These differences result in deferred tax assets and liabilities, including net operating loss carry forwards, research and development tax credits and foreign tax credits. A portion of these net operating losses are a result of stock option deductions, and therefore the benefit from these losses will be charged directly to additional paid in capital. We assess the likelihood that our deferred tax assets will be recovered from future taxable income and to the extent we believe that recovery is not likely, we establish a valuation allowance. To the extent that we establish a valuation allowance or increase this allowance in a period, the impact will be included in the tax provision in the statement of operations.
Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against our deferred tax assets. We have recorded a valuation allowance due to uncertainties related to our ability to utilize our deferred tax assets, primarily consisting of certain net operating loss carry forwards and research and development tax credits, before they expire. The valuation allowance is based on our estimates of taxable income by jurisdiction in which we operate and the period over which our deferred tax assets will be recoverable. In the event that actual results differ from these estimates or we adjust these estimates in future periods, we may need to establish an additional valuation allowance that could materially impact our financial position and results of operations. At December 31, 2006, we continued to have a 100% valuation allowance against our deferred tax assets.
We have taken the position under Accounting Principles Board Opinion No. 23, Accounting for Income Taxes-Special Areas, that all earnings of our foreign subsidiaries are permanently re-invested. Therefore, no U.S. taxes have been provided on these unremitted accumulated foreign earnings.
The above listing is not intended to be a comprehensive list of all of our accounting policies. Our significant accounting policies are more fully described in Note 1 to our consolidated financial statements. See our audited consolidated financial statements and notes thereto included in this Annual Report on Form 10-K which contain accounting policies and other disclosures required by accounting principles generally accepted in the United States.
Results of Operations
The following is an overview of our results of operations for the last three years (in thousands):
(1) See Note 2, “Restatement of Previously Issued Financial Statements” to the Consolidated Financial Statements included in Item 8
The following table sets forth certain consolidated financial data as a percentage of our total revenue for the last three years:
(1) See Note 2, “Restatement of Previously Issued Financial Statements” to the Consolidated Financial Statements included in Item 8
Year Ended December 31, 2006 Compared with Year Ended December 31, 2005
(1) See Note 2, “Restatement of Previously Issued Financial Statements” to the Consolidated Financial Statements included in Item 8
Revenues
We derive our revenues from two sources: product and services. Product revenues include revenues from sales of licenses for use of our software products. Services revenues consist of fees for maintenance contracts, consulting services, and training courses related to our products.
Total revenues were $16.9 million for the year ended December 31, 2006 as compared to $17.0 million for the same period in 2005, a decrease of $0.1 million. The decrease in revenue is attributable to a decrease of $0.9 million, or 14%, in license revenues partially offset by an increase of $0.8 million, or 7%, in service revenues. Product revenues decreased mainly due to a general decrease in sales during the year. Service revenues increased primarily due to work performed on several large government consulting contracts in 2006 and were partially offset by a decline in maintenance revenues. International revenues accounted for 49% of total revenues in 2006 and 53% in 2005, while U.S. revenues accounted for 51% and 47% in 2006 and 2005, respectively.
Product. Product revenues decreased by $0.9 million, or 14%, to $5.6 million for the year ended December 31, 2006 from $6.4 million in 2005. Product revenues from international customers were $3.7 million, or 66% of total product revenue in 2006, and $4.3 million, or 67% of total product revenue in 2005. Product revenues from international customers decreased due to a general decrease in demand. U.S. product revenues were $1.9 million or 34% of total product revenue in 2006, and $2.1 million or 33% of total product revenue in 2005.
Services. Service revenues increased $0.8 million, or 7%, to $11.4 million for the year ended December 31, 2006 from $10.6 million in 2005. Maintenance revenues decreased $0.2 million, or 3%, to $6.8 million in 2006 compared to $7.0 million in 2005. The decrease in maintenance revenues was a result of maintenance service agreements that expired and were not renewed that were only partially offset by new product maintenance due to a decline in license sales. Consulting revenues increased $0.9 million, or 24%, to $4.6 million in 2006 compared to $3.7 million in 2005. The increase in consulting revenues was due to work performed on several large U.S. government contracts in 2006.
Cost of Revenues
Cost of revenues consists of consulting labor, technical support costs, and the costs of material and labor involved in producing and distributing our software. Cost of revenues was $5.1 million for the year ended December 31, 2006 as compared to $5.0 million for the same period in 2005, an increase of $0.1 million, or 2%. The increase in cost of revenues was primarily the result of increased personnel and costs associated with a long term contract completed in 2006 offset by the decrease in subcontractor costs as we transitioned to using our employees to perform consulting services. The average number of employees associated with the cost of revenue was 28 for 2006 and 26 for 2005. There were 26 consulting and product support employees as of December 31, 2006.
Product cost decreased to $0.4 million in 2006, a decrease of $0.1 million from 2005. This decrease was a result of the completion of amortization associated with an acquisition and a reduction in facility costs associated with cost reduction programs and the consolidation of our headquarter facility in 2006. The average number of employees associated with product cost was three and four in 2006 and 2005 respectively. There were two product support employees as of December 31, 2006.
Services cost was $4.7 million in 2006, an increase of $0.2 million, or 4%, from $4.5 million in 2005. The increase was primarily the result of a $0.4 million increase in personnel expense and a $0.1 million increase in costs associated with a long term contract completed in 2006, partially offset by $0.3 million decrease in subcontractor costs as we moved to using employees to perform consulting services. The average number of employees associated with service cost was 24 and 23 for 2006 and 2005, respectively. There were 24 service employees as of December 31, 2006.
Gross margin on revenues remained relatively constant at 70% for both 2006 and 2005.
Operating Expenses
Total operating expenses were $12.6 million in 2006 (74% of total revenues) as compared to $13.2 million (77% of revenues) in 2005; a decrease of $0.6 million, or 5%. The decrease in operating expenses was primarily the result of a $0.8 million decrease in personnel costs, a $0.5 million decrease in commission plans, a $0.5 million decrease in facility costs, a $0.2 million decrease in marketing and company development professional services, a $0.2 million decrease in product development subcontracts for a project that was terminated in January 2006, a $0.1 million reduction in travel costs, a $0.1 million reduction in recruiting and relocation expense, partially offset by a one time $0.5 million restructuring cost, a $0.4 million increase in legal costs, a $0.4 million increase in professional services in support of the restatement, a $0.2 million increase in accounting in support of the restatement, a $0.1 million increase in stock based compensation, and a $0.1 million increase in bad debt reserve. The average number of employees associated with operating expenses was 50 in 2006 and 58 in 2005. There were 39 operating employees as of December 31, 2006.
Sales and Marketing. Sales and marketing expenses consist primarily of costs associated with personnel involved in the sales and marketing process, sales commissions, sales facilities, travel and lodging, trade shows and seminars, advertising and promotional materials. For the year ended December 31, 2006, sales and marketing expenses decreased by $1.0 million, or 19%, to $4.4 million (26% of total revenues) compared to $5.4 million (32% of total revenues) in 2005. The decrease in expenses was primarily the result of a $0.5 million decrease in commission based on a new commission structure, lower sales and fewer salespeople, $0.2 million of decreased personnel cost, $0.2 million in reductions in marketing programs, $0.1 million reduction in facility costs as a result of cost containment programs and a new consolidated lease in our headquarters, $0.1 million of decreased travel, and a $0.1 million decrease in recruiting and relocation expenses. The average number of employees associated with sales and marketing was 13 in 2006 and 16 in 2005. There were nine sales and marketing employees as of December 31, 2006.
Research and Development. Research and development expenses consist primarily of costs associated with personnel, equipment and facilities. For the year ended December 31, 2006, research and development expenses decreased by $0.9 million to $3.0 million (18% of total revenue) as compared to $3.9 million during 2005 (23% of total revenue). This decrease was a result of $0.4 million in personnel costs primarily associated with the discontinuation of our TrueManage development program, a $0.2 million reduction in facility costs as a result of cost containment programs and a new consolidated lease in our headquarters office, and a $0.2 million reduction in contractors associated with the discontinuation of several development efforts. The average number of employees associated with research and development was 20 in 2006 and 24 in 2005. There were 17 research and development employees as of December 31, 2006.
General and Administrative. General and administrative expenses consist primarily of personnel costs for finance, administration, operations, and general management, as well as legal and accounting expenses. For the year ended December 31, 2006, general and administrative expenses increased by $0.8 million to $4.6 million (28% of total revenue) as compared to $3.9 million during 2005 (23% of total revenue). This increase was a result of $0.4 million of additional legal expenses related to corporate planning and the restatement, $0.4 million of additional outside professional services related to the restructuring and restatement, , a $0.2 million increase in accounting in support of the restatement, a one time $0.1 million severance expense, $0.1 million related to our adoption of SFAS 123(R), Accounting for Share Based Payment, for the recognition of expense related to stock options, $0.1 million associated with a bad debt reserve reversal in 2005 that was not repeated in 2006, partially offset by $0.2 million reduction in facility costs as a result of cost containment programs and a new consolidated lease in our headquarters office, $0.1 million reduction in personnel expense, and $0.2 million of termination settlement fees in 2005 that were not repeated in 2006. The average number of employees associated with general and administrative expense was 13 in 2006 and 18 in 2005. There were 13 general and administrative employees as of December 31, 2006.
Restructuring. On August 6, 2006, we announced a restructuring plan intended to reduce costs and return the company to sustainable profitability. The restructuring plan, which involved a reduction in workforce and consolidation of offices, has been implemented in response to our recent operating losses and our renewed focus on core products and services. The plan reduced our workforce by 15 employees, or approximately 20 % of our regular full-time staff, and closed two sales offices. We incurred $0.5 million of restructuring expenses for the year ended December 31, 2006 and no restructuring expenses in 2005. The majority of the expenses relate to employee severance payments. All of these charges will result in cash expenditure, of which approximately $0.3 million were paid in the year ended December 31, 2006 and the remainder will be paid during the second quarter of 2007.
Other (Loss) income
Other (loss) income consists primarily of foreign exchange transaction gains and losses, interest income and interest expense. For the year ended December 31, 2006, other loss was $31,000, compared to $67,000 for the year ended December 31, 2005. We realized foreign exchange expenses of $71,000 associated with invoices billed in U.S. dollars and paid in Euros that were impacted by the fluctuations of the Euro during 2006. These expenses were partially offset by a $29,000 gain from the write-off of intercompany loans associated with the closing of our UK subsidiary. Interest income for the year ended December 31, 2006 was $3,000, down from $15,000 in 2005. Interest expense for the year ended December 31, 2006 decreased to $18,000 compared to $23,000 in 2005.
Income Taxes
Our provision for income taxes results from anticipated income tax credits in the U.S. based on operating loss carry forwards offset by tax liabilities in foreign jurisdictions where our wholly owned subsidiaries have taxable income but may not have operating loss carry forwards to reduce tax obligations. We recorded a provision for income taxes of $20,000 and $11,000 for the years ended December 31, 2006 and 2005, respectively. The tax provisions for 2006 and 2005 primarily represent taxes on income generated in certain foreign jurisdictions, where we do not have operating loss carry forwards.
Year Ended December 31, 2005 Compared with Year Ended December 31, 2004 (As Restated)
(1) See Note 2, “Restatement of Previously Issued Financial Statements” to the Consolidated Financial Statements included in Item 8
Revenues
We derive our revenues from two sources: product and services. Product revenues include revenues from sales of licenses for use of our software products. Services revenues consist of fees for maintenance contracts, consulting services, and training courses related to our products.
Total revenues were $17.0 million for the year ended December 31, 2005 as compared to $17.7 million for the same period in 2004, a decrease of $0.7 million. The decrease in revenue is attributable to a decrease of $0.9 million, or 13%, in product revenues partially offset by an increase of $0.3 million, or 3%, in service revenues. Product revenues decreased mainly due to a decrease in sales in the third quarter of 2005. Service revenues increased primarily due to several government contracts in 2005 and were partially offset by a decline in maintenance revenues. International revenues accounted for 53% of total revenues in 2005 and 51% in 2004, while U.S. revenues accounted for 47% and 49% in 2005 and 2004, respectively.
Product. Product revenues decreased by $0.9 million, or 13%, to $6.4 million for the year ended December 31, 2005 from $7.3 million in 2004. Product revenues from international customers were $4.4 million, or 69% of total product revenue in 2005, and $4.3 million, or 59% of total product revenue in 2004. Product revenues from international customers increased due to increased demand from customers in the telecommunication industry and new business in Asia. U.S. product revenues were $2.1 million or 33% of total product revenue in 2005, and $3.1 million or 42% of total product revenue in 2004. The decrease from 2005 to 2004 was a result of several large government license contracts in 2004 that were not repeated in 2005.
Services. Service revenues increased $0.3 million, or 3%, to $10.6 million for the year ended December 31, 2005 from $10.3 million in 2004. Maintenance revenues decreased $0.2 million, or 3%, to $7.0 million in 2005 compared to $7.2 million in 2004. The decrease in maintenance revenues was a result of maintenance service agreements that expired and were not renewed that were only partially offset by new product maintenance due to a decline in license sales. Consulting revenues increased $0.7 million, or 25%, to $3.5 million in 2005 compared to $2.8 million in 2004. The increase in consulting revenues was due to several large U.S. government contracts in 2005. Training revenues decreased 33%, to $0.2 million in 2005 compared to $0.3 million in 2004.
Cost of Revenues
Cost of revenues consists of consulting labor, technical support costs, and the costs of material and labor involved in producing and distributing our software. Cost of revenues was $5.0 million for the year ended December 31, 2005 as compared to $4.9 million for the same period in 2004, an increase of $0.1 million, or 2%. The increase in cost of revenues was primarily the result of increased personnel and subcontractor costs related to consulting projects partially offset by the recognition of costs that were previously deferred, associated with the long term contract completed in 2004 that was not repeated in 2005. The average number of employees associated with the cost of revenue was 26 for both 2005 and 2004. There were 27 cost of revenue employees as of December 31, 2005.
Product cost decreased to $0.5 million in 2005, a decrease of $0.2 million from 2004. This decrease was a result of a contractor license fee in 2004 that did not occur in 2005. The average number of employees associated with product cost was three in both 2005 and 2004. There were three product employees as of December 31, 2005.
Services cost was $4.5 million in 2005, an increase of $0.3 million, or 7%, from $4.2 million in 2004. The increase was primarily the result of a $0.4 million increase in contractor costs, a $0.1 million increase in personnel expense and a $0.1 million increase in travel to support the additional services, partially offset by $0.2 million decrease of a one time cost in 2004 for the completion of a long term project that was previously deferred. The average number of employees associated with service cost was 23 for both 2005 and 2004. There were 24 service employees as of December 31, 2005.
Gross margin on revenues decreased from 72% in 2004 to 70% in 2005 due to the net change in revenue and cost of revenue described above.
Operating Expenses
Total operating expenses were $13.2 million in 2005 (77% of total revenues) as compared to $11.9 million (67% of revenues) in 2004; an increase of $1.3 million, or 11%. The increase in operating expenses was primarily the result of a $0.7 million increase in personnel costs, a $0.4 million increase in marketing and company development professional services, a $0.4 million increase in commissions based on a new sales commission plan structure, a $0.2 million one time charge for severance fees and a $0.1 million increase in travel charges, partially offset by a $0.4 million decrease in bonuses due to our loss in 2005, a $0.1 million decrease in recruiting fees, and a $0.1 million decrease in research and development contract fees as consultants were converted to employees. The average number of employees associated with operating expenses was 58 in 2005 and 53 in 2004. There were 55 operating employees as of December 31, 2005.
Sales and Marketing. Sales and marketing expenses consist primarily of costs associated with personnel involved in the sales and marketing process, sales commissions, sales facilities, travel and lodging, trade shows and seminars, advertising and promotional materials. For the year ended December 31, 2005, sales and marketing expenses increased by $0.8 million, or 17%, to $5.4 million (31% of total revenues) compared to $4.6 million (26% of total revenues) in 2004. The increase in expenses was primarily the result of a $0.4 million increase in commission based on a new commission structure, $0.1 million of additional personnel cost, $0.1 million in additional marketing programs, $0.1 additional recruiting fees, and $0.1 million of additional travel. The average number of employees associated with sales and marketing remained the same at 16 employees in 2005 and 2004. There were 15 sales and marketing employees as of December 31, 2005.
Research and Development. Research and development expenses consist primarily of costs associated with personnel, equipment and facilities. For the year ended December 31, 2005, research and development expenses increased by $0.6 million to $3.9 million (23% of total revenue) as compared to $3.3 million during 2004 (19% of total revenue in 2004) This increase was a result of $0.8 million in additional personnel costs, offset by a $0.1 million decrease in contractor fees as contractors were hired as employees and $0.1 million decrease in bonus expense as a result of our overall loss in 2005. The average number of employees associated with research and development remained the same at 24 employees in 2005 and 2004. There were 24 research and development employees as of December 31, 2005.
General and Administrative. General and administrative expenses consist primarily of personnel costs for finance, administration, operations, and general management, as well as legal and accounting expenses. General and administrative expenses remained the same at $3.9 million for 2005 and 2004 (22% of total revenues in both 2005 and 2004). While the overall expenses were the same, our professional service fees increased by $0.3 million and our legal fees increased by $0.1 million, offset by a decrease in our recruiting fees of $0.1 million, a decrease in personnel fees of $0.1 million, a decrease in accounting fees of $0.1 million and a decrease in our bonus expense due to our overall loss in 2005 of $0.2 million. The average number of employees associated with general and administration remained unchanged from 2004 at 18 employees in 2005. There were 16 general and administrative employees as of December 31, 2005.
Other (Loss) income
Other (loss) income consists primarily of foreign exchange transaction gains and losses, interest income and interest expense. For the year ended December 31, 2005, other loss was $67,000, compared to other income of $17,000 for the year ended December 31, 2004. We realized foreign exchange expenses of $39,000 associated with invoices billed in U.S. dollars and paid in Euros that were impacted by the weakening of the Euro currency during 2005. These expenses were partially offset by a $24,000 gain from the write-off of intercompany loans associated with the closing of our German and UK subsidiaries. Interest income for the year ended December 31, 2005 was $15,000, down from $31,000 in 2004. Interest expense for the year ended December 31, 2005 increased $12,000, or 113%, to $23,000 compared to $11,000 in 2004.
Income Taxes
Our provision for income taxes results from anticipated income tax credits in the U.S. based on operating loss carry forwards offset by tax liabilities in foreign jurisdictions where our wholly owned subsidiaries have taxable income but may not have operating loss carry forwards to reduce tax obligations. We recorded a provision for income taxes of $11,000 for the year ended December 31, 2005. We recorded benefits of $38,000 for the year ended December 31, 2004. The tax provision/benefit for 2005 and 2004 primarily represent taxes and refunds on income generated in certain foreign jurisdictions, where we do not have operating loss carry forwards.
Liquidity and Capital Resources
Cash and cash equivalents were consistent at $3.2 million at both December 31, 2006 and 2005. Cash provided by operations was $0.1 million and $0.8 million for the years ended December 31, 2006 and 2005, respectively. Cash provided by operations in 2006 was primarily due to a net loss of $0.8 million, adjusted for non-cash changes (depreciation and amortization, loss on disposal of equipment, provision for bad debt and the non-cash portion of compensation) partially offset by an increase of accounts receivable of $1.0 million, an increase in prepaid expense and other assets of $0.1 million, an increase in payable and accrued expenses of $0.3 million, and a decrease in deferred revenue of $1.1 million.
Cash used by investing activities remained consistent at $0.3 million for both periods ending December 31, 2006 and 2005 and primarily consisted of $0.3 million used to purchase equipment.
Cash used by financing activities in 2006 were $0.1 million as compared to $27,000 in 2005. This primarily consisted of proceeds from the exercise of stock options and issuance of common stock under stock plans, partially off set by borrowings and principal payments on capital leases.
We currently finance our operations, along with capital expenditures, primarily through cash flows from operations, short-term financing arrangements, and our current cash and cash equivalents. We believe that our existing cash and cash equivalents and investments in marketable securities will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least the next 12 months.
Contractual Obligations
Our contractual obligations as of December 31, 2006 were as follows:
Our lease commitments consist of operating leases primarily for our facilities and computer equipment. We have capital leases for certain communications and computer equipment. Our obligations relating to these leases, net of rental income from sub-leases, was approximately $0.7 million in 2006, $1.2 million in 2005, and $1.2 million in 2004.
Off-Balance Sheet Arrangements
We have not entered into any off-balance sheet arrangements that have or are likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, or capital expenditures as capital resources that are material to investors.
Stock Repurchase Program
In the third quarter of 1998, we began a program to repurchase up to 650,000 shares of our common stock on the open market. As of December 31, 2006, a total of 501,300 shares had been repurchased at a cost of approximately $1,869,000. We have not purchased any shares of our common stock since March 1999. In 2006, we reissued 11,312 shares with a weighted average fair value of $1.75 to non-employee directors and executives. In 2005, we reissued 20,588 shares with a weighted average fair value of $3.30 to non-employee directors and executives. In 2004, we reissued 24,943 shares with a weighted average fair value of $1.73 to non employee directors and a consultant. As of December 31, 2006, 332,369 shares remained in treasury at a cost of $1,239,736.
Related Party Transactions
On January 9, 2002 we entered into a three-year Original Equipment Manufacturer agreement with Integration Objects Inc., an offshore Tunisian corporation involving three employees who continue to work for us. In March 2005, July 2005, June 2006 and April 2007 we extended the agreement for additional increments. The contract expired on February 13, 2007. On February 15, 2007 we signed a new one-year Original Equipment Manufacturer agreement which will expire on February 14, 2008. Both agreements call for the payment of royalties, based on a fixed and determinable percentage of the product sales price, in connection with our use of their product. These payments are to be made within 30-days after payment from the end user is received. In April 2007 we terminated one of the employees involved with Integration Objects and determined that the other two employees were no longer associated with Integration Objects. We paid Integration Objects a total of $62,946 and $76,648 for the years ending December 31, 2006 and 2005 respectively. At December 31, 2006 we had unpaid royalties to Integration Objects of $52,624.
On April 21, 2005 we entered into a six month consulting agreement with Cianciotta Holdings, Inc., an entity wholly-owned by Frank Cianciotta, who was then a member of our board of directors. Pursuant to the agreement, Cianciotta Holdings, Inc. provided business development and sales consulting services to us, which services were performed by Mr. Cianciotta. The agreement called for payments of $6,500 per month to assist in strategic business development opportunities. In September 2005, we entered into a consulting agreement with Market Partners, Inc., a provider of consulting and technology solutions. Pursuant to the agreement, Market Partners provides business development and sales consulting services to us, which services were provided by Mr. Cianciotta, who was a subcontractor for Market Partners. We agreed to pay Market Partners $10,000 per month for consulting services and an additional $3,333 per month for the first six months of the agreement as a performance bonus. After the first six months, the monthly performance bonus payment under the agreement was to be an amount equal to 5% of our gross revenue for web hosted business or software delivered on a monthly service fee basis. We terminated the agreement effective March 1, 2006. Mr. Cianciotta resigned from our board of directors effective October 27, 2005. We paid Mr. Cianciotta or Market Partners a total of $45,426 and $111,203 for the years ending December 31, 2006 and 2005 pursuant to these consulting agreements. At December 31, 2006, we had no unpaid consulting fees owed to Mr. Cianciotta or Market Partners.
Recent Accounting Pronouncements
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements, which provides enhanced guidance for using fair value to measure assets and liabilities. SFAS No. 157 establishes a common definition of fair value, provides a framework for measuring fair value under U.S. generally accepted accounting principles and expands disclosure requirements about fair value measurements. SFAS No. 157 is effective for financial statements issued in fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company is currently evaluating the impact, if any, the adoption of SFAS No. 157 will have on the consolidated financial statements.
In September 2006, the SEC issued Staff Accounting Bulletin (“SAB 108”), which expresses the Staff’s views regarding the process of quantifying financial statement misstatements. The bulletin was effective at fiscal year end 2006. The implementation of this bulletin had no impact on the Company’s results of operations, cash flows or financial position.
In June 2006, the Financial Accounting Standards Board (FASB) issued Interpretation No.48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No.109 (FIN 48). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements in accordance with Statement 109 and prescribes a recognition threshold and measurement attribute for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Additionally, FIN 48 provides guidance on recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006, with early adoption permitted. We will adopt FIN 48 on January 1, 2007. We are currently evaluating the impact that the adoption of FIN 48 will have on our consolidated financial statements.
ITEM 7A.
ITEM 7A. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK
Investment Portfolio
We do not use derivative financial instruments in our investment portfolio. If we place our funds in instruments other than demand deposit accounts we use instruments that meet high credit quality standards such as money market funds, government securities, and commercial paper. We limit the amount of credit exposure to any one issuer. At December 31, 2006, substantially all of our funds were in demand deposit accounts and government securities.
Impact of Foreign Currency Rate Changes
Our contracts with customers are generally denominated in U.S. dollars or Euros. For the year ended December 31, 2006, we incurred $15,000 in exchange rate fluctuations related to customer contracts and the timing between invoicing and payment. We do not use foreign exchange forward contracts to hedge our foreign currency denominated receivables. There can be no assurance that changes in foreign currency rates, relative to the U.S. dollar, will not materially affect our consolidated results in the future.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of Gensym Corporation:
We have audited the accompanying consolidated balance sheet of Gensym Corporation and subsidiaries as of December 31, 2006 and 2005 and the related consolidated statements of operations, stockholders’ deficit and comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2006. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (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. The Company is not required to have, nor were we engaged to perform an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Gensym Corporation and subsidiaries as of December 31, 2006 and 2005 and the consolidated results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 1 to the consolidated financial statements, the Company changed its method of accounting for share-based payments upon the adoption of Statement of Financial Accounting Standards No. 123(R), Share-Based Payment, effective January 1, 2006. As discussed in Note 2 to the consolidated financial statements, the consolidated financial statements as December 31, 2005 and for each of the years in the two-year period ended December 31, 2005 have been restated.
/s/ VITALE, CATURANO & COMPANY, LTD.
Boston, Massachusetts
May 1, 2007
GENSYM CORPORATION
CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share data)
The accompanying notes are an integral part of these consolidated financial statements.
(1) See Note 2, “Restatement of Previously Issued Financial Statements” to the Consolidated Financial Statements
GENSYM CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
The accompanying notes are an integral part of these consolidated financial statements.
(1) See Note 2, “Restatement of Previously Issued Financial Statements” to the Consolidated Financial Statements
GENSYM CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands, except per share data)
The accompanying notes are an integral part of these consolidated financial statements
(1) See Note 2, “Restatement of Previously Issued Financial Statements” to the Consolidated Financial Statements
GENSYM CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT) AND
COMPREHENSIVE INCOME (LOSS)
(In thousands, except share and per share data)
The accompanying notes are an integral part of these consolidated financial statements.
(1) See Note 2, “Restatement of Previously Issued Financial Statements” to the Consolidated Financial Statements
GENSYM CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES
We are a provider of rule engine software and services for mission-critical solutions that support and automate decisions in real time. Our flagship G2 software applies real-time rule technology for decisions that optimize operations and that detect, diagnose, and resolve costly problems. With applications based on G2, organizations in manufacturing, utilities, communications, transportation, aerospace, finance, and government increase the agility of their business operations and achieve greater levels of performance.
During the year ended December 31, 2006, we realized an operating and overall loss, but achieved positive cash flow. This compares to the year ended December 31, 2005 when we realized an operating and overall loss and positive cash flow, and the year ended December 31, 2004 when we achieved operating and overall profitability and positive cash flow. Based on the results of 2005 and the first and second quarters of 2006, management implemented a restructuring plan designed to return the company to profitability by the end of 2006 without sacrificing our strong engineering investments in a next generation of products. We believe that our current cash and cash equivalent balance and cash flows from operations will be sufficient to meet our operating, investing and financing cash flow requirements through at least December 31, 2007. Our ability to achieve growth and profitability in 2007 and beyond depends on successful releases of our next generation of G2 and G2-based products, on market acceptance of our existing and next generation of products and related services, and on renewal of maintenance contracts for customer support at near-current levels.
The accompanying consolidated financial statements reflect the application of certain significant accounting policies, as described in this note and elsewhere in the accompanying consolidated financial statements and notes.
(a) Principles of Consolidation
The accompanying consolidated financial statements include the accounts of Gensym Corporation and its wholly owned subsidiaries. All material intercompany transactions and balances have been eliminated in consolidation.
(b) Revenue Recognition
We derive revenues from two primary sources: (1) product licenses and (2) services revenues, which include maintenance, consulting, and education revenues. While the basis for software revenue recognition is substantially governed by the provisions of Statement of Position No. 97-2, Software Revenue Recognition (SOP 97-2), and Statement of Position No. 98-9, Modification of SOP 97-2, Software Revenue Recognition with Respect to Certain Transactions, (SOP 98-9), Statement of Position No. 81-1, Accounting for Construction-type and Certain Production-type Contracts (SOP 81-1), as issued by the American Institute of Certified Public Accountants, and SEC Staff Accounting Bulletin 104, Revenue Recognition (SAB 104), we exercise judgment and use estimates in connection with the determination of the amount of software license and services revenues to be recognized in each accounting period.
For software license arrangements that do not require significant modification or customization of the underlying software, we recognize license revenue when: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred (generally FOB shipping point or electronic distribution); (3) the fee is deemed fixed or determinable; and (4) collection is probable. A significant majority of our license revenues are recognized in this manner. For term licenses that include the right to use software bundled with maintenance for the duration of the term, we recognize revenue ratably over such term.
We assess whether fees are fixed or determinable and free of contingencies or significant uncertainties at the time of sale and recognize revenue if all other revenue recognition criteria are met. If the fee is not fixed or determinable, revenue is recognized as payments become due from the customer.
Our license arrangements generally do not include acceptance provisions. However, if an arrangement includes an acceptance provision, revenue is recognized upon the earlier of receipt of a written customer acceptance or expiration of the acceptance period.
Our software is distributed directly through our sales force and indirectly through alliances with resellers. Revenue arrangements with resellers are recognized upon delivery of the software to the reseller provided all other revenue recognition criteria, as specified above, have been satisfied. For resellers with rights of return, we recognize revenue upon delivery of the software to the end user.
We account for software license revenues included in multiple element arrangements using the residual method prescribed in SOP 98-9. Under the residual method, the fair value of the undelivered elements, such as maintenance, consulting, and education services, based on vendor specific objective evidence is deferred and the remaining portion of the arrangement fee is allocated to the delivered elements, generally, the software licenses. If evidence of the fair value of one or more of the undelivered services does not exist, revenues are deferred and recognized when delivery of those services occurs or fair value can be established. We determine vendor specific objective evidence of fair value for services revenues based upon our current pricing for those services when sold separately and vendor specific objective evidence of fair value for maintenance services is measured by substantive renewal rates. Our current pricing practices are influenced primarily by product type, purchase volume, maintenance term, and customer location.
Our software arrangements may include consulting services sold separately under consulting engagement contracts that generally include implementation. These services may also be provided completely or partially by independent third-parties experienced in providing such consulting and implementation in coordination with dedicated customer personnel. Revenues from these arrangements are generally accounted for separately from the license revenue because they meet the criteria for separate accounting, as defined in SOP 97-2. The more significant factors considered in determining whether the revenue should be accounted for separately include the nature of services, such as consideration of whether the services are essential to the functionality of the licensed product, degree of risk, availability of services from other vendors, timing of payments and impact of milestones or acceptance criteria on the realizability of the software license fee.
For projects that require customization and development of the software, we account for the software and services as prescribed in SOP 81-1. Under this method, the software license revenue is recognized ratably over the term of the consulting engagement or at the time of delivery of contractual milestones.
Maintenance services generally include rights to unspecified upgrades, when and if available, telephone support, updates, and bug fixes. Maintenance revenue is recognized ratably over the term of the maintenance contract on a straight-line basis when all the revenue recognition requirements are met. Historically we have not offered any specified upgrade rights to an existing product.
Consulting services that are sold separately from license revenue are generally recognized as the services are performed on a time and materials basis. Consulting revenues for fixed-price contracts are recognized using a proportional performance model. If there is a significant uncertainty about the project completion or receipt of payment for the consulting services, revenue is deferred until the uncertainty is sufficiently resolved.
Education revenues are recognized as the related training services are provided.
(c) Cost of Revenue
Cost of revenue includes direct costs to manufacture and distribute product, as well as related royalties due to third parties, and the direct costs of providing consulting, product support, and training.
(d) Deferred Revenue
Deferred revenue primarily consists of maintenance contracts, where revenue is recognized over the contract period. For all software license transactions in which there are significant outstanding obligations, the associated revenue is deferred and recognized once such obligations are fulfilled. For certain long term projects revenue is deferred until customer acceptance is received. Revenue for licenses sold to resellers with a right of return are deferred until delivery to the end user.
(e) Cash and Cash Equivalents
For the years ended December 31, 2006 and 2005, substantially all of our cash was held in demand deposit accounts and government securities with maturities of less than 90 days. Cash equivalents are short-term, highly liquid investments with original maturity dates of less than three months. Cash and cash equivalents were $3.2 million at December 31, 2006 and $3.2 million at December 31, 2005.
(f) Accounts Receivable and Allowance for Doubtful Accounts
We establish reserves against accounts receivable for potential credit losses when we determine that receivables are at risk for collection, based on the length of time the receivables are outstanding, historical bad debts, customer concentrations, customer credit-worthiness, and current economic trends.
(g) Concentration of Credit Risk
Financial instruments, which potentially subject us to concentrations of credit risk, are principally cash, cash equivalents, and accounts receivable. We place our cash and cash equivalents in highly rated institutions. One customer accounted for 10% of total accounts receivable at December 31, 2006. One customer accounted for 13% of total accounts receivable at December 31, 2005. We have no significant off-balance-sheet risk such as foreign exchange contracts, options contracts, or other foreign hedging arrangements. Bad debts are written off against the reserve when identified.
(h) Property and Equipment
Property and equipment are stated at cost and depreciated using the straight-line method over the estimated useful lives of the assets. Maintenance and repairs are expensed when incurred; additions and improvements are capitalized. When assets are retired or otherwise disposed of, the assets and related allowances for depreciation and amortization are eliminated from the accounts and any resulting gain or loss is reflected in our consolidated statement of operations. The estimated useful lives by asset class are as follows:
Asset Classification
Estimated Useful Lives
Computer equipment and software
3 Years
Furniture and fixtures and office equipment
5 Years
Leasehold improvements and capital leases
Shorter of lease term or useful life
(i) Intangible and Long-Lived Assets
Intangible and long-lived assets are amortized over their estimated economic useful life using the straight-line method and are carried at cost less accumulated amortization. We review long-lived assets for impairment whenever events or changes in business circumstances indicate that the carrying value of the assets may not be fully recoverable or that the useful lives of these assets are no longer appropriate. Each impairment test is based on a comparison of the estimated undiscounted cash flows to the recorded value of the asset. If an impairment is indicated, the asset is written down to its estimated fair value based upon a discounted cash flow analysis with a corresponding charge to the operating results. The cash flow estimates used to determine the impairment, if any, contain management’s best estimates using appropriate assumptions and projections at that time.
(j) Comprehensive Income (Loss)
Comprehensive income (loss) consists of net income (loss) and other comprehensive income (loss), which includes foreign currency translation adjustments. For purposes of comprehensive income (loss) disclosures, we do not record tax provisions or benefits for the net changes in foreign currency translation adjustment, as we intend on permanently reinvesting undistributed earnings in our foreign subsidiaries.
(k) Research and Development and Software Development Costs
We have evaluated the establishment of technological feasibility of our various products during the development phase. Due to the dynamic changes in the market, we have concluded that technological feasibility is not established until the development phase of the project is nearly complete. The time period during which costs could be capitalized from the point of reaching technological feasibility until the time of general product release is very short and, consequently, the amounts that could be capitalized are not material to our financial position or results of operations. Therefore, we charge all research and development expenses, which consist primarily of costs of personnel, equipment, and facilities to operations in the period incurred.
(l) Advertising Costs
Advertising costs are expensed as incurred. Advertising expenses were not material for all years presented.
(m) Foreign Currency Translation
Assets and liabilities of our foreign operations are translated into U.S. dollars at current exchange rates, and income and expense items are translated at average rates of exchange prevailing during the year. In general, unrealized gains and losses arising from translation are accumulated as a separate component of stockholders’ equity and realized gains and losses arising from transactions denominated in foreign currencies are included in other income. In 2004 and 2005, we evaluated all intercompany receivables and payable and determined they were long term in nature. In 2006 all intercompany receivables and payables were written off in their respective countries. Translation gains and losses related to long term intercompany receivables and payables are included in accumulated other comprehensive income on the accompanying consolidated balance sheet.
(n) Income Taxes
Our income tax expense includes U.S. and international income taxes. Certain items of income and expense are not reported in tax returns and financial statements in the same year. We recognize deferred income taxes based on the expected future tax consequences of differences between the financial statement basis and the tax basis of assets and liabilities, calculated using enacted tax rates in effect for the year in which the differences are expected to be reflected in the tax return.
(o) Segment Reporting
Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by management in deciding how to allocate resources and in assessing performance of the business. We report financial information as a single segment.
(p) Computation of Earnings (Loss) per Share
Basic earnings and loss per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding. Diluted earnings (loss) per share is computed by dividing net income (loss) by the sum of the weighted average common shares outstanding plus additional common shares that would have been outstanding if potentially dilutive common shares had been issued. For purposes of this calculation, stock options are considered to be stock equivalents in periods in which they have a dilutive effect. Options that are anti-dilutive are excluded from this calculation. The following is a reconciliation of basic and diluted weighted average shares used in the computation of earnings (loss) per share:
(1) See Note 2, “Restatement of Previously Issued Financial Statements” to the Consolidated Financial Statements
For the years ended December 31, 2006 and 2005, options to purchase 830,072 and 1,665,224 shares of common stock, respectively, were outstanding, but were not included in the computation of diluted earnings per share. In 2006 and 2005, the shares were anti-dilutive as we had a net loss for the periods. For the year ended December 31, 2004 options to purchase 466,923 shares of common stock were outstanding but were not in the computation of diluted earnings per share because the options’ exercised prices were greater than the average market price of the common stock and thus would be antidilutive.
(q) Stock-Based Compensation
We issue stock options to our employees and outside directors and provide employees the right to purchase stock pursuant to stockholder approved stock option plans.
Prior to January 1, 2006, we accounted for employee stock-based compensation using the intrinsic value based method as prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB No. 25) and related interpretations. Accordingly, no compensation expense was required to be recognized as long as the exercise price of our stock options was equal to the market price of the underlying stock on the date of grant.
Effective January 1, 2006, we adopted Statement of Financial Accounting Standard (“SFAS”) No. 123 (Revised 2004), Share-Based Payment (SFAS No. 123R). Under the provisions of SFAS No. 123R, we recognize the fair value of stock compensation in net income, over the requisite service period of the individual grantees, which generally equals the vesting period. All of our stock compensation is accounted for as equity instruments and there have been no liability awards granted.
We have elected the modified prospective transition method for adopting SFAS No. 123R. Under this method, the provisions of SFAS No. 123R apply to all awards granted or modified after the date of adoption. The unrecognized expense of awards not yet vested at the date of adoption are recognized in net income in the periods after the date of adoption using the same valuation method (i.e. Black-Scholes) and assumptions determined under the original provisions of SFAS No. 123, Accounting for Stock-Based Compensation, as disclosed in our previous filings. Accordingly, prior period financials have not
been restated for this purpose. Under the provisions of SFAS 123(R), we recorded a net expense of $131,000 of stock-based compensation on our consolidated condensed statements of operations for the year ended December 31, 2006, including $10,000 of compensation related to the issuance of 5,306 shares of common stock to our board of directors members for the year ended December 31, 2006. The stock-based compensation for the year ended December 31, 2006 is included in the following expense categories (in thousands):
During the year ended December 31, 2006, we also issued 6,006 shares of common stock with a fair value of $10,000 to members of management in lieu of cash payment for a portion of their bonus accrued in 2005. This amount was excluded from the table above.
The adoption of SFAS No. 123R had no effect on cash flow from operations for the year ended December 31, 2006. SFAS No. 123R requires the presentation of pro forma information for the comparative period prior to the adoption as if all of the Company’s employee stock options had been accounted for under the fair value method of the original SFAS No. 123. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation to the prior-year period (in thousands, except per share data).
(1) See Note 2, “Restatement of Previously Issued Financial Statements” to the Consolidated Financial Statements
Our results for the year ended December 31, 2005 included $39,000 of stock-based compensation related to the issuance of 12,964 shares of common stock to our board of directors members. During the year ended December 31, 2005 we recorded $8,000 of compensation expense related to options in accordance with APB No. 25.
During the year ended December 31, 2005 we also issued 7,624 shares of common stock with a fair market value of $29,000 to members of management in lieu of cash payment for a portion of their bonus accrued during 2004. This amount was excluded from the table above.
We utilized the Black-Scholes valuation model for estimating the fair value of the stock compensation granted after the adoption of SFAS No. 123R. The weighted-average fair values of the options granted under the stock option plans were $1.67, $3.09 and $1.65 for the years ended December 31, 2006, 2005 and 2004 respectively, using the following assumptions:
The dividend yield of zero is based on the fact that we have never paid cash dividends and have no present intention to pay cash dividends. Expected volatility is based on the historical volatility of our common stock over the period commensurate with or longer than the expected life of the options. The risk-free interest rate is based upon interpolation of various U.S. Treasury rates on the date of grant. The expected life is based upon historical experience.
Based on our historical voluntary turnover rates, an annualized estimated forfeiture rate of 6% has been used in calculating the recorded expense. Under the true-up provisions of SFAS No. 123R, additional expense will be recorded if the actual forfeiture rate is lower than estimated, and a recovery of prior expense will be recorded if the actual forfeiture is higher than estimated.
As of December 31, 2006, we had $36,000 of unrecognized compensation cost related to unvested awards, which we expect to recognize over a weighted-average period of 2 years.
Total intrinsic value of options exercised for the year ended December 31, 2006 and 2005 was $429,000 and $494,000, respectively. The total intrinsic value of outstanding options for the year ended December 31, 2006 and 2005 was $168,000 and $ 1,402,000. The total intrinsic value of exercisable options for the year ended December 31, 2006 and 2005 was $166,000 and $1,241,000.
In November 2005, the Financial Accounting Standards Board (FASB) issued FASB Staff Position SFAS 123R-3 Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards. The Company has elected to adopt the alternative transition method provided by this FASB Staff Position for calculating the tax effects (if any) of stock-based compensation expense pursuant to SFAS 123R. The alternative transition method includes simplified methods to establish the beginning balance of the additional paid-in capital pool related to the tax effects of employee stock-based compensation, and to determine the subsequent impact to the additional paid-in capital pool and the consolidated statements of operations and cash flows of the tax effects of employee stock-based compensation awards that are outstanding upon adoption of SFAS 123R.
(r) Use of Estimates in the Preparation of Financial Statements
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
(s) Recent Accounting Pronouncements
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements, which provides enhanced guidance for using fair value to measure assets and liabilities. SFAS No. 157 establishes a common definition of fair value, provides a framework for measuring fair value under U.S. generally accepted accounting principles and expands disclosure requirements about fair value measurements. SFAS No. 157 is effective for financial statements issued in fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company is currently evaluating the impact, if any, the adoption of SFAS No. 157 will have on the consolidated financial statements.
In September 2006, the SEC issued Staff Accounting Bulletin (“SAB 108”), which expresses the Staff’s views regarding the process of quantifying financial statement misstatements. The bulletin was effective at fiscal year end 2006. The implementation of this bulletin had no impact on the Company’s results of operations, cash flows or financial position.
In June 2006, FASB issued Interpretation No.48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No.109 (FIN 48). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements in accordance with Statement 109 and prescribes a recognition threshold and measurement attribute for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Additionally, FIN 48 provides guidance on recognition, classification, interest and penalties, accounting in interim periods, disclosure and
transition. FIN 48 is effective for fiscal years beginning after December15, 2006, with early adoption permitted. We will adopt FIN 48 on January 1, 2007. We are currently evaluating the impact that the adoption of FIN 48 will have on our consolidated financial statements.
2. Restatement of Previously Issued Financial Statements.
Background of the Restatement of Condensed Consolidated Financial Statements and Remedial Measures.
Review of Accounting for Software License and Service Agreement Transactions
On July 19, 2006, we announced that our Audit Committee had commenced a review of the revenue recognition accounting for certain software license and service agreement transactions entered into during fiscal 2004 and 2005. The Audit Committee notified our independent registered public accounting firm and engaged outside legal counsel and outside accounting specialists to assist it with the review.
Based on its preliminary review as of the announcement date, the Audit Committee concluded, in consultation with and upon the recommendation of management, that previously issued financial statements included in our Annual Reports on Form 10-K for the fiscal years ended December 31, 2004 and 2005 and in our Quarterly Reports on Form 10-Q for the fiscal quarters ended March 31, June 30 and September 30, 2005 and March 31, 2006, and all of our related earnings releases and similar communications relating to all such fiscal periods, should no longer be relied upon.
Under the direction of the Audit Committee and the supervision of our Chief Executive Officer and Chief Financial Officer, with the assistance of outside legal counsel and outside accounting specialists, our accounting staff performed extensive analyses of sales orders. The original documentation for software license and service agreement transactions recorded between January 1, 2000 and March 31, 2006 was reviewed, including a risk assessment on each transaction based on characteristics determined to indicate potential for incorrect accounting treatment - among those characteristics were:
•
non-standard maintenance terms
•
extended payment terms
•
license upgrades without associated maintenance
•
temporary access codes
•
return or upgrade rights with distributors and resellers
•
consulting services provided beyond those considered routine
•
delayed delivery
•
orders containing references to earlier transactions
The review of the documentation and the risk assessment were performed by employees knowledgeable about our products, services and customers, with the assistance of outside legal counsel and outside accounting specialists.
When the risk assessment indicated potential for accounting problems, the accounting treatment as originally recorded was reviewed to determine whether the order had been accounted for correctly. The original and the corrected accounting treatments were compared, with differences (amount and timing) accumulated appropriately to support restatement. The results of this investigation revealed that revenue for some transactions had been recognized before one or more of the required criteria for revenue recognition were met. As a result, we have recorded adjustments to our historical financial results relating to the timing of the recognition of revenue and the allocation of revenue between license fees and maintenance. These adjustments are summarized below, and generally have the effect of deferring revenue previously recognized until later periods.
On August 14, 2006, November 13, 2006 and May 22, 2007 we filed Forms 12b-25 with the Securities and Exchange Commission stating that we would be unable to file timely quarterly reports of Form 10-Q for the fiscal quarters ended June 30, 2006, September 30, 2006 and March 31, 2007, respectively. On April 3, 2007, we filed a Form 12b-25 stating that we would be unable to file timely our annual report on Form 10-K for the year ended December 31, 2006.
In the November 13, 2006 filing, we stated that the scope of the Audit Committee’s investigation had been expanded to include software license and services agreements entered into from 2000 to 2004. We also reported that the expanded scope included a self-initiated review of historical stock option grant practices and related accounting treatment.
Review of Stock Option Practices and Related Stock-Based Compensation Expense
Under the direction of a special committee of the Board of Directors, we also conducted an internal review relating to our stock option grants and stock option practices. The special committee, with the assistance of outside legal counsel and outside accounting specialists, reviewed the stock option grants to our officers, directors and employees from January 1, 1996 to March 31, 2006 under our various stock option plans in effect during this period. The special committee also retained separate legal counsel to support its review.
Our accounting staff has also reviewed the stock option grants and stock option practices during this period. For each award, the accounting staff reviewed the applicable option agreement, the applicable stock option plan, documentation authorizing the award and documentation supporting the optionee’s date of hire and/or date of termination as well as the accounting rules in effect at the time. We use a commercially available software tool called Equity Edge to track and value our option grants. Equity Edge assists us in the calculation of stock compensation expense based upon the information entered on the date of grant. Among the practices identified that resulted in incorrect accounting treatment were the following:
•
new hire awards with grant dates and prices inconsistent with the date of hire;
•
awards with grant dates and/or exercise prices that differed from those authorized;
•
awards for which the data input into Equity Edge differed from the documentation; and
•
awards granted with exercise prices lower than fair market value on the date of grant or without proper authorization.
The special committee of the Board of Directors received regular detailed status reports and reviewed the data with outside legal counsel and outside accounting specialists as it deemed necessary.
During the stock option review process, we determined that two grants under our 1987 Stock Plan representing 1,440 and 960 shares previously reported with an expiration date of November 20, 2008 should have expired on January 7, 2003 and September 10, 2002 respectively. Our outstanding stock option reports have been restated to reflect this correction.
Internal Revenue Code Section 421 prohibits the granting of Incentive Stock Options, referred to as ISOs, with an exercise price below fair market value of the underlying common stock on the date of grant. For those options which were intended to be ISO’s but which we subsequently determined had exercise prices below the fair market value of the underlying common stock on the date of grant, we accrued Federal and state income taxes, payroll taxes, penalties and interest at the applicable rates, if the income was not reported on the individual’s Form W-2. Our total additional expense for the accrued taxes, penalties and interest was under $8,000.
Our review of historic stock option granting practices did not uncover systematic backdating or other errors related to option grants. We did, however, identify mistakes in accounting for certain option grants where the measurement date for accounting purposes was incorrectly applied. As a result, we are required to record non-cash adjustments for stock-based compensation expense in accordance with Accounting Principle Board Opinion No. 25, Accounting for Stock Issued to Employees as summarized below.
Other Accounting Adjustments
During the course of the reviews described above, foreign tax filing errors and certain accounting timing adjustments were identified. We were notified in 2006 by Dutch tax authorities of errors in the tax returns of our Dutch subsidiary, Gensym BV, for 2003 and 2004 which, when corrected, entitled us to a refund of taxes previously paid. We also identified several items related to our consolidation and treatment of certain intercompany items that were reported in incorrect accounting periods in 2003 and 2004.
Findings, Restatement and Remediation
In connection with the findings of our review of accounting for certain software license and service agreement transactions, we have implemented enhanced accounting policies and internal controls, as well as improved sales policies and procedures relating to sales, license delivery, consulting management and product exchanges and returns. We have also
begun to strengthen our financial reporting competencies, develop internal controls and compliance training programs, implement personnel changes where necessary and establish corporate policies, practices and controls which are clear, concise and consistent.
Cumulative Effect of Adjustments on Accumulated Deficit
The following table presents the cumulative effect of adjustments resulting from the reviews described above for the periods shown.
(1) See Note 2, “Restatement of Previously Issued Financial Statements” to the Consolidated Financial Statements
The tables below set forth the effect of the adjustments as of December 31, 2005 and for the years ended December 31, 2005 and 2004 as applicable:
GENSYM CORPORATION
CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share amounts)
GENSYM CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
GENSYM CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(3) PROPERTY AND EQUIPMENT
Property and equipment consists of the following at December 31, (in thousands):
Depreciation and amortization expense, including amounts related to assets acquired pursuant to capital leases, for the years ended December 31, were as follows (in thousands):
(4) INTANGIBLE ASSETS
On March 12, 2003, we acquired certain intellectual property from Key Control, Inc. This intellectual property comprises intelligent objects for embedding in process management applications. In connection with the acquisition of this developed technology, we paid $250,000. This amount was amortized over a three year period and amortization expense for the years ended December 31, 2006, 2005 and 2004 were $20,833, $83,333 and $83,333, respectively. The asset was fully amortized in 2006.
(5) STOCKHOLDERS’ EQUITY
(a) Common Stock
Our authorized capitalization consists of 20,000,000 shares of common stock and 2,000,000 shares of preferred stock.
(b) Stock Option Plans
The following table shows the our stock option plans, the number of shares reserved for issuance by our Board of Directors, and the number of shares available for future issuance as of December 31, 2006:
At our annual meeting of stockholders held on May 27, 2004, shareholders voted to amend our 2000 Stock Incentive Plan to increase the number of shares of common stock authorized for issuance from 800,000 to 1,050,000.
The 1987 Stock Plan provided for the grant of incentive stock options, nonqualified stock options, stock awards, and direct sales of stock. The board of directors has resolved not to grant any more options under the 1987 Stock Plan. The 1994 Stock Option Plan provided for the grant of incentive stock options and nonqualified stock options, and no more will be granted per the above. The 1997 Stock Incentive Plan provides for the grant of incentive stock options, nonqualified stock options, restricted stock and other stock-based awards. The 2000 Stock Incentive Plan provides for the grant of incentive stock options, nonqualified stock options, restricted stock and other stock-based awards. Under these plans, incentive stock options may be granted at an exercise price not less than the fair market value of our common stock on the date of grant or, in the case of 10% stockholders, not less than 110% of the fair market value. Nonqualified stock options may be granted by the board of directors at its discretion.
The terms of exercise of stock options granted under these plans are determined by the board of directors. Incentive stock options generally vest over a three year period and expire no later than 10 years from the date of grant.
The 1995 Director Stock Option Plan (the “Director Plan”) was approved by the stockholders in January 1996 and was amended in May 1997. The Director Plan provides for the grant of stock options to purchase our Common Stock to our non-employee directors. These stock options vest in equal portions over a five-year period and expire 10 years from the date of grant. This plan expired on December 31, 2005.
Effective January 1, 2005, each director became eligible to receive an option to purchase 2,500 shares of our common stock on the first business day of each calendar quarter from and after January 1, 2005. All options are granted at an exercise price equal to the fair market value of our common stock on the date of the grant and are immediately exercisable and exercisable for up to 10 years from the date of the grant.
Effective March 31, 2006, options were no longer to be granted to any non-employee director (1) who owns 5% or more of Gensym’s outstanding common stock or (2) if and to the extent the grant would cause the total number of shares subject to options ever granted by us to the non-employee director, excluding options that expired without exercise at a time when the exercise price exceeded the market price of our common stock, to exceed 100,000 (subject to adjustment for stock-splits, dividends and similar events).
The following table summarizes the stock option activity for each of the three years in the period ended December 31, 2006:
The range of exercise prices for stock options outstanding and stock options exercisable at December 31, 2006 is as follows:
Our 1995 Employee Stock Purchase Plan (the “Purchase Plan”) was adopted by the Board of Directors in November 1995 and approved by the stockholders in January 1996. The Purchase Plan authorized the sale of common stock to participating employees. Effective June 15, 2004, our Board of Directors voted to discontinue the Purchase Plan and the Purchase Plan terminated in accordance with its terms on December 31, 2005. Under the Purchase Plan, we have sold 1,159,603 shares as of December 31, 2005. No shares were issued in 2006 and 2005, and 54,036 shares were issued in 2004, under the Purchase Plan.
(c) Stock Repurchase Program
In 1998, we began a program to repurchase up to 650,000 shares of our common stock on the open market. As of December 31, 2005, 501,300 shares had been repurchased at a cost of approximately $1.9 million. We have not purchased any shares of our common stock since March 1999. We reissued 11,312, 20,588, and 24,943,with a weighted average fair value of $1.75, $3.30 and $1.73 to employees, non-employee directors and consultants during 2006, 2005 and 2004, respectively. As of December 31, 2006, 332,369 shares remained in treasury at a cost of $1.2 million.
(6) INCOME TAXES
Income (loss) before provision for income taxes consists of the following (in thousands):
(1) See Note 2, “Restatement of Previously Issued Financial Statements” to the Consolidated Financial Statements included in Item 8.
The components of the provision (benefit) for income taxes for the years ended December 31, are as follows (in thousands):
(1) See Note 2, “Restatement of Previously Issued Financial Statements” to the Consolidated Financial Statements
Foreign withholding taxes represent amounts withheld by foreign customers and remitted to the applicable foreign tax authorities in connection with foreign revenues. Foreign income taxes represent corporate income taxes relating to the operations of our foreign subsidiaries.
The components of the net deferred tax asset recognized in the accompanying consolidated balance sheets at December 31, 2006 and 2005 were as follows (in thousands):
(1) See Note 2, “Restatement of Previously Issued Financial Statements” to the Consolidated Financial Statements
In accordance with SFAS No. 109, Accounting for Income Taxes, management has evaluated the positive and negative evidence bearing upon the realizability of its deferred tax assets. Our management has determined that a valuation allowance of $13.6 million and $13.4 million as of December 31, 2006 and 2005, respectively, is required to be recorded against deferred tax assets in both the U.S. and foreign jurisdictions where it is more likely than not that the assets are not realizable.
As of December 31, 2006, we had federal and state net operating loss (“NOL”) carryforwards of approximately $27, million and $21 million which expire at various dates through 2026 and 2011, respectively. A portion of these net operating losses are a result of stock option deductions, and therefore the benefit from these losses, if realized, will be charged to additional paid in capital. We also have federal and state research and development tax credit carryforwards of approximately $2 million and $1 million at December 31, 2006, which expire at various dates through 2026 and 2021, respectively. Under the Internal Revenue Code, certain substantial changes in our ownership may limit the amount of net operating loss and tax credit carryforwards that can be utilized to offset future taxable income or tax liability.
The provision (benefit) for income taxes differs from the amount computed by applying the statutory federal income tax rate as follows:
(7) COMMITMENTS AND CONTINGENCIES
(a) Leases
We lease our facilities under operating leases and certain computers and telephone equipment under capital leases expiring through 2011. The future minimum annual payments under these leases at December 31, 2006 are as follows:
Rent, office lease and equipment lease expense under the above leases and net of rental income from sub-leases, was approximately $0.7 million in 2006, $1.2 million in 2005, and $1.2 million in 2004.
(b) Litigation
We are involved in various lawsuits, claims and inquiries, most of which are routine to the nature of our business. In the opinion of our management, the resolution of these matters will not have a material adverse effect on our financial position, results of operations or cash flows.
(c) Guarantor Arrangements
In November 2002, the FASB issued FIN No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others an Interpretation of FASB Statements No. 5, 57, and 107 and Rescission of FASB Interpretation No. 34 (See Note 2). The following is a summary of our agreements that we have determined are within the scope of FIN No. 45:
As permitted under Delaware law, we have agreements whereby it indemnifies its officers and directors for certain events or occurrences while the officer or director is, or was serving, at our request in such capacity. The term of the indemnification period is for the officer or director’s lifetime. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited; however, we have a Director and Officer insurance policy that limits its exposure and enables us to recover a portion of any future amounts paid. As a result of our insurance policy coverage, we believe the estimated fair value of these indemnification agreements is minimal. All of these indemnification agreements were grandfathered under the provisions of FIN No. 45 as they were in effect prior to December 31, 2002. Accordingly, we believe our liability for these agreements as of December 31, 2006 and 2005 is not material.
We enter into standard indemnification agreements in our ordinary course of business. Pursuant to these agreements, we indemnify, hold harmless, and agree to reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally our business partners or customers, in connection with any U.S. patent or any copyright or other intellectual property infringement claim by any third party with respect to our products. The term of these indemnification agreements is generally perpetual any time after execution of the agreement. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited. We have never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, we believe the estimated fair value of these agreements is minimal. Accordingly, we believe our liabilities for these agreements as of December 31, 2006 and 2005 are not material.
We generally warrant that our unmodified software products, when used as specified, will substantially conform to the applicable user documentation for a specified period of time (generally six months, and longer in jurisdictions with applicable statutory requirements). Additionally, we generally warrant that our consulting services will be performed in a professional and workmanlike manner. In general, liability for these warranties is limited to the amounts paid by the customer. If necessary, we would provide for the estimated cost of product and service warranties based on specific warranty claims and claim history, however, we have never incurred significant expense under our product or service warranties. As a result we believe the estimated fair value of these agreements is immaterial. We also generally offer indemnification with respect to certain types of intellectual property claims and, occasionally, other matters
(8) RESTRUCTURING CHARGE
In June 2006, our board of directors approved a restructuring plan that included a workforce reduction and the closure of two sales offices. The restructuring plan consisted of reductions in employee headcount totaling 15 employees from all operating groups and geographic areas. In accordance with this plan, we recorded a restructuring charge of $0.5 million in 2006. Substantially all of the charge represents amounts to be paid in cash. The charge was based on estimates of the cost of the workforce reduction program, including special termination benefits, settlement and involuntary severance benefits related to postretirement benefit plans in Europe, and related legal costs. At December 31, 2006 there remained an accrual of $0.2 million relating to this restructuring plan which we expect to pay by the end of 2007.
(9) ACCRUED EXPENSES
Accrued expenses consist of the following at December 31, 2006 and 2005:
(10) RETIREMENT PLAN
We have a 401(k) retirement plan in which substantially all of our permanent employees are eligible to participate. Participants may contribute up to 60% of their annual compensation to the plan, subject to statutory limitations.
Effective January 1997, we amended the Gensym Corporation 401(k) Plan (the “Plan”) to allow for employer matching contributions. We have elected to contribute an amount equal to 50% of the first 4%, and 25% of the next 4% of an employee’s compensation (as defined) contributed to the Plan as an elective deferral. Our contributions to the Plan were $0.1 million in 2006, $0.1 million in 2005 and $0.1 million in 2004.
(11) SEGMENT REPORTING
Domestic and international sales as a percentage of total revenues are as follows:
(1) See Note 2, “Restatement of Previously Issued Financial Statements” to the Consolidated Financial Statements
Domestic and international long-lived assets, net of depreciation were as follows:
(12) ALLOWANCE FOR DOUBTFUL ACCOUNTS
(13) RELATED PARTY TRANSACTION
On January 9, 2002 we entered into a three-year Original Equipment Manufacturer agreement with Integration Objects Inc., an offshore Tunisian corporation involving three employees who continue to work for us. In March 2005, July 2005, June 2006 and April 2007 we extended the agreement for additional increments. The contract expired on February 13, 2007. On February 15, 2007 we signed a new one-year Original Equipment Manufacturer agreement which will expire on February 14, 2008. Both agreements call for the payment of royalties, based on a fixed and determinable percentage of the product sales price, in connection with our use of their product. These payments are to be made within 30-days after payment from the end user is received. In April 2007 we terminated one of the employees involved with Integration Objects and determined that the other two employees were no longer associated with Integration Objects. We paid Integration Objects a total of $62,946 and $76,648 for the years ending December 31, 2006 and 2005 respectively. At December 31, 2006 we had unpaid royalties to Integration Objects of $52,624.
On April 21, 2005 we entered into a six month consulting agreement with Cianciotta Holdings, Inc., an entity wholly-owned by Frank Cianciotta, who was then a member of our board of directors. Pursuant to the agreement, Cianciotta Holdings, Inc. provided business development and sales consulting services to us, which services were performed by Mr. Cianciotta. The agreement called for payments of $6,500 per month to assist in strategic business development opportunities. In September 2005, we entered into a consulting agreement with Market Partners, Inc., a provider of consulting and technology solutions. Pursuant to the agreement, Market Partners provides business development and sales consulting services to us, which services were provided by Mr. Cianciotta, who was a subcontractor for Market Partners. We agreed to pay Market Partners $10,000 per month for consulting services and an additional $3,333 per month for the first six months of the agreement as a performance bonus. After the first six months, the monthly performance bonus payment under the agreement was to be an amount equal to 5% of our gross revenue for web hosted business or software delivered on a monthly service fee basis. We terminated the agreement effective March 1, 2006. Mr. Cianciotta resigned from our board of directors effective October 27, 2005. We paid Mr. Cianciotta or Market Partners a total of $45,426 and $111,203 for the years ending December 31, 2006 and 2005 pursuant to these consulting agreements. At December 31, 2006, we had no unpaid consulting fees owed to Mr. Cianciotta or Market Partners.
(14) SELECTED QUARTERLY FINANCIAL DATA FOR 2005 AND 2004 (UNAUDITED)
As described in Note 2 “Restatement of Consolidated Financial Statements” the quarterly information for the first quarter of 2006 and the four quarters of 2005 have been restated. The effects of this restatement are reflected below.
(1) See Note 2, “Restatement of Previously Issued Financial Statements” to the Consolidated Financial Statements
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES
Not applicable
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures as of December 31, 2006. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of December 31, 2006, as a result of the material weaknesses in our internal controls over financial reporting described below, our chief executive officer and chief financial officer concluded that, as of such date, our disclosure controls and procedures were not effective.
In July 2006, we announced that our Audit Committee had undertaken a detailed investigation of the revenue recognition accounting for software license and service agreement transactions entered into during fiscal 2004 and 2005. In November 2006, we expanded the investigation to include software license and services agreements entered into from 2000 to 2004. We also began a self-initiated review of historical stock option grant practices and related accounting treatment. The investigation and review were conducted with the assistance of outside legal counsel and outside accounting specialists. Based on the investigation and review, management and the Audit Committee concluded that errors in revenue recognition, which primarily result in the deferral of revenue into later periods than originally recognized, stock compensation and other accounting adjustments required us to restate previously reported financial results. The restatement effected previously reported results from 2000 through the first quarter of 2006.
In connection with the restatement, we assessed the effectiveness of our internal control over financial reporting. We and our independent registered public accounting firm, Vitale, Caturano & Company, Ltd., identified and reported to our Audit Committee material weaknesses in our internal control over financial reporting identified in connection with the audit of our financial statements for the year ended December 31, 2006. These material weaknesses include entity-level control weaknesses as well as weaknesses in process and transaction controls as defined in the Committee of Sponsoring Organizations of the Treadway Commission (COSO) criteria.
The following material weaknesses collectively resulted in us prematurely recognizing revenue, thereby causing revenue to be overstated in an earlier period and understated in a later period, deferred revenue to be understated in any period, costs and expenses to vary in any particular period and our net loss to be understated in an earlier period and overstated in a later period. As a consequence, we have restated our historical financial statements, as described elsewhere in this Annual Report on Form 10-K, resulting in a (reduction) or increase in revenue in 2005 and 2004 of ($579,000) and $101,000, respectively and an (increase) or reduction in net loss in 2005 and 2004 of $(597,000) in 2005 and $62,000 in 2004.
We identified the following material weaknesses in connection with the audit of our financial statements for the year ended December 31, 2006:
•
inappropriate level of responsibility for contract review and approval, as well as revenue recognition decisions;
•
insufficient flow of documentation and information between operations and finance personnel;
•
inappropriate responsibility of vice president of operations in overseeing the performance of the sales force and approving contracts;
•
insufficient review of contracts by the operations personnel to ensure proper data entry of standard and non-standard terms;
•
insufficient tracking of the issuance and return of license key codes;
•
insufficient tracking of inventory maintained by resellers; and
•
insufficient processes for approving, issuing, documenting and accounting for stock option grants.
Beginning in the quarter ended June 30, 2006 we took a number of corrective actions to address the material weaknesses discussed above, including:
•
implementing enhanced accounting policies and internal controls, as well as improved sales policies and procedures, relating to sales, license delivery, consulting management and product exchanges and returns;
•
developing and implementing internal controls and compliance training programs for sales, operations and finance;
•
implementing personnel changes;
•
establishing clear and concise corporate polices, practices and controls; and
•
implementing formal and documented procedures for approving, issuing, documenting and accounting for stock option grants.
In addition, we implemented changes to our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter ended December 31, 2006 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. These changes include:
•
implementation of a multi-person review process of revenue packages, including system generated reports, expanded documentation requirements and approval requirements of the chief financial officer; and
•
formalization of ongoing reporting of contract statuses and related issues to senior management, including the chief financial officer
We note, however, that a control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues including instances of fraud, if any, have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, our control systems may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected and could be material and require a restatement of our financial statements.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None
PART III
Item 10.
Item 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Our certificate of incorporation and by-laws provide that the number of directors constituting the entire board of directors shall be determined from time to time by resolution of the board of directors and that the board shall be divided into three classes, with no one class having more than one director more than any other class.
Set forth below are the names of each member of our board of directors, their ages, the year in which they first became directors, their principal occupations and employment during at least the past five years and the names of the other public companies of which they serve as a director.
Class I Directors
Class II Directors
Name and Period
of Service as a Director
Age
Principal Occupation, Other Business Experience
During The Past Five Years and Other Directorships
Robert B. Ashton
President and Chief Executive Officer since 2006
Director since 2005
Mr. Ashton has been a private investor in private and public technology companies since 1995 and is currently our largest stockholder. Prior to 1995, Mr. Ashton founded two database utility companies, Bridge Technology, which was sold to Peregrine Systems, and DB View, which was sold to VM Software. Mr. Ashton is also currently a director of segNET Technologies, Inc., a private company that provides advanced digital communications solutions.
Class III Directors
Name and Period
of Service as a Director
Age
Principal Occupation, Other Business Experience
During The Past Five Years and Other Directorships
David A. Smith (1) (2)
Chairman of the Board since 2006
Director since 2004
Mr. Smith has served as chairman and chief technology officer of Qwaq, Inc., a real-time broadband communication infrastructure company, since November 2005. He has also served as chief technology officer of 3Dsolve Inc., a simulation learning company, since July 2001, and has served as a consultant and chief architect for Croquet, an open source operating system, since August 2001. From January 1999
to July 2001, Mr. Smith was the chief executive officer of Timeline Computer Entertainment, an entertainment software company. In 1998 he co-founded and was director of Red Storm Entertainment, an entertainment software company. Mr. Smith was founder of Virtus Corporation, a 3D modeling and visualization software company, and served as its chief executive officer and chief technology officer from January 1990 to January 1999.
(1) Member of the compensation and corporate governance committee.
(2) Member of the audit committee.
Directors Emeritus
From time to time our company designates honorary Directors Emeritus in gratitude for valued service to Gensym provided by former directors and to acknowledge the contribution that those individuals have made to our company. Set forth below is the name of the individual who currently serves as Directors Emeritus, his principal occupations and the years in which he served on the board of directors of our company.
Theodore Johnson served on our board of directors from 1986 to 2004. Mr. Johnson has been an independent venture investor since 1982.
Code of Business Conduct and Ethics
We have adopted a Code of Ethics that applies to our officers, including our principal executive, financial and accounting officers, and our directors and employees. We have posted the Code of Ethics on our Internet Web site at www.gensym.com under the “Corporate Governance” section of the Investor Relations webpage. We intend to make all required disclosures concerning any amendments to or waivers from, our Code of Ethics on our Internet Web site.
Section 16(a) Beneficial Ownership Reporting Compliance
Section 16(a) of the Securities Exchange Act of 1934 requires our directors, executive officers and the holders of more than 10% of our common stock to file initial reports of ownership and reports of changes in ownership with the Commission. Directors, executive officers and 10% stockholders are required by Securities and Exchange Commission regulations to furnish us with copies of all Section 16(a) forms they file. To our knowledge, based solely on a review of our records and written representations by the persons required to file these reports, we believe that during 2006 our reporting persons complied with all Section 16(a) filing requirements.
Executive Officers
Our executive officers as of April 15, 2007 are as follows:
Name
Age
Position
Robert Ashton
President and Chief Executive Officer
Stephen D. Allison
Vice President, Finance, Chief Financial Officer and Treasurer
Philippe C. Printz
Vice President, Engineering
Robert Ashton has served as President and Chief Executive Officer since August 2006. Mr. Ashton has been a private investor in private and public technology companies since 1995 and is currently our largest stockholder. Prior to 1995, Mr. Ashton founded two database utility companies, Bridge Technology, which was sold to Peregrine Systems, and DB View, which was sold to VM Software. Mr. Ashton is also currently a director of segNET Technologies, Inc., a private company that provides advanced digital communications solutions.
Stephen D. Allison has served as vice president, finance, chief financial officer and treasurer since March 2004. From 2000 to 2003, Mr. Allison served as chief financial officer for Webhire, an Internet-based provider of solutions for human resources professionals. From 1997 to 2000, he served as chief financial officer of PRI Automation, a supplier of automation systems for the semiconductor industry. Previously, Mr. Allison held senior financial and operations management positions at Helix Technology, a developer of vacuum technology solutions, from 1995 to 1997, Behring Diagnostics, a clinical diagnostic company, from 1991 to 1995, and at Teradyne, Inc., a supplier of automatic test equipment, from 1974 to 1989.
Philippe C. Printz has served us in a variety of roles since joining us December 1996, including vice president, engineering since April 2003, senior director, engineering from November 2002 through April 2003, director of application development from November 2001 to November 2002, and manager of product development from December 1999 to November 2001. From January 1989 to December 1996, Mr. Printz held a number of management positions in business development and engineering at the Bruker Companies, an international supplier of products for life science, biotechnical and process analytical applications.
Audit Committee
A current copy of the Audit Committee charter is posted on the Investors/Corporate Governance section of our website, www.gensym.com. The audit committee met 8 times during 2006.
The members of the audit committee are Thomas E. Swithenbank (Chair), John A. Shane and David A. Smith. The board of directors has determined that each of the members of the audit committee is independent as defined under the rules of the NASDAQ Stock Market, including the independence requirements contemplated by Rule 10A-3 under the Exchange Act. The board of directors has also determined that Thomas E. Swithenbank and John A. Share are “audit committee financial experts” as defined by applicable SEC rules.
Compensation Committee
A current copy of the Compensation and Corporate Governance Committee charter is posted on the Investors/Corporate Governance section of our website, www.gensym.com. The current members of our compensation and corporate governance committee are David A. Smith (Chair), John A. Shane and Thomas E. Swithenbank. The compensation and corporate governance committee met 23 times in 2006.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Compensation Discussion and Analysis
We have a compensation committee of three independent directors. That committee has been delegated authority from our board of directors and its activities are governed by a compensation committee charter. One of the roles of the compensation committee under its charter is to review and approve annually all compensation decisions relating to our executive officers. Our compensation committee utilizes external analyses and other benchmarking to inform its executive compensation decisions and processes.
Objectives and Philosophy of Our Executive Compensation Program
The primary objectives of our executive compensation program are to:
•
attract, retain and motivate skilled and knowledgeable executive talent;
•
ensure that executive compensation is aligned with our corporate strategies and business objectives;
•
promote the achievement of key strategic and financial performance measures by linking short- and long-term cash and equity incentives to the achievement of measurable corporate and individual performance goals; and
•
align executives’ incentives with the creation of stockholder value.
To achieve these objectives, our compensation committee evaluates our executive compensation program with the objective of setting compensation at levels the committee believes to be competitive with those of other companies in our industry. In addition, our executive compensation program ties a substantial portion of each executive’s overall compensation to key strategic, financial and operational goals set by our board of directors, such as annual bookings targets. We also provide a portion of our executive compensation in the form of equity awards that vest over time, which we believe will help to retain our executives and to align their interests with those of our stockholders by allowing the executives to participate in the longer term success of our company as reflected in stock price appreciation.
Components of our Executive Compensation Program
At this time, the primary elements of our executive compensation program are:
•
base salaries;
•
cash bonuses;
•
equity incentive awards; and
•
benefits and other compensation.
We do not have any formal or informal policy or target for allocating compensation between long-term and short-term compensation, between cash and non-cash compensation or among the different forms of non-cash compensation. Instead, we have determined subjectively on a case-by-case basis the appropriate level and mix of the various compensation components.
Base salaries.
Base salaries are used to recognize the experience, skills, knowledge and responsibilities required of all our employees, including our executives. Base salaries for our executives typically have been set in our offer letter to the executive at the outset of employment. However, from time to time in the discretion of our board of directors consistent with our executive compensation program objectives, base salaries for our executives, together with other components of compensation, are evaluated for adjustment based on an assessment of an executive’s performance and compensation trends in our industry. In January 2006, our then Executive Officer’s salaries increased between four and twenty-three percent in recognition of each Executive Officer’s achievements in the prior year and to keep our salaries in line with that of others in our industry.
Cash bonuses.
In addition to base salaries, our executives are eligible to receive cash bonuses based on our financial performance measured on an annual basis and individual objectives. The bonus plans are designed to reward achievement or corporate financial goals and major business objectives. The corporate financial performance measures, which have typically been developed by our board of directors, are given the greatest weight in this bonus analysis.
The target bonus percent for executives are between 30% and 50% of the executives’ base salary. Cash bonuses typically are paid annually based on achievement of financial measures and individual objectives. The annual payment based on financial measures is determined after year-end.
Cash bonuses awarded with respect to 2006 and set forth in the Summary Compensation Table below were granted based on achievement of major business objectives. Because we did not achieve our financial goals, no bonuses were awarded under the financial performance portion of each executive’s plan. Mr. Printz was the only executive who received a cash bonus in 2006 based on achievement of the individual objectives within his plan.
Our former Vice President of Operations was not compensated on the same general basis as the other named executive officers with respect to cash bonuses. Instead, he received $5,000 per quarter until Gensym hired a new head of worldwide sales. Because he left Gensym after the second quarter and prior to the hiring of a head of worldwide sales, he was only paid $5,000 for the first and second quarters of 2006.
For 2007, we have not established a cash bonus plan for executives.
Equity incentive awards.
Our equity award program is the primary vehicle for offering long-term incentives to our executives. Our equity awards to executives have typically been made in the form of stock options. Although we do not have any equity ownership guidelines for our executives, we believe that equity grants provide our executives with a direct link to our long-term performance create an ownership culture and align the interests of our executives and our stockholders. In addition, the vesting feature of our equity grants should further our objective of executive retention because this feature provides an incentive to our executives to remain in our employ during the vesting period.
In determining the size of equity grants to our executives, our board of directors has considered comparative share ownership of executives in our compensation peer group, our company-level performance, the applicable executive’s performance, the amount of equity previously awarded to the executive, the vesting of such awards and the recommendations of management.
We typically make an initial equity award of stock options or restricted stock to new executives in connection with the start of their employment. Grants of equity awards, including those to executives, are all approved by our board of directors and generally are granted based on the fair market value of our common stock. Typically, the equity awards we grant to our executives vest over three years beginning on the first anniversary of the date of grant. This vesting schedule is consistent with the vesting of stock options granted to other employees.
Typically in the first quarter of each year, at the discretion of our board of directors and consistent with our executive compensation program objectives, our board of directors approves new equity awards to reestablish or bolster incentives to retain employees, including executives. In determining the equity awards for each of the executives set forth on the table Grants of Plan-Based Awards in 2006 below, our board of directors took into account company-level performance, the applicable executive’s performance and informal benchmarking by executive position against companies in our industry and related industries.
We do not have a program, plan or practice of selecting grant dates for equity compensation to our executive officers in coordination with the release of material non-public information. Equity award grants are made from time to time in the discretion of our board of directors consistent with our executive compensation program objectives.
Benefits and other compensation.
We maintain broad-based benefits that are provided to all employees, including medical and dental insurance, life and disability insurance and a 401(k) plan. Other benefits we offer to all full-time employees include programs for job-related educational assistance and discount programs for the purchase of commercial products and services. Executives are eligible to participate in all of our employee benefit plans, in each case on the same basis as other full-time employees.
Employment Agreements.
Typically we enter into employment offer letters with our executive officers. We do not usually enter into change in control or severance arrangements with executive officers with the exception of Mr. Hawkinson and Mr. Schultz as outlined below.
Robert B. Ashton. On August 3, 2006, we entered into an employment letter agreement with Robert B. Ashton defining the terms of his at-will employment with Gensym as President and Chief Executive Officer. Under the terms of the employment letter agreement, Mr. Ashton receives a salary of $1,250 for each day during which Mr. Ashton provides service to Gensym in his capacity as President and Chief Executive Officer (which is based on an annualized salary of $287,500).
Lowell D. Hawkinson. We entered into an employment offer letter with Lowell Hawkinson in August 2004 defining the terms of his at-will employment as our chairman of the board, an executive position. In 2005, Mr. Hawkinson received an annual base salary of $180,000, which was determined by the recommendation of then chief executive officer, Mr. Mayyasi, and as was approved by the compensation committee of our board of directors. In connection with Mr. Mayyasi’s resignation from the board of directors and the termination of his employment with us, on January 27, 2006, we entered into a new employment letter agreement with Mr. Hawkinson defining the terms of his at-will employment with us as president and chief executive officer. Under the terms of the employment letter agreement, Mr. Hawkinson received an annual base salary of $287,500 and participated in a bonus plan with an annual incentive bonus of up to 50% of his annual base salary. The employment letter agreement provided that Mr. Hawkinson’s 2006 bonus would become immediately payable upon a change of control of Gensym, which, terminated the August 2004 employment offer letter between us and Mr. Hawkinson. Also in January 2006, we granted to Mr. Hawkinson an option to purchase 300,000 shares of our common stock, with an exercise price per share of $1.80 per share, and entered into a stock option agreement with Mr. Hawkingon to evidence the option grant. The option was to vest in three equal annual installments, commencing January 13, 2006, and vested fully upon a change of control. In January 2006, in connection with Mr. Hawkinson becoming our president and chief executive officer, we entered into a severance benefits agreement with Mr. Hawkinson. Pursuant to the severance benefits agreement, in the event that we discharged Mr. Hawkinson from employment without cause (as defined in the severance benefits agreement), he would have been entitled to receive his base salary in effect on the date his employment was terminated and certain other benefits for a severance period of one year. Under the terms of the severance benefits agreement, Mr. Hawkinson was not entitled to severance benefits if his employment is terminated for cause, as a result of his death or disability or due to his own resignation.
On August 25, 2006, we entered into a separation letter agreement with Mr. Hawkinson in connection with his resignation from Gensym. We agreed to pay Mr. Hawkinson six months salary continuation and his COBRA premiums for medical, dental and vision insurance coverage for eighteen months. The separation letter agreement also terminated the severance benefits agreement between Gensym and Mr. Hawkinson dated January 25, 2006.
Kim D. Mayyasi. We entered into an employment offer letter with Kim Mayyasi in August 2004 defining the terms of his at-will employment as our president and chief executive officer. During the fiscal year ended December 31, 2005, Mr. Mayyasi received an annual base salary of $287,500 and received a bonus of $45,832. Also in August 2004, we granted to Mr. Mayyasi an option to purchase 300,000 shares of our common stock, with an exercise price per share of $1.83 per share, and entered into a stock option agreement with Mr. Mayyasi to evidence the option grant. The option was to vest in three equal annual installments, commencing August 30, 2005, and vested fully upon a change of control. We also entered into a severance benefits agreement with Mr. Mayyasi in August 2004. Under the terms of the severance benefits agreement, Mr. Mayyasi was not entitled to severance benefits if his employment was terminated for cause, as a result of his death or disability or due to his own resignation. Cause is defined in the severance benefits agreement as (1) a good faith finding by our board of directors of the material failure to perform assigned duties for us, provided that the deficiencies have not been cured within thirty days notice, (2) a good faith finding by our board of directors of dishonesty, gross negligence or misconduct in the carrying out of assigned duties, or (3) the indictment or conviction of, or the entry of a pleading of guilty or nolo contendere to, any crime involving moral turpitude or any felony. Pursuant to Mr. Mayyasi’s severance benefits agreement, in the event that Mr. Mayyasi was discharged from employment by us without cause, he was entitled to receive his base salary in effect on the date his employment is terminated and certain other benefits for a severance period of one year. Since Mr. Mayyasi resigned in January 2006, the severance benefits agreement was terminated without payment of any benefits.
Carl D. Schultz. We entered into a severance benefit agreement with Carl Schultz on September 9, 1999. Pursuant to the severance benefits agreement, in the event that we discharged Mr. Schultz from employment without cause, he would have been entitled to receive his base salary in effect on the date his employment is terminated and certain other benefits for a severance period of six months. Under the terms of the severance agreement, Mr. Schultz was not entitled to severance benefits if his employment was terminated for cause, as a result of his death or disability or due to his own resignation. Cause is defined in the severance benefits agreement as (1) a good faith finding by our board of directors of the material failure to perform assigned duties for us, (2) a good faith finding by our board of directors of dishonesty, gross negligence or misconduct in the carrying out of assigned duties, or (3) the conviction of, or the entry of a pleading of guilty or nolo contendere to, any crime involving moral turpitude or any felony. On August 16, 2006, Gensym entered into a new severance letter agreement with Mr. Schultz in connection with his departure from Gensym. Under the terms of the severance letter agreement, Gensym agreed to pay Mr. Schultz two months salary continuation and his COBRA premiums for medical, dental and vision insurance coverage for two months. The separation letter agreement also terminated the severance benefits agreement between Gensym and Mr. Schultz dated September 9, 1999.
Tax Considerations
Section 162(m) of the Internal Revenue Code of 1986, as amended, generally disallows a tax deduction for compensation in excess of $1.0 million paid to our chief executive officer and our four other most highly paid executive officers. Qualifying performance-based compensation is not subject to the deduction limitation if specified requirements are met. We generally intend to structure the performance-based portion of our executive compensation, when feasible, to comply with exemptions in Section 162(m) so that the compensation remains tax deductible to us. However, our board of directors may, in its judgment, authorize compensation payments that do not comply with the exemptions in Section 162(m) when it believes that such payments are appropriate to attract and retain executive talent.
Summary Compensation Table For Fiscal Year 2006
The table below summarizes 2006 compensation paid to or earned by our Chief Executive Officer, our Chief Financial Officer, our two other most highly compensated executive officers and our two prior Chief Executive Officers, who we refer to collectively as our “named executive officers.”
(1) Represents the amount of compensation cost to our company in fiscal year 2006 with respect to awards granted in fiscal year 2006 and previous fiscal years, as computed in accordance with Statement of Financial Accounting Standards (SFAS) No. 123R. For option awards outstanding at the time we adopted SFAS No. 123R, our compensation cost has been estimated as if we utilized the modified prospective transition method. In order to perform these calculations, the fair value of each stock option is determined on the date of grant using the Black-Scholes option pricing model and the fair value of each stock award is measured by the closing price of our company’s common stock on the Pink Sheets on the date of grant. See Note 1 of the consolidated financial statements in this Annual Report on Form 10-K for the year ended December 31, 2006 regarding assumptions underlying valuation of equity awards.
(2)
During 2006, none of our executive officers earned preferential or above-market earnings on deferred compensation.
(3) Lowell Hawkinson, our former chairman and chief executive officer signed a separation letter agreement on August 25, 2006 pursuant to which Mr. Hawkinson received a six month continuation of his salary.
(4) Kim Mayyasi, our former President and Chief Executive Officer left Gensym on January 27, 2006.
(5) In accordance with his separation letter agreement, Carl Schultz, our former Vice President, Operations was paid an additional two months salary continuation in a lump sum in January, 2007.
(6) Consists of 401(k) matching contribution.
(7) Consists of $13,029 in insurance premiums and a $1551 tax gross up payment for Mr. Allison’s April 21, 2004 option grant.
(8) Consists of $10,272 in insurance premiums, $143,750 in severance payments, $17,043 in paid time off and $15,513 in continuation of health coverage under COBRA.
(9) Consists of $1081 in insurance premiums.
(10) Consists of $3766 in 401(k) matching contributions, $8,267 in insurance premiums, and $11,443 in paid time off and $1,827 in continuation of health coverage under COBRA.
(11) Consists of $3550 in 401(k) matching contributions and $8,267 in insurance premiums.
(12) Lowell Hawkinson, our former chairman and chief executive officer, terminated his employment in August 2006 so there was no value to the options.
Grants Of Plan-Based Awards Table For Fiscal Year 2006
The following table sets forth information regarding bonuses and stock option grants to each named executive officer.
(1) Mr. Ashton received this option as a non-employee director in January of 2006.
Outstanding Equity Awards At Fiscal Year-End Table At Fiscal Year-End For 2006
The following table sets forth information regarding the outstanding stock options held by our named executive officers as of December 31, 2006.
(1) Mr. Ashton received these grants on October 26, 2005 and January 3, 2006 as a non-employee director pursuant to our director compensation policy. Both grants were immediately exercisable.
(2) This option vests at the earlier of the date upon which our stock price reaches $10.00 per share or seven years from the grant date.
Option Exercises And Stock Vested For Fiscal Year 2006
The following table sets forth the number of shares acquired pursuant to the exercise of options by, and the number of restricted stock awards that vested for, our named executive officers during 2006 and the aggregate dollar amount realized by our Named Executive Officers upon exercise of the options.
(1)
Mr. Hawkinson exercised 250,000 options upon his departure from Gensym in November 2006.
(2)
Mr. Schultz exercised 77,334 options upon his departure from Gensym in September and October 2006.
Severance and Change-in-Control Benefits
We had employment and severance agreements with Lowell B. Hawkinson, our former chairman and chief executive officer; Carl Schultz, our former vice president, operations; and Kim Mayyasi, our former president and chief executive officer. These arrangements are discussed in more detail under “Compensation Discussion and Analysis” above.
DIRECTOR COMPENSATION
We use a combination of cash and equity-based compensation to attract and retain candidates to serve on our board of directors. We do not compensate directors who are also our employees for their service on our board of directors. Therefore, Mr. Hawkinson did not receive any compensation for his service on our board of directors.
Meeting Fees
Members of the board of directors who are not employees of the Company are paid $1,000 for physical attendance and $500 for telephonic attendance at board of directors, and $2,500 as a quarterly retainer for each committee on which the director serves. These directors are also reimbursed for their expenses incurred in connection with their attendance at board of directors and committee meetings.
Annual Retainers
In addition to meeting fees, in 2006, we paid non-employee directors an annual retainer of $12,000 and a $2,500 quarterly retainer for each committee on which the director serves.
Equity Compensation
Each non-employee director receives a non-statutory option to purchase 10,000 shares of Common Stock upon initial election as director and on the first calendar day of each quarter each non-employee director is entitled to receive a non-statutory option to purchase 2500 shares of our common stock. Beginning in March 2006, the initial and quarterly option grants to directors will no longer be granted to any director if and to the extent the grant would cause the director’s total number of shares and options (whether or not vested and regardless of exercise price) to exceed 100,000 shares or to any non-employee director who owns more than 5% or more of Gensym’s outstanding common stock. All options granted to directors are granted at an exercise price equal to the fair market value of our common stock on the date of the grant, are immediately exercisable and are exercisable for up to 10 years from the date of grant.
Director Compensation Table
The following table sets forth a summary of the compensation we paid to our non-employee directors for service on our board in 2006:
(1) The amount shown represents the amount of compensation cost that the company recognized for fiscal 2006 for all options held by each of the directors as computed in accordance with SFAS No. 123R utilizing the modified prospective transition method. In accordance with SFAS No. 123R, the fair value of each stock option is determined on the date of grant
using the Black-Scholes option pricing model. This value is then amortized ratably over the vesting period. See Note 1 of the consolidated financial statements in our Annual Report on Form 10-K for the year ended December 31, 2006 regarding assumptions underlying valuation of equity awards. The grant date fair value, computed in accordance with SFAS No. 123R, of stock options granted to each of our non-employee directors in 2006 was $37,145 see below (3). The grant date fair value was determined by using the Black-Scholes option-pricing model. As of December 31, 2006, each director had the following number of options outstanding: Mr. Smith: 32,500; Mr. Ashton:12,500; Mr. Swithenbank:100,000; and Mr. Shane: 95,000.
(2) Mr. Ashton was a non-employee director until he joined the company as Interim Chief Executive Officer and President in August 2006.
(3) Represents director compensation percentage paid in stock pursuant to director compensation policy in effect prior to March 31, 2006.
Compensation and Corporate Governance Committee Interlocks and Insider Participation
The current members of the compensation and corporate governance committee are David A. Smith (Chair), John A. Shane and Thomas E. Swithenbank. No member of the compensation committee was at any time during 2006, or formerly, an officer or employee of our company or any of our subsidiaries. No member of our compensation committee had any relationship with us during 2006 requiring disclosure under Item 404 of Regulation S-K under the Securities Exchange Act of 1934.
None of our executive officers has served as a member of the board of directors or compensation committee (or other committee serving an equivalent function) of any other entity that had one or more executive officers serving as a member of our board of directors or compensation committee.
Report of the Compensation Committee on Executive Compensation
The compensation committee of our board of directors has reviewed and discussed this Compensation Discussion and Analysis with our management. Based on its review and discussions with our management, the compensation committee recommended to our board of directors that the Compensation Discussion and Analysis be included in this Annual Report on Form 10-K.
COMPENSATION COMMITTEE
David A. Smith, Chairman
John A. Shane
Thomas E. Swithenbank
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Security Ownership of Certain Beneficial Owners and Management
The following table, except as otherwise noted, sets forth information about the beneficial ownership of our common stock as of May 1, 2007 by:
•
the stockholders we know to beneficially own more than 5% of our outstanding common stock;
•
each of our current directors;
•
our chief executive officer and the other named executive officers; and
•
all of our current directors, director nominees and executive officers as a group.
Beneficial ownership is determined in accordance with the rules of the Securities and Exchange Commission based upon voting or investment power over the securities. Unless otherwise indicated, each person or entity listed in the table has sole voting and investment power with respect to all shares listed as owned by such person or entity. The inclusion of shares in the table does not constitute an admission that the named stockholder is a direct or indirect beneficial owner of the shares. Unless otherwise noted, the address of each person listed in the table is: c/o Gensym Corporation, 52 Second Avenue, Burlington, MA 01803.
* Less than 1% of outstanding shares of common stock
(1) The number of shares beneficially owned by each director and executive officer is determined under rules promulgated by the Securities and Exchange Commission (the “Commission”), and the information is not necessarily indicative of beneficial ownership for any other purpose. Under the Commission’s rules, beneficial ownership includes any shares as to which the individual has sole or shared voting power or investment power and also any shares which the individual has the right to acquire within 60 days after May 1, 2007 through the exercise of any stock option or other right. The inclusion herein of such shares, however, does not constitute an admission that the named stockholder is a direct or indirect beneficial owner of such shares. Unless otherwise indicated, each person or entity named in the table has sole voting power and investment power (or shares such power with his or her spouse) with respect to all shares of capital stock listed as owned by such person or entity.
(2) Number of shares deemed outstanding includes 7,878,404 shares of Gensym common stock outstanding as of May 1 2007 and any options for shares that are exercisable by such beneficial owner within 60 days after May 1, 2007.
(3) Beneficial ownership, as of November 12, 2003, as reported on Amendment to Form 4 filed with the Commission on December 2, 2003.
(4) Includes 12,000 shares of common stock held by Mr. Hawkinson’s adult children, as to which shares Mr. Hawkinson disclaims beneficial ownership. Beneficial ownership, as of April 15, 2006, as reported on our Annual Report on Form 10-K/A for the fiscal year ended December 31, 2005.
(5) Beneficial ownership, as of December 31, 2006, as reported on Amendment to Schedule 13G filed with the Commission on January 30, 2007.
(6) Includes 12,500 shares of common stock subject to outstanding options that are exercisable within the 60 day period following May 1, 2007.
(7) Includes 3,405 shares held by Palmer Service Corporation, of which Mr. Shane is the President and sole stockholder. Mr. Shane disclaims beneficial ownership of such shares except to the extent of his pecuniary interest therein. Also includes 92,000 shares of common stock subject to outstanding stock options that are exercisable within the 60-day period following May 1, 2007.
(8) Includes 32,500 shares of common stock subject to outstanding stock options that are exercisable within the 60-day period following May 1, 2007.
(9) Includes 97,000 shares of common stock subject to outstanding stock options that are exercisable within the 60-day period following May 1, 2007.
(10) Includes 50,000 shares of common stock subject to outstanding stock options that are exercisable within the 60-day period following May 1, 2007.
(11) Includes 46,300 shares of common stock subject to outstanding stock options that are exercisable within the 60-day period following May 1, 2007.
(12) Includes an aggregate of 330,300 shares of common stock subject to outstanding stock options that are exercisable within the 60-day period following May 1, 2007.
Equity Compensation Plan Information
The following table provides information about our common stock that may be issued upon exercise of options, warrants and rights under all of our equity compensation plans as of December 31, 2006.
(1) Includes our:
1994 Stock Option Plan, as amended.
1995 Director Stock Option Plan, as amended.
1997 Stock Incentive Plan
2000 Stock Incentive Plan, as amended.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
Our board of directors is committed to upholding the highest legal and ethical conduct in fulfilling its responsibilities and recognizes that related party transactions can present a heightened risk of potential or actual conflicts of interest. Accordingly, as a general matter, it is our preference to avoid related party transactions.
In accordance with our audit committee charter, members of the audit committee, all of whom are independent directors, review and approve all related party transactions for which approval is required under applicable laws or regulations, including SEC rules. Current SEC rules define a related party transaction to include any transaction, arrangement or relationship in which we are a participant and the amount involved exceeds $120,000, and in which any of the following persons has or will have a direct or indirect interest:
•
our executive officers, directors or director nominees;
•
any person who is known to be the beneficial owner of more than 5% of our common stock;
•
any person who is an immediate family member, as defined under Item 404 of Regulation S-K, of any of our executive officers, directors or director nominees or beneficial owner of more than 5% of our common stock; or
•
any firm, corporation or other entity in which any of the foregoing persons is employed or is a partner or principal or in a similar position or in which such person, together with any other of the foregoing persons, has a 5% or greater beneficial ownership interest.
In addition, the audit committee reviews and investigates any matters pertaining to the integrity of management, including conflicts of interest and adherence to our Code of Business Conduct and Ethics. Under our Code of Business Conduct and Ethics, our directors, officers and employees are expected to avoid any relationship, influence or activity that would cause or even appear to cause a conflict of interest. Under our Code of Business Conduct and Ethics, a director is required to promptly disclose to our board of directors any potential or actual conflict of interest involving him or her. In accordance with our Code of Business Conduct and Ethics, the board of directors will determine an appropriate resolution on a case-by-case basis. All directors must recuse themselves from any discussion or decision affecting their personal, business or professional interests.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES.
Independent Registered Public Accounting Firm Fees and Other Matters
The following table sets forth information regarding fees billed for services rendered by Vitale, Caturano & Company, Ltd., our current registered public accounting firm, for the fiscal years ended December 31, 2006, December 31, 2005 and December 31, 2004.
(1) All audit related fees are attributable to procedures performed on the Company’s revenue and stock option restatements
Audit Fees
Audit fees consist of fees related to professional services rendered in connection with the audit of our annual financial statements, the reviews of the financial statements included in each of our Quarterly Reports on Form 10-Q, international statutory audits, and accounting consultations that relate to the audited financial statements and are necessary to comply with generally accepted auditing standards.
Audit-Related Fees
Audit-related fees consist of fees for assurance and related services that are reasonably related to the performance of the audit and the review of our financial statements and which are not reported under “Audit Fees.” These services relate to audits of employee benefit plans, specific internal control process reviews and consultations regarding internal controls, financial accounting and reporting standards. During 2006 these fees related to procedures performed on the revenue and stock option restatements.
Tax fees
Tax fees consist of fees billed for professional services related to tax compliance services, including the preparation of tax returns for our expatriates, international tax returns, tax advice and assistance with international tax audits.
Pre-Approval Policy and Procedures
The audit committee has adopted policies and procedures relating to the approval of all audit and non-audit services that are to be performed by our registered public accounting firm. This policy generally provides that we will not engage our registered public accounting firm to render audit or non-audit services unless the service is specifically approved in advance by the audit committee or the engagement is entered into pursuant to one of the pre-approval procedures described below.
From time to time, the audit committee may pre-approve specified types of services that are expected to be provided to us by our registered public accounting firm during the next 12 months. Any such pre-approval is detailed as to the particular service or type of services to be provided and is also generally subject to a maximum dollar amount.
The audit committee has also delegated to the chairman of the audit committee the authority to approve any audit or non-audit services to be provided to us by our registered public accounting firm. Any approval of services by a member of the audit committee pursuant to this delegated authority is reported on at the next meeting of the audit committee. During fiscal year 2006, no services were provided to us by Vitale, Caturano & Company, Ltd. or any other accounting firm other than in accordance with the pre-approval policies and procedures described above.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES AND REPORTS ON FORM 8-K
(a) (1) FINANCIAL STATEMENTS
The following documents are included in Item 8 of this Annual Report on Form 10-K:
Consolidated Balance Sheets as of December 31, 2006 and 2005 (as restated)
Consolidated Statements of Operations for each of the three years in the period ended December 31, 2006
Consolidated Statements of Stockholders’ Equity (Deficit) for each of the three years in the period ended December 31, 2006
Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 2006
Notes to Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm on Consolidated Financial Statements at December 31, 2006 and 2005 (as restated) and for the years then ended.
(2) FINANCIAL STATEMENT SCHEDULES
All schedules have been omitted since the required information is not applicable or not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements or the notes thereto.
(3) EXHIBITS
The exhibits listed in the accompanying Exhibit Index are filed as part of this Annual Report on Form 10-K.
(b) Exhibits
The exhibits listed in the accompanying Exhibit Index are filed as part of this Annual Report on Form 10-K.
(c) Financial Statement Schedules
All schedules have been omitted since the required information is not applicable or not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements or the notes thereto.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
GENSYM CORPORATION
(Registrant)
Dated: June 6, 2007
By:
/s/ Robert Ashton
Robert Ashton
President and Chief Executive Officer
Pursuant to the requirements of the Securities and 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:
EXHIBIT INDEX -
* Filed herewith.
# Identifies exhibit with respect to which certain portions have been granted confidential treatment.
+ Identifies exhibits constituting management contract or compensatory plan of arrangement required to be filed as an exhibit to this Annual Report on Form 10-K