Item 1. Business
You should read the Business section in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and the Consolidated Financial Statements and Notes thereto included elsewhere in this report and with the understanding that our actual future results may differ materially from expectations. All forward-looking statements made in this report are qualified by these cautionary statements. You are cautioned that forward-looking statements are not guarantees of future performance and are made only as of the date of this report, and we undertake no obligation, other than as may be required by law, to update or revise these statements for any reason, including to reflect changes in assumptions, the occurrence of unanticipated events or changes in future operating results over time.
Overview
Witness Systems, Inc. (“Witness”) is a publicly traded company that provides workforce optimization software and services that help businesses capture customer intelligence and optimize their work performance. We were incorporated in Delaware in 1997 and had 834 employees as of December 31, 2006. Our Impact 360TM solution is an integrated offering of software products that provide comprehensive workforce optimization functionality, including quality monitoring, high volume compliance and IP recording, workforce management, performance management and electronic learning (“e-learning”). Our quality monitoring products record multimedia interactions, including traditional voice, Web chat and email, based on user-defined business rules to enable our customers to evaluate the performance of their customer service representatives, or CSRs, wherever they may be located in the enterprise. Our full-time
compliance applications are designed to record high volume voice conversations between CSRs and customers for purposes such as compliance recording and sales verification. Our workforce management products enable our customers to develop strategic staffing plans, deploy skilled resources and evaluate productivity of CSRs in a contact center, branch bank or back office operations. Our performance management applications provide comprehensive analytics, including performance scorecards, and reports of customer interaction and CSR performance. Our e-learning applications deliver ongoing training tailored to CSR needs and competencies. We also provide consulting and implementation services, training and support to customers that use our software products. Primarily deployed in contact centers-as well as the remote, branch and back offices of global organizations, the workforce optimization solution captures, analyzes and enables users to share and act on cross-functional information across the enterprise. With Impact 360, organizations can improve interactions and the underlying back-office processes that enhance the customer experience and build customer loyalty.
We have more than 3,000 customers, including more than 60 Fortune 100 companies. Our solutions are used in a wide variety of industries worldwide, including financial services, communications services, manufacturing, utilities, retail, transportation, travel and outsourcing. No individual customer accounted for 10% or more of our revenue in 2006, 2005 or 2004. We market and sell our products through both our direct sales force and through indirect channels. Our indirect sales channel includes reseller, distributor, original equipment manufacturer, or “OEM”, and similar arrangements with key vendors in the contact center workforce optimization market.
Pending Acquisition of Witness by Verint Systems Inc.
On February 11, 2007, we entered into an Agreement and Plan of Merger (the “Merger Agreement”) with Verint, a Delaware corporation pursuant to which Witness expects to merge with a wholly-owned subsidiary of Verint, and thereby becoming a wholly-owned subsidiary of Verint (“the Merger”). At the effective time of the Merger, each outstanding share of our common stock will be converted into the right to receive $27.50 in cash, less any applicable withholding taxes and without interest. Under the Merger Agreement, each outstanding stock option of Witness that is vested at the effective time of the merger and has an exercise price below $27.50 will be cancelled and exchanged for a cash payment by Verint in an amount equal to the excess (if any) of $27.50 over the exercise price per option share multiplied by the number of shares of Witness common stock subject to such vested option. Witness stock options that are vested at the effective time of the merger and have an exercise price above $27.50 will be cancelled without payment. Each outstanding stock option of Witness that is unvested at the effective time of the merger will be assumed by Verint and will become an option to purchase shares of Verint common stock on the same terms and conditions as were applicable to the stock option immediately prior to the effective time of the merger. The number of shares of Verint common stock subject to each assumed option will be determined by multiplying the number of shares of Witness common stock that were subject to the unvested option immediately prior to the effective time of the merger by the conversion ratio set forth in the Merger Agreement, and rounding that result down to the nearest whole number of shares of Verint common stock. The per share exercise price for the assumed option will be determined by dividing the per share exercise price of the Witness common stock subject to the unvested option as in effect immediately prior to the effective time of the Merger by the conversion ratio, and rounding that result up to the nearest whole cent. The conversion ratio is the ratio obtained by dividing $27.50 by the average of the closing sales prices of a share of Verint common stock for the twenty consecutive trading days immediately before the closing of the Merger (subject to adjustment for stock splits and dividends).
We have filed a preliminary proxy statement with the Securities and Exchange Commission (“SEC”), and we plan to mail to our stockholders a definitive proxy statement in connection with the Merger once we obtain approval from the SEC. The definitive proxy statement will contain important information about the Merger and related matters. Investors and security holders are urged to read the definitive proxy statement carefully when it is available.
Except as otherwise expressly noted, all statements and information in this filing presume our continuation as a going concern and as an independent public company, which will not be the case if the Merger is completed.
Industry Background and Trends
The workforce optimization solutions market has evolved in recent years to address the increasing challenges faced by enterprises in managing their customer service and sales activities effectively. The overall goal of workforce optimization in the customer service function is to enable companies to balance the competing objectives of maximizing customer satisfaction and increasing revenue, while at the same time controlling customer service costs. Customer contact centers, branch banks, help desks, and billing and order fulfillment departments regularly represent the key focal points for personal interaction between a business and its customers, making the effectiveness of the CSRs and other staff critical to the overall success of the business.
We believe several key trends are driving the workforce optimization market, including:
Voice over Internet Protocol (“VoIP”) technologies. The convergence of voice and data communications technologies, most notably through the rapid adoption of VoIP, is changing the landscape of telecommunications infrastructure. VoIP, or IP telephony, is a software-based technology that enables the conversion of voice communications into data packets that can be routed over any IP-based network, as opposed to traditional circuit-switched voice transmission lines. Many companies are replacing legacy analog voice infrastructures in their contact centers with VoIP telephony infrastructure to realize the many benefits of IP-based communications, including reduced costs and enablement of advanced business communication applications. These equipment upgrades typically require new deployments of workforce optimization solutions designed to support IP environments. VoIP applications also permit the customer service function to extend beyond traditional contact centers by facilitating easier access to customer interaction information.
Software solutions running on open systems. Organizations are increasingly seeking to deploy information technology and business software applications based on open standards that run on commercially available, non-proprietary hardware. The use of open systems, as opposed to applications that run on proprietary hardware systems offered by a single vendor, generally provides for lower cost of ownership and greater flexibility in their information technology infrastructures.
Integration of workforce optimization applications. Increasingly, companies worldwide are seeking an integrated offering of workforce optimization applications, including quality monitoring and high-volume compliance recording, workforce management, performance management and e-learning. By integrating these applications, an enterprise can reduce costs by eliminating duplicative hardware, streamlining implementation and reducing administration requirements. Integration also makes the applications easier to use through a single unified graphical user interface. Most important, by integrating these applications under one framework, enterprises gain the ability to manage their workforce performance in a closed loop, including evaluating and analyzing complete customer interactions through multiple media, identifying opportunities and performance gaps, scheduling personnel based on strengths and weaknesses, applying targeted instruction for continuous improvement, integrating instruction into a workforce schedule, and compensating employees based on actual performance.
Increasing complexity of customer service operations. Customer service operations at many organizations have become increasingly complex, driven by the demand for highly available and effective customer service. For example, contact centers have become the primary points of customer contact for organizations, as the contact centers have evolved from providing solely inbound customer support to handling support, service, sales, bill payment and numerous other customer interactions. Organizations are facilitating customer service interactions across multiple media, including traditional voice, Web chat, instant messaging, guided browser sessions and e-mail, and are therefore challenged to maintain a
consistently high level of customer service across all media channels. Moreover, as a result of recent trends toward offshore and outsourced contact center operations, managing and optimizing the quality of customer interactions has become more important, and more difficult, than ever.
Impact 360
Impact 360, our integrated workforce optimization solution, enables organizations to capture, analyze and act on cross-functional information concerning workforce performance, customer interactions and customer service processes. Impact 360 offers a unified framework for workforce optimization that provides organizations a holistic view of performance and enables them to leverage this information to provide more effective and efficient customer service. Our new solutions framework supports both traditional time division multiplexing, or TDM, switch environments and IP telephony environments and executes on standard operating systems and hardware platforms.
The integrated components of our workforce optimization solution encompass quality monitoring and high-volume compliance recording, workforce management, performance management and e-learning. Impact 360 is available as a fully integrated solution, in specific packages or as separate applications. Impact 360 provides numerous benefits to our customers, including reduced infrastructure costs, rapid implementation and central administration. More importantly, shared access to information across all functions in the customer service value chain enables our customers to make informed decisions that can generate cost savings, improve decision making and increase competitive advantages. We also offer related consulting and implementation services, training and support.
The components of our solution include:
Quality monitoring and high-volume compliance recording. Our recording solutions enable the recording of a CSR’s multimedia interactions with a customer through traditional voice, Web chat, instant messaging, guided browser sessions and e-mail. The CSR’s voice interaction with a customer can be synchronized with the CSR’s corresponding computer desktop activities, such as data entry, screen navigation and data retrieval, for review and analysis by supervisors. Quality monitoring selectively records interactions based on user-defined business rules, while high-volume compliance recording stores all interactions between an organization’s CSRs and its customers for purposes such as legal or regulatory compliance and sales verification. Our solutions enable companies to evaluate the performance of CSRs, analyze the effectiveness of supporting systems and enhance the quality of service being delivered.
Workforce management. Our workforce management solutions simplify the task of forecasting and scheduling, enabling contact centers to balance cost, service level and agent preferences. Users can analyze historical data to forecast future interaction volumes and service handle times in order to schedule the optimal number of agents, with the required skill sets, at the necessary times. As a result, organizations can reduce costs by staffing appropriately to meet workload demands, drive business growth, and improve employee effectiveness and retention.
Performance management. Our performance management solutions provide comprehensive analysis of customer interaction and CSR performance. Leveraging performance scorecards with industry-accepted and user-defined key performance indicators, these solutions combine data derived from our evaluation application with data from other business systems, such as customer relationship management software, enterprise resource planning software and integrated telephony applications. Our solution also offers data visualization, search capabilities and speech analytics. Using our solutions, supervisors can obtain a quick, streamlined view of performance relative to strategic organizational objectives. The reporting, dynamic analysis and performance scorecard capabilities of these solutions provide organizations with business intelligence that can lead to increased revenue, heightened service quality and improved operational efficiencies.
E-learning. Our e-learning solutions deliver ongoing training tailored to CSR competencies in order to achieve continuous performance improvement. The e-learning management software tracks training
completion and compiles transcripts to enhance CSR skills. When the e-learning applications are integrated with other Impact 360 components, a supervisor can review a recorded customer interaction, evaluate the CSR’s performance and prioritize customized training and lesson plans for the CSR. Our solution enables targeted learning content to be delivered directly to a CSR’s desktop through a series of standardized lessons or customized lessons created from recorded interactions. E-learning can enable companies to reduce employee turnover and to build customer loyalty through a more highly skilled and motivated workforce.
Customer Feedback. Our customer feedback solution surveys customers immediately after their interactions with agents over the IVR, Web, and e-mail with short, dynamic surveys that are delivered based on user-defined business rules. Because these surveys are dynamic and intelligent, context-based, and timely, they impact customers in a measurably positive manner and deliver response rates greater than those obtained through traditional questionnaires. As a result, organizations can move beyond mere sampling to capture data-even with large numbers of customers and multiples sites.
Witness Service Network
The Witness Service Network is our approach to consulting, training and support services that accompany our Impact 360 solutions. Our service and support offerings are designed to enable our customers to achieve a rapid return on investment and realize the maximum benefit our solutions provide by enabling organizations to optimize their contact center operations. Our services consist of implementation services, training, business consulting and customer support.
The initial implementation engagement for our Impact 360 solutions is typically completed within 30 to 60 days from the start date of the implementation phase. Training services provide the skills and knowledge necessary to enable business and technical users to utilize the Impact 360 solutions. Training is provided at our global training centers, on-site at the customers’ location or via our web-based education and training management system. In addition, we offer customized training programs tailored to the specific needs of our customers.
Our business consulting services are designed to help customers gain the most value from the Impact 360 solution to optimize the people, processes and technology deployed throughout their contact center operations. Witness Systems Strategic Consulting Services include:
· AdviceLine-Provides guidance on operational or business practice questions through ten one-hour, one-on-one sessions with a Witness Systems contact center expert delivered over the phone or web;
· Business Discovery-Identifies and quantifies how Witness Systems solutions can improve performance within the contact center or back office operations;
· Business Implementation Accelerator-Addresses the broader issues of large-scale workforce optimization software deployments, such as changes to staffing, policies and procedures, that are often overlooked during system implementation;
· Calibrating Quality for Consistency-Provides the insight needed to develop and perform consistent quality monitoring evaluations for contact center agents and customer service representatives;
· Communicating in a Changing Environment-Develops a plan for communicating the guidelines, expectations, and objectives of an Impact 360 deployment to multiple levels of the organization;
· Custom Report Enablement-Shows how to use Impact 360’s reporting tools and database schema to create and run custom reports;
· High Impact Coaching-Teaches best practices for deploying a successful program to coach contact and service center staff effectively;
· Leveraging Contact Editing-Shows how the contact editing functionality within Impact 360 Workforce Optimization and Quality Monitoring can be used effectively as part of an eLearning program;
· Measuring for ROI Success-Defines key metrics that enable users to quantify the return on investment (ROI) provided by their Impact 360 solution;
· Quality Evaluation Optimization-Creates meaningful quality monitoring evaluation forms that tie quality initiatives to specific corporate, contact center, agent, and customer objectives;
· Quality Monitoring Configuration Consulting-Provides an in-depth understanding of Impact 360 Quality Monitoring’s different configurable options to support current and future customization;
· Workforce Management Model Validation-Identifies areas within the contact center that can cause the Impact 360 Workforce Management data model to become obsolete (such as attrition, new queues, and additional skill sets); and
· Workforce Optimization Assessment-Evaluates the people, processes, and technologies within the contact center to determine their efficiency and effectiveness.
The support operation provides customer support services including access to major and minor releases, service packs and hot fixes, remote diagnostics and installation. Customer support is offered in two distinct plans with services that range from 12 hour phone access Monday through Friday to 24 hours, 7 days a week. We provide support services via the telephone, e-mail and via an on-line knowledgebase of product-related information.
Our Strategy
Our objective is to be a leading provider of workforce optimization software and services to help global enterprises improve all aspects of customer service, from contact center customer interactions to remote and branch offices and underlying back office processes. Key elements of our strategy include the following:
Extend the breadth and depth of the Impact 360 solution. We believe Impact 360 provides today’s most comprehensive, integrated offering of workforce optimization products designed to manage, analyze and improve the customer service function. We intend to continue investing in research and development to enhance the functionality, effectiveness and ease of use of our Impact 360 solution, as well as to expand the number of third-party applications with which our software can readily integrate.
Maximize sales to existing customers. We have a large installed base of customers, many of which currently utilize only a subset of our workforce optimization products or have not deployed our products in all of their contact centers or elsewhere throughout their customer service operations. We believe these customers represent a significant opportunity for us to generate additional sales of complementary products and services. Impact 360 has been designed to enable cross-selling and upselling of additional products to customers already utilizing our software. During 2006, we generated approximately 82% of our license revenue through sales to existing customers.
Capitalize on the growing adoption of VoIP. Our Impact 360 solution fully supports VoIP telephony infrastructure. As companies upgrade to VoIP telephony infrastructure in their customer service operations, they will typically need to upgrade their workforce optimization solutions. This dynamic provides us with a unique opportunity to displace competitive solutions with Impact 360, and we intend to aggressively pursue companies engaging in telephony infrastructure upgrades. In addition, because VoIP provides small and medium-sized businesses with a new opportunity to deploy workforce optimization solutions at a more reasonable price, we have the opportunity to sell Impact 360 to a segment of the market that has historically been unable to afford these solutions. In order to address this opportunity, we have created a version of Impact 360 specifically designed to meet the needs of small and medium-sized businesses.
Expand our indirect sales channel. Historically, the majority of our sales have been driven by our direct sales force. In recent years, we have significantly bolstered our indirect sales channel through reseller, distributor and OEM arrangements with key hardware and service providers in the contact center market. For example, Avaya, an OEM provider, bundles our workforce optimization software products with sales of its converged communications (TDM and IP) infrastructure hardware solutions. We have also announced a similar OEM agreement with Nortel and BT (Trading Room Systems). We are also seeking to expand our relationships with and among systems integrators. In addition to broadening our overall sales leverage, we believe these channel partnerships provide an efficient means to enable us to penetrate one of the fastest growing segments in the contact center industry, the small and medium-sized business segment.
Expand our business through strategic acquisitions. We intend to pursue acquisitions of businesses, technologies and products that we believe will complement our existing operations and enhance our position in the workforce optimization market. In 2003 we acquired Eyretel Plc, which strengthened our market presence internationally and expanded our capabilities in the compliance recording market, and in 2005 we acquired Blue Pumpkin Software, Inc., a leading provider of workforce management products. In 2006 we acquired Demos Solutions Consulting Group Ltd. also known as Demos Solutions (“Demos”) and Exametric, Inc. (“Exametric”), two leaders in supplying enterprise productivity and resource planning solutions to the financial services industry.
Research and Development
We believe our software development capabilities are essential to our strategy of enhancing our core technology, developing additional applications, incorporating that technology and maintaining the competitiveness of our software. We devote a substantial portion of our resources to developing new software and features, extending and improving our software technology, debugging and quality testing our products and researching new technological initiatives in our market. We believe that our future success depends in part upon our ability to continue to enhance existing software, respond to changing customer requirements and develop and introduce new or enhanced software that incorporates new technological developments and emerging industry standards.
As of December 31, 2006, we had 301 associates (including 93 contractors) engaged in research and development activities. Research and development expenditures, exclusive of acquired in-process research and development, for the years ended December 31, 2006, 2005 and 2004 were $33.3 million, $26.7 million and $20.8 million, respectively. We anticipate our research and development costs will increase in 2007.
Competition
Our software and services compete in the emerging market for products that record and analyze customer interactions and provide electronic learning applications. This market is intensely competitive and experiences rapid changes in technology. We believe that we compete effectively and that we enjoy a competitive advantage based upon:
· the functionality and quality of our products,
· the ease of use and ability of our products to operate with a variety of hardware and software products,
· our ability as a single vendor to offer a full suite of applications,
· our ability to implement our products quickly,
· the responsiveness of our customer support, and
· our reputation in the marketplace.
Our competitors include:
· traditional call-logging vendors;
· quality monitoring suppliers to the contact center industry;
· workforce management, forecasting and scheduling vendors to the call center, branch banking and back office operations industries;
· electronic learning vendors;
· business analytics vendors;
· large telecom solution providers;
· enterprise software vendors;
· systems integrators and consulting firms; and
· new, larger and more established entities that may acquire, invest in or form joint ventures with providers of recording or performance enhancing software solutions.
In addition, we have developed, and intend to continue to develop, relationships with companies that resell our software, companies that integrate the software with their technology and products and companies that provide us with customer referrals or leads. Some of these companies have similar, and often more established, relationships with our competitors, and may recommend the products and services of competitors to customers instead of our software and services. In addition, through their relationships with us, these companies could learn about our software and the market for our software and services and could develop and sell competing products and services.
The principal competitive factors in our market include:
· product performance, reliability and features;
· ability to effectively integrate products into customers’ environments;
· user scalability and open architecture;
· third-party integration;
· quality and speed of product implementation;
· ease-of-use for customers;
· analytic capabilities of the product;
· how quickly new products and product enhancements can be brought to market;
· customer support; and
· pricing of products and services.
Our success will depend on our ability to compete effectively based on these factors. Further, we expect that competition will increase as other established and emerging companies enter our market and as new products, services and technologies are introduced. Increased competition may result in price reductions, lower gross margins and loss of market share. This could materially and adversely affect our business, financial condition and results of operations.
Proprietary Rights
General. Our success depends to a significant degree on the legal protection of our software and other proprietary technology rights. We rely on a combination of patent, trade secret, copyright and trademark laws and confidentiality and non-disclosure agreements with employees and third parties to establish and protect our proprietary rights. These measures may not be sufficient to protect proprietary rights, and we cannot be certain that third parties will not misappropriate our technology and use it for their own benefit. Also, most of these protections do not preclude our competitors from independently developing products with functionality or features substantially equivalent or superior to our software. Any failure to protect our intellectual property could have a material adverse effect on our business.
Licenses. Our licenses are designed to prohibit unauthorized use, copying and disclosure of our software technology. When we license our software to customers, we require license agreements containing confidentiality terms customary in the industry in order to protect our proprietary rights in the software. These agreements generally warrant that the software will materially comply with written documentation. We assert that we own or have sufficient rights in the software we distribute and have not violated the intellectual property rights of others. We license our products in a format that does not permit the users to change the software code. In addition, because we treat the source code for our products as a trade secret, all employees and third parties who require access to the source code are first required to sign non-disclosure agreements.
Patents. As of December 31, 2006, we had 13 U.S. and 3 non-U.S patents. We cannot assure you that we will file new patent, trademark or copyright applications, that any future applications will be approved, that any existing or future patents, trademarks or copyrights will adequately protect our intellectual property or that any existing or future patents, trademarks or copyrights will not be challenged by third parties.
Trademarks and service marks. As of December 31, 2006, we had 11 registered trademarks in the U.S and 7 trademarks registered internationally. We also claim common law protections for other marks we use in our business. Competitors and other companies could adopt similar marks, or try to prevent us from using our marks, consequently impeding our ability to build brand identity and possibly leading to customer confusion. We are aware of certain uses, U.S. trademark registrations, and U.S. trademark applications for our “eQuality” trademark and its variations that predate our use and the April 30, 2002 issuance of the U.S. registration for our trademark eQuality®. It is possible that the owner of legal rights resulting from one or more of these prior uses, U.S. trademark registrations, or U.S. trademark applications will bring legal action to challenge our registration of and/or our continued use of the trademark eQuality®, and may also seek compensation for damages resulting from our use of our registered trademark if such challenging party prevails on such a claim. As a result, we cannot assure you that our registration of this trademark will be undisturbed, or that this use will not result in liability for trademark infringement, trademark dilution, and/or unfair competition.
Availability of Reports and Other Information.
Our corporate Web site is http://www.witness.com. We make available on this Web site, free of charge, access to our Annual Reports on Forms 10-K, Quarterly Reports on Forms 10-Q, Current Reports on Form 8-K, Proxy Statement on Schedule 14A and amendments to those materials filed or furnished pursuant to Section 13(a) or 15(d) of the Securities and Exchange Act of 1934 as soon as reasonably practicable after we electronically submit such materials to the Securities and Exchange Commission. In addition, the Commission’s Web site is http://www.sec.gov. The Commission makes available on its Web site, free of charge, reports, proxy and information statements, and other information regarding issuers, such as us, that file electronically with the Commission. Information provided on our Web site or on the Commission’s Web site is not part of this Annual Report on Form 10-K.
Item 1A.
Item 1A. Risk Factors
Our future operating results may vary substantially from period to period. The price of our common stock will fluctuate in the future, and an investment in our common stock is subject to a variety of risks, including, but not limited to, the specific risks identified below. Inevitably, some investors in our securities will experience gains while others will experience losses depending on the prices at which they purchase and sell our securities. Prospective and existing investors should consider the following factors in evaluating our business or an investment in our securities. If any of the following or other risks actually occurs, our business, financial condition and results of operations could be adversely affected. In that case, the trading price of our common stock could decline.
Our business and operating results may be adversely affected by our proposed acquisition by Verint.
On February 11, 2007, we signed an Agreement and Plan of Merger with Verint. Pursuant to the Merger Agreement, a wholly owned subsidiary of Verint will merge with and into Witness Systems, Witness Systems will become a wholly owned subsidiary of Verint, and each outstanding share of our common stock will be exchanged for the right to receive $27.50 in cash, less any applicable withholding taxes and without interest.
The Merger is subject to several conditions, including approval by our stockholders, the expiration of applicable waiting periods under antitrust laws and certain other regulatory approvals and other customary closing conditions. We have made customary representations and warranties and covenants in the Merger Agreement, including covenants relating to obtaining the requisite approval of the Company’s stockholders and the conduct of our business between the date of the signing of the Merger Agreement and the closing of the Merger. We anticipate that the Merger will be consummated in the second quarter of 2007.
The announcement of the Merger could have an adverse effect on our revenue if customers delay, defer or cancel purchases pending consummation of the planned Merger. Current and prospective customers could be reluctant to purchase our products and services due to potential uncertainty about the combined company’s product offerings and its support and servicing of our existing products. If our announcement of the Merger causes our customers to delay purchase decisions pending consummation of the planned Merger, our business and operating results could be materially adversely affected. The uncertainty surrounding the proposed Merger may also cause employee turnover or impair our ability to add new employees to the company. Any significant employee turnover or delays in hiring forecasted positions could have an adverse effect on our business and operating results.
If our planned acquisition by Verint is not completed, our business, operating results and stock price may be adversely affected.
If the planned Merger with Verint is not completed, we could suffer a number of consequences that could adversely affect our business, operating results and stock price, including the following:
· the market price of our common stock could decline following an announcement that the Merger has been abandoned, to the extent that the current market price reflects a market assumption that the Merger will be completed;
· we could, under certain circumstances, be required to pay Verint a termination fee of approximately $35.5 million;
· we would remain liable for our costs related to the transaction, such as legal, accounting and certain investment banking fees, and we expect these costs to be significant; and
· activities relating to the Merger may divert our management’s attention from our business and cause disruptions among our employees and our relationships with customers and business partners,
thus detracting from our ability to grow revenue and minimize costs and possibly leading to a loss of revenue and market position that we may not be able to regain if the transaction does not occur.
Our operating results for 2001 to 2004 have been adversely impacted by the results of the voluntary review of our stock option practices and grants.
In connection with our recent stock options review, we restated our Consolidated Financial Statements for each of the years ended December 31, 2001 through December 31, 2005, and for the first quarter of 2006. Accordingly, you should not rely on financial information included in the reports on Form 10-K, Form 10-Q and Form 8-K previously filed by us, the related opinions of our independent registered public accounting firm, earnings press releases and similar communications issued by us, for periods ended on or before March 31, 2006, all of which have been superseded in their entirety by the information contained in our 2005 Form 10-K/A and our amended Quarterly Report on Form 10-Q/A for the three months ended March 31, 2006, each filed on February 8, 2007.
Based on the results of the stock option review, we concluded that, pursuant to Accounting Principles Board (“APB”) No. 25, Accounting for Stock Issued to Employees, and related interpretations, the accounting measurement dates for certain stock option grants, covering options to purchase approximately 4.6 million shares of our common stock, differed from the measurement dates previously used for such awards. As a result, revised measurement dates were applied to the affected option grants, and we recorded a total of $9.5 million in additional stock-based compensation expense for the years 2000 through 2005. The additional stock-based compensation expense was amortized over the service period relating to each option, typically four years, with approximately 90% of the total expense recorded in years prior to 2004.
These expenses had the effect of decreasing income from operations, net income, and net income per share (basic and diluted) in affected periods in which we reported income, and increasing loss from operations, net loss, and net loss per share in affected periods in which we reported a loss. Further information regarding the effect of the restatement on our Consolidated Financial Statements for various periods is provided in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in Part II, Item 7 of this Report.
An SEC inquiry and litigation relating to certain of our stock option grants remain pending and could have an adverse effect on our business, operating results and stock price and may divert the attention of our management and other key employees.
An informal inquiry by the SEC relating to our stock option granting practices remains pending, as does derivative and class action litigation against the Company and certain of our Board of Directors and officers. Although we believe that we have made appropriate corrections to our Consolidated Financial Statements for matters relating to stock options, we cannot rule out the possibility that these proceedings may require further adjustments to the Financial Statements and other disclosures set forth in this Annual Report on Form 10-K. In addition, these proceedings are likely to result in additional legal expense that may affect our results in future periods, and may also result in diversion of management attention and other resources, as well as fines, penalties, damages and other sanctions. The U.S. Attorney’s Office for the Northern District of Georgia has also been given access to the documents and information provided by us to the SEC. Action by the SEC, the U.S. Attorney’s Office or other governmental agencies could result in civil or criminal actions against us and/or certain of our former officers, directors and/or employees and might result in monetary and other sanctions.
As discussed in Note 14 of Notes to Consolidated Financial Statements, included in Part IV, Item 15 of this Report, civil litigation described in the preceeding paragraph includes allegations, among other, that certain of our current and former directors and officers improperly dated stock option grants to enhance
their own profits on the exercise of such options or for other improper purposes. Although we and the other defendants intend to defend these claims vigorously, there are many uncertainties associated with any litigation, and we cannot assure you that these actions will be resolved without substantial costs and/or settlement charges. We have entered into indemnification agreements with each of our present and former directors and officers. Under those agreements, we are (with certain exceptions) required to indemnify each such director or officer against expenses, including attorneys’ fees, judgments, fines and settlements, paid by such individual in connection with the pending litigation.
The resolution of the pending investigations by the SEC and U.S. Attorney’s Office, the defense of our pending civil litigation, and the defense of any additional litigation relating to our past stock option practices or the February 2007 restatement of our prior Consolidated Financial Statements could result in significant costs and diversion of the attention of management and other key employees.
The implementation of new accounting rules related to the expensing of stock-based awards negatively impacted our operating results in 2006 and is expected to continue to do so in 2007 and thereafter. Any subsequent changes in accounting rules may also have an adverse effect on our results of operations.
We adopted Statement of Financial Accounting Standards (“SFAS”) No. 123(R), Share-Based Payment, effective January 1, 2006. SFAS No. 123(R) requires all share-based payment awards to employees, including grants of stock options, restricted stock units and employee stock purchase rights, to be recognized in our Consolidated Financial Statements based on their respective grant date fair values and does not allow the previously permitted pro forma disclosure-only method as an alternative to Financial Statements recognition. The adoption of SFAS No. 123(R) may have a significant adverse impact on our reported results of operations because the stock-based compensation expense is charged directly against our reported earnings. Stock-based compensation expense and unvested stock-based compensation will increase to the extent that we increase our work force, grant additional equity awards to employees or assume unvested equity awards in connection with acquisitions.
If we fail to protect our intellectual property, third parties may use our technology for their own benefit.
Our success and ability to compete depends to a significant degree upon our proprietary technology. We rely on a combination of patent, trade secret, copyright and trademark laws and confidentiality agreements with employees and third parties to establish and protect our proprietary rights. These measures may not be sufficient to protect our proprietary rights, and we cannot be certain that third parties will not misappropriate our technology and use it for their own benefit. Also, most of these protections do not preclude our competitors from independently developing products with functionality or features substantially equivalent or superior to our software. Any infringement of our proprietary rights could negatively affect our future operating results.
As of December 31, 2006, we had 11 registered trademarks in the U.S. and 13 U.S. and 3 non-U.S patents. We cannot assure you that we will file new patent or trademark applications, that any future applications will be approved, that any existing or future patents, trademarks or copyrights will adequately protect our intellectual property or that any existing or future patents, trademarks or copyrights will not be challenged by third parties.
We are aware of certain uses, U.S. trademark registrations, and U.S. trademark applications for our “eQuality” trademark and its variations that predate our use, and the April 2002 issuance of the U.S. registration for our trademark eQuality®. It is possible that an owner of legal rights resulting from prior use, registrations, or applications will bring legal action to challenge our registration of and/or our use of the trademark eQuality®, and may also seek compensation for damages resulting from our use this trademark. As a result, we cannot assure you that our registration of this trademark will be undisturbed, or that this use will not result in liability for trademark infringement, trademark dilution, and/or unfair competition.
Moreover, the laws of certain foreign countries do not protect our intellectual property rights to the same extent as do the laws of the United States. Furthermore, policing the unauthorized use of our products is difficult, and litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets or to determine the validity and scope of the proprietary rights of others. Litigation could result in substantial costs and diversion of resources and could negatively affect our future operating results.
Claims by other companies that our software infringes their intellectual property could require us to incur substantial costs or prevent us from selling our software or services.
Third parties have in the past claimed, and it is possible that third parties will in the future claim, that we have infringed their current or future intellectual property. We expect that we and other participants in our industry will be increasingly subject to infringement claims as the number of competitors and products grows. Any claims, with or without merit, which are generally uninsurable, could be time-consuming, result in costly litigation, require us to reengineer or redevelop our software, cause product shipment delays or require us to enter into royalty or licensing agreements, any of which could negatively affect our operating results. Any efforts to reengineer our software or obtain licenses from third parties may not be successful, could be extremely costly and would likely divert valuable management and product development resources.
For example, claims have been asserted against us in lawsuits involving Knowlagent, STS and NICE (as described in Item 3, “Legal Proceedings”, of Part I). We cannot assure you that we will be successful in defending against the claims that have been asserted or any other claims that may be asserted. We also cannot assure you that such claims will not have a material adverse effect on our business, financial condition, or operations. Defending infringement claims or other claims involves substantial costs and diversion of management resources. In addition, to the extent we are not successful in defending such claims, we may be subject to injunctions with respect to the use or sale of certain of our products or to liabilities for damages to the claimants or to customers to whom we have indemnification commitments, and we may be required to obtain licenses which may not be available on reasonable terms. In addition, we cannot assure you that legal action claiming patent infringement will not be commenced against us, or that we would prevail in litigation given the complex technical issues and inherent uncertainties in patent litigation. In addition, users of our software may become subject to claims if our software is alleged to infringe the intellectual property rights of others. These software users could attempt to hold us responsible for these claims and any resulting harm they suffer. If a patent claim against us were to be successful and we could not obtain a license on acceptable terms or license a substitute technology or redesign to avoid infringement, we may be prevented from distributing our software or required to incur significant expense and delay in developing non-infringing software. Such a result could have a material adverse effect on our business, financial condition and results of operations.
Because our products have a long sales cycle, it is more difficult to plan our expenses and forecast our results; and our operating results may fail to meet investor expectations and may fluctuate materially from period to period, which may adversely affect our stock price.
It typically takes three to nine months from the time we qualify a sales lead until we sign a sales contract with the customer. As a result, it is difficult for us to predict the quarter in which a particular sale will occur. If our sales cycle unexpectedly lengthens for one or more large orders or a significant number of small orders, it would delay the timing of our revenue, but not the timing of most of our corresponding expenses. Lengthening of our sales cycle could also increase the total cost of a sale due to additional employee time and costs associated with the sale. Material changes in our sales cycle could cause our quarterly revenue or operating results to be below the expectations of investors, and the price of our common stock could fall substantially.
Our customers’ decision process regarding their purchase of our products and services is relatively long due to several factors, including:
· the complex nature of our products, requiring our need to educate potential customers about the uses and benefits of our products;
· competition for the corporate resources necessary to finance the purchase and implementation of our products;
· customers’ budgeting and purchasing cycles;
· general economic conditions;
· the extent of customers’ evaluation and internal approval process often required before purchasing our products and services; and
· delayed purchases due to announcements of new products or enhancements by our competitors or us.
If our products and services are not used and accepted by existing and prospective customers, our business and results of operations will be adversely affected.
The market for workforce optimization software, including software that records and analyzes customer interactions and that forecast and schedules employees, is still developing. Our success depends on the use and acceptance of our software and services by existing and prospective customers. In addition, demand for our software remains uncertain because our existing and potential customers may:
· not understand the benefits of using workforce optimization software generally or, more specifically, software which records and analyzes the interactions between a business and its customers or which optimizes the forecasting and scheduling of employees;
· not achieve favorable results using our software;
· experience technical difficulty in implementing our software;
· use alternative methods such as online self-help to solve the same business problems our software is intended to address; or
· close contact centers.
Our quarterly results are difficult to predict and adverse fluctuations in operating results could cause our stock price to fall.
Our quarterly revenue and operating results are difficult to predict and could fluctuate significantly from period to period. In particular, we typically derive a significant portion of our software product revenue toward the end of each quarter and from a small number of relatively large orders. The delay or failure to close anticipated sales in a particular quarter could reduce our revenue in that quarter and subsequent quarters over which revenue for the sale could be recognized. In addition, because our revenue from installation and training services largely correlates with our product revenue, a decline in product revenue could also cause a decline in our professional services revenue in the same quarter or in subsequent quarters. Our quarterly revenue is difficult to forecast for several reasons, including the following:
· changes in demand for our products and services;
· the tendency of customers to delay software purchases until the end of the fiscal quarter;
· lengthening of our customers’ budgeting and purchasing cycles;
· timing of any acquisitions and related costs;
· delays in installations of our software;
· varying sales and implementation cycles for our products and services from customer to customer;
· the failure of our customers to renew their maintenance service agreements;
· the timing of hiring new services employees and the rate at which these employees become productive; and
· the development and performance of our distribution channels.
As a result of these and other factors, we believe that quarter-to-quarter comparisons of our operating results may not be a good indicator of our future performance, and you should not rely on them to predict our future performance or the performance of our stock price. If our revenue or operating results fall below the expectations of investors or securities analysts, the price of our common stock would likely decline.
We may be unable to manage and expand our international operations, which may adversely affect our business and operating results.
We derived revenues of $97.2 million, $84.6 million and $68.1 million in 2006, 2005 and 2004, respectively, from customers located outside the United States. Our operations outside of the United States at December 31, 2006, consisted of operations located in Australia, Brazil, Canada, China, Germany, India, Japan, Mexico, the Netherlands, Singapore, South Africa and the United Kingdom. We have also established relationships with a number of international resellers.
We intend to expand our international operations through acquisitions, internal business expansion and strategic business relationships. These efforts require significant management attention and financial resources. We may not be able to successfully penetrate international markets or, if we do, we may not be able to grow or to maintain adequate profit margins in these markets. Because of the complex nature of our international expansion, it may adversely affect our business and operating results. International expansion and sales are subject to many risks, including the following:
· limited development of an international market for our software and services;
· expanding and training our international sales force and support operations;
· higher costs of employment in certain international locations;
· difficulties in producing localized versions of our products;
· political and economic instability;
· potentially adverse tax consequences of operating in foreign countries;
· international laws and regulations, including trade restrictions, local labor ordinances, changes in tariff rates and import and export licensing requirements;
· longer payment cycles and difficulties in collecting accounts receivable;
· currency fluctuations;
· cultural differences which may affect workforce performance and sales processes;
· difficulties and expenses associated with complying with a variety of foreign laws; and
· unexpected changes in regulatory requirements.
As we further expand our operations outside the United States, we will also face new competitors and competitive environments. In addition to the risks associated with our domestic competitors, foreign competitors may pose an even greater risk, because they may possess a better understanding of their local markets and have better working relationships with local infrastructure providers and others. In particular, because telephone protocols and standards are unique to each country, local competitors will have more experience with, and may have a competitive advantage in, these markets. We may not be able to obtain similar levels of knowledge, which could place us at a significant competitive disadvantage. In addition, we have limited experience in developing local language versions of our products or in marketing our products to international customers. We may not be able to successfully translate, market, sell and deliver our products internationally.
If we are unable to maintain a productive direct sales force, our business and operating results could be adversely affected.
We believe that our future success will depend on maintaining a productive direct sales force. Historically, it has taken us up to six months to train new sales personnel before they reach an acceptable level of productivity. We have also experienced difficulty in recruiting sales personnel with experience in computer and telephone integration technologies. We cannot assure you that we will be able to continue to manage turnover and hire new sales personnel to meet our needs. If the personnel we hire are less qualified than we expect, it may take us more time to train them before they reach an acceptable level of productivity, which could increase our costs and reduce our revenue.
If we are unable to expand the distribution of our products through indirect sales channels, our business and operating results could be materially adversely affected.
Our strategy is to continue to increase the proportion of customers served through indirect sales channels, such as select resellers and a variety of strategic marketing alliances. Product revenue, excluding hardware revenue, from our indirect sales channel represented approximately 44% and 41% of total product revenue in 2006 and 2005, respectively. We expect revenue from our indirect sales channel and, accordingly, our dependence on distribution partners, to increase as we establish relationships with companies to resell our software worldwide. We cannot assure you that we will be able to maintain productive relationships with our current partners, or that we will be able to establish similar relationships with additional resellers on a timely basis, if at all.
Some resellers with which we do business have similar, and often more established, relationships with our competitors, and may recommend the products and services of our competitors to customers instead of our software and services. We cannot provide assurance that these distribution partners will devote adequate resources to selling our software and services or that our resellers may not learn about our products and the market for our software and services and develop and sell competing products and services. As a result, our relationships with resellers could lead to increased competition for us.
Competition in our business could adversely affect our revenue, profitability and market share.
The market for products that record customer interactions, forecast and schedule employees, analyze performance and/or provide electronic learning is intensely competitive, evolving and is subject to rapid changes in technology. We believe our principal competitors include, but are not limited to:
· traditional call-logging vendors;
· quality monitoring suppliers to the contact center industry;
· workforce management, forecasting and scheduling vendors to the call center, branch banking and back office operations industries;
· electronic learning vendors;
· business analytics vendors;
· large telecom solution providers;
· enterprise software vendors;
· systems integrators and consulting firms; and
· new, larger and more established entities that may acquire, invest in or form joint ventures with providers of recording or performance enhancing software solutions.
Many of our current and potential competitors have longer operating histories, more established business relationships, larger customer bases, a broader range of products and services, greater name recognition and substantially greater financial, technical, marketing, personnel, management, service, support and other resources than we do. As a result, our current and potential competitors may be able to respond more quickly to new or emerging technologies and changes in customer requirements, take better advantage of acquisitions and other opportunities, devote greater resources to marketing and selling their products and services and adopt more aggressive pricing policies. We cannot assure you that our current or potential competitors will not develop products comparable or superior in terms of price and performance features to those developed by us.
In addition, many of our competitors market their products through resellers and companies that integrate their technology and products with those of the competitor. These resellers and technology partners often have strong business relationships with our customers and potential customers. For example, some of our competitors have better and more long standing relationships than we do with telephone switch vendors. Our competitors may use these business relationships to market and sell their products and compete for potential customers. It is also possible that resellers or technology partners may acquire or be acquired by one or more of our competitors, which would further solidify their business relationships.
We expect that competition will increase as other established and emerging companies enter our market and as new products, services and technologies are introduced. Increased competition may result in price reductions, lower gross margins and loss of market share, any of which could materially and adversely affect our business, financial condition and results of operations.
Our heavy reliance on sales of our recording, quality monitoring and workforce management software exposes us to risks of obsolescence due to changes in competitive product offerings.
We have derived a substantial portion of our product revenues from sales of our recording, quality monitoring and workforce management software products. We expect revenue from these products to continue to account for a significant portion of our revenue for the foreseeable future. As a result, any factors affecting the markets for these products could materially and adversely affect our business, financial condition and results of operations. We cannot assure you that the market will continue to demand our current products or those we will be successful in marketing any new or enhanced products. If our competitors release new products that are superior to our products in performance or price, demand for our products may decline. A decline in demand for our products as a result of competition, technological change or other factors would reduce our total revenues and adversely affect profitability.
If we fail to develop new software or improve our existing software, we may not remain competitive.
The markets for our products are characterized by rapidly changing technology, frequent new product introductions and enhancements, changes in customer demands and evolving industry standards. Our existing products could be rendered obsolete if we fail to continue to advance our technology. We have also found that the technological life cycles of our products are difficult to estimate, partially because of changing demands of our customers. We believe that our future success will depend on our ability to continue to enhance our current product line while we concurrently develop and introduce new products that keep pace with competitive and technological developments. These developments require us to anticipate customers’ future needs and to continue to make substantial product development investments. Although we are presently developing a number of product enhancements to our product suites, we cannot assure you that these enhancements will be completed on a timely basis or gain customer acceptance. In addition, failure to develop new software or improve existing software products may adversely affect our ability to maintain our maintenance renewal rate which could adversely affect our revenue.
Our liability to customers may be substantial if our products fail to perform properly.
Our software is used in a complex operating environment that requires its integration with computer and telephone networks and other business software applications. If our products fail to function as required, we may be subject to claims for substantial damages. Courts may not enforce provisions in our contracts that would limit our liability or otherwise protect us from liability for damages. Although we maintain general liability insurance coverage, including coverage for errors or omissions, this coverage may not continue to be available on reasonable terms or in sufficient amounts to cover claims against us. In addition, our insurer may disclaim coverage as to any future claim. If claims exceeding the available insurance coverage are successfully asserted against us, or our insurer imposes premium increases, large deductibles or co-insurance requirements on us, our business, financial position, and results of operations could be adversely affected.
If an original equipment manufacturer that is part of our indirect sales channel experiences technical difficulties, our product sales through that channel may be adversely affected.
When we sell our software through an original equipment manufacturer, or OEM, our software is embedded in the OEM’s product, which we sometimes refer to as the “environment” for our software. When the OEM’s product uses our software, there is a risk that the “environment” will fail or that it will not achieve the compatibility with our product that we and the OEM seek. If this happens, our software might not function properly, or the OEM might sell less of it, or both, which could have a material adverse effect on our revenues, operating cash flows and the growth of our business.
Our software may contain undetected errors or “bugs,” resulting in harm to our reputation and operating results.
Software products as complex as those offered by us might contain undetected errors or failures when first introduced or when new versions are released. We cannot assure you, despite testing by us and by current and prospective customers that errors will not be found in new products or product enhancements after commercial release. Any errors found may cause substantial harm to our reputation and result in a loss in revenue and additional unplanned expenses to remedy any defects.
If our advanced compliance recording applications fail to record our customers’ interactions, we may be subject to liability and our reputation may be harmed.
Many of our customers use our advanced compliance recording applications to record and store interactions with customers to provide back-up and verification of transactions and to guard against risks posed by lost or misinterpreted voice communications. These customers rely on our applications to record,
store and retrieve voice data in a timely, reliable and efficient manner. If our applications fail to record our customers’ interactions or our customers are unable to retrieve the recordings when necessary, we may be subject to liability and our reputation may be harmed.
If we are unable to maintain the security of our systems, our business, financial condition and operating results could be harmed.
The occurrence or perception of security breaches in the operation of our business or suffered by third parties using our products could harm our business, financial condition and operating results. Our customers use our products to compile and analyze highly sensitive or confidential information. We may come into contact with such information or data when we perform support or maintenance functions for our customers. While we have internal policies and procedures for employees performing these functions, the perception that we have improperly handled sensitive, confidential information could have a negative effect on our business. If, in handling this information, we fail to comply with privacy or security laws, we could incur civil liability to government agencies, customers and individuals whose privacy is compromised. If personal information is received or used from sources outside the U.S., we could be subject to civil, administrative or criminal liability under the laws of other countries. In addition, while we implement sophisticated security measures, third parties may attempt to breach our security or inappropriately use our products through computer viruses, electronic break-ins and other disruptions. If successful, confidential information may be improperly obtained and we may be subject to lawsuits and other liability. Any internal or external security breaches could harm our reputation, and even the perception of security risks, whether or not valid, could inhibit market acceptance of our products.
Fluctuations in foreign currency exchange rates could affect our financial results.
We may experience gains and losses resulting from fluctuations in currency exchange rates. Moreover, in locations where we price our products in U.S. dollars, our sales could be affected adversely by declines in foreign currencies relative to the dollar, thereby making our products more expensive in local currencies. In locations where we sell our products in local currencies, we could be competitively unable to increase our prices to reflect fluctuations in exchange rates. We do not use derivative instruments to manage our foreign exchange risk, and we cannot predict the impact that future exchange rate fluctuations may have on our results.
Certain provisions in agreements that we have entered into may expose us to liability for breach that is not limited in amount by the terms of the contract.
Certain contract provisions, principally confidentiality and indemnification obligations in certain of our license agreements, could expose us to risks of loss that, in some cases, are not limited by contract to a specified maximum amount. If we fail to perform to the standards required by these contracts, we could be subject to additional liability and our business, financial condition and results of operations could be materially and adversely affected.
If we are unable to maintain the compatibility of our software with certain other products and technologies, our future business would be adversely affected.
Our software must integrate with software and hardware solutions provided by a number of our existing and potential competitors. For example, our products must integrate with phone switches made by the telephone switch vendors and computer telephony software applications offered by other software providers. These competitors or their business partners could alter their products so that our software no longer integrates well with them, or they could delay or deny our access to software releases that allow us to timely adapt our software to integrate with their products. If we cannot adapt our software to changes in necessary technology, it may significantly impair our ability to compete effectively, particularly if our software must integrate with the software and hardware solutions of our competitors.
If our professional services employees do not provide installation services effectively and efficiently, our customers may not use our installation services or may stop using our software.
Our customers ordinarily purchase installation, training and maintenance services together with our products. The functionality of our products is not dependent on our installation and training services. We believe that the speed and quality of installation services are competitive factors in our industry. If our installation services are not satisfactory to our customers, the customers may choose not to use our installation services or they may not license our software in the future. As a result, we would lose licensing and services revenue, and it could harm our reputation. In addition, our revenues realized from the performance of maintenance services are material to our operating results, and a failure to provide adequate maintenance support to our customers would result in reduced maintenance revenues and have an adverse effect on our operating results.
We may make acquisitions or investments that are not successful and that adversely affect our ongoing operations.
We may acquire or make investments in companies, products, services and technologies that we believe complement our business and assist us in quickly bringing new products to market. We have limited experience in making acquisitions and investments. As a result, our ability to identify and evaluate prospects, complete acquisitions and properly manage the integration of businesses is relatively unproven. If we fail to properly evaluate and execute acquisitions or investments, it may have a material adverse effect on our business and operating results. In making or attempting to make acquisitions or investments, we face a number of risks, including:
· identifying suitable candidates, performing appropriate due diligence, identifying potential liabilities and negotiating acceptable terms;
· reducing our working capital and hindering our ability to expand or maintain our business, if we make acquisitions using cash;
· the potential distraction of our management, diversion of our resources and disruption of our business;
· retaining and motivating key employees of the acquired companies;
· managing operations that are distant from our current headquarters and operations;
· entering into geographic markets in which we have little or no prior experience;
· competing for acquisition opportunities with competitors that are larger than we are or have greater financial and other resources than we have;
· accurately forecasting the financial impact of a transaction;
· assuming liabilities of acquired companies, including litigation related to the operation of the business prior to the acquisition;
· maintaining good relations with the customers and suppliers of the acquired company;
· potentially dilutive issuances of securities as consideration for an acquisition;
· effectively integrating acquired companies and achieving expected synergies; and
· the impairment of the value of the assets acquired in any corporate acquisition.
If we need additional financing to maintain or expand our business, it may not be available on favorable terms, if at all.
Although we believe our current cash and borrowing capacity will be sufficient to meet our anticipated cash needs for at least the next 12 months and the foreseeable future, we may need additional funds to expand or meet all of our operating needs. If we need additional financing, we cannot be certain that it will be available to us on favorable terms, or at all. If we raise additional funds by issuing equity securities or convertible debt, the ownership interest of our stockholders could be significantly diluted, and any additional equity securities we issue may have rights, preferences or privileges senior to the rights of our stockholders. Also, the terms of any additional financing we obtain may significantly limit our future financing and operating activities. If we need funds and cannot obtain them on acceptable terms, we may be unable to:
· develop and enhance our software to remain competitive;
· take advantage of future opportunities, such as acquisitions;
· respond to changing customer needs and our competitors’ innovations; or
· attract and retain qualified key personnel.
Any of these events could significantly harm our business and financial condition and limit our growth.
Our inability to source hardware could harm our business.
A number of customers expect us to source hardware to support the implementation of our software. We seek to reduce the amount of hardware sales in the future and have transferred the fulfillment of hardware orders to third-party distributors. Thus, we are largely dependent on third parties for the supply of hardware components to our customers. If these hardware distributors experience financial, operational or quality assurance difficulties, or if there is any other disruption in our relationships, we may be required to locate alternative hardware sources. We are subject to the following risks due to our hardware distribution system:
· cancellations of orders due to unavailability of hardware;
· increased hardware prices, which may make our products less attractive; and
· additional development expense to modify our products to work with new hardware configurations.
Even if we and/or our distributors are successful in locating alternative sources of supply, alternative suppliers could increase prices significantly. In addition, alternative components may malfunction or interact with existing components in unexpected ways. The use of new suppliers and the modification of our products to function with new systems would require testing and may require further modifications, which may result in additional expense, diversion of management attention and other resources, inability to fulfill customer orders or delay in fulfillment, reduction in quality and reliability, customer dissatisfaction, and other adverse effects on our reputation, business and operating results.
We have reported material weaknesses in internal controls over financial reporting and cannot assure you that additional material weaknesses will not be identified in the future. If our internal controls over financial reporting or disclosure controls and procedures are not effective, there may be errors in our Consolidated Financials Statements that could require a restatement or our filings may not be timely and investors may lose confidence in our reported financial information, which could lead to a decline in our stock price.
The Sarbanes-Oxley Act of 2002 imposes certain duties on us and our executives, Board of Directors and attorneys. Our efforts to comply with the requirements of Section 404 have resulted in increased general and administrative expense and a diversion of management time and attention from revenue-
generating activities to compliance activities, and we expect these efforts to require the continued commitment of significant resources. We have reported material weaknesses in internal control over financial reporting which we found in connection with our evaluation of controls and procedures as of December 31, 2006. If we fail to maintain the adequacy of our internal controls, we may not be able to ensure that we can conclude on an ongoing basis that we have effective internal controls over financial reporting. Failure to maintain effective internal controls over financial reporting could result in investigation and/or sanctions by regulatory authorities, and could have a material adverse effect on our business and operating results, investor confidence in our reported financial information, and the market price of our common stock.
Our stock price has been volatile.
The market price of our common stock has been subject to significant fluctuations in response to variations in quarterly operating results and other factors. In addition, the stock market has experienced significant volatility that has particularly affected the market prices of equity securities of many technology companies and that often has been unrelated or disproportionate to the operating performance of these companies. Any announcement with respect to any adverse variance in revenue or earnings from levels generally expected by securities analysts or investors could have a significant adverse effect on the trading price of our common stock. In addition, factors such as announcements of technological innovations or new products by us, our competitors or third parties, changing conditions in the customer relationship management software market, changes in the market valuations of similar companies, loss of a major customer, additions or departures of key personnel, changes in estimates by securities analysts, announcements of extraordinary events, such as acquisitions or litigation, or general economic conditions may have an adverse effect on the market price of our common stock. With the announcement of our pending Merger with Verint pursuant to which our stockholders would receive a fixed cash price of $27.50 per share of our common stock (less any applicable withholding taxes and without interest), the market price of our common stock may depend more on developments and expectations relating to the probability and timing of completion of the Merger and may be less subject to fluctuation resulting from other changes.
Government regulation of telephone and Internet monitoring could cause a decline in the use of our software, result in increased expenses for us or subject our customers and us to liability.
As the telecommunications industry continues to evolve, state, federal and foreign governments (including supranational governmental organizations such as the European Union) and industry associations may increasingly regulate the monitoring of telecommunications and telephone and Internet monitoring and recording products, such as our software. We believe that increases in regulation could come in a number of different forms, including regulations regarding privacy, protection of personal information such as Social Security numbers, credit card information and employment. For example, the State of California enacted the Database Security Breach Act, which requires any business that suffers a computer security breach to immediately notify customers in California if personal information has been compromised, and the payment card industry has adopted regulations that require additional security regarding the storage of consumers’ credit card numbers. The adoption of any new regulations or changes to existing regulations could cause a decline in the use of our software and could result in increased expense for us as we modify our software to accommodate these regulations. Moreover, these regulations could subject our customers or us to liability. Whether or not these regulations are adopted, if we do not adequately address the privacy concerns of consumers, companies may be hesitant to use our software. If any of these events occur, it could materially and adversely affect our business.
If we are unable to attract and retain key personnel, our ability to effectively manage and grow our business would suffer.
Our success greatly depends on our ability to hire, train, retain and motivate qualified personnel, particularly in sales, marketing, research and development, service and support. We face significant competition for individuals with the skills required to perform the services we offer. If we are unable to attract and retain qualified personnel or if we experience high personnel turnover, it could prevent us from effectively managing and expanding our business.
Our success also depends upon the continued service of our executive officers. Any of our executive officers and other employees could terminate his or her relationship with us at any time. The loss of the services of our executive officers or other key personnel, particularly if lost to competitors, could materially and adversely affect our business.
Our certificate of incorporation and bylaws, as well as Delaware law, may inhibit a takeover of our company, which could limit the price investors might be willing to pay for our securities.
Should our proposed Merger with Verint not be consummated our amended and restated certificate of incorporation and bylaws, as well as Delaware law, contain provisions that might enable our management to resist a takeover of our company by some other person or entity. For example, our stockholders cannot take action by written consent or call a special meeting to remove our Board of Directors. In addition, our directors serve for staggered terms, which makes it difficult to remove all our directors at once. Further, in October 2002, our Board of Directors approved, and we implemented, a stockholder rights plan which has the effect of causing substantial dilution to a person or group that attempts to acquire us on terms not approved by the Board of Directors.
These anti-takeover provisions might discourage, delay or prevent a change in the control of our company or a change in our management. These provisions could also discourage proxy contests and make it more difficult for you and other shareholders to elect directors and take other corporate actions. The existence of these provisions could also limit the price that investors might be willing to pay in the future for our securities.
Item 1B.
Item 1B. Unresolved Staff Comments
We have not received any written comments regarding our periodic or current reports from the staff of the Securities and Exchange Commission that were issued 180 days or more before the end of our fiscal year ended December 31, 2006, and therefore no issues remain unresolved.
Item 2.
Item 2. Properties
Our principal administrative, marketing, product development, training and support facilities are located in Roswell, Georgia, a suburb of Atlanta, where we lease approximately 96,400 square feet under a lease that expires in 2007. We occupy approximately 26,000 square feet in Leatherhead, United Kingdom under a lease that expires in 2014, which includes administrative, marketing, product development and support facilities. In addition, we lease offices in the United States, Australia, Brazil, Canada, China, India, Japan, Mexico, Singapore, and the United Kingdom. We believe our facilities are in good operating conditions, suitable and adequate for our current and expected near-term requirements.
Item 3.
Item 3. Legal Proceedings
On December 11, 2002, we filed in the United States District Court for the Northern District of Georgia, Atlanta Division, a lawsuit against Knowlagent, Inc. (“Knowlagent”), which is the assignee of United States (“U.S.”) Patent Nos. 6,324,282 B1 and 6,459,787 B2. Knowlagent has accused our eQuality
Now software of infringing the above patents. We filed suit seeking a declaration that we did not and do not infringe either of the two patents listed above, as well as a declaration that the above patents are invalid and unenforceable. We also filed a claim requesting that if the patents are found to be valid, that one of our own employees be named the rightful inventor of the patents. We also requested monetary damages in an amount equal to the amount that Knowlagent has received from its use of the above patents. On December 31, 2002, Knowlagent filed its answer to our complaint as well as two counterclaims, alleging that we infringe and contribute to the infringement by others of the above patents; Knowlagent seeks both monetary damages and an injunction in connection with its counterclaim. On June 6, 2005, the Court held a claim construction hearing and issued a claim construction order on June 8, 2005. The case is now proceeding to expert discovery and summary judgment phases.
On July 20, 2004, STS Software Systems Ltd. (“STS Software”), a wholly-owned subsidiary of NICE Systems, Ltd. (“NICE Ltd.”), filed a patent infringement suit in the U.S. District Court for the Southern District of New York against us (“New York Action”). The New York Action asserts that our products, including eQuality ContactStore for IP, infringe United States (“U.S.”). Patent No. 6,122,665 (“the ‘665 patent”) and seeks only injunctive, not monetary, relief. On the same day, we filed a declaratory judgment action against STS Software in the U.S. District Court for the Northern District Georgia (“Georgia Action”). We seek a declaration from the court that we have not infringed any valid claim of the ‘665 patent. By Order entered December 16, 2004, Judge Koeltl of the U.S. District Court for the Southern District of New York granted our motion to transfer the New York Action to the Northern District of Georgia, which has now consolidated the former New York Action with the Georgia Action. On July 7, 2005, the Court also granted STS leave to amend its complaint to add three patents to the dispute, namely: U.S. Patent Nos. 6,865,604; 6,871,229; and 6,880,004 (respectively, “the ‘604 patent,” “the ‘229 patent,” and “the ‘004 patent”; collectively, “the STS patents”), again seeking solely injunctive relief. We answered the first amended complaint and asserted counterclaims on July 29, 2005, collectively, through which we deny infringement of any valid claim of the STS patents and seek a declaration to that effect. The Court entered its claim construction ruling on January 16, 2007, and the case is progressing through its remaining discovery phases.
On August 30, 2004, we filed in the United States District Court for the Northern District of Georgia, Atlanta Division, a lawsuit against NICE Systems, Inc. (“NICE Inc.”), a wholly-owned subsidiary of NICE Ltd., alleging patent infringement. Specifically, we have alleged that NICE products, including the NiceUniverse products that include screen capture and synchronized screen and voice capture technologies, infringe claims of U.S. Patent Nos. 5,790,798 (“the ‘798 Patent”) and 6,510,220 (“the ‘220 Patent”), both entitled “Method and Apparatus for Simultaneously Monitoring Computer User Screen and Telephone Activity from a Remote Location.” We have sought an injunction and money damages for NICE’s infringement of these two patents. NICE Inc. has answered and counterclaimed for declaratory judgments of non-infringement and invalidity. Since then, on February 24, 2005, we filed suit against NICE Ltd. because of its infringing activities in violation of the ‘798 and ‘220 patents, including importation of the accused NICE products. By order dated April 5, 2005, the court has consolidated the NICE Inc. and NICE Ltd. actions. The Court entered its claim construction ruling on January 5, 2007, and the case is progressing through its remaining discovery phases.
On January 19, 2006, we filed in the United States District Court for the Northern District of Georgia, Atlanta Division, a lawsuit against NICE Systems, Inc. and NICE Systems, Ltd. (collectively “NICE”), alleging patent infringement. Specifically, we have alleged that NICE products, including NicePerform and related products that include the ability to monitor communications to detect the presence of at least one predetermined parameter, infringe claims of U.S. Patent No. 6,404,857 B1 (“the ‘857 Patent”), entitled “Signal Monitoring Apparatus for Analyzing Communications.” We have sought an injunction and money damages for NICE’s infringement of the ‘857 patent. On March 6, 2006, NICE answered and
counterclaimed, alleging that the ‘857 patent is not infringed and is invalid. The case has been set on a discovery calendar and is at a preliminary stage.
On May 10, 2006, NICE Systems, Inc. and NICE Systems Ltd. (collectively “NICE”), filed a patent infringement suit seeking monetary damages and injunctive relief in the U.S. District Court for the District of Delaware against us (“Delaware Action”). The Delaware Action asserts that our products, including ContactStore, ContactStore for IP, ContactStore for Communications Manager, Quality for Communications Manager, and eQuality Balance, infringe one or more claims of ten U.S. Patents: U.S. Patent Nos. 5,274,738; 5,396,371; 5,819,005; 6,249,570; 6,728,345; 6,775,372; 6,785,370; 6,870,920; 6,959,079; and 7,010,109 (“the Delaware Patents”). We answered NICE’s complaint on June 30, 2006, through which we deny infringement of any valid claim of any of the Delaware Patents. The case has been set on a discovery calendar and is at a preliminary stage.
On December 27, 2006, NICE Systems, Inc. and NICE Systems Ltd. (collectively, “NICE”), filed a declaratory judgment action against us in the U.S. District Court for the Northern District Georgia, relating to U.S. Patent No. 6,757,361 (“the ‘361 Patent”), entitled “Signal Monitoring Apparatus Analyzing Voice Communication Content.” NICE seeks a declaration from the court that the claims of the ‘361 Patent are invalid, and that NICE has not infringed any valid claim of the ‘361 Patent. The Company has moved to dismiss or stay the case while a previously filed reissue proceeding remains pending in the Patent Office. The motion remains pending.
On August 29, 2006, A. Edward Miller filed a shareholder derivative lawsuit in the United States District Court for the Northern District of Georgia (Atlanta Division) naming Witness Systems, Inc. (the “Company”) as a nominal defendant and naming all of our current Board of Directors and a number of our current officers as defendants. Miller v. Gould, et al., Civil Action No. 1:06-CV-2039 (N.D. Ga.). The complaint alleges purported violations of federal and state law, including breaches of fiduciary duty, abuse of control, constructive fraud, corporate waste, unjust enrichment, gross mismanagement and violations of certain antifraud provisions of the federal securities laws (including Sections 10(b) and 14(a) of the Securities Exchange Act of 1934 and Rules 10b-5 and 14a-9 thereunder) in connection with certain stock option grants made by the Company. The complaint seeks monetary damages in unspecified amounts, disgorgement of profits, an accounting, rescission of stock option grants, imposition of a constructive trust over the defendants’ stock options and proceeds derived therefrom, punitive damages, reimbursement of attorneys’ fees and other costs and expenses, an order directing the Company to adopt or put to a stockholder vote various proposals relating to corporate governance, and other relief as determined by the court. On November 15, 2006, the Company and the other defendants filed a motion to dismiss the complaint in its entirety on a variety of grounds, including plaintiffs’ failure to allege demand futility. Rather than respond to that Motion, plaintiffs on January 9, 2007 filed an Amended Complaint. On March 9, 2007, the Company and the other defendants filed a motion to stay or dismiss the amended complaint.
A class action securities lawsuit has been filed by an individual on August 14, 2006 claiming to be a stockholder of the Company naming the Company and certain of its Board of Directors and officers as defendants in connection with certain stock option grants made by the Company. Rosenberg v. Gould, et al., Civil Action No. 1:06-CV-1894 (N.D. Ga.). The complaint, filed in the United States District Court for the Northern District of Georgia, alleges violations of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder and seeks unspecified damages, attorneys’ fees and other costs and expenses, unspecified extraordinary, equitable and injunctive relief, and other relief as determined by the court. A lead plaintiff has been designated, and the Amended Complaint is due on March 26, 2007. The Company and the other defendants will respond to the complaint when appropriate.
On October 27, 2006, the Company received a notice of informal nonpublic inquiry from the Securities and Exchange Commission requesting certain documents and information relating to the
company’s stock option grant practices from February 2000 to the present. We intend to cooperate fully with all matters related to this request.
On March 14, 2007, the Company was served with a complaint by Doron Aspitz, the former chief executive officer of Blue Pumpkin Software, Inc., in California Superior Court for the County of Santa Clara (Case No. 107CV078480). The complaint names the Company as defendant and purports to assert eight causes of action, for promissory estoppel, promissory fraud, negligent misrepresentation, breach of fiduciary duty, vote buying, violation of Section 17200 of the California Business and Professions Code, violation of Section 1101 of the California general Corporation Law, and unjust enrichment. The complaint purports to seek over $5.0 million in compensatory damages as well as other unquantified punitive and exemplary damages, disgorgement, and attorneys’ fees and costs. The complaint was filed on or about January 19, 2007 but no effort was made to serve the complaint until approximately mid-March 2007, and no response is presently due. The Company will respond to the complaint at an appropriate time and intends to contest the complaint vigorously.
From time to time we may be involved in other legal proceedings and/or litigation arising in the ordinary course of our business that might impact on our financial position, our results of operations, or our cash flows.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of security holders during the fourth quarter ended December 31, 2006.
PART II
Item 5.
Item 5. Market for Our Common Equity and Related Stockholder Matters and Issuer Purchases of Equity Securities
Common Stock-Listing on the Nasdaq Stock Market
Our common stock trades on the Nasdaq Stock Market under the symbol “WITS”. As of December 31, 2006, due to our delay in filing our quarterly reports on Form 10-Q for the quarters ended June 30, 2006 and September 30, 2006, we were not in compliance with the Nasdaq Stock Market filing requirements for continued listing as set forth in Marketplace Rule 4310(c)(14). We have since filed our quarterly reports on Form 10-Q for the quarters ended June 30, 2006 and September 30, 2006 and by letter dated February 15, 2007, the Nasdaq Listing Hearing and Review Council notified us of its determination that we have demonstrated compliance with all Nasdaq Marketplace Rules. The letter further states that the previously reported delisting proceedings with respect to our securities are now closed and that our securities will continue to be listed on the Nasdaq Stock Market.
The following table sets forth, the high and low sale price per share of the common stock on the Nasdaq Stock Market in each of the last eight quarters:
The closing sale price of our common stock as reported by the Nasdaq Stock Market on March 8, 2007 was $26.51.
Dividend Policy. We have not paid any cash dividends on our common stock to date. Our Board of Directors determines whether or not we will pay dividends. The Board of Directors considers a number of factors in deciding whether or not to pay dividends, including our earnings, our capital requirements and our financial condition. Currently, the Board of Directors intends to retain all earnings, if any, for use in our business operations and, accordingly, does not expect to declare or pay any dividends in the foreseeable future.
Rule 10b5-1-Trading Plans. Our Board of Directors approved an amendment to our insider trading policy to permit our officers, directors and other insiders to enter into trading plans or arrangements to sell shares of our common stock complying with Rule 10b5-1 of the Securities Exchange Act of 1934, as amended. Trading plans provide for sales, subject to price restrictions, daily limits and other contingencies, of shares of our common stock.
Holders. As of March 8, 2007, we had 118 holders of record of our common stock. We believe that we have more than 5,000 beneficial owners.
Issuer Purchases of Equity Securities
In 2002, our Board of Directors authorized a stock repurchase program to spend up to $10.0 million to repurchase our common stock. As of December 31, 2006, we had repurchased 1.0 million shares of our common stock for $3.1 million, which were retired. As at December 31, 2006, 6.9 million shares are available for repurchase, however, we have not repurchased our common stock since 2003 and do not presently plan to repurchase additional common stock.
Performance Graph
The performance graph below compares the cumulative total shareholder return on the Company’s common stock with the cumulative total return on the equity securities of companies included in the Nasdaq composite index and Research Data Group (“RDG”) Software composite index. The RDG Software composite index is comprised of over 80 publicly traded software companies including Adobe Systems, Citrix Systems, Comverse Techlology, Microsoft Corp., Oracle Corp. and SAP AG. The graph assumes an investment of $100 on December 31, 2001. We have not declared any dividends in the period represented in this performance graph. The performance graph represents past performance and is not necessarily indicative of future price performance of our common stock.
COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*
Among Witness Systems, Inc., The NASDAQ Composite Index
And The RDG Software Composite Index
* $100 invested on 12/31/01 in stock or index-including reinvestment of dividends.
Fiscal year ending December 31.
Item 6.
Item 6. Selected Financial Data
The following selected consolidated financial data should be read in conjunction with the Consolidated Financial Statements and Notes thereto and with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this report (in thousands, except for per share data):
(a) We commenced the consolidation of Demos and Exametric, Inc. on October 2, 2006.
(b) We commenced the consolidation of Blue Pumpkin Software, Inc. and Optimis Group Limited on January 25, 2005 and May 24, 2005, respectively.
(c) We commenced the consolidation of Eyretel plc on March 22, 2003.
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations is intended to provide investors with an understanding of the Company’s past performance, its financial condition and its prospects and should be read in conjunction with the Consolidated Financial Statements and Notes thereto included elsewhere in this report. Investors should carefully review the information contained in this report under Item1A “Risk Factors” beginning on page 10. The following will be discussed and analyzed:
· Stock Option Practices and Restatement of Consolidated Financial Statements
· Overview
· Critical Accounting Policies and Estimates
· Recent Accounting Pronouncements
· Results of Operations
· Liquidity and Capital Resources
Stock Option Practices and Restatement of Consolidated Financial Statements
Beginning in late May 2006, the Company’s management initiated a preliminary internal review of the Company’s historical stock option practices and related accounting treatment in response to general media attention concerning stock option grants at various public companies and shareholder interest with respect to this particular issue. On August 8, 2006, in response to the results of management’s preliminary internal review, our Board of Directors voluntarily formed a Special Committee of independent directors to review our stock option practices and grants during the period between the date of the Company’s initial public offering on February 10, 2000 and August 31, 2002. The Special Committee undertook its investigation with the assistance of independent counsel and accounting experts retained by its counsel. The Special Committee reviewed all 5.7 million stock options granted throughout the period covered by its investigation. In December 2006, the Special Committee completed its review and reported its findings and recommendations to our full Board of Directors. The Special Committee did not find fraud or intentional misrepresentation in the financial reporting of the option grants that it analyzed but found inaccuracies in the determination of measurement dates for certain stock option grants affecting the Company’s accounting and disclosures. For a number of these grants, the Special Committee found that it was likely that the stated grant date was selected in hindsight based on price given the lack of supporting documentation and that the option price was the low price in a given month or quarter. Such grants were found to be present during 2000 and through approximately mid-year 2001. The Special Committee concluded that it was not necessary to expand the investigation to cover periods after August 31, 2002. Among the various key considerations in reaching this conclusion were: 1) as noted above, the Special Committee did not find fraud or intentional misrepresentation in the financial reporting of the option grants that it analyzed; 2) the Special Committee’s investigation found that the last instance of likely grant date selection based on stock price occurred in mid-2001; and 3) the Special Committee observed that the option granting practices of the Company became more formal and regularized during the latter phase of the period subject to its review.
In addition to the Special Committee investigation, the Company, with the assistance of outside legal counsel, reviewed the Company’s stock option practices and grants for the periods subsequent to August 31, 2002. This review evaluated 90 percent of the 11.1 million options granted after August 31, 2002. The review was designed not only to provide a high degree of grant review coverage, but also to appropriately assess the propriety of measurement dates for each of the various types of options granted during this period. Among others, option grant types covered included: 1) new employee grants in
connection with the acquisition of businesses; 2) semi-annual employee ranking grants; 3) routine non-officer grants for such events as new hires, promotions, sales achievement, etc; and 4) officer grants, including grants to the Company’s then Chief Executive Officer (“CEO”). This review did not find fraud or intentional misrepresentation in the financial reporting relating to option grants but identified errors in the determination of measurement dates. However, such errors were relatively immaterial and did not exhibit evidence of selection of a favorable grant date and price in hindsight.
In those instances during the two review periods where the fair market value of our common stock at the originally stated grant date was lower than the fair market value on the redetermined measurement date, in accordance with APB No. 25 and related interpretations, we concluded that we should have recorded stock-based compensation expense which was not accounted for in our previously issued Consolidated Financial Statements.
As a result of the findings described above, our restated Consolidated Financial Statements as of December 31, 2005 reflected a cumulative decrease in net income of approximately $9.5 million for the years 2000 to 2005 due to non-cash adjustments to stock-based compensation expense. The stock-based compensation expense is primarily based on APB No. 25 which are intrinsic value based charges that are amortized over the vesting terms of the stock options. In connection with the restatement, we identified additional adjustments that needed to be recorded to our historical Consolidated Financial Statements. These adjustments consisted primarily of purchase accounting relating to acquisition of Blue Pumpkin, income taxes and miscellaneous other items. The cumulative effect of the restatement adjustments on our Consolidated Balance Sheet as of December 31, 2005 resulted in an increase in the accumulated deficit of $10.5 million, an increase in additional paid-in capital of $5.8 million and increases in assets and liabilities of $2.8 million and $7.5 million, respectively. Although there were no option measurement dating issues, our 2006 Consolidated Financial Statements are impacted by option grants in prior years where the measurement dates have been adjusted.
As a result of the Special Committee’s review, we restated our Consolidated Financial Statements for each of the years ended December 31, 2001 through December 31, 2005, and for the first quarter of 2006. Accordingly, you should not rely on financial information included in the reports on Form 10-K, Form 10-Q and Form 8-K previously filed by us, the related opinions of our independent registered public accounting firm, earnings press releases and similar communications issued by us, for periods ended on or before March 31, 2006, all of which have been superseded in their entirety by the information contained in our 2005 Form 10-K/A and our amended Quarterly Report on Form 10-Q/A for the three months ended March 31, 2006, each filed February 8, 2007.
Overview
We are a leading provider of workforce optimization software and services that help businesses capture customer intelligence and optimize their work performance. Our Impact 360 solution features quality monitoring, compliance and IP recording, workforce management, performance management and e-learning. Our quality monitoring products record multimedia interactions, including traditional voice, Web chat and email, based on user-defined business rules to enable our customers to evaluate the performance of their customer service representatives (“CSRs”) wherever they may be located in the enterprise. Our full-time compliance applications are designed to record high volume voice conversations between CSRs and customers for purposes such as compliance recording and sales verification. Our workforce management products enable our customers to develop strategic staffing plans, deploy skilled resources and evaluate productivity of CSRs in a contact center, branch bank or back office operations. Our performance management applications provide comprehensive analytics, including performance scorecards, and reports of customer interaction and CSR performance. Our e-learning applications deliver ongoing training tailored to CSR needs and competencies. We also provide consulting and implementation services, training and support to customers that use our software products. Primarily deployed in contact
centers-as well as the remote, branch and back offices of global organizations, the workforce optimization solution captures, analyzes and enables users to share and act on cross-functional information across the enterprise. With Impact 360, organizations can improve interactions and the underlying back-office processes that enhance the customer experience and build customer loyalty.
Our Impact 360 solution is an integrated offering of software products that provide comprehensive workforce optimization functionality, including quality monitoring and high-volume compliance recording, workforce management, performance management and electronic learning, or e-learning. Our quality monitoring products record multimedia interactions, including traditional voice, Web chat and email, based on user-defined business rules to enable our customers to evaluate the performance of their CSRs wherever they may be located in the enterprise. Our high-volume compliance applications are designed to record high volume, full-time performance of the voice conversations between CSRs and customers for purposes such as compliance recording and sales verification. Our workforce management products enable our customers to develop strategic staffing plans, deploy skilled resources and evaluate productivity of CSRs. Our performance management applications provide comprehensive analytics, including performance scorecards, and reports of customer interaction and CSR performance. Our e-learning applications deliver ongoing training tailored to CSR needs and competencies. We also provide consulting and implementation services, training and support to customers that use our software products.
We derive product revenue by licensing software and derive services revenue by providing related installation, training, consulting, and maintenance services. We also derive a relatively small portion of product revenue by selling hardware to customers. The majority of our product revenue is derived from recording, quality monitoring (“QM”) and workforce management (“WFM”) software. We sell our products through our direct sales force and through our indirect sales channels. Our indirect sales channels consist of distributors, resellers, systems integrators and Original Equipment Manufacturers (“OEM”). Distributors and resellers purchase product from us at a discount and then resell our products to end-users (or, in the case of distributors, to other resellers) and referral partners are paid a fee for referring sales leads to us or for assisting us in a sales order. Systems integrators are information technology (“IT”) consulting service companies who recommend our products during client engagements. Through OEM agreements, we co-develop products, which are sold by the OEM as part of their portfolio of products.
We intend to continue to expand our global sales channels by entering into new reseller, distributor, OEM and similar arrangements with key vendors in the contact center workforce optimization market. In 2006, 2005 and 2004, approximately 44%, 41% and 32%, respectively, of our license revenue has been derived from the indirect sales channel.
We plan to grow our product revenue and maintain our competitive position from a technology perspective through the timely introduction of new products, such as pre-packaged solutions, which add capabilities such as performance analysis and e-learning management to our core quality monitoring and workforce management solutions. We also believe the market shift from traditional hardware based recording to VoIP represents a significant growth opportunity and our software solutions support both of these recording environments. In addition, we believe our product offerings can be marketed toward branch-office and back-office initiatives for business process monitoring, which represents a new market for us. Factors that may impact our ability to grow our product revenue, however, include our ability to remain competitive from a technology perspective; market acceptance of our new products; our ability to maintain our product pricing integrity; and our ability to expand our global sales channels.
We also plan to grow our services revenue in concert with our product revenue. When our customers license our products, they generally purchase installation, training and one year of support services. Therefore, as we generate product revenue, we also generate related services revenue. In addition, our customers generally renew their maintenance contracts with us each year. Therefore, our maintenance revenue increases as our customer base increases. Factors that may influence our ability to grow our
services revenue, however, include our ability to continue to increase product revenues, provide services that enable and enhance our customers’ ability to improve the efficiency and effectiveness of their call center operations and our ability to maintain a high level of customer success and satisfaction.
On January 24, 2005, we acquired Blue Pumpkin Software, Inc. (“Blue Pumpkin”), a privately held California corporation. With this acquisition, we expanded our workforce optimization solution to include advanced workforce management software and services solutions including forecasting, scheduling, adherence and planning applications. Pursuant to the Merger Agreement and Plan of Reorganization, dated December 16, 2004 (the “Blue Pumpkin Merger Agreement”), we paid $36 million in cash which was funded from our existing cash and investments and issued 1.9 million shares of Witness’ common stock valued at $33.5 million (measured based on the date the stock consideration became fixed pursuant to the application of a formula specified in the Blue Pumpkin Merger Agreement). On May 24, 2005, the shares issued in connection with the acquisition were registered for resale with the Securities and Exchange Commission. Pursuant to the Blue Pumpkin Merger Agreement, cash of $4 million and 210,000 shares of common stock valued at approximately $3.7 million on the date of acquisition were placed into escrow and was released to Witness during the month of March 2006 in satisfaction and settlement of claims that Witness brought against the escrow fund, including claims from the settlement of IEX Corporations’s (“IEX”) litigation. See Note 5 of the Consolidated Financial Statements included elsewhere in this report for discussion of the Blue Pumpkin acquisition.
On May 23, 2005, we acquired Optimis Group Limited (“Optimis”), a UK-based provider of workforce optimization software solutions. Blue Pumpkin owned a minority interest in an operating subsidiary of Optimis, the balance of which was acquired through the Optimis acquisition. We paid $5.0 million in cash and other consideration that was financed from our existing cash and investments. Ten percent of the aggregate acquisition consideration was held in escrow and was released in August 2006.
On October 2, 2006, we acquired Exametric, a leading software solutions company specializing in workforce management and optimization for the financial services industry. The total consideration paid for Exametric was cash of approximately $23 million. Approximately $2.4 million of the aggregate consideration will be held in escrow until October 2, 2007, or longer, if claims are brought against the escrow fund and remain pending on that date. The escrow fund will be available to indemnify Witness for losses resulting from, among other things, breaches of representations, warranties, covenants and certain transaction costs.
On October 2, 2006, we acquired Demos, a leading productivity solution provider for the financial services industry. The total purchase consideration in 2006 for Demos was cash of approximately $6.3 million, including $0.3 million earned in 2006 as part of the potential for an earn-out of approximately $18.0 million based on the growth of the business over the next several years. Ten percent (10%) of the initial consideration plus ten percent (10%) of any earn-out earned will be held in escrow until October 2, 2007, or longer, if claims are brought against the escrow fund and remain pending on that date. The escrow fund will be available to indemnify Witness for losses resulting from, among other things, breaches of representations, warranties and covenants.
During 2006, 2005 and 2004, 44%, 46% and 48%, respectively, of our revenue was derived from customers outside the United States. We had 838 full-time employees, excluding approximately 93 contractors located in the Asia-Pacific region, at December 31, 2006, compared to 619 at December 31, 2005 and 485 at December 31, 2004. As of December 31, 2006, 316 full-time employees were located outside the United States.
Critical Accounting Policies and Estimates
The discussion and analysis of our financial condition and results of operations is based upon our Consolidated Financial Statements, which have been prepared in accordance with accounting principles
generally accepted in the United States of America. The preparation of these Consolidated Financial Statements requires us to make certain estimates and judgments that affect our reported assets, liabilities, revenue and expenses, and our related disclosure of contingent assets and liabilities. On an on-going basis, we re-evaluate our estimates, accounting policies and judgments including those related to revenue recognition, the collectibility of receivables, accounting for acquisitions, impairment of long-lived assets, income taxes and stock-based compensation to ensure that our Consolidated Financial Statements are presented fairly and in accordance with generally accepted accounting Principles. We base our estimates on historical experience and on various assumptions that we believe to be reasonable under the circumstances. However, because future events and their effects cannot be determined with certainty, actual results may differ from these estimates under different assumptions or conditions and such differences could be material. Management believes that the following accounting policies and estimates are critical to understanding and evaluating our reported financial results. Management has reviewed these critical accounting policies and estimates with the Audit Committee of our Board of Directors.
Revenue Recognition. We recognize revenue in accordance with the American Institute of Certified Public Accountants’ Statement of Position (“SOP”) No. 97-2, Software Revenue Recognition, and SOP No. 98-9, Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions and Emerging Issues Task Force (“EITF”) No. 00-21, Revenue Arrangements with Multiple Deliverables. Revenue is primarily derived from licensing software and providing related services including maintenance. We also derive a relatively small portion of product revenue by selling hardware to customers. Product revenue, which includes software and hardware, is recognized when persuasive evidence of an arrangement exists, delivery of the product has occurred, the fee is fixed or determinable, collection is probable and vendor specific objective evidence of fair value (“VSOE”) exists to allocate revenue to the undelivered elements of the arrangement. We report hardware revenue gross in accordance with EITF No. 99-19, Reporting Revenue Gross as a Principal versus Net as an Agent, because the factors indicating gross reporting outweigh the factors indicating net reporting. We recognize revenue using the residual method of accounting since we generally have VSOE for maintenance and professional services, but not for the software and hardware elements of the order. Under the residual method, services revenue, including maintenance and professional services, is deferred at an amount equal to its fair value until those elements are delivered. Consequently, product revenue for the software and hardware is recognized (i) upon delivery of those products when we have VSOE for the related maintenance and professional services sold and (ii) at an amount representing the difference between the total order amount and the amount deferred. For customer orders that include hardware, hardware revenue is accounted for as a separate unit of accounting in accordance with guidance provided in EITF 00-21.
Services revenue includes installation, training, consulting, maintenance and reimbursable travel expenses. Revenue from installation, training and consulting services is recognized upon performance of the related services and is offered and billed as separate elements of contracts. Reimbursable travel expenses revenue is recognized upon incurrence of the related expenses. The functionality of the software and any hardware sold is not dependent on installation and training services and customization is not required to enable our customers to use our products. Maintenance is offered as a separate element and the majority of contracts include the right to unspecified upgrades on a when-and-if available basis. Maintenance revenue is deferred and recognized ratably over the term of the related contract.
Allowance for Doubtful Accounts. We perform ongoing evaluations of our customers and continuously monitor collections and payments and estimate an allowance for doubtful accounts based on the aging of the underlying receivables, our historical experience with write-offs and any specific customer collection issues that we have identified. While such credit losses have historically been within our expectations and we believe appropriate reserves have been established, we cannot assure that we will continue to experience the same credit loss rates that we have experienced in the past or adequately predict future credit losses. If the financial condition of our customers were to deteriorate and resulted in
an impairment of their ability to make payments, additional allowances may be required which would result in an additional selling, general and administrative expense in the period such determination is made.
Our revenue recognition policy is significant because our revenues are a key component of our results of operations. We follow very specific and detailed guidelines, discussed above, in measuring revenues; however, certain judgments and estimates affect the application of our revenue policy described above. Further, assessment of collectibility is particularly critical in determining whether or not revenues should be recognized. We also record provisions for estimated sales allowances on product and service related revenues at the time the related revenues are recorded. These estimates are based on historical sales and services allowances, analysis of customer credits and other known factors. If future sales credits prove to be greater than the historical data and the estimates we used to calculate these provisions, our revenues could be overstated.
Accounting for Acquisitions. Accounting for acquisitions requires management to make judgments and estimates in determining the purchase price, the fair value of the assets and liabilities acquired and merger-related and integration costs. In recording the Blue Pumpkin and Optimis acquisitions in 2005 and the Demos and Exametric acquisitions in 2006, significant judgment was required in estimating:
· valuation of deferred revenue,
· valuation of intangible assets and acquired in-process research and development, and
· other liabilities existing at the time of acquisition.
Changes to purchase price estimates, including contingent purchase price earn-outs, are reflected as adjustments to goodwill and/or other acquired assets to the extent information was requested but not received at the date of acquisition. Other adjustments are reflected in our results of operations. In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 142, Goodwill and Other Intangible Assets, goodwill and intangible assets with indefinite useful lives are not amortized, but are tested for impairment annually or more frequently if circumstances indicate their value may no longer be recoverable.
Impairment of Long-Lived Assets. Long-lived assets, such as property and equipment and intangible assets, are accounted for in accordance with SFAS No. 144, Accounting for Impairment or Disposal of Long-lived Assets and are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. All of our identifiable intangible assets are amortized using the straight-line method. Useful lives of amortizable intangible assets are reviewed annually with any changes in estimated useful lives being accounted for prospectively over the revised remaining useful life. Recoverability of assets to be held and used would be measured by a comparison of the carrying amount of an asset to the estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated undiscounted future cash flows, an impairment charge is recognized in the amount by which the carrying amount of the asset exceeds the fair value of the asset. The determination of estimated future cash flows, however, requires management to make estimates. Future events and changes in circumstances may require us to record a significant impairment charge in the period in which such events or changes occur. Impairment testing requires considerable analysis and judgment in determining the results. If other assumptions and estimates were used in our evaluations, the results could differ significantly.
Accounting for Income Taxes. We account for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes, which requires recognition of deferred income tax assets and liabilities for temporary differences between the financial reporting and tax bases of recorded assets and liabilities and the expected benefits of net operating loss and credit carry forwards. SFAS No. 109 requires that deferred income tax assets be reduced by a valuation allowance if it is more likely than not that some portion or all
of the deferred income tax assets will not be realized. Historically, we have provided a complete valuation allowance against the deferred income tax asset. We evaluate the realizability of our deferred income tax assets, primarily resulting from net operating loss and credit carry forwards, and adjust our valuation allowance, if necessary.
As of December 31, 2006, we eliminated $7.3 million of the valuation allowance related to deferred income tax assets in the UK. The utilization of deferred tax assets, primarily net operating loss carry forwards arising from acquisitions, results in a reduction in goodwill and the recognition of tax expense associated with the purchased deferred tax assets.
The utilization of net operating loss carry forwards generated by the tax deduction for stock option exercises results in an increase to additional-paid-in-capital and the recognition of tax expense. Under SFAS No. 123(R), Share-Based Payment, the realization of tax benefits resulting from stock option exercises results in an increase to additional-paid-in-capital and the recognition of tax expense. Under SFAS No. 123(R), we will continue to follow the with-and-without approach and consider the impact of excess stock option deductions last when computing our income tax provision. Due to the existence of net operating loss carry forwards, $5.0 million of income tax benefits originating from stock option deductions have not reduced taxes payable and, therefore, have not been realized or recorded in 2006.
Estimates and judgments are required in determining our worldwide income tax provision. In the ordinary course of conducting business globally, there are many transactions and calculations whose ultimate tax outcome cannot be certain. Although we believe our estimates and judgments are reasonable, no assurance can be given that the final tax outcome of these matters will not be different from what is reflected in our historical income tax provisions and accruals. Such differences could have a material impact on our income tax provision and operating results in the period in which such a determination is made.
Stock-Based Compensation. On January 1, 2006, we adopted SFAS No.123(R), which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees including employee stock options and shares made available through the employee stock purchase plan based on the grant date fair value of those awards. We determine the fair value of share-based payment awards on the date of grant using Black-Scholes option-pricing model. The fair value of share-based awards is affected by stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, our expected stock price volatility over the term of the awards, and actual and projected employee stock option exercise behavior. SFAS No. 123(R) also requires that forfeitures be estimated over the vesting period of an award, rather than being recognized as a reduction of compensation expense when the forfeiture actually occurs. We adopted SFAS No. 123(R) using the modified prospective transition method. Our Consolidated Financial Statements as of and for the year ended December 31, 2006 reflect the impact of SFAS No. 123(R).
In accordance with the modified prospective transition method, our Consolidated Financial Statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS No. 123(R). This statement requires us to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in our Consolidated Statement of Operations. Stock-based compensation expense recognized under SFAS No. 123(R) for the year ended December 31, 2006 was $13.8 million. Prior to the adoption of SFAS No. 123(R), we accounted for stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board (“APB”) No. 25, Accounting for Stock Issued to Employees, as allowed under SFAS No. 123, Accounting for Stock-Based Compensation.
On November 10, 2005, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position No. FSP123(R)-3, Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards. We elected to adopt the alternative transition method provided in the FSP for calculating the tax effects of stock-based compensation pursuant to SFAS No. 123(R). The alternative transition method includes simplified methods to establish the beginning balance of the additional-paid-in capital pool (“APIC pool”) related to the tax effects of employee stock-based compensation, and to determine the subsequent impact on the APIC pool and the Consolidated Statement of Cash Flows of the tax effects of employee stock-based compensation awards that were outstanding upon adoption of SFAS No. 123(R).
Recent Accounting Pronouncements
In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 108 (“SAB 108”) Financial Statements-Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements, effective for fiscal years ending after November 15, 2006. SAB 108 requires the utilization of a dual-approach to assessing the quantitative effects of financial misstatements. This dual-approach includes both an income statement assessment and a balance sheet assessment. Upon our adoption of SAB 108 as of December 31, 2006, we determined that we needed to record a $1.4 million cumulative adjustment, net of tax of $0.5 million, to decrease our opening accumulated deficit balance for the year 2006. This adjustment was to correct certain prior year differences that had previously been considered immaterial to the 2005 and 2004 Consolidated Financial Statements. See Note 1, “Summary of Significant Accounting Policies,” of the Notes to the Consolidated Financial Statements included elsewhere in this report for discussion of Recent Accounting Pronouncements.
Results of Operations
The table below shows operating data as a percentage of total revenue for the periods indicated:
Impact of Demos, Exametric, Blue Pumpkin and Optimis Acquisitions
The acquisition of Demos and Exametric in 2006 increased our reported revenues in 2006 by an estimated $4.5 million. Operating expenses, expressed as a percentage of total revenue, increased in 2006 compared to the same period in 2005 due to a charge of $0.8 million in acquired in-process research and development costs, an increase of $0.5 million in merger-related and integration costs and additional intangible asset amortization of $0.9 million, all related to these 2006 acquisitions.
The acquisition of Blue Pumpkin and Optimis in 2005 increased our reported revenues in 2005 by an estimated $25 million. Operating expenses increased in 2005 compared to the same period in 2004 due to a charge of $9.0 million in acquired in-process research and development costs, an increase of $3.7 million in merger-related and integration costs and additional intangible asset amortization of $9.3 million, all related to these 2005 acquisitions.
Total revenue
Total revenue increased by 20% to $221.8 million in 2006 compared to 2005 and 31% to $185.3 million in 2005 compared to 2004. The increase in total revenue can be attributed to acquisitions and the continued growth of our business. Effective April 1, 2006, we began recognizing revenue from one OEM partner upon receipt of valid purchase orders versus royalty reports because it was determined, based on the Company’s historical experience with this particular partner, that fixed and determinable pricing exists at the time the order is placed by the partner. The number of installed customer sites grew to 4,700 sites at the end of 2006 from 4,209 sites at the end of 2005 and 2,799 sites at the end of 2004. International revenue increased 15% in 2006 compared to 2005 and 24% in 2005 compared to 2004.
Product revenue
Product revenue includes hardware and software revenue. Although hardware sales are incidental to our business, we expect that we will continue to sell hardware to our existing customers as well as to new customers whose preference is to make joint purchases of hardware and software. It is difficult to estimate future hardware revenue due to its incidental nature.
Product revenue, excluding hardware revenue of $8.0 million in 2006, $5.7 million in 2005 and $7.6 million in 2004, increased 14% and 37% in 2006 and 2005, respectively, compared to prior years. The increase in software revenue growth in 2006 is largely attributed to our expanded product line, particularly Impact 360, as well as additional revenue recognized from the indirect sales channel. Our Impact 360 solution consists of software products and services designed to optimize the workforce, processes and technology involved in the customer service function. We periodically review our revenue recognition policy with regard to our indirect sales channel in order to account for current trends surrounding collectability.
Product revenue as a percentage of total revenue has decreased slightly over the past three years due to increased services revenue, as discussed below. Our product pricing has remained relatively consistent over the past three years. The percentage of product revenue, excluding hardware revenue, derived from our indirect sales channel increased to 44% in 2006 from 41% in 2005 and 32% in 2004. This increase results from our strategy to expand our indirect sales channels.
New customers accounted for 18%, 25% and 22%, respectively, of product revenue, excluding hardware revenue, in 2006, 2005 and 2004, with the balance of revenue representing follow-on revenue from our existing customer base. We receive follow-on revenue from our customers when they purchase additional user licenses or license additional applications at existing sites and when they license our products at new sites. We expect to generate the majority of our product revenue from existing customers during 2007.
Services revenue
Services revenue, consisting of installation, training, consulting, maintenance support and reimbursable travel expenses, increased 22% to $135.9 million in 2006 compared to 2005 and 33% to $111.1 million in 2005 compared to 2004. The increases were due to installation and training services related to new product sales and to customers renewing their maintenance contracts with us thereby increasing our recurring maintenance revenue stream. The percentage of Witness customers that have renewed their maintenance contracts with us has historically exceeded 90%. We believe that maintenance contracts will be renewed at a comparable rate during 2007. Our services pricing has remained consistent over the past three years. We expect services revenue, in absolute dollars, to increase over time due to the compounding effect of renewals of annual maintenance contracts from existing customer sites and to remain relatively constant as a percentage of total revenue, excluding hardware revenue, in 2007.
Total cost of revenue
Total cost of revenue increased 16% to $71.5 million in 2006 compared to 2005 and 32% to $61.5 million in 2005 compared to 2004. Expressed as a percent of revenue, gross profit margins were 68% in 2006 and 67% in 2005 and 2004. The increase in gross profit margin in 2006 resulted primarily from productivity gains achieved in the professional services organization, offset by an inclusion of stock-based compensation expense of $2.2 million. Excluding hardware, stock-based compensation and the amortization of intangible assets resulting from acquisitions, gross profit margins have remained consistent at 74% in 2006, 2005 and 2004. We expect our gross profit margin, excluding hardware and amortization of intangible assets, to remain relatively constant in 2007.
Cost of product revenue
Cost of product revenue consists of amortization of acquired technology, hardware costs, royalties due to third parties for software components that are embedded in our software applications, amortization of capitalized software development costs and packaging costs. Amortization of acquired technology was $7.4 million in 2006 and $9.2 million in 2005 and $4.4 million in 2004. The decrease in amortization in 2006 was attributable to a portion of the technology acquired in the 2003 Eyretel acquisition becoming fully amortized during the year. The increase in the amortization of acquired technology in 2005 was largely due to the acquisition of Blue Pumpkin.
Cost of hardware revenue was $8.1 million $5.8 million and $7.3 million in 2006, 2005 and 2004, respectively. The increase in cost of hardware revenue in 2006 corresponds to the increase in hardware product revenue in 2006. Cost of software revenue, decreased 19% in 2006 compared to 2005 and increased 24% in 2005 compared to 2004. The year-over-year cost of software revenue fluctuation results from the royalties due to third parties for software included in our product offerings which vary period-over-period in proportion to the sales of certain software products. Expressed as a percentage of software revenue, the cost of software revenue was 4%, 6% and 4% in 2006, 2005 and 2004, respectively. As we develop upgrades of our existing products and add new offerings to our product suite, we may add additional third-party technology into our products, which would increase the cost of software revenue in the future.
Cost of services revenue
Cost of services revenue for installation, training, consulting and maintenance services include personnel costs and related expenses and allocated overhead. Personnel costs include salaries, bonuses, stock-based compensation and benefits. Cost of services revenue increased 24% to $52.7 million in 2006 compared to 2005. The increase in 2006 is consistent with the increase in services revenue and is due primarily to an increase in the number of employees engaged in customer support services and the
inclusion of $2.2 million stock-based compensation expense. Cost of services revenue increased 30% to $42.4 million in 2005 compared to 2004 due primarily to an increase in the number of employees and contractors engaged in customer support services mainly as a result of the Blue Pumpkin and Optimis acquisitions. Cost of services revenue as a percentage of services revenue was 39%, 38% and 39% in 2006, 2005 and 2004, respectively. We anticipate that our services margins will remain relatively constant in 2007. We expect our customer service organization to continue to grow over time and, therefore, we anticipate that our cost of services revenue, in absolute dollars, will increase as we grow our customer base.
Operating Expenses
Selling, General and Administrative. Selling, general and administrative (“SG&A”) expense consists primarily of personnel costs, sales commissions, marketing programs, professional fees, the amortization of certain intangibles, stock-based compensation expense and provisions for bad debt expense. SG&A expense increased 34% to $115.0 million in 2006 compared to 2005 due to the inclusion of $9.2 million stock-based compensation expense, an increase in legal and professional fees, accrued expense associated with severance to be paid to the former CEO and higher staffing levels. Legal and professional fees in 2006 include $5.5 million related to the stock option review matter. We have Directors and Officers insurance coverage that is provided for defense fees and costs incurred in connection with the class action and derivative action (the “litigation”) made against Witness as a result of the stock option review matter. However, in accordance with SFAS No. 5, Accounting for Contingencies, we have concluded that an insurance reimbursement receivable cannot be recorded at this time due to uncertainties relating to the recovery that is neither probable nor estimatable as of December 31, 2006. SG&A expense increased 31% to $86.0 million in 2005 compared to 2004 due primarily to higher amortization expenses and the increased size of our Company after the acquisitions of Blue Pumpkin and Optimis.
Research and Development. Research and development (“R&D”) expense consists primarily of personnel and consulting costs to support product development, and allocated overhead. R&D costs are generally expensed as incurred and include software development costs incurred prior to the establishment of technological feasibility. Costs incurred subsequent to establishing technological feasibility are capitalized and amortized over their estimated useful lives to cost of product revenue. As of December 31, 2006 and 2005, $0.7 million and $0.5 million, respectively, in software development costs were capitalized of which $0.6 million and $0.5 million were amortized to cost of product revenue in 2006 and 2005, respectively. R&D expense increased 25% to $33.3 million in 2006 compared to 2005, primarily due to the increased number of employees engaged in research and development activities and the inclusion of $2.4 million stock-based compensation expense in 2006. R&D expense increased 28% to $26.7 million in 2005 compared to 2004 primarily due to the increased number of employees engaged in research and development activities as a result of the Blue Pumpkin acquisition. We expect total R&D expense to increase in absolute dollars but decrease as a percentage of total revenue during 2007 as compared to 2006.
Merger-Related and Integration Costs. We incurred merger-related and integration costs of $2.7 million in 2006, primarily due to the Blue Pumpkin, Demos and Exametric acquisitions. We incurred merger-related and integration costs of $4.5 million in 2005 due to the Blue Pumpkin and Optimis acquisitions, and $0.5 million during 2004 due to the Eyretel acquisition. The 2006 and 2005 merger-related and integration costs are comprised primarily of costs of transitional employees and other contractors, travel, legal and advertising costs.
Acquired In-Process Research and Development. During 2006 and 2005, we estimated that $0.8 million and $9.0 million of the purchase price of Exametric and Blue Pumpkin, respectively, represented acquired in-process research and development (“IPR&D”) that had not yet reached technological feasibility as defined by SFAS No. 86, Accounting for the Cost of Computer Software to Be Sold, Leased or Otherwise Marketed, and had no alternative future use. Accordingly, these amounts were immediately charged to expense upon consummation of the acquisition. The value of the IPR&D was determined with
the assistance of an independent third-party appraiser by utilizing a discounted cash flow methodology, focusing on the income-producing capabilities of the in-process technologies and taking into consideration: stage of completion; complexity of work to date and to complete; anticipated product development and introduction schedules; forecasted product sales cycles; internal and external risk factors; revenue and operating expense estimates; contributory asset charges, and costs already incurred and the expected costs to complete.
Interest and Other Income, Net
Interest and other income, net for year 2006, 2005 and 2004, respectively is as follows (in thousands):
The increase in interest income in 2006 is due to higher cash and investment balances resulting from our sale of additional common stock in December 2005. Higher foreign currency losses in 2006 resulted from a weakening U.S dollar against other currencies, particularly the British pound sterling.
Provision for Income Taxes
We recorded a provision for federal alternative minimum tax, deferred taxes and foreign income tax in 2006, a provision for federal alternative minimum tax and foreign income tax in 2005, and a provision for foreign income tax in 2004, net of federal tax benefits. Of the ($3.8) million provision benefit for the year ended December 31, 2006, ($4.7) million relates to the provision for foreign deferred taxes. Specifically, ($4.4) million relates to the release of the valuation allowance for deferred tax assets of the Company’s primary U.K. subsidiary, Witness Systems Ltd. The remaining $0.6 million of the tax provision relates primarily to current federal alternative minimum tax, current foreign taxes, and customer withholding tax.
The provision for income taxes in 2006, 2005 and 2004 benefited from the utilization of net operating loss carryforwards from prior years. We have net operating loss carry forwards aggregating $78.1 million for U.S. income tax purposes and $31.0 million for foreign income tax purposes remaining as of December 31, 2006. We expect that the provision for income taxes in 2007 will benefit from the utilization of these net operating loss carry forwards. However, the utilization of certain net operating loss carry forwards arising from acquisitions may result in the recognition of deferred income tax expense.
Quarterly Results of Operations
The following tables present unaudited quarterly statements of operations data for each of the last eight quarters in the two-year period ended December 31, 2006, as well as the percentage of total revenue represented by each item. The information has been derived from our unaudited Consolidated Financial Statements, which have been prepared on substantially the same basis as the audited Consolidated Financial Statements contained in this report. The unaudited Consolidated Financial Statements contain all adjustments, consisting only of normal recurring adjustments that we consider to be necessary to present fairly this information when read in conjunction with the Consolidated Financial Statements and Notes thereto appearing elsewhere in this report. The results of operations for any quarter are not necessarily indicative of the results to be expected for any future period.
(a) We commenced the consolidation of Demos and Exametric on October 2, 2006.
(b) We commenced the consolidation of Blue Pumpkin Software, Inc and Optimis on January 25, 2005 and May 23, 2005, respectively.
(a) We commenced the consolidation of Demos and Exametric on October 2, 2006.
(b) We commenced the consolidation of Blue Pumpkin Software, Inc and Optimis on January 25, 2005 and May 23, 2005, respectively.
The increase in total revenue in the fourth quarter of 2006 reflects the consolidation of Demos and Exametric, which were acquired in October 2006. The increase in total revenue, beginning in the first and second quarters of 2005, reflects the consolidation of Blue Pumpkin and Optimis, which were acquired in January and May 2005, respectively. Our second and fourth quarters generally have higher product revenue than the first and third quarters due to our customers’ budgeting and spending patterns.
Our quarterly operating results, particularly product revenues, have experienced significant fluctuations in the past, and we expect that this pattern will continue in the future. For instance, quarterly results may fluctuate based on the timing of sales due to customer calendar-year budgeting cycles, slow summer purchasing patterns and compensation policies that tend to compensate sales personnel, typically in the latter half of the year, for achieving annual quotas. As a result of the foregoing and other factors, we believe that quarter-to-quarter comparisons of results are not necessarily meaningful, and such comparisons should not be relied upon as indications of future performance.
Liquidity and Capital Resources
In March 2007, we reduced our line of credit from $15.0 million to $2.0 million and extended the maturity date on the $2.0 million line of credit to March 2008. At our election, borrowings under the line of credit bear interest at the bank’s prime rate, which was 8.25% on December 31, 2006, or LIBOR plus
300 basis points. Borrowings under the revolving line of credit are limited to 85% of eligible accounts receivable, as defined by the agreement. The revolving line of credit is secured by all of our assets and requires compliance with various covenants, including liquidity ratios and EBITDA requirements, among others. As of December 31, 2006, we were in compliance with all bank covenants.
As of December 31, 2006, we had no amounts outstanding under the line of credit and the amount available for borrowing was $14.0 million, which was net of outstanding letters of credit of $1.0 million. The letters of credit secure the lease on our corporate headquarters facility and have decreasing schedules that ultimately expire in 2007. In addition, we have a £0.3 million ($0.6 million) letter of credit securing our premises leased in the United Kingdom.
We anticipate spending at least $8.0 million in capital expenditures in 2007 primarily for computer equipment and software. We believe that our capital expenditures may increase over the next several years as we expand our facilities and acquire equipment to support the expansion of our research and development activities and internal management and information systems. We believe that our existing cash and investment balances, together with our anticipated cash flows from operations, will be sufficient to meet our working capital and capital expenditures for at least the next twelve months.
On February 11, 2007, we entered into a definitive agreement under which Verint will acquire Witness for $27.50 per share in cash, less any applicable withholding taxes, without interest. Verint currently expects to fund the Merger through up to $650 million in senior secured debt financing from Lehman Brothers, Deutsche Bank, Credit Suisse and certain of its affiliates. Comverse Technology, the 57% majority stockholder in Verint, has committed to finance up to $293 million of the purchase price through the purchase of additional equity in Verint in the form of preferred stock. The remainder will be paid for with existing cash from the combined company. The Merger is expected to close in the second quarter of 2007, pending approvals from regulators and Witness stockholders.
The restatement of our Consolidated Financial Statements, as a result of the findings of our stock option review and certain other matters, did not materially or adversely affect our liquidity or capital resources.
Market Risk
Our market risk exposure primarily relates to fluctuations in foreign exchange rates and interest rates. As of December 31, 2006, we have not entered into derivative or hedging transactions to manage risk in connection with such fluctuations. Due to the relative strength of foreign currencies compared to the U.S. dollar during 2006 and 2004, foreign currency translations contributed $2.5 million and $3.4 million to our cash balances at December 31, 2006 and 2004, respectively. Due to the relative weakness of foreign currencies compared to the U.S. dollar, the translation of our subsidiaries cash denominated in foreign currencies reduced our 2005 cash balances by $2.3 million. Within our foreign-based operations, where transactions may be denominated in foreign currencies, we are subject to market risk with respect to fluctuations in the relative value of currencies. Currently, we have foreign-based operations in Australia, Brazil, Canada, China, Germany, India, Japan, Mexico, the Netherlands, Singapore, South Africa and the United Kingdom that conduct transactions in either the local currency of the location or U.S. dollars. We are exposed to adverse movements in foreign currency exchange rates because we translate foreign currencies into U.S. dollars for reporting purposes. Cumulative translation adjustment changes resulted in an increase of $3.4 million and a decrease of $1.9 million in stockholders’ equity in 2006 and 2005, respectively. Net foreign exchange (losses) gains reflected in our operating results were ($1.0) million, ($0.2) million and $0.3 million in 2006, 2005 and 2004, respectively.
Exposure to market rate risk for changes in interest rates relates to our investment portfolio and any potential borrowing. Our investments are made with capital preservation and liquidity as our primary objectives. We generally hold only high-grade investments such as commercial paper, corporate bonds,
auction rate securities and U.S. government agency securities. To reduce our Balance Sheet exposure to variations in asset values, our investment policy guidelines specify that we invest in the highest investment grade securities and maintain a weighted average maturity of nine months or less for our entire portfolio. Our investment portfolio may contain securities with maturities of up to three years. While this minimizes our interest rate risk to asset values, our results are exposed to fluctuations in interest income due to changes in market rates.
Contractual Obligations and Off Balance Sheet Arrangements
As of December 31, 2006, our contractual cash obligations associated with lease obligations is as follows (in thousands):
We entered into a software licensing agreement in 2005 which requires us to pay an additional $1.3 million in 2007 for the right to distribute a vendor’s software as part of our workforce optimization solution. This amount has been recorded as an accrued liability as of December 31, 2006. Imputed interest expense associated with the payment is not significant.
On April 6, 2006, Blue Pumpkin and IEX reached an agreement to settle all claims asserted between the two companies. As part of the final settlement, Witness paid $8.25 million to IEX’s parent company in April 2006 and agreed to make six annual payments of $0.5 million ($3.0 million in total) from April 2007 through 2012.
On October 2, 2006, we acquired Demos, a leading productivity solution provider for the financial services industry. The total purchase consideration in 2006 for Demos was cash of approximately $6.3 million, including $0.3 million earned in 2006 as part of the potential for an earn-out of approximately $18 million based on the growth of the business over the next several years.
As of December 31, 2006, we did not have any other material contractual commitments or any off-balance sheet arrangements.
Item 7A.
Item 7A. Qualitative and Quantitative Disclosures About Market Risk
See Management’s Discussion and Analysis of Financial Condition and Results of Operations, Item 7 of Part II of this Annual Report for a discussion of market risk.
Item 8.
Item 8. Financial Statements and Supplementary Data
Our Consolidated Financial Statements, together with related notes and the reports of KPMG LLP, our independent registered public accounting firm, are set forth on the pages indicated in Item 15.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures
None.
Item 9A.
Item 9A. Controls and Procedures.
Evaluation of Disclosure Controls and Procedures. We maintain disclosure controls and procedures designed to provide reasonable assurance that information required to be disclosed in the periodic reports we file with the SEC is recorded, processed, summarized and reported accurately and within the time periods specified in the rules of the SEC. We carried out an evaluation as of December 31, 2006, under the
supervision and the participation of our management, including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), of the design and operation of these disclosure controls and procedures pursuant to Exchange Act Rule 13a-15(c). Based upon that evaluation, our CEO and CFO concluded that our disclosure controls and procedures were not effective due to material weaknesses discussed in Management’s Report on Internal Control Over Financial Reporting on page hereof.
Changes in Internal Control. There was no change in internal control over financial reporting that occurred during the three months ended December 31, 2006 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
We are currently in the process of implementing the following remediation steps to address the material weaknesses referenced above:
· Create a detailed acquisition accounting checklist in order to ensure purchase price consideration is properly measured and recorded;
· Revise our policies and procedures related to our review of the tax provision to provide for sufficient analysis of the accounting for valuation allowances established in a business combination. Specifically, revise the review procedures performed by our tax professionals and outside consultants to ensure applicable issues are appropriately considered;
· Formalize our review procedures over the allowance for uncollectible accounts to ensure aged receivables and specific customer collection issues are appropriately considered when estimating and recording the allowance for uncollectible accounts; and
· Formalize our policies and procedures related to the recognition of deferred revenue, including enhanced monitoring of aged deferred revenues associated with certain service projects, as well as certain accounting policies related to maintenance contracts.
Management’s Report on Internal Control over Financial Reporting. See Part IV, Item 15 page for Management’s Report on Internal Control Over Financial Reporting.
Item 9B.
Item 9B. Other Information
Effective December 6, 2006, Mr. David Gould voluntarily agreed to step down as the Chairman of the Company’s Board of Directors and was replaced by Mr. Dan Lautenbach, a member of the Company’s Board of Directors since 2002. Effective January 3, 2007, Mr. David Gould voluntarily resigned from his position as Chief Executive Officer of the Company and as a member of the Company’s Board of Directors and was replaced by Mr. Nicholas Discombe, who has served as the Company’s President and Chief Operating Officer since April 2003. Pursuant to an agreement dated January 3, 2007 and later amended on February 2, 2007, Mr. Gould will continue as an employee until April 30, 2007. Upon termination of employment, Mr. Gould will be entitled to separation payments of $29,333 per month for 12 months. In return, Mr. Gould agreed to the termination of his employment agreement and change in control agreement.
PART III
Certain information required by Part III is omitted from this Report in that the Company will file a definitive proxy statement within 120 days after the end of this fiscal year pursuant to Regulation 14A (the “Proxy Statement”) for its 2007 Annual Meeting of Stockholders proposed to be held on June 15, 2007, and the information included therein is incorporated herein by reference.
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance
Code of Ethics
We have adopted a Code of Ethics within the meaning of Item 406(b) of Regulation S-K. This Code of Ethics applies to our principal executive officer, principal financial officer and principal accounting officer. This Code of Ethics is publicly available on our website at http://www.witness.com. If we make substantive amendments to this Code of Ethics or grant any waiver, including any implicit waiver, we will disclose the nature of such amendment or waiver on our website or in a report on Form 8-K within four business days of such amendment or waiver.
Audit Committee Financial Expert
Our Board of Directors has determined that at least one person serving on the Audit Committee is an “audit committee financial expert” as defined under Item 401(h) of Regulation S-K. Joel Katz, the Chairman of the Audit Committee, is an “audit committee financial expert” and is independent as defined under applicable SEC and Nasdaq Stock Market rules.
The other information required by this Item is incorporated by reference from the Proxy Statement under the headings “Election of Directors” and “Executive Compensation.”
Item 11.
Item 11. Executive Compensation
The information required by this Item is incorporated by reference from the Proxy Statement under the heading “Executive Compensation.”
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The information required by this Item is incorporated by reference from the Proxy Statement under the heading “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.”
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence
The information required by this Item is incorporated by reference from the Proxy Statement under the heading “Executive Compensation.”
Item 14.
Item 14. Principal Accountant Fees and Services
The information required by this Item is incorporated by reference from the Proxy Statement under the heading “Audit Fees and Services.”
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules
(a) The following documents are filed as part of this report:
1.
Financial Statements
Management’s Report on Internal Control Over Financial Reporting
Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting
Report of Independent Registered Public Accounting Firm on Consolidated Financial Statements
Consolidated Balance Sheets as of December 31, 2006 and 2005
Consolidated Statements of Operations for the years ended December 31, 2006, 2005 and
Consolidated Statements of Stockholders’ Equity and Comprehensive Income (Loss) for the years ended December 31, 2006, 2005 and 2004
Consolidated Statements of Cash Flows for the years ended December 31, 2006, 2005 and
Notes to Consolidated Financial Statements
2.
Financial Statement Schedule
Schedule II-Valuation and Qualifying Accounts
3.
Signatures
(b) Exhibits
Exhibit
Number
Description
2.1(12)
Merger Agreement and Plan of Reorganization by and among Witness Systems, Inc., Baron Acquisition Corporation, Blue Pumpkin Software, Inc., and, solely with respect to Article VIII and Article IX, Laurence R. Hootnick as Shareholder Agent and The U.S. Stock Transfer Corporation as Depository Agent dated December 16, 2004
2.2(18)
Agreement and Plan of Merger among Verint Systems Inc., White Acquisition Corporation and the Company dated February 11, 2007
3.1(2)
Fifth Amended and Restated Certificate of Incorporation of the Company
3.2(1)
Amended and Restated Bylaws of the Company
3.3(7)
Form of Certificate of Designation for Series A Junior Participating Preferred Stock
4.1(2)
See Exhibit 3.1 for provisions of the Fifth Amended and Restated Certificate of Incorporation of the Company defining rights of the holders of Common Stock of the Company.
4.2(4)
See Exhibit 3.2 for provisions of the Amended and Restated Bylaws of the Company defining rights of the holders of Common Stock of the Company
4.3(1)
Specimen Stock Certificate
4.4(7)
Form of Rights Agreement, dated October 25, 2002, between the Company and SunTrust Bank which includes the form of Certificate of Designation for the Series A Junior Participating Preferred Stock as Exhibit A, the form of Rights Certificate as Exhibit B and the Summary of Rights to Purchase Preferred Stock as Exhibit C
4.5(17)
Amendment to Rights Agreement entered into as of February 11, 2007 between the Company and Computershare Trust Company, N.A
Exhibit
Number
Description
10.1(3)
Lease Agreement between the Company and Colonial Center at Mansell Overlook/Colonial Business Center dated July 28, 2000
10.2(9)
Lease Agreement between Eyretel plc and Cornhill Insurance plc at Kings Court dated December 24, 1999
10.3(13)
Lease Agreement between the Company and Mission Towers, LLC at Freedom Circle Drive dated February 18, 2005
10.4(1)
Amended and Restated Stock Incentive Plan of the Company
10.5(2)
Amendment No. 1 to the Company’s Amended and Restated Stock Incentive Plan
10.6(9)
Amendment No. 2 to the Company’s Amended and Restated Stock Incentive Plan
10.7(5)
Form of Stock Option Grant Certificate
10.8(4)
Employee Stock Purchase Plan of the Company
10.11(9)
Director and Key Executive Stock Ownership Incentive Policy
10.12(13)
Form of Inducement Grant for Employees of Blue Pumpkin
10.13(1)
Employment Agreement entered into between David B. Gould and the Company effective February 2, 1999
10.14(1)
Amendment No. 1 to Employment Agreement entered into between David B. Gould and the Company, dated as of August 2,
10.15(1)
Restricted Stock Award Agreement dated March 31, 1999, between the Company and David Gould
10.16(8)
Employment Agreement entered into between Nicholas S. Discombe and the Company, dated as of June 29, 2003
10.17(9)
2003 Broad Based Option Plan
10.18(9)
2003 Non-Employee Director Stock Option Plan
10.19(1)
Form of Indemnification Agreement for executive officers and directors of the Company
10.20(11)
Form of Change of Control Agreement entered into with certain senior officers of the company
10.21(1)
Subsidiary License and Distribution Agreement
10.22(6)
Loan and Security Agreement between the Company and Silicon Valley Bank dated April 3, 2002
10.23(6)
Loan Modification Agreement between the Company and Silicon Valley Bank dated November 12, 2002
10.24(6)
Revolving Promissory Note between the Company and Silicon Valley Bank dated November 12, 2002
10.25(9)
Second Loan Modification Agreement between the Company and Silicon Valley Bank dated May 14, 2003
Exhibit
Number
Description
10.26(9)
Third Loan Modification Agreement between the Company and Silicon Valley Bank dated November 13, 2003
10.27(10)
Fourth Loan Modification Agreement between the Company and Silicon Valley Bank dated January 8, 2004
10.28(10)
Fifth Loan Modification Agreement between the Company and Silicon Valley Bank dated March 10,
10.29(13)
Sixth Loan Modification Agreement between the Company and Silicon Valley Bank dated January 12,
10.30(14)
Seventh Loan Modification Agreement between the Company and Silicon Valley Bank dated March 10,
10.31(14)
Amended and Restated Stock Incentive Plan
10.32(14)
Amended and Restated Stock Incentive Plan
10.33(15)
Eight Loan Modification Agreement between the Company and Silicon Valley Bank dated March 31,
10.34(15)
Amended and Restated Stock Incentive Plan
10.35(15)
Amended and Restated Stock Incentive Plan
10.36(16)
Amendment No.1 to the Witness Systems, Inc. Amended and restated Stock Incentive plan
10.37(16)
Amended & Restated Employee Stock Purchase Plan.
10.38(16)
Form of Inducement Grant for Contractors who will become employee of Witness Systems Software India PVT Ltd
10.39(17)
Separation and Release Agreement entered into as of January 3, 2007 between the Company and David Gould
10.40(18)
First Amendment to Separation and Release Agreement entered into as of February 2, 2007 between the Company and David Gould
10.41*
Tenth Loan Modification Agreement between the Company and Silicon Valley Bank dated March 8,
21.1*
List of subsidiaries
23.1*
Report of Independent Registered Public Accounting Firm on Consolidated Financial Statements Schedule
23.2*
Consent of Independent Registered Public Accounting Firm
23.3*
Consent of Independent Business Valuation Experts
31.1*
Certificate of the Chief Executive Officer
31.2*
Certificate of the Chief Financial Officer
32.1*
Certifications Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
* Filed herewith
(1) Incorporated by reference to exhibits previously filed with the Company’s Registration Statement on Form S-1 (File No. 333-91383)
(2) Incorporated by reference to exhibits previously filed with the Company’s Registration Statement on Form S-8 (File No. 333-67416)
(3) Incorporated by reference to exhibits previously filed with the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2000
(4) Incorporated by reference to exhibits previously filed with the Company’s Annual Report on Form 10-K for the year ended December 31, 1999
(5) Incorporated by reference to exhibits previously filed with the Company’s Annual Report on Form 10-K for the year ended December 31, 2000
(6) Incorporated by reference to exhibits previously filed with the Company’s Quarterly Report on Form 10-Q for the period ended September 30, 2002
(7) Incorporated by reference to exhibits previously filed with the Company’s Current Report on Form 8-K on November 4, 2002
(8) Incorporated by reference to exhibits previously filed with the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2003
(9) Incorporated by reference to exhibits previously filed with the Company’s Annual Report on Form 10-K for the year ended December 31, 2003
(10) Incorporated by reference to exhibits previously filed with the Company’s Quarterly Report on Form 10-Q for the period ended March 31, 2004
(11) Incorporated by reference to exhibits previously filed with the Company’s Quarterly Report on Form 10-Q for the period ended September 30, 2004
(12) Incorporated by reference to exhibits previously filed with the Company’s Current Report on Form 8-K on January 27, 2005
(13) Incorporated by reference to exhibits previously filed with the Company’s Annual Report on Form 10-K for the year ended December 31, 2004
(14) Incorporated by reference to exhibits previously filed with the Company’s Quarterly Report on Form 10-Q for the period ended March 31, 2005
(15) Incorporated by reference to exhibits previously filed with the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2005
(16) Incorporated by reference to exhibits previously filed with the Company’s Annual Report on Form 10-K for the year ended December 31, 2005
(17) Incorporated by reference to exhibits previously filed with the Company’s Current Report on Form 8-K on January 9, 2007
(18) Incorporated by reference to exhibits previously filed with the Company’s Current Report on Form 8-K on February 15, 2007
WITNESS SYSTEMS, INC. AND SUBSIDIARIES
Index to Consolidated Financial Statements
Management’s Report on Internal Control Over Financial Reporting
Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting
Report of Independent Registered Public Accounting Firm on Consolidated Financial Statements
Consolidated Balance Sheets as of December 31, 2006 and 2005
Consolidated Statements of Operations for the years ended December 31, 2006, 2005, and 2004
Consolidated Statements of Stockholders’ Equity and Comprehensive Income (Loss) for the years ended December 31, 2006, 2005, and 2004
Consolidated Statements of Cash Flows for the years ended December 31, 2006, 2005, and 2004
Notes to Consolidated Financial Statements
Schedule II-Valuation and Qualifying Accounts
Signatures
Management’s Report on Internal Control Over Financial Reporting
The management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934. The Company maintains accounting and internal control systems which are intended to provide reasonable assurance that assets are safeguarded against loss from unauthorized use or disposition, transactions are executed in accordance with management’s authorization and accounting records are reliable for preparing financial statements in accordance with accounting principles generally accepted in the United States.
Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting also can be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. However, these inherent limitations are known features of the financial reporting process. Therefore, it is possible to design into the process safeguards to reduce, though not eliminate, this risk.
A material weakness in internal control over financial reporting is defined by Public Company Accounting Oversight Board (“PCAOB”) Auditing Standard No. 2 as a significant deficiency, or combination of significant deficiencies, that results in more than remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.
As of December 31, 2006, management conducted an assessment of the effectiveness of our internal control over financial reporting based upon the framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”), Internal Control-Integrated Framework. Based on this assessment, management concluded that as of December 31, 2006, we did not maintain effective control over financial reporting, due to the following material weaknesses:
(1) We did not have effective policies and procedures to provide for appropriate consideration of all payments made to the selling shareholders in a business combination. This deficiency resulted in a material error in our preliminary 2006 Consolidated Financial Statements.
(2) We did not have policies and procedures sufficiently detailed to ensure appropriate accounting for the reduction of deferred income tax asset valuation allowances established as part of a business combination. As a result, there were material errors in goodwill and income tax expense in our preliminary 2006 Consolidated Financial Statements.
(3) Our evaluation and review of the allowance for uncollectible accounts receivable was not sufficiently thorough and objective to ensure accounts receivable were recorded at their net realizable value. Specifically, our evaluation and review of the allowance for uncollectible accounts receivable did not adequately consider the aging of certain receivables and specific customer collection issues that existed at December 31, 2006. As a result, there were errors in accounts receivable and operating expenses in our preliminary 2006 Consolidated Financial Statements.
(4) Our policies and procedures over the recognition of deferred revenue from maintenance and other service contracts were not sufficient to ensure that revenue was recognized in the appropriate period in accordance with U.S. generally accepted accounting principles. Specifically, our policies and procedures did not provide for sufficient analysis of contracts included in deferred revenue to determine the timing of recognition. This deficiency resulted in errors in revenue and deferred revenue in our preliminary 2006 Consolidated Financial Statements.
These material weaknesses result in more than a remote likelihood that a material misstatement in the annual or interim financial statements would not be prevented or detected.
Management’s assessment of the effectiveness of internal control over financial reporting as of December 31, 2006 has been audited by KPMG LLP, an independent registered public accounting firm. Their report appears immediately after this report.
Witness Systems, Inc.
March 30, 2007
Report of Independent Registered Public Accounting Firm
on Internal Control Over Financial Reporting
The Board of Directors
Witness Systems, Inc.:
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting (page), that Witness Systems, Inc. did not maintain effective internal control over financial reporting as of December 31, 2006, because of the effect of the material weaknesses identified in management’s assessment, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Witness Systems, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
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 effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
A material weakness is a control deficiency, or combination of 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. The following material weaknesses have been identified and included in management’s assessment:
(1) The Company did not have effective policies and procedures to provide for appropriate consideration of all payments made to the selling shareholders in a business combination. This deficiency resulted in a material error in the Company’s preliminary 2006 consolidated financial statements.
(2) The Company did not have policies and procedures sufficiently detailed to ensure appropriate accounting for the reduction of deferred income tax asset valuation allowances established as part
of a business combination. As a result, there were material errors in goodwill and income tax expense in the Company’s preliminary 2006 consolidated financial statements.
(3) Management’s evaluation and review of the allowance for uncollectible accounts receivable was not sufficiently thorough and objective to ensure accounts receivable were recorded at their net realizable value. Specifically, management’s evaluation and review of the allowance for uncollectible accounts receivable did not adequately consider the aging of certain receivables and specific customer collection issues that existed at December 31, 2006. As a result, there were errors in accounts receivable and operating expenses in the Company’s preliminary 2006 consolidated financial statements.
(4) The Company’s policies and procedures over the recognition of deferred revenue from maintenance and other service contracts were not sufficient to ensure that revenue was recognized in the appropriate period in accordance with U.S. generally accepted accounting principles. Specifically, the Company’s policies and procedures did not provide for sufficient analysis of contracts included in deferred revenue to determine the timing of recognition. This deficiency resulted in errors in revenue and deferred revenue in the Company’s preliminary 2006 consolidated financial statements.
Each of the aforementioned material weaknesses in internal control over financial reporting individually resulted in more than a remote likelihood that a material misstatement of the Company’s interim or annual financial statements would not have been prevented or detected.
In our opinion, management’s assessment that Witness Systems, Inc. did not maintain effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, because of the effect of the material weaknesses described above on the achievement of the objectives of the control criteria, Witness Systems, Inc. has not maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Witness Systems, Inc. and subsidiaries as of December 31, 2006, and the related consolidated statements of operations, stockholders’ equity and comprehensive income (loss), and cash flows for the year ended December 31, 2006. These material weaknesses were considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2006 consolidated financial statements, and this report does not affect our report dated March 30, 2007, which expressed an unqualified opinion on those consolidated financial statements.
/s/ KPMG LLP
Atlanta, Georgia
March 30, 2007
Report of Independent Registered Public Accounting Firm on Consolidated Financial Statements
The Board of Directors
Witness Systems, Inc.:
We have audited the accompanying consolidated balance sheets of Witness Systems, Inc. and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of operations, stockholders’ equity 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 audits 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. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Witness Systems, Inc. and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles.
As discussed in Notes 1 and 11 to the consolidated financial statements, effective January 1, 2006, the Company changed its method of accounting for share-based compensation by adopting Statement of Financial Accounting Standards No. 123(R), Share-Based Payment.
Also, as discussed in Note 1 to the Consolidated Financial Statements, effective December 31, 2006, the Company changed its method of quantifying errors by adopting Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Witness Systems, Inc.’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 30, 2007, expressed an unqualified opinion on management’s assessment of, and an adverse opinion on the effective operation of, internal control over financial reporting.
/s/ KPMG LLP
Atlanta, Georgia
March 30, 2007
WITNESS SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)
See accompanying Notes to Consolidated Financial Statements.
WITNESS SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
See accompanying Notes to Consolidated Financial Statements.
WITNESS SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND
COMPREHENSIVE INCOME (LOSS)
Years Ended December 31, 2006, 2005 and 2004
(In thousands)
See accompanying Notes to Consolidated Financial Statements.
WITNESS SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
See accompanying Notes to Consolidated Financial Statements.
WITNESS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006, 2005 and 2004
1. Summary of Significant Accounting Policies
Business-Witness Systems, Inc. (“Witness”) is a publicly traded company that provides workforce optimization software and services that help businesses capture customer intelligence and optimize their work performance. Our Impact 360 solution features quality monitoring, compliance and IP recording, workforce management, performance management and e-learning. Our quality monitoring products record multimedia interactions, including traditional voice, Web chat and email, based on user-defined business rules to enable our customers to evaluate the performance of their customer service representatives (“CSRs”), wherever they may be located in the enterprise. Our compliance applications are designed to record high volume voice conversations between CSRs and customers for purposes such as compliance recording and sales verification. Our workforce management products enable our customers to develop strategic staffing plans, deploy skilled resources and evaluate productivity of CSRs in a contact center, branch bank or back office operations. Our performance management applications provide comprehensive analytics, including performance scorecards, and reports of customer interaction and CSR performance. Our e-learning applications deliver ongoing training tailored to CSR needs and competencies. We also provide consulting and implementation services, training and support to customers that use our software products. Primarily deployed in contact centers - as well as the remote, branch and back offices of global organizations, the workforce optimization solution captures, analyzes and enables users to share and act on cross-functional information across the enterprise. With Impact 360, organizations can improve interactions and the underlying back-office processes that enhance the customer experience and build customer loyalty.
We are headquartered in Roswell, Georgia with operations in the United States, Australia, Brazil, Canada, China, Germany, India, Japan, Mexico, the Netherlands, Singapore, South Africa and the United Kingdom. We were originally incorporated in 1988 in Georgia and were reincorporated in Delaware in 1997.
Principles of Consolidation and Reclassifications-The Consolidated Financial Statements include the Financial Statements of Witness Systems, Inc. and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. Certain prior year amounts have been reclassified to conform to the current year presentation.
Use of Estimates-The Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these Consolidated Financial Statements requires us to make certain estimates and judgments that affect our reported assets, liabilities, revenues and expenses, and our related disclosure of contingent assets and liabilities. We base our estimates on historical experience and on various assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.
Cash and Cash Equivalents and Investments-Cash and cash equivalents consist of cash on deposit, money market accounts, commercial paper and U.S. Government agency securities. All highly liquid investments with original maturities of three months or less at the time of purchase are classified as cash equivalents.
Investments are classified as available for sale and are carried at fair market value. Unrealized holding gains and losses on such investments are reported as a separate component of accumulated other
comprehensive income until realized. If a decline in fair value is determined to be other than temporary, the cost basis of the individual security is written down to fair value as a new cost basis resulting in a realized loss. Realized gains and losses from sales are based on the specific identification method. Our investments are presented as current assets as they represent the investment of cash available to be used in current operations within the next year.
Restricted Cash Held in Escrow-Pursuant to the Blue Pumpkin Merger Agreement discussed in Note 5, “Blue Pumpkin and Optimis Acquisitions,” cash of $4.0 million was placed in escrow on the date of acquisition. The escrow fund was established to compensate Witness, subject to certain limitations, for potential losses that could result from, among other things, the IEX litigation and other specified litigation. The escrow fund is reflected as restricted cash held in escrow on our Consolidated Balance Sheet as of December 31, 2005 and was released to Witness in 2006.
Allowance for Doubtful Accounts-We perform ongoing evaluations of our customers and continuously monitor collections and payments and estimate an allowance for doubtful accounts based on the aging of the underlying receivables, our historical experience with write-offs and any specific customer collection issues that we have identified. While such credit losses have historically been within our expectations and we believe appropriate reserves have been established, we cannot assure that we will continue to experience the same credit loss rates that we have experienced in the past or adequately predict future credit losses. If the financial condition of our customers were to deteriorate and resulted in an impairment of their ability to make payments, additional allowances may be required which would result in additional selling, general and administrative expense in the period such determination is made.
Property and Equipment-Property and equipment are stated at cost, less accumulated depreciation and amortization. Property and equipment are depreciated and amortized using the straight-line method over the estimated useful lives of the assets. Leasehold improvements are amortized using the straight-line method over the shorter of the estimated life of the asset or the remaining term of the lease. Property and equipment generally has the following estimated useful lives and is comprised of the following amounts (in thousands):
Depreciation and amortization on property and equipment was $5.8 million, $4.4 million and $3.2 million in 2006, 2005 and 2004, respectively.
Long-Lived Assets-As required by Statement of Financial Accounting Standards (“SFAS”) No. 144, Accounting for Impairment or Disposal of Long-lived Assets, long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used would be measured by a comparison of the carrying amount of an asset to the estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its undiscounted estimated future cash flows, an impairment charge is recognized in the amount by which the carrying amount of the asset exceeds the fair
value of the asset. To date, no events or changes in circumstances have occurred that would require us to test long-lived assets for recoverability.
Goodwill and Intangible Assets-Goodwill and intangible assets are accounted for in accordance with SFAS No.142, Goodwill and Intangible Assets. This statement requires that goodwill and intangible assets with indefinite lives should not be amortized, but should be tested for impairment on an annual basis, or more often if an event occurs or circumstances change that indicate that the fair value of a reporting unit or indefinite-lived intangible asset might have fallen below its carrying amount.
Revenue Recognition and Deferred Revenue-We recognize revenue in accordance with the American Institute of Certified Public Accountants’ Statement of Position (“SOP”) 97-2, Software Revenue Recognition, and SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions and Emerging Issues Task Force (“EITF”) No. 00-21, Revenue Arrangements with Multiple Deliverables. Revenue is primarily derived from licensing software and providing related services including maintenance. Product revenue, which can include software and hardware, is recognized when persuasive evidence of an agreement exists, delivery of the product has occurred, the fee is fixed or determinable, collection is probable and vendor specific objective evidence of fair value (“VSOE”) exists to allocate revenue to the undelivered elements of the arrangement. The Company reports hardware revenue gross in accordance with EITF No. 99-19, Reporting Revenue Gross as a Principal versus Net as an Agent, because the factors indicating gross reporting outweigh the factors indicating net reporting. We recognize revenue using the residual method of accounting when customer orders contain multiple elements, including the sale of licensed software, hardware, maintenance, and professional services. We generally have VSOE for maintenance and professional services, but not for the software and hardware elements of the order. Under the residual method, services revenue, including maintenance and professional services, is deferred at an amount equal to VSOE until those elements are delivered. Consequently, product revenue for the software and hardware is recognized (i) upon delivery of those products when we have VSOE for the related maintenance and professional services sold and (ii) at an amount representing the difference between the total order amount and the amount deferred. For customer orders that include hardware, hardware revenue is accounted for as a separate unit of accounting in accordance with guidance provided in EITF No. 00-21.
Services revenue includes installation, training, consulting, maintenance and reimbursable travel expenses. Revenue from installation, training and consulting services is recognized upon performance of the related services and is offered and billed as separate elements of contracts. Reimbursable travel expenses revenue is recognized upon incurrence of the related expenses. The functionality of the software and any hardware sold is not dependent on installation and training services and customization is not required to enable our customers to use our products. Maintenance is offered as a separate element and the majority of contracts include the right to unspecified upgrades on a when-and-if available basis. Maintenance revenue is deferred and recognized ratably over the term of the related maintenance contract.
Our revenue recognition policy is significant because our revenues are a key component of our results of operations. We follow very specific and detailed guidelines in measuring revenues; however, certain judgments and estimates affect the application of our revenue policy described above. Further, assessment of collectibility is particularly critical in determining whether or not revenues should be recognized. We also record provisions for estimated sales allowances on product and service related revenues at the time the related revenues are recorded. These estimates are based on historical sales and services allowances, analysis of customer credits and other known factors. If future sales credits prove to be greater than the historical data and the estimates we used to calculate these provisions, our revenues could be overstated.
Deferred revenue consists primarily of amounts collected from customers for products and services that have not met the criteria for revenue recognition.
Advertising Costs-Advertising costs are expensed as incurred. Advertising expenses were $0.4 million, $0.5 million and $0.3 million in 2006, 2005 and 2004, respectively.
Research and Development Costs-Research and development costs consist primarily of personnel and consulting costs involved with product development and allocated overhead. These costs are expensed as incurred and include software development costs incurred prior to the establishment of technological feasibility and stock-based compensation expense (in 2006).
Software Development Costs-In accordance with SFAS No. 86, Accounting for the Costs of Computer Software to be sold, leased, or Otherwise Marketed, software development costs are expensed until technological feasibility of the product has been established and are capitalized commencing upon the establishment of technological feasibility through the time of general release to customers. Amortization of software development costs begins when the product is available for general release and is amortized using the greater of: (1) the straight-line method over the expected life of the product or (2) the ratio of current product revenue to the total of current and future product revenue. At each balance sheet date, the unamortized software development costs are compared to the net realizable value of the underlying product and to the extent any unamortized capitalized costs exceed the net realizable value of the asset, those costs are written off. As of December 31, 2006, and 2005, unamortized software development costs were $1.3 million and $1.2 million, respectively, and are included in other assets on the accompanying Consolidated Balance Sheets. During 2006, 2005 and 2004, $0.7 million, $0.5 million and $0.4 million in software development costs were amortized to cost of product revenue.
Merger-Related Costs and Purchase Price Contingencies-In accounting for acquisitions, we accrue for certain loss contingencies that exist at the date of acquisition. We reduce such liabilities as those contingencies are resolved or if we determine that the contingency no longer represents a probable loss. Any adjustments to these liabilities are reflected as adjustments to goodwill and/or other acquired assets to the extent information was requested but not received at the date of acquisition. Other adjustments are reflected in our results of operations, except as prescribed by EITF No. 95-3, Recognition of Liabilities in Connection with a Purchase Business Combination.
Stock-Based Compensation-On January 1, 2006, we adopted SFAS No.123(R), Share-Based Payment, which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees including employee stock options and shares made available through the employee stock purchase plan based on the grant date fair value of those awards. We determine the fair value of share-based payment awards on the date of grant using Black-Scholes option-pricing model. The fair value of share-based awards is affected by stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, our expected stock price volatility over the term of the awards, and actual and projected employee stock option exercise behavior. SFAS No. 123(R) also requires that forfeitures be estimated over the vesting period of an award, rather than being recognized as a reduction of compensation expense when the forfeiture actually occurs. We adopted SFAS No. 123(R) using the modified prospective transition method. Our Consolidated Financial Statements as of December 31, 2006 reflect the impact of SFAS No. 123(R).
In accordance with the modified prospective transition method, our Consolidated Financial Statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS No. 123(R). This statement requires us to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in our Consolidated Statement of Operations. Stock-based compensation expense recognized under SFAS No. 123(R) for the year ended December 31, 2006 was $13.8 million. Prior to the adoption of SFAS No. 123(R), we accounted for stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles
Board (“APB”) No. 25, Accounting for Stock Issued to Employees as allowed under SFAS No. 123, Accounting for Stock-Based Compensation.
The following table illustrates the effect on net (loss) income and net (loss) income per share if we had applied the fair value method as prescribed by SFAS No. 123 (in thousands, except per share data):
Income Taxes-We account for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes, which requires companies to recognize deferred income tax assets and liabilities using enacted tax rates for the effect of temporary differences between the book and tax bases of recorded assets and liabilities. The effect on deferred income tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. SFAS No. 109 also requires that deferred income tax assets be reduced by a valuation allowance if it is more likely than not that some portion or all of the deferred income tax asset will not be realized. We evaluate the realizability of our deferred income tax assets and establish a valuation allowance to reduce our deferred income tax assets based on an assessment of the likelihood of their realization. We consider certain relevant criteria including deferred income tax liabilities that can be used to offset deferred income tax assets, estimates of future taxable income of appropriate character within the carry forward period available, and tax planning strategies.
Net Income (Loss) Per Share-We calculate net income (loss) per share pursuant to SFAS No. 128, Earnings Per Share. Basic net income (loss) per share is calculated by dividing our net income (loss) by the weighted average number of shares outstanding during the period. When the effects are not anti-dilutive, diluted net income (loss) per share is computed by dividing our net income (loss) by the weighted average number of shares outstanding and the dilutive impact of all dilutive stock options. The dilutive impact of stock options is determined by applying the treasury stock method. (See Note 2 for further information.)
Fair Value of Financial Instruments-At December 31, 2006 and 2005, our financial instruments included cash and cash equivalents, investments, accounts receivable and accounts payable. We believe the carrying values of cash and cash equivalents, accounts receivable and accounts payable approximate fair values because of the short-term maturities of these instruments. Our investments are carried at fair value.
Foreign Currency-Generally, the functional currency has been determined to be the local currency for our foreign subsidiaries. As a result, those subsidiaries’ assets and liabilities are translated at year-end exchange rates and income statement items are translated at average exchange rates prevailing during the year. Such translation adjustments are recorded as a component of stockholders’ equity and other comprehensive income (loss).
Net gains (losses) from foreign currency denominated transactions are included in interest and other income, net and were ($1.0) million, ($0.2) million and $0.3 million in 2006, 2005 and 2004, respectively.
Recent Accounting Pronouncements-In June 2006, the Financial Accounting Standard Board (“FASB”) issued Interpretation (“FIN”) No. 48, “Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109.” This Interpretation prescribes a recognition threshold and measurement attribute for the Financial Statement recognition and measurement of a tax position taken or expected to be taken in a tax return, and provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. This Interpretation is effective for us as of January 1, 2007. We are currently evaluating the impact of adopting FIN No. 48 on our financial position, cash flows, and results of operations.
In June 2006, the FASB issued EITF No. 06-3, “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That is, Gross versus Net Presentation)”. This EITF requires disclosure of the accounting policy of any tax assessed by a governmental authority that is directly imposed on a revenue-producing transaction (i.e., sales, use, value added) on a gross (included in revenue and costs) or net (excluded from revenue) basis. This EITF is effective for us as of January 1, 2007. We are currently assessing the impact of the EITF on our results of operations.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements”, which becomes effective beginning on January 1, 2008. SFAS No. 157 addresses the definition of fair value, the methods used to measure fair value and the expanded disclosures about fair value measurement of a company’s assets and liabilities. SFAS No. 157 requires that the fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability. We are currently assessing the impact of the SFAS No. 157 on our results of operations and financial position.
In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 108 (“SAB 108”) Financial Statements-Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements, effective for fiscal years ending after November 15, 2006. SAB 108 requires the utilization of a dual-approach to assessing the quantitative effects of financial misstatements. This dual approach includes both an income statement method and a balance sheet method.
Upon our adoption of SAB 108 as of December 31, 2006, we determined that we needed to record a $1.4 million cumulative adjustment, net of tax of $0.5 million, to decrease our opening accumulated deficit balance for year 2006. This adjustment was to correct certain prior year differences that had previously been considered immaterial under the Company’s method of evaluating uncorrected misstatements to the 2005 and 2004 Consolidated Financial Statements, but were considered material under the dual approach. The following table reflects the matters included in this cumulative adjustment (in thousands):
2. Net Income (Loss) Per Share
The following is a reconciliation of the numerator and denominator used in the calculation of basic and diluted net income (loss) per share (in thousands, except per share data):
The total number of share equivalents excluded from the calculations of historical diluted net loss per common share for 2005 was 2,695,822 calculated using the treasury stock method. (See Note 11 for further information on stock options.) We have excluded all outstanding stock options from the calculation of diluted net loss per common share for 2005 because we reported a loss in 2005 and all such securities are anti-dilutive. In 2006, 2005 and 2004, 2,634,888, 348,467 and 461,087 stock options, respectively, were excluded from the computation of diluted earnings per share because they had an anti-dilutive effect.
3. Cash and Cash Equivalents and Investments
The amortized cost, gross unrealized gain (loss) and fair market value of cash and cash equivalents and investments available for sale as of December 31, 2006 and 2005 were as follows (in thousands):
At December 31, 2006, the fair market value of investments with maturity dates ranging from 91 days to one year totaled $53.6 million and an investment with a maturity date of greater than 1 year totaled $4.0 million. The unrealized holding losses of $17,000 at December 31, 2006 relates to corporate debt securities with an A plus rating and U.S. Government agency securities with fair market values of $16.5 million and $9.0 million, respectively. As of December 31, 2006, the corporate debt and U.S. Government agency have not been in a loss position for more than 12 months, and we believe this impairment to be temporary. At December 31, 2005, the fair market value of investments with remaining maturity dates ranging from 91 days to one year totaled $13.5 million and an investment with a maturity
date of 13 months totaled $1.4 million. The unrealized holding losses of $2,000 at December 31, 2005 relates mainly to one corporate debt security with an A plus rating with a fair market value of $1.4 million.
We recorded interest income of $6.4 million, $1.1 million and $1.0 million during 2006, 2005 and 2004, respectively.
4. Intangible Assets
The following tables present the components of intangible assets (in thousands):
The increase in the intangible assets balances in 2006 is primarily due to acquisitions discussed in Note 6. The increase in the intangible assets balances in 2005 is due to the acquisition of Blue Pumpkin and Optimis as discussed in Note 5. The acquired technology, distribution arrangements and customer lists are being amortized using the straight-line method over one to seven years, and the other intangibles assets, which include trademarks, patents and non-compete agreements, are being amortized using the straight-line method over two to five years. The intangible assets and related amortization expenses are subject to foreign currency translation and deferred income tax adjustments. Foreign currency translation resulted in approximately $2.1 million increase in accumulated amortization during 2006. Amortization of intangible assets included in the accompanying Consolidated Statements of Operations is as follows (in thousands):
The estimated future amortization expense of the intangible assets as of December 31, 2006 is as follows (in thousands):
5. Blue Pumpkin and Optimis Acquisitions
On January 24, 2005, we acquired Blue Pumpkin Software, Inc. (“Blue Pumpkin”), a privately held California corporation. With this acquisition, we expanded our workforce optimization solution to include advanced workforce management software and services solutions including forecasting, scheduling, adherence and planning applications. Pursuant to our Merger Agreement and Plan of Reorganization, dated December 16, 2004, with Blue Pumpkin (the “Blue Pumpkin Merger Agreement”), we paid $36 million in cash which was funded from our existing cash and investments and issued 1.9 million shares of Witness’ common stock valued at $33.5 million (measured based on the date the stock consideration became fixed pursuant to the application of a formula specified in the Blue Pumpkin Merger Agreement). On May 24, 2005, the shares issued in connection with the acquisition were registered for resale with the Securities and Exchange Commission. Pursuant to the Blue Pumpkin Merger Agreement, cash of $4.0 million and 210,000 shares of common stock valued at approximately $3.7 million on the date of acquisition were placed into an escrow fund to compensate Witness, subject to certain limitations, for potential losses that could result from, among other things, the IEX litigation and other specified litigations, and breaches of Blue Pumpkin’s representations, warranties or covenants in the Blue Pumpkin Merger Agreement.
On December 15, 2005, Tekelec, IEX’s parent company, and Witness reached a tentative agreement to settle all claims asserted between them. As part of the final settlement entered into in April 2006, Witness made payment of $8.25 million to Tekelec, and agreed to make six annual payments of $0.5 million ($3.0 million in total) from April 2007 through 2012. In accordance with APB No. 21, Interest on Receivables and Payables, we recorded a $0.7 million discount representing the difference between the face value and the present value of the $3.0 million. The escrow fund was released to Witness during March 2006 in satisfaction and settlement of claims that Witness brought against the escrow fund, including claims for losses resulting from the settlement of the IEX litigation. As part of the agreement to release the escrow, Witness issued shares of common stock for proceeds of approximately $3.1 million. These shares were issued at a discount of approximately $1.35 million, which was recorded as a charge to earnings in our Consolidated Statement of Operations for the year ended December 31, 2006.
We commenced consolidation of Blue Pumpkin on January 25, 2005 and the acquisition was accounted for using the purchase method of accounting in accordance with SFAS No. 141, Business Combinations. The following summarizes the total purchase price for Blue Pumpkin (in thousands):
Under the purchase method of accounting, the total purchase price is allocated to Blue Pumpkin’s net tangible and intangible assets based upon their estimated fair value as of the date of the acquisition with any amount paid in excess of the fair value of the net assets recorded as goodwill. Based upon the purchase price and review of the net assets acquired and liabilities assumed, the purchase price allocation, is as follows (in thousands):
The fair values of identifiable intangible assets were determined with the assistance of Taylor Consulting Group, Inc., an independent third-party appraiser using both an income and a cost approach taking into consideration the nature, risks, historical patterns, economic characteristics, and future considerations of the assets. As of the closing date of the merger, technological feasibility of the in-process research and development (“IPR&D”) had not been established and the technology had no alternative future use. Accordingly, we charged the value of the IPR&D at the date of the acquisition to expense. The amount of the purchase price allocated to IPR&D was based on established valuation techniques used in the software industry. The fair value assigned to the acquired IPR&D was determined using a discounted cash flow methodology, which discounts expected future cash flows to present value.
The key assumptions used in the valuation include, among others, expected completion date of the in-process projects identified as of the acquisition date, estimated cost to complete the projects, revenue contributions and expense projections assuming the resulting product has entered the market, and discount rates based on the risks associated with the development life cycle of the in-process technology acquired. The discount rates used in the present value calculations are obtained from a weighted-average cost of capital analysis, adjusted upward to account for the inherent uncertainties surrounding the successful development of the IPR&D, the expected profitability levels of such technology, and the uncertainty of technological advances that could potentially impact the estimates. We assume the pricing model for the resulting product of the acquired IPR&D to be standard within its industry. We did not take into consideration any consequential amount of expense reductions from integrating the acquired IPR&D with other existing in process or completed technology.
The key considerations underlying the valuation of acquired in-process research and development from Blue Pumpkin are as follows: a) guidance from SFAS No. 2, Accounting for Research and Development Costs and FASB Interpretation No. 4, Applicability of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase Method; b) percent completed as of the acquisition date; c) estimated costs to date, as well as costs to complete the technology; and d) the numerous technical, cost, market, and timing risks we face before the technology becomes technologically feasible.
Unaudited pro forma information reflecting the acquisition of Blue Pumpkin as if it occurred on January 1, 2004 is as follows (in thousands, except per share amounts):
The pro forma results include adjustments for the amortization expense of intangible assets arising from the acquisition and the reversal of interest income assuming the cash portion of the purchase was paid from available cash. In addition, the pro forma results do not reflect any adjustments for IPR&D charges, because of their non-recurring nature, and cost savings and synergies that we believe would have resulted had the acquisition occurred on January 1, 2005.
On May 23, 2005, we acquired Optimis Group Limited (“Optimis”), a UK-based provider of workforce optimization software solutions. Blue Pumpkin owned a minority interest in an operating subsidiary of Optimis, the balance of which was acquired through the Optimis acquisition. We paid $5.0 million in cash and other consideration, which was financed from our existing cash and investments. Ten percent of the aggregate merger consideration was held in escrow and was released in August 2006 to Optimis shareholders. Acquisition of Optimis resulted in $5.3 million in additional goodwill.
6. Other Acquisitions
Acquisition of Demos
On October 2, 2006, we acquired Demos, a leading productivity solution provider for the financial services industry. The total purchase consideration in 2006 for Demos was cash of approximately $6.3 million, including $0.3 million earned in 2006 as part of the potential for an earn-out of approximately $18.0 million based on the growth of the business over the next several years. Ten percent (10%) of the initial consideration plus ten percent (10%) of any earn-out earned will be held in escrow until October 2, 2007, or longer, if claims are brought against the escrow fund and remain pending on that date. The escrow fund will be available to indemnify Witness for losses resulting from, among other things, breaches of representations, warranties and covenants.
We commenced the consolidation of Demos on October 2, 2006 and the acquisition was accounted for using the purchase method of accounting in accordance with SFAS No. 141. The following summarizes the total preliminary purchase price for Demos (in thousands):
Under the purchase method of accounting, the total purchase price is allocated to Demos’ net tangible and intangible assets based upon their estimated fair value as of the date of the acquisition with any amount paid in excess of the fair value of the net assets recorded as goodwill. Based upon the purchase price and review of the net assets acquired and liabilities assumed, the purchase price allocation, is as follows (in thousands):
Acquisition of Exametric
On October 2, 2006, we acquired Exametric, a leading software solutions company specializing in workforce management and optimization for the financial services industry. The total consideration paid for Exametric was cash of approximately $23 million. Approximately $2.4 million of the aggregate consideration will be held in escrow until October 2, 2007, or longer, if claims are brought against the escrow fund and remain pending on that date. The escrow fund will be available to indemnify Witness for losses resulting from, among other things, breaches of representations, warranties, covenants and certain transaction costs.
We commenced the consolidation of Exametric on October 2, 2006 and the acquisition was accounted for using the purchase method of accounting in accordance with SFAS No. 141. The following summarizes the total preliminary purchase price for Exametric (in thousands):
Under the purchase method of accounting, the total purchase price is allocated to Exametric’s net tangible and intangible assets based upon their estimated fair value as of the date of the acquisition with any amount paid in excess of the fair value of the net assets recorded as goodwill. Based upon the purchase price and review of the net assets acquired and liabilities assumed, the purchase price allocation, is as follows (in thousands):
The fair values of Exametric and Demos identifiable intangible assets were determined using both an income and a cost approach taking into consideration the nature, risks, historical patterns, economic characteristics, and future considerations of the assets.
Other Acquisition and Investment
In addition to the above, we acquired another company and made an investment in a technology-related company during 2006. The acquisition resulted in $4.6 million in additional goodwill. In accordance with APB No. 18, “The Equity Method of Accounting for Investments in Common Stock”, the investment in the technology-related company was accounted for using the cost method of accounting and is included in other assets on the Consolidated Balance Sheet as of December 31, 2006. The pro forma effect of the 2006 acquisitions were not material to our Consolidated Financial Statements.
7. Acquisition-Related Restructuring Accruals and Merger-Related and Integration Costs
As a result of the Demos and Exametric acquisitions in 2006, we recorded $0.2 million in acquisition-related restructuring accruals related to personnel reductions. As a result of the Blue Pumpkin and Optimis acquisitions in 2005, we recorded $ 2.4 million in certain acquisition-related restructuring accruals primarily related to personnel reductions. All such costs met the criteria for accrual as outlined in EITF No. 95-3, Recognition of Liabilities in Connection with a Purchase Business Combination, and were included in the assets acquired and liabilities assumed in the purchase of Demos, Exametric, Blue Pumpkin, Optimis and Eyretel. The following table summarizes the restructuring accrual activity (in thousands):
The following table summarizes all merger-related and integration costs that were charged to expense during the years ended December 31, 2006, 2005 and 2004 (in thousands):
During 2006, we incurred merger-related and integration costs in the amount of $2.2 million pertaining to the acquisitions of Blue Pumpkin and Optimis. These expenses were primarily associated with legal and professional fees and a discount on shares sold to the Blue Pumpkin shareholders in connection with the IEX settlement. We also incurred merger-related and integration costs in the amount of $0.5 million pertaining to the acquisitions of Demos and Exametric. During 2005, we incurred merger-related and integration costs pertaining to the acquisitions of Blue Pumpkin and Optimis comprised primarily of legal costs, transitional employees and other contractors, and travel and advertising costs. Merger-related and integration costs incurred in 2004 totaled $0.5 million and related to the acquisition of Eyretel.
8. Accrued Expenses
Accrued expenses consisted of the following (in thousands):
9. Line of Credit
In March 2007, we reduced our line of credit from $15.0 million to $2.0 million and extended the maturity date on the $2.0 million line of credit to March 2008. At our election, borrowings under the line of credit bear interest at the bank’s prime rate, which was 8.25% on December 31, 2006, or LIBOR plus 300 basis points. Borrowings under the revolving line of credit are limited to 85% of eligible accounts receivable, as defined by the agreement. The revolving line of credit is secured by all of our assets and requires compliance with various covenants, including liquidity ratios and EBITDA requirements, among others. As of December 31, 2006, we were in compliance with all bank covenants.
As of December 31, 2006, we had no amounts outstanding under the line of credit and the amount available for borrowing was $14.0 million, which was net of outstanding letters of credit of $1.0 million. The letters of credit secure the lease on our corporate headquarters facility and have decreasing schedules that ultimately expire in 2007. In addition, we have a £0.3 million ($0.6 million) letter of credit securing our leased premises in the United Kingdom.
10. Stockholders’ Equity
Accumulated Comprehensive Income-Accumulated other comprehensive income consisted of the following (in thousands):
Stock Repurchases-In 2002, our Board of Directors authorized a stock repurchase program to spend up to $10.0 million to repurchase our common stock. As of December 31, 2006, we had repurchased 1.0 million shares of our common stock for $3.1 million, which were retired. The Company has not repurchased its common stock since 2003 and does not presently plan to repurchase additional common stock.
Sale of Additional Shares of Common Stock-In December 2005, we issued 4.7 million additional shares of common stock resulting in $88.8 million in net proceeds.
11. Stock-Based Compensation and Employee Benefit Plans
Effective January 1, 2006, we adopted SFAS No. 123(R) using the modified prospective application transition method. SFAS No. 123(R) requires us to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service period. We recognize stock-based
compensation expense over the awards’ vesting periods using the accelerated method as provided for by FIN No. 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans. Prior to the adoption of SFAS No. 123(R), we accounted for stock-based awards to employees using the intrinsic value method in accordance with APB No. 25 as allowed under SFAS No. 123.
Our net income (loss) for the years ended December 31, 2006, 2005 and 2004 includes $13.8 million, $0.4 million and $0.8 million, respectively, of stock-based compensation expense and $0.2 million in 2006, 2005 and 2004, of related income tax benefits recorded to additional paid-in-capital. Cash received from stock option exercises for the years ended December 31, 2006, 2005 and 2004 was $12.4 million, $10.5 million and $13.0 million, respectively.
As of December 31, 2006, there was $14.7 million of total unrecognized stock-based compensation expense related to unvested share-based compensation arrangements granted under all stock option plans. That cost is expected to be recognized over a weighted-average period of 1.2 years.
A summary of all stock option plans activity as of December 31, 2006 is as follows:
(a) The aggregate intrinsic values were computed by applying the following formula = (market value of an option as of December 31, 2006 - the exercise price at which the option was granted) x the number of common stock options.
(b) The number of shares vested + expected to vest as of December 31, 2006 is computed by applying the following formula = Number of shares vested as of December 31, 2006 + (shares not vested as of December 31, 2006*[100%-forfeiture rate])
The following table summarizes information about stock options outstanding and exercisable as of December 31, 2006:
The total intrinsic value of stock options exercised in 2006, 2005 and 2004 is as follows (in thousands):
The weighted-average grant date fair value of stock options granted during 2006, 2005 and 2004 was $7.47, $7.52 and $5.77 per share, respectively. The weighted-average grant date fair values were determined using the Black-Scholes option-pricing model with the following weighted-average assumptions:
(1) The expected term of employee stock options represents the weighted-average period the stock options are expected to remain outstanding. The following factors were considered in estimating the expected term using the Black-Scholes model:
· The vesting period of the awards
· Employees’ past exercise and post-vesting employment departure behavior
· Expected volatility of the price of the underlying share
(2) We used 3.3 year historical stock-price volatility as the expected volatility assumption which aligns with the expected term of the options granted during the year ended December 31, 2006. We believe that historical volatility reflects our current assessment of expected volatility. Prior to 2006, we used historical stock price volatility in accordance with SFAS No. 123 for purposes of our pro forma disclosure.
(3) The forfeiture rates are determined taking into consideration historical forfeiture rates. SFAS No. 123(R) requires forfeitures be estimated at the time of option grants and revised, as necessary, in subsequent periods if actual forfeitures differ from those estimates. Prior to adoption of SFAS No. 123(R), our pro forma disclosures accounted for actual forfeitures as they occurred.
(4) The risk-free interest rate assumptions are based on the rate currently available on zero-coupon U.S. Treasury instruments with a remaining term equal to the expected term of the share option.
Stock Incentive Plans-We have three stock incentive plans: (i) the 1999 Stock Incentive Plan (the “1999 Plan”); (ii) the 2003 Broad Based Option Plan (the “2003 Plan”); and (iii) the 2003 Non-employee Director Stock Option Global Plan (the “Director Plan”).
1999 Plan-Under the 1999 Plan, we may grant shares of common stock in the form of stock options, restricted stock awards, or stock appreciation rights to employees and key persons affiliated with Witness, as defined. In 2001, our stockholders modified a provision to increase, without further approval required, the number of shares authorized each year beginning on January 1, 2002 by a number equal to the lesser of 10% of the total number of shares of common stock then outstanding or 3,000,000 shares. As of December 31, 2006, we had 1,213,942 shares available for future grant.
In 2003, we adopted the Director and Key Executive Stock Ownership Incentive Policy (the “Policy”) under the 1999 Plan. The Policy intended to promote the interests of Witness and its stockholders by encouraging members of the Board of Directors and key executives to purchase shares of our common stock. Under the Policy, an eligible person who purchased at least 500 shares and up to 3,000 shares of our common stock in the open market was automatically and immediately granted five options from our 1999 Plan for each share purchased, with an exercise price equal to the closing price of our common stock on the date of purchase. One-half of the options vested on the first anniversary of the grant date, and the remaining options vested in 12 equal monthly installments thereafter. The Policy expired on June 15, 2004 and 122,500 options were granted under this Policy.
During 2005, 603,500 stock options were granted to certain Blue Pumpkin and Optimis employees as an inducement to join Witness. During 2006, 469,000 stock options were granted to certain Demos and Exametric employees as an inducement to join Witness. The inducement options are exercisable for five years from the date of grant and will first become exercisable, as to 25 percent of the total amount, after one year from the date of grant, and commencing 13 months after grant and until the end of the 47th month following grant, the options will become exercisable as to an additional two percent per month and the balance upon the 48th month following grant.
2003 Plan-In connection with the Eyretel acquisition, we established the 2003 Plan for former Eyretel employees. The 2003 Plan became effective in June 2003, allowing us to grant shares of common stock in the form of stock options. As of December 31, 2006, we had 414,333 shares available for future grant. We do not anticipate increasing the number of shares available for issuance under the 2003 Plan.
Director Plan-The Director Plan became effective in 2003, allowing us to grant non-employee members of our Board of Directors non-qualified options to purchase shares of our common stock pursuant to a formula award. As of December 31, 2006, we had 352,000 shares available for future grant.
Each plan remains in effect until the earlier of the tenth anniversary of its effective date or the date on which all reserved shares have been issued or are no longer available for use. Option vesting terms typically range from two to four years. Options granted since July 1, 2004, have five-year terms from the date of grant. Options granted prior to July 1, 2004 have ten-year terms from the date of the grant. The 1999 Plan and the 2003 Plan provide for accelerated vesting in the event that an employee is terminated without cause or for good reason following a change in control. The Director Plan provides for accelerated vesting upon a change of control. To the extent that accelerated vesting of options occurs, we may have a future charge. Our policy is to issue new shares upon share option exercise.
Employee Stock Purchase Plan-The Employee Stock Purchase Plan (“ESPP”) allows our employees to elect up to 15% of their pay to purchase through payroll deductions shares of common stock at a price per share of 95% of the fair market value at the end of each quarterly option period. The ESPP includes a provision to increase, without further approval required, the number of shares authorized each year on January 1 by a number equal to the lesser of 2% of the total number of shares of common stock then outstanding or 900,000 shares. As of December 31, 2006, 510,952 shares of common stock have been issued under the ESPP.
Retirement Plans-We have a U.S. tax-qualified defined contribution plan under Section 401(k) of the Internal Revenue Code (the “401(k) Plan”). Employees are eligible to participate the first of the month following their date of hire. The 401(k) Plan allows participants to contribute up to 100% of eligible compensation, subject to U.S. Internal Revenue Service limitations. The 401(k) Plan also provides for discretionary employer matching contributions. We also have a personal savings plan (“Savings Plan”) for our United Kingdom employees. In accordance with the Inland Revenue limitations, employees are eligible to invest of up to 35% of base salary in the Savings Plan, which includes employer contributions ranging from 5% to 7% of employee compensation. We contributed $0.6 million, $0.5 million and $0.8 million to the 401(k) Plan and Savings Plan in 2006, 2005 and 2004, respectively.
Stockholder’s Rights Plan-We have a stockholder rights plan (the “Rights Plan”) which has the effect of causing substantial dilution to a person or group that attempts to acquire Witness on terms not approved by the Board of Directors. Under the Rights Plan, we issued a dividend of one right for each share of our common stock, par value of $0.01 per share, held by stockholders of record as of the close of business on November 4, 2002. Each right will entitle stockholders to purchase one unit of a share of our Series A Junior Participating Preferred Stock for $25.00. The rights generally will be exercisable only upon the occurrence of certain events, and will expire on November 4, 2012 unless earlier terminated.
Prior to entering into the Merger Agreement, on February 11, 2007, our Board of Directors adopted and approved an amendment to the Rights Plan, which amends certain sections and definitions of the Rights Plan thereby rendering the Rights Plan inapplicable to the acquisition by Verint or its affiliates of shares of Witness common stock in connection with the merger.
As a result of the amendment, (1) the preferred stock purchase rights issued under the Rights Plan will be inapplicable to the merger, the Merger Agreement and the other transactions contemplated by the Merger Agreement, (2) the merger will not cause the rights to separate from the shares of our common stock or permit the our stockholders to exercise the rights, and (3) the preferred stock purchase rights issued under the Rights Plan will expire immediately prior to the effective time of the merger.
The Rights Plan has no present dilutive effect on our capital structure, nor does it affect reported earnings per share or change the way our shares of common stock are traded. Neither the adoption of the Rights Plan, nor the dividend distribution of the rights, was taxable to our shareholders or Witness.
Change of Control-Our senior officers, including our named executive officers, have change of control agreements, which in general, provide the officers with severance benefits in the event of a change in control as defined. The agreements provide for Witness to pay the officer a multiple of his, or her, base salary and target bonus, in a lump sum, as well as a minimum pro rata bonus for the year in which the change of control occurs, and payment of COBRA continuation coverage (for all but two officers), life insurance premiums and long-term disability insurance premiums for a fixed period of time. In addition, most of the agreements provide for a gross-up payment for U.S. federal “golden parachute” excise taxes that might result from the receipt of the severance payments. The severance payments vary by seniority, and involve multiples of 1.0 or 1.5 times the sum of base salary and bonus. In the change of control agreements other than those for our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), payments are made only if there is both a change of control of Witness and a termination of employment of the officer without cause (or a constructive termination) as determined by the terms of the respective agreements.
12. Income Taxes
Income (losses) before income taxes from U.S. operations were ($6.5) million, ($1.3) million and $10.2 million in 2006, 2005 and 2004, respectively. Income (losses) before income taxes from foreign operations were $10.2 million, ($0.2) million and ($1.2) million in 2006, 2005 and 2004, respectively.
We recorded a provision for income tax benefit of ($3.8) million during the year ended December 31, 2006, of which ($4.7) million relates to the provision for foreign deferred taxes. Specifically, ($4.4) million relates to the release of the valuation allowance against deferred tax assets for Witness Systems Ltd. The remaining provision consists of $0.2 million for the U.S. federal alternative minimum income tax (“AMT”), $0.2 million for foreign withholding income taxes, and $0.2 million for other taxes. For the same periods during 2005 and 2004, the tax expense of $3.0 million and $0.3 million, respectively, was primarily related to deferred tax expense resulting from the release of the valuation allowance associated with the acquired deferred income tax assets of Blue Pumpkin, and foreign income tax.
The components of the provision for income tax expense for 2006, 2005 and 2004 are as follows (in thousands):
Income tax expense (benefit) differed from the amounts computed by applying the statutory U.S. federal income tax rate of 35% to income (loss) before provision for income taxes as a result of the following (in thousands):
The income tax effects of temporary differences that give rise to significant portions of our deferred income tax assets and liabilities are presented below (in thousands):
The net change in the valuation allowance for deferred income tax assets for 2006 was a decrease of ($10.0) million, and an increase in 2005 and 2004 of $23.3 million and $4.6 million, respectively. The valuation allowance decrease in 2006 is comprised of $1.2 million for current activity, ($7.4) for the release of the valuation allowance for Witness Systems Ltd., ($2.7) million of deferred tax liabilities reducing the valuation allowance as a result of the Exametric acquisition, ($0.5) million for the adjustment under SAB 108, and other miscellaneous adjustments of ($0.5) million. Included in the valuation allowance for deferred income tax assets as of December 31, 2006 is $21.8 million from the Blue Pumpkin acquisition and $2.1 million from the Eyretel acquisition in 2003 which, when reversed, will result in the reduction of goodwill or intangible assets prior to being reflected as an income tax provision benefit. For 2006, Witness Systems Ltd. recorded a credit to other identified intangible assets in the amount of $0.8 million related to the release of a portion of its valuation allowance.
At December 31, 2006, we had federal net operating loss, federal research and experimentation credit, and foreign tax credit carryforwards for U.S. federal income tax purposes of $78.1 million, $6.3 million and $0.8 million, respectively, which expire in varying amounts beginning in the year 2011 and which, in part, may be subject to various limitations. We also have incurred net foreign losses in the amount of $30.5 million as of December 31, 2006 which are available to offset future taxable income in their respective foreign jurisdictions. These foreign losses expire in varying amounts beginning in 2006.
As of December 31, 2006, the U.S. and U.K. net operating loss carryforwards include tax deductions of approximately $42.2 million and $9.8 million, respectively, resulting from the exercise of stock options. In accordance with APB No. 25, any income tax benefit derived from these tax deductions is reflected as additional paid-in capital at the time we recognize any such income tax benefit. Under SFAS No. 123(R), any excess tax benefits not realized in 2006 (i.e. reduction to taxable income) cannot be recorded as a tax benefit (i.e cannot be reported as a deferred tax asset) until such benefits reduce the tax payable. As a result, the above excess tax benefits are being tracked separately and will be recorded when realized under the “with and without” approach.
During 2006, we also recognized as income tax expense approximately $0.2 million of AMT that would have been payable had there been no stock option deductions under the “with and without” approach as it relates to the ordering of its excess stock option deductions. Actual stock option deductions incurred for income tax purposes results in no actual payment of AMT. A “hypothetical” deferred income tax asset is created by the “hypothetical” AMT expense incurred.
Undistributed accumulated and current earnings of our foreign subsidiaries totaled approximately ($47.3) million and $10 million, respectively, at December 31, 2006. We consider those earnings reinvested indefinitely and, accordingly, provide no provision for U.S. federal and state income taxes. Upon distribution of those earnings in the form of dividends or otherwise, we may be subject to withholding taxes payable to various foreign countries, however, no U.S. income taxes will be generally incurred due to net operating loss carryovers available to offset the income from the dividend payment. Determination of the amount of unrecognized deferred U.S. income tax liability is not practicable because of the complexities associated with its hypothetical calculation.
13. Segment and Geographic Information
We consider ourselves to be in a single industry segment, specifically licensing and servicing of software applications to the customer interaction recording and analysis market. Our chief operating decision maker receives financial information by geographic region; however, our operating segments are aggregated into one reportable segment based upon similar economic characteristics, products, services and delivery methods.
World-wide annual revenue based on customer location is as follows (in thousands):
The rest of world revenue was derived primarily from customers located in Australia, Canada, China, India and Japan. No individual customer accounted for more than 10% of consolidated revenue during 2006, 2005 or 2004, or accounts receivable at December 31, 2006 or 2005.
Long-lived assets, including goodwill and intangible assets, by geography are as follows (in thousands):
14. Commitments and Contingencies
Operating Commitments-We lease office facilities, including our corporate headquarters, and certain office furniture and equipment under various noncancelable operating lease agreements. Future minimum payments under leases with remaining terms greater than one year at December 31, 2006, and for the next five years and in the aggregate are as follows (in thousands):
Lease expense for the years ended December 31, 2006, 2005, and 2004 was $5.2 million, $5.7 million and $5.7 million, respectively.
We entered into a software licensing agreement in 2005 which requires us to pay an additional $1.3 million in 2007 for the right to distribute a vendor’s software as part of our workforce optimization solution. This amount has been recorded as accrued liabilities as of December 31, 2006. Imputed interest expense associated with the payment is not significant.
On April 6, 2006, Blue Pumpkin and IEX reached an agreement to settle all claims asserted between the parties. As part of the final settlement, Witness paid $8.25 million to IEX’s parent company, in April 2006 and agreed to make six annual payments of $0.5 million ($3.0 million in total) from April 2007 through 2012.
On October 2, 2006, we acquired Demos, a leading productivity solution provider for the financial services industry. The total purchase consideration in 2006 for Demos was cash of approximately $6.3 million, including $0.3 million earned in 2006 as part of the potential for an earn-out of approximately $18 million based on the growth of the business over the next several years. A portion of such potential earn-out is subject to acceleration in the event there is a change in control of the Company.
Legal Proceedings-On December 11, 2002, we filed in the United States District Court for the Northern District of Georgia, Atlanta Division, a lawsuit against Knowlagent, Inc. (“Knowlagent”), which is the assignee of United States (“U.S.”) Patent Nos. 6,324,282 B1 and 6,459,787 B2. Knowlagent has accused our eQuality Now software of infringing the above patents. We filed suit seeking a declaration that we did not and do not infringe either of the two patents listed above, as well as a declaration that the above patents are invalid and unenforceable. We also filed a claim requesting that if the patents are found to be valid, that one of our own employees be named the rightful inventor of the patents. We also requested monetary damages in an amount equal to the amount that Knowlagent has received from its use of the above patents. On December 31, 2002, Knowlagent filed its answer to our complaint as well as two counterclaims, alleging that we infringe and contribute to the infringement by others of the above patents; Knowlagent seeks both monetary damages and an injunction in connection with its counterclaim. On June 6, 2005, the Court held a claim construction hearing and issued a claim construction order on June 8, 2005. The case is now proceeding to expert discovery and summary judgment phases.
On July 20, 2004, STS Software Systems Ltd. (“STS Software”), a wholly-owned subsidiary of NICE Systems, Ltd. (“NICE Ltd.”), filed a patent infringement suit in the U.S. District Court for the Southern District of New York against us (“New York Action”). The New York Action asserts that our products, including eQuality ContactStore for IP, infringe United States (“U.S.”). Patent No. 6,122,665
(“the ‘665 patent”) and seeks only injunctive, not monetary, relief. On the same day, we filed a declaratory judgment action against STS Software in the U.S. District Court for the Northern District Georgia (“Georgia Action”). We seek a declaration from the court that we have not infringed any valid claim of the ‘665 patent. By Order entered December 16, 2004, Judge Koeltl of the U.S. District Court for the Southern District of New York granted our motion to transfer the New York Action to the Northern District of Georgia, which has now consolidated the former New York Action with the Georgia Action. On July 7, 2005, the Court also granted STS leave to amend its complaint to add three patents to the dispute, namely: U.S. Patent Nos. 6,865,604; 6,871,229; and 6,880,004 (respectively, “the ‘604 patent,” “the ‘229 patent,” and “the ‘004 patent”; collectively, “the STS patents”), again seeking solely injunctive relief. We answered the first amended complaint and asserted counterclaims on July 29, 2005, collectively, through which we deny infringement of any valid claim of the STS patents and seek a declaration to that effect. The Court entered its claim construction ruling on January 16, 2007, and the case is progressing through its remaining discovery phases.
On August 30, 2004, we filed in the United States District Court for the Northern District of Georgia, Atlanta Division, a lawsuit against NICE Systems, Inc. (“NICE Inc.”), a wholly-owned subsidiary of NICE Ltd., alleging patent infringement. Specifically, we have alleged that NICE products, including the NiceUniverse products that include screen capture and synchronized screen and voice capture technologies, infringe claims of U.S. Patent Nos. 5,790,798 (“the ‘798 Patent”) and 6,510,220 (“the ‘220 Patent”), both entitled “Method and Apparatus for Simultaneously Monitoring Computer User Screen and Telephone Activity from a Remote Location.” We have sought an injunction and money damages for NICE’s infringement of these two patents. NICE Inc. has answered and counterclaimed for declaratory judgments of non-infringement and invalidity. Since then, on February 24, 2005, we filed suit against NICE Ltd. because of its infringing activities in violation of the ‘798 and ‘220 patents, including importation of the accused NICE products. By order dated April 5, 2005, the court has consolidated the NICE Inc. and NICE Ltd. actions. The Court entered its claim construction ruling on January 5, 2007, and the case is progressing through its remaining discovery phases.
On January 19, 2006, we filed in the United States District Court for the Northern District of Georgia, Atlanta Division, a lawsuit against NICE Systems, Inc. and NICE Systems, Ltd. (collectively “NICE”), alleging patent infringement. Specifically, we have alleged that NICE products, including NicePerform and related products that include the ability to monitor communications to detect the presence of at least one predetermined parameter, infringe claims of U.S. Patent No. 6,404,857 B1 (“the ‘857 Patent”), entitled “Signal Monitoring Apparatus for Analyzing Communications.” We have sought an injunction and money damages for NICE’s infringement of the ‘857 patent. On March 6, 2006, NICE answered and counterclaimed, alleging that the ‘857 patent is not infringed and is invalid. The case has been set on a discovery calendar and is at a preliminary stage.
On May 10, 2006, NICE Systems, Inc. and NICE Systems Ltd. (collectively “NICE”), filed a patent infringement suit seeking monetary damages and injunctive relief in the U.S. District Court for the District of Delaware against us (“Delaware Action”). The Delaware Action asserts that our products, including ContactStore, ContactStore for IP, ContactStore for Communications Manager, Quality for Communications Manager, and eQuality Balance, infringe one or more claims of ten U.S. Patents: U.S. Patent Nos. 5,274,738; 5,396,371; 5,819,005; 6,249,570; 6,728,345; 6,775,372; 6,785,370; 6,870,920; 6,959,079; and 7,010,109 (“the Delaware Patents”). We answered NICE’s complaint on June 30, 2006, through which we deny infringement of any valid claim of any of the Delaware Patents. The case has been set on a discovery calendar and is at a preliminary stage.
On December 27, 2006, NICE Systems, Inc. and NICE Systems Ltd. (collectively, “NICE”), filed a declaratory judgment action against us in the U.S. District Court for the Northern District Georgia, relating to U.S. Patent No. 6,757,361 (“the ‘361 Patent”), entitled “Signal Monitoring Apparatus Analyzing Voice Communication Content.” NICE seeks a declaration from the court that the claims of the ‘361
Patent are invalid, and that NICE has not infringed any valid claim of the ‘361 Patent. The company has moved to dismiss or stay the case while a previously filed reissue proceeding remains pending in the Patent Office. The motion remains pending.
On August 29, 2006, A. Edward Miller filed a shareholder derivative lawsuit in the United States District Court for the Northern District of Georgia (Atlanta Division) naming Witness Systems, Inc. (the “Company”) as a nominal defendant and naming all of our current Board of Directors and a number of our current officers as defendants. Miller v. Gould, et al., Civil Action No. 1:06-CV-2039 (N.D. Ga.). The complaint alleges purported violations of federal and state law, including breaches of fiduciary duty, abuse of control, constructive fraud, corporate waste, unjust enrichment, gross mismanagement and violations of certain antifraud provisions of the federal securities laws (including Sections 10(b) and 14(a) of the Securities Exchange Act of 1934 and Rules 10b-5 and 14a-9 thereunder) in connection with certain stock option grants made by the Company. The complaint seeks monetary damages in unspecified amounts, disgorgement of profits, an accounting, rescission of stock option grants, imposition of a constructive trust over the defendants’ stock options and proceeds derived therefrom, punitive damages, reimbursement of attorneys’ fees and other costs and expenses, an order directing the Company to adopt or put to a stockholder vote various proposals relating to corporate governance, and other relief as determined by the court. On November 15, 2006, the Company and the other defendants filed a motion to dismiss the complaint in its entirety on a variety of grounds, including plaintiffs’ failure to allege demand futility. Rather than respond to that Motion, plaintiffs on January 9, 2007 filed an Amended Complaint. On March 9, 2007, the Company and the other defendants filed a motion to stay or dismiss the amended complaint.
A class action securities lawsuit has been filed by an individual on August 14, 2006 claiming to be a stockholder of the Company naming the Company and certain of its Board of Directors and officers as defendants in connection with certain stock option grants made by the Company. Rosenberg v. Gould, et al., Civil Action No. 1:06-CV-1894 (N.D. Ga.). The complaint, filed in the United States District Court for the Northern District of Georgia, alleges violations of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder and seeks unspecified damages, attorneys’ fees and other costs and expenses, unspecified extraordinary, equitable and injunctive relief, and other relief as determined by the court. A lead plaintiff has been designated, and the Amended Complaint is due on March 26, 2007. The Company and the other defendants will respond to the complaint when appropriate.
On October 27, 2006, the Company received a notice of informal nonpublic inquiry from the Securities and Exchange Commission requesting certain documents and information relating to the company’s stock option grant practices from February 2000 to the present. We intend to cooperate fully with all matters related to this request.
On March 14, 2007, the Company was served with a complaint by Doron Aspitz, the former chief executive officer of Blue Pumpkin Software, Inc., in California Superior Court for the County of Santa Clara (Case No. 107CV078480). The complaint names the Company as defendant and purports to assert eight causes of action, for promissory estoppel, promissory fraud, negligent misrepresentation, breach of fiduciary duty, vote buying, violation of Section 17200 of the California Business and Professions Code, violation of Section 1101 of the California general Corporation Law, and unjust enrichment. The complaint purports to seek over $5.0 million in compensatory damages as well as other unquantified punitive and exemplary damages, disgorgement, and attorneys’ fees and costs. The complaint was filed on or about January 19, 2007 but no effort was made to serve the complaint until approximately mid-March 2007, and no response is presently due. The Company will respond to the complaint at an appropriate time and intends to contest the complaint vigorously.
From time to time we may be involved in other legal proceedings and/or litigation arising in the ordinary course of our business that might impact on our financial position, our results of operations, or our cash flows.
Indemnifications and Warranties-We more often than not indemnify our customers against damages and costs resulting from claims of patent, copyright, or trademark infringement associated with use of our software in its software licensing agreements. We have historically not made any payments under such indemnifications. However, we continue to monitor the conditions that are subject to the indemnifications to identify whether it is probable that a loss has occurred, and would recognize any such losses under the indemnifications when those losses are probable and estimable. In addition, we warrant to customers that our software products operate substantially in accordance with the software product’s specifications. Historically, no material costs have been incurred related to software product warranties and no significant costs are expected in the future.
We have entered into indemnification agreements with each of our present and former directors and officers. Under those agreements, we are (with certain exceptions) required to indemnify each such director or officer against expenses, including attorneys’ fees, judgments, fines and settlements, paid by such individual in connection with the pending litigation relating to our stock option granting practices.
15. Subsequent Events
On February 11, 2007, we entered into an Agreement and Plan of Merger (the “Merger”) with Verint Systems Inc., a Delaware corporation. At the effective time of the Merger, each outstanding share of Witness’ common stock will be converted into the right to receive $27.50 in cash, less any applicable withholding taxes and without interest. Under the Merger Agreement, each outstanding stock option of Witness that is vested at the effective time of the merger and has an exercise price below $27.50 will be cancelled and exchanged for a cash payment by Verint in an amount equal to the excess (if any) of $27.50 over the exercise price per option share multiplied by the number of shares of Witness common stock subject to such vested option. Witness stock options that are vested at the effective time of the merger and have an exercise price above $27.50 will be cancelled without payment. Each outstanding stock option of Witness that is unvested at the effective time of the merger will be assumed by Verint and will become an option to purchase shares of Verint common stock on the same terms and conditions as were applicable to the stock option immediately prior to the effective time of the merger. The number of shares of Verint common stock subject to each assumed option will be determined by multiplying the number of shares of Witness common stock that were subject to the unvested option immediately prior to the effective time of the merger by the conversion ratio set forth in the Merger Agreement, and rounding that result down to the nearest whole number of shares of Verint common stock. The per share exercise price for the assumed option will be determined by dividing the per share exercise price of the Witness common stock subject to the unvested option as in effect immediately prior to the effective time of the merger by the conversion ratio, and rounding that result up to the nearest whole cent. The conversion ratio is the ratio obtained by dividing $27.50 by the average of the closing sales prices of a share of Verint common stock as reported for the twenty consecutive trading days immediately before the closing of the merger (subject to adjustment for stock splits and dividends). The Merger Agreement does not prohibit Verint from making necessary adjustments to the conversion ratio by modifying the exercise price per share and taking such other actions as may be necessary or appropriate to comply with Section 409A of the Internal Revenue Code of 1986, as amended and preserve the intended tax treatment of each outstanding unvested option. We have agreed to freeze our employee stock purchase plan effective April 1, 2007 and to prohibit participants in the plan from increasing their payroll deductions or commencing purchase elections from those in effect on February 11, 2007. We have also agreed to terminate our employee stock purchase plan immediately as of or prior to the effective time of the merger.
Effective January 3, 2007, Mr. David Gould voluntarily resigned from his position as Chief Executive Officer of the Company and as a member of the Company’s Board of Directors and was replaced by Mr. Nicholas Discombe, who has served as the Company’s President and Chief Operating Officer since April 2003. Pursuant to an agreement dated January 3, 2007 and later amended on February 2, 2007, Mr. Gould will continue as an employee until April 30, 2007. Upon termination of employment, Mr. Gould will be entitled to separation payments of $29,333 per month for 12 months. The amount was accrued for as of December 31, 2006. In return, Mr. Gould agreed to the termination of his employment agreement and change in control agreement. In accordance with the original terms of the standard employee option agreement, stock options held by Mr. Gould of approximately 620,000 shares continue to vest throughout his employment period. While his option agreement was not amended, in accordance with SFAS No. 123(R), we recorded $1.9 million in stock-based compensation expense in the first quarter of 2007 to reflect a defacto modification of those options.
Schedule II
Valuation and Qualifying Accounts
(In thousands)
SIGNATURES
Pursuant to the requirements of Section 13 of 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons in the capacities and on the date indicated
/s/ NICK DISCOMBE
Chief Executive Officer and Director
March 30, 2007
Nick Discombe
/s/ WILLIAM F. EVANS
Executive Vice President and Chief
March 30, 2007
William F. Evans
Financial Officer
/s/ TOM BISHOP
Director
March 30, 2007
Tom Bishop
/s/ THOMAS J. CROTTY
Director
March 30, 2007
Thomas J. Crotty
/s/ JOEL G. KATZ
Director
March 30, 2007
Joel G. Katz
/s/ DAN LAUTENBACH
Chairman of the Board
March 30, 2007
Dan Lautenbach
/s/ PETER SINISGALLI
Director
March 30, 2007
Peter Sinisgalli