-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, JimGqupc9Lgz+K1mXvhvI1b0f6T6VDFSr81y7DQXvYrOQf7WCW4HHugGYOCrpFb7 6BYaB64oXjnbIhjd5vBnNg== 0000950128-98-000662.txt : 19980326 0000950128-98-000662.hdr.sgml : 19980326 ACCESSION NUMBER: 0000950128-98-000662 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 8 CONFORMED PERIOD OF REPORT: 19971231 FILED AS OF DATE: 19980325 SROS: NASD FILER: COMPANY DATA: COMPANY CONFORMED NAME: TOLLGRADE COMMUNICATIONS INC \PA\ CENTRAL INDEX KEY: 0001002531 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-TELEPHONE INTERCONNECT SYSTEMS [7385] IRS NUMBER: 251537134 STATE OF INCORPORATION: PA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 000-27312 FILM NUMBER: 98572570 BUSINESS ADDRESS: STREET 1: 493 NIXON RD CITY: CHESWICK STATE: PA ZIP: 15024 BUSINESS PHONE: 4122742156 10-K 1 TOLLGRADE COMMUNICATIONS, INC. 1 SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997 COMMISSION FILE NUMBER 0-27312 TOLLGRADE COMMUNICATIONS, INC. (Exact name of registrant as specified in its charter) PENNSYLVANIA 25-1537134 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 493 NIXON ROAD, CHESWICK, PENNSYLVANIA 15024 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: 724-274-2156 SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: COMMON STOCK, PAR VALUE $.20 PER SHARE (Title of Class) Indicate by a check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registration was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No --- --- Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.___ The Registrant estimates that as of March 13, 1998, the aggregate market value of shares of the Registrant's Common Stock held by non-affiliates (excluding for purposes of this calculation only, 751,355 shares of Common Stock held of record or beneficially by the executive officers and directors of the Registrant as a group) of the Registrant was $107,473,112. As of March 13, 1998, the Registrant had outstanding 5,853,936 of its Common Stock. DOCUMENTS INCORPORATED BY REFERENCE Parts of Form 10-K into which Document Document is incorporated - -------- ------------------------ Portions of the Annual Report to Shareholders for the year ended December 31, 1997 II and IV Portions of the Proxy Statement to be distributed in connection with the 1998 Annual Meeting of Shareholders III 2 PART I CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995. The statements contained in this Annual Report on Form 10-K, specifically those contained in Item 1 "Business" and Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operation," and statements incorporated by reference into this Form 10-K from the 1997 Annual Report to Shareholders, along with statements in other reports filed with the Securities and Exchange Commission, external documents and oral presentations, which are not historical are "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements represent Tollgrade Communications, Inc.'s (the "Company") present expectations or beliefs concerning future events. The Company cautions that such statements are qualified by important factors that could cause actual results to differ materially from those in the forward-looking statements. Results actually achieved may differ materially from expected results included in these statements. Those factors which specifically related to the Company's business include the following: rapid technological change along with the need to continually develop new products; dependence on a single product line; competition; dependence on key employees; management of Company's growth; dependence on certain customers; dependence on certain suppliers; proprietary rights and risks of third party claims of infringement; and government regulation. ITEM 1. BUSINESS. The Company was incorporated in Pennsylvania in 1986 and began operations in 1988. Its principal offices are located at 493 Nixon Road, Cheswick, Pennsylvania 15024 and its telephone number is (724) 274-2156. The Company designs, engineers, markets and supports proprietary products which enable telephone companies to use their existing line test systems to remotely diagnose problems in "plain old telephone service" ("POTS") lines containing both copper and fiber optics. POTS lines comprise the vast majority of lines in service today throughout the world. In addition to traditional voice service, POTS includes lines for popular devices such as computer modems and fax machines. POTS excludes the more complex lines, such as data communications service lines, commonly referred to as "special services." POTS line test systems, located at telephone companies' central offices, diagnose problems in the "local loop", which is the portion of the telephone network which connects end users to a telephone company's central office, and is comprised primarily of copper wireline. The ability to remotely test reduces the time needed to identify and resolve problems and eliminates or reduces the cost of dispatching a technician to the problem site. Most POTS line test systems were designed for use over copper wireline only, so that the introduction of fiber-optic technology into the local loop renders it inaccessible to these test systems. The Company's metallic channel unit ("MCU(R)") products solve this problem by extending test-system access through the fiber-optic portion into the copper portion of the local loop. Products. The Company's MCU products plug into the digital loop carrier ("DLC") systems that are large systems manufactured by equipment vendors such as AT&T, that are used by telephone companies to link the copper and fiber-optic portions of the local loop. DLC systems are located at the telephone company central offices and at remote sites within a local user area, and effectively multiplex the services of the copper lines into a single fiber-optic line. In many instances, several DLC systems are located at a single remote site to serve several thousand different end-user homes and offices. Generally, for every DLC remote site, two MCU line testing products are deployed. To ensure compatibility with these DLC systems, the Company pays royalties pursuant to license agreements for the use of proprietary design integrated circuits ("PDICs"). The PDICs are the design and property of the DLC system manufacturer from which they are purchased. The Company maintains license agreements with and pays royalties to 2 3 Lucent Technologies, Fujitsu Network Transmission Systems, Inc., NEC American, Inc. and Reliance Comm/Tec Corporation. In general, the current terms for expiration of these agreements range at various times between August 1998 and an indefinite duration, with renewal provisions (unless earlier terminated) for periods of between one and five years. In addition, certain of these agreements can be terminated prior to renewal. The Company incurred $1,075,800, $1,893,000 and $2,014,000, respectively in 1995, 1996 and 1997 as royalties under the license agreements, which royalties are calculated either based on a percentage of the list price of MCU products or a fixed amount per unit which incorporate the technology licensed under each such agreement.Certain of the license agreements require the Company to maintain the confidentiality of the licensor's proprietary information and/or the terms and conditions of the agreement itself. In addition, the Company maintains license agreements which do not contain royalty provisions with Advanced Fibre Communications, DSC Technologies Corporation, Northern Telecom Inc., UTSTARCOM, Inc., and most recently entered into license agreements with Next Level Communications and SAT Division Reseaux et Telecommunications (a French Corporation) for which products are still in the early phase of development. The expiration dates of these agreements range at various times between July 1998 and November 2004, with renewal provisions (unless earlier terminated) for periods of one or more years. Future license agreements entered into by the Company may contain terms comparable to, or materially different than, the terms of existing agreements as competitive and other conditions warrant. The loss of PDICs license agreements or the inability of the Company to maintain an adequate supply of PDICs could have a material adverse effect on the Company's business. Other MCU technology is also used with home and business alarm systems. As with home service line testing, home alarm systems must be monitored from the alarm company's headquarters along a hybrid copper and fiber-optic line. The Company's alarm-related MCU products are used to facilitate the transport of analog alarm signals from subscriber homes to alarm company monitoring stations across the hybrid telephone network. These units plug into equipment at both central office and remote locations. MCU products accounted for more than 93%, 93% and 94% of the Company's sales in 1995, 1996 and 1997, respectively. In addition, the Company has recently entered into a license agreement with C-Cor Electronics, Inc. (a cable television systems developer) in which the Company will develop and subsequently provide its status monitoring transponder technology that will be incorporated into C-Cor's cable network management system. Product and Technology Development. The Company's product development personnel are organized into teams, each of which is effectively dedicated to a specific product line(s) or technology. Each product team also implements the Company's ongoing "value engineering" programs which are designed to replace the Company's products with successive generations having additional features and/or lower costs. The Company continuously monitors developing technologies and introduces products as defined standards and markets emerge. In addition, the Company continues to investigate the development of new applications for its MCU technology and other technologies to service the telecommunications industry. During 1995, 1996 and 1997, research and development expenses were approximately $2,637,000, $3,921,000 and $5,945,000, respectively. Proprietary Rights. The names "Tollgrade(R)", "MCU(R)" and "Micro-Bank(R)", and the Company's corporate logo are registered trademarks of the Company. "Team TollgradeSM" is a service mark of the Company and "Lighthouse(TM)", "Digitest(TM)" and "Telaccord(TM)" are trademarks for which registration has been applied. The Company has obtained three patents on the MCU products with expiration dates ranging from 2010 to the year 2014. In addition, the Company has five U.S. provisional and two international patent cooperation treaty ("PCT") patent applications pending. The Company will seek additional patents from time to time related to its research and development activities. The Company protects its trademarks, patents, inventions, trade secrets, and other proprietary rights by contract, trademark, copyright and patent registration, and internal security. 3 4 Customers. The Company's primary customers are the five regional Bell operating companies ("RBOCs"), which are Ameritech Corporation, Bell Atlantic Corporation, BellSouth Corporation, SBC Communications Inc., and US WEST Inc., as well as major independent telephone companies such as Sprint and Southern New England Telephone Company. Historically, almost all of the Company's sales have been made to the RBOCs (86% in 1997). Bell Atlantic Corporation and BellSouth Corporation accounted for 30% and 24%, respectively, of the Company's total sales in 1997. The Company's relationships with its customers are material to the Company's business, and the loss of any such relationship could have a material adverse effect on the Company's business. Manufacturing. The Company's manufacturing operations consist primarily of quality control, functional testing, final assembly, burn-in and shipping. During 1997, the Company received ISO 9001 registration from British Standards Institution, Inc. ISO 9000 is a harmonized set of standards that define quality assurance management. Written by the International Organization for Standardization ("ISO"), it is recognized throughout the United States, Canada, the European Union and Japan. To be registered, the Company developed and maintains internal documentation and processes to support the production of quality products to ensure customer satisfaction. For a portion of 1997 and prior years, the Company utilized one key independent subcontractor to perform a majority of the circuit board assembly and in-circuit testing work on its products. The Company also utilized other subassembly contractors on a more limited basis. During the third quarter, 1997, the key subcontractor notified the Company that its services would be phased out, at the latest, during early 1998. The Company is in the process of phasing out the use of that subcontractor, and is now utilizing two other subassembly subcontractors that had been utilized by the Company on a more limited basis in the past. The loss of the subcontractors could cause delays in the Company's ability to meet production obligations and could have a material adverse effect on the Company's results of operations. In addition, shortages of raw material to, or production capacity constraints at, the Company's subcontractors could negatively affect the Company's ability to meet its production obligations and result in increased prices for affected parts. Any such reduction may result in delays in shipments of the Company's products or increases in the price of components, either of which could have a material adverse impact on the Company. The Company currently procures all of its components from outside suppliers. Generally, the Company uses industry standard components for its products. Application specific integrated circuits ("ASICs") are a key component to the manufacturing process and are custom made to the Company's specifications. Although the Company has generally been able to obtain ASICs on a timely basis, a delay in the delivery of these components could have a material adverse impact on the Company. Backlog. The Company's backlog at December 31, 1997 was approximately $1.6 million, as compared to approximately $0.9 million at December 31, 1996. The increase was due largely to the receipt of certain orders under Original Equipment Manufacturer ("OEM") arrangements scheduled for shipment in the first quarter of 1998 and beyond. The Company includes in backlog all firm purchase orders for products regardless of their ship date. Because of the quick turnaround that the customers expect on their orders, which is sometimes one to two weeks, and because of the possibility of customer changes in delivery schedules or cancellation of orders, the Company's backlog as of any particular date may not be indicative of actual revenues expected for any future period. Competitive Conditions. The deciding competitive factors in the Company's market include price, product features, performance, reliability, service and support, breadth of product line, technical documentation and prompt delivery. The Company believes that it competes favorably on all of these factors, and certain of its products have proprietary or patented features. The Company also attempts to enter into development agreements for its MCU products with the manufacturers of DLC and other complex systems, which serves to ensure compatibility for its products. Competition would increase if new companies enter the Company's product markets or existing competitors expand their product lines. For instance, the recently enacted telecommunications reform legislation has lifted the restrictions which previously prevented the RBOCs from manufacturing telecommunications equipment. Pursuant to this legislative reform, the RBOCs, which are the Company's largest customers, may become competitors of the 4 5 Company in the markets served by the Company. For the Company's line-testing MCU devices, the primary competitive products are the remote monitoring units made by Teradyne, Inc. and the Harris Dracon division of Harris Corporation. The Company's MCU is simpler and less costly to install and permits the full complement of centralized testing to be performed as quickly and accurately as with copper by-pass wiring. The Company believes that Wiltron Company, Inc. and the Tau-Tron division of General Signal Corporation, providers of special services test systems, could expand into POTS line testing. The alarm-related MCU product's primary competitor is the Turbo 2000 unit made by Antec Corporation. Employees. At December 31, 1997 the Company had 205 full-time employees, all in the United States. None of the Company's employees is represented by a collective bargaining agreement. Government Regulation. The telecommunications industry is subject to regulation in the United States and other countries. Federal and state regulatory agencies, including the FCC and various state public utility commissions and public service commissions, regulate most of the Company's domestic customers. While such regulation does not typically affect the Company directly, the effects of such regulations on the Company's customers may, in turn, adversely impact the Company's business and operating results. Governmental authorities also have promulgated regulations which, among other things, set installation and equipment standards for private telecommunications systems and require that all newly installed hardware be registered and meet certain government standards. ITEM 2. PROPERTIES. The Company's headquarters and principal administrative, engineering and assembly facilities are located in Cheswick, Pennsylvania and occupy approximately 67,000 square feet. The Company occupies its current facilities under a lease that expires in December, 1998 with successive options to renew through 2010. The Company believes that its current facilities are adequate to support its present level of operations and there is ample room to support continued sales growth for the foreseeable future. ITEM 3. LEGAL PROCEEDINGS. There are currently no outstanding or pending material legal proceedings with respect to the Company or its business. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. During the fourth quarter of 1997, there were no matters submitted to a vote of security holders through solicitation of proxies or otherwise. 5 6 EXECUTIVE OFFICERS OF THE COMPANY Information relating to the executive officers of the Company as of January 31, 1998 is set forth below: R. Craig Allison Chairman of the Board since April 1990; also Chief Executive Officer from April 1990 until September 1995; Director since 1986; father of Christian L. Allison, Chief Executive Officer; Age 57. Christian L. Allison Chief Executive Officer since September 1995; Treasurer from May 1992 until April 1997; President from October 1993 until September 1995; prior thereto, Chief Operating Officer; Director since 1992; son of R. Craig Allison, Chairman of the Board; Age 37. Sara M. Antol Chief Counsel and Secretary since April 1996; prior thereto, employed by the law firm of Babst, Calland, Clements and Zomnir P.C.; Age 36. Robert L. Cornelia Executive Vice President, Operations since May 1996; Vice President, Manufacturing from October 1993 until May 1996; prior thereto, Production Manager; Age 35. Bradley N. Dinger Controller since September 1996; prior thereto Assistant Controller of AMSCO International, Inc. (manufacturer of health care equipment) from May 1993 until September 1996; prior thereto, Corporate Accounting Manager of AMSCO; Age 35. Herman Flaminio Executive Vice President, Marketing Services, Planning and Technical Support since July 1997; Senior Vice President, Marketing and Strategic Products from October 1993 to June 1997; prior thereto, Director of Marketing, Technical Support and Planning; brother of Rocco L. Flaminio, Vice Chairman, Chief Technology Officer and a Director; Age 58. Rocco L. Flaminio Vice Chairman and Chief Technology Officer since October 1993; prior thereto, President; Director since December 1995; brother of Herman Flaminio, Senior Vice President; Age 73. Mark C. Frey Senior Vice President, Engineering since 1993; prior thereto, Vice President, Engineering; Age 44. Joseph P. Giannetti Vice President, Human Resources, Safety and Security since June 1995; Director of Safety and Environmental on a part-time basis from June 1993 until June 1995; prior thereto, worked on a contract basis for Pittsburgh Applied Research Corporation (a contractor in research and development services); Age 61. Frederick J. Kiko Senior Vice President, Design Engineering since 1988; Age 54. 6 7 Samuel C. Knoch Chief Financial Officer since August 1996; Treasurer since April 1997; Controller of AMSCO International, Inc. (manufacturer of health care equipment) from October 1994 until August 1996; Director of Internal Audit at AMSCO from June 1993 until October 1994; prior thereto, employed by the accounting firm of Arthur Andersen & Co.; Age 42. Geoffrey W. Lea Vice President, Sales N.A./L.A. since July 1997;Vice President, Marketing & Special Assignment Sales Administration from August 1996 to June 1997; Vice President, Sales from September 1995 until August 1996; Vice President, Marketing from January 1995 until September 1995; prior thereto, Regional Sales Manager for ADC Telecommunications Inc.(a manufacturer of telecommunications equipment); Age 39. Gregory M. Nulty Vice President, Marketing since December 1994; prior thereto, Senior Product Manager for Pulse Communications, Inc. ( a DLC system vendor and subsidiary of Hubbel, Inc.); Age 44. Joseph G. O'Brien Senior Vice President, Organizational Development since October 1997; Director of Employee Development from April 1997 until October 1997; Coordinator, Elderberry Junction, Goodwill Industries (a charitable organization) from May 1995 until April 1997; Director of Public Relations of Goodwill Industries from June 1994 until May 1995; prior thereto, Roman Catholic Priest, Diocese of Greensburg, Pennsylvania; Age 38. Timothy D. O'Brien Director of Communications since August 1997; Vice President of Ketchum Public Relations ( a public relations firm) from November 1995 until August 1997; prior thereto, Account Supervisor at Ketchum; Age 37. Mark B. Peterson Executive Vice President, Sales since October 1997; prior thereto, Testing Application Group product manager (MLT and Switched Access Remote Test Systems (SARTS) product lines) of Lucent Technologies (a manufacturer of communication systems, software and products and formerly AT&T Bell Laboratories) from October 1995 until October 1997; prior thereto, various other management level positions at Lucent in systems engineering, hardware design, system test and product manaagement; Age 37. Matthew J. Rosgone Vice President, Purchasing since July 1996; Director of Purchasing from July 1995 until July 1996; prior thereto, Buyer; Age 29. 7 8 PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS. Information relating to the market for the Company's Common Stock and other matters related to the holders thereof is set forth under the caption "Common Stock Market Prices" on page 26 of the Company's 1997 Annual Report to Shareholders and is incorporated herein by reference. ITEM 6. SELECTED FINANCIAL DATA. A summary of selected financial data for the Company, including each of the last five fiscal years in the period ended December 31, 1997, is set forth under the caption "Selected Consolidated Financial Data" on page 6 of the Company's 1997 Annual Report to Shareholders and is incorporated herein by reference. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. A discussion of the Company's financial condition and results of operations is set forth under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 7 through 11 of the Company's 1997 Annual Report to Shareholders and is incorporated herein by reference. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The Company's consolidated financial statements, together with the report thereon of Coopers & Lybrand L.L.P., are set forth on pages 13 through 25 of the Company's 1997 Annual Report to Shareholders and are incorporated herein by reference. Such financial statements and supplementary data are listed in Item 14(a) (1), "Exhibits, Financial Statement Schedules, and Reports on Form 8-K." ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. In addition to the information reported in Part I of this Form 10-K, under the caption "Executive Officers of the Company", the information required by this item appears beneath the captions "Election of Directors" and "Executive Compensation -- Section 16(a) Beneficial Ownership Reporting Compliance" in the Company's definitive proxy statement for its 1998 Annual Meeting of Shareholders and is incorporated herein by reference. 8 9 ITEM 11. EXECUTIVE COMPENSATION. Information relating to executive compensation is set forth beneath the caption "Executive Compensation" in the Company's definitive proxy statement for its 1998 Annual Meeting of Shareholders and is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Information relating to the security ownership of beneficial owners of 5% or more of the Common Stock and of the executive officers and directors of the Company is set forth under the caption "Stock Ownership of Management and Certain Beneficial Owners" in the Company's definitive proxy statement for its 1998 Annual Meeting of Shareholders and is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Information relating to certain relationships and related transactions is set forth beneath the caption "Certain Relationships and Related Transactions" in the Company's definitive proxy statement for its 1998 Annual Meeting of Shareholders and is incorporated herein by reference. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a)(1) The following financial statements and supplementary data are incorporated in Item 8 of Part II of this Form 10-K by reference to pages 12 through 26 of the Company's 1997 Annual Report to Shareholders, which are incorporated herein by reference: Statement of Management's Responsibility for Financial Reporting, dated January 27, 1998 Report of Independent Accountants, dated January 27, 1998 Consolidated Balance Sheets at December 31, 1996 and 1997 Consolidated Statements of Operations for the three years ended December 31, 1997 Consolidated Statements of Shareholders' Equity for the three years ended December 31, 1997 Consolidated Statements of Cash Flows for the three years ended December 31, 1997 Notes to Consolidated Financial Statements Statements of Operations Data by Quarter (a)(2) The following financial statement schedule is included herewith on page 15 and made a part hereof: Schedule II (Valuation and Qualifying Accounts) 9 10 (a)(3) The following exhibits are included herewith and made a part hereof:
Exhibit Number Description - ------ ----------- 3.1 Amended and Restated Articles of Incorporation of the Company, filed as Exhibit 3.1 to the Company's Registration Statement on Form S-1 (Reg. No. 33-98322) (as amended, the "S-1") and incorporated herein by reference thereto. 3.2 Bylaws of the Company, filed as Exhibit 3.2 to the S-1 and incorporated herein by reference thereto. 4.1 Rights Agreement, dated as of July 23, 1996 between the Company and Chase Mellon Shareholder Services, L.L.C., filed as Exhibit 1 to the Company's Registration Statement on Form 8-A and incorporated herein by reference thereto. 10.1 Common Stock Purchase Agreement dated November 7, 1994, between the Company and the investors listed on Schedule A thereto (attachments and exhibits omitted), filed as Exhibit 10.1 to the S-1 and incorporated herein by reference thereto. 10.2 Credit Agreement, dated as of July 1, 1995, by and between the Company and Creditanstalt Corporate Finance, Inc. (schedules and exhibits omitted), filed as Exhibit 10.2 to the S-1 and incorporated herein by reference thereto. 10.3* 1995 Long-Term Incentive Compensation Plan, filed as Exhibit 10.3 to the S-1 and incorporated herein by reference thereto. 10.4 License Agreement, dated August 24, 1993 between Fujitsu Network Transmission Systems, Inc. and the Company, filed as Exhibit 10.4 to the S-1 and incorporated herein by reference thereto. 10.5 License Agreement, dated September 26, 1994 between NEC America, Inc. and the Company, filed as Exhibit 10.5 to the S-1 and incorporated herein by reference thereto. 10.6 Interface License Agreement, dated March 22, 1995 between Northern Telecom Inc. and the Company, filed as Exhibit 10.7 to the S-1 and incorporated herein by reference thereto. 10.7 Technical Information Agreement, dated February 1, 1993 between American Telephone and Telegraph Company and the Company, filed as Exhibit 10.8 to the S-1 and incorporated herein by reference thereto. 10.8 Technology License Agreement, dated November 16, 1994 between DSC Technologies Corporation and the Company, filed as Exhibit 10.12 to the S-1 and incorporated herein by reference thereto. 10.9 License Agreement, dated August 24, 1993 between Reliance Comm/Tec Corporation and the Company, filed as Exhibit 10.13 to the S-1 and incorporated herein by reference thereto. 10.10* Employment Agreement, dated as of December 13, 1995, between the Company and R. Craig Allison, filed as Exhibit 10.10 of the Annual Report of Tollgrade Communications, Inc. on Form 10-K for the year ended December 31, 1995 (the "1995 Form 10-K").
10 11 10.11* Employment Agreement, dated as of December 13, 1995, between the Company and Christian L. Allison, filed as Exhibit 10.11 of the 1995 Form 10-K. 10.12* Stock Option Agreement entered into January 1, 1994 between the Company and Frederick Kiko, together with a schedule listing substantially identical agreements with Christian L. Allison and Rocco L. Flaminio, filed as Exhibit 10.12 of the 1995 Form 10-K. 10.13* Stock Option Agreement entered into July 7, 1994 between the Company and R. Craig Allison, together with a schedule listing substantially identical agreements with Gordon P. Anderson, John H. Guelcher, Richard H. Heibel and Joseph T. Messina, filed as Exhibit 10.13 of the 1995 Form 10-K. 10.14* Stock Option Agreement entered into December 14, 1995 between the Company and R. Craig Allison, together with a schedule listing substantially identical agreements with Gordon P. Anderson, Jeffrey Blake, John H. Guelcher, Richard H. Heibel, Joseph T. Messina and Douglas T. Halliday, filed as Exhibit 10.14 of the 1995 Form 10-K. 10.15* Form of Stock Option Agreement dated December 14, 1995 and December 29, 1995 for Non- Statutory Stock Options granted under the 1995 Long-Term Incentive Compensation Plan, filed as Exhibit 10.15 of Form 10-K for the year ended December 31, 1996 ("the 1996 Form 10-K"). 10.16* Change in Control Agreement, entered into May 30, 1996 between the Company and Sara M. Antol, together with a schedule listing substantially identical agreements with Robert Cornelia, Ruth Dilts, Herman Flaminio, Rocco Flaminio, Mark Frey, Joseph Giannetti, Samuel Knoch, Goeffrey Lea, Gregory Nulty and Matthew Rosgone, filed as Exhibit 10.1 of the Report on Form 10-Q of the Company filed on August 13, 1996. 10.17* Change in Control Agreement, entered into September 9, 1996 between the Company and Bradley N. Dinger, filed as Exhibit 10.1 of the Report on Form 10-Q of the Company filed on November 12, 1996. 10.18* Form of Stock Option Agreement for Non-Statutory Stock Options granted under the 1995 Long- Term Incentive Compensation Plan, filed as Exhibit 10.2 of the Report on Form 10-Q of the Company filed on November 12, 1996. 10.19* Form of Non-employee Stock Option Agreement entered into December 13, 1996 and December 30, 1997 between the Company and Lawrence Arduini, filed as Exhibit 10.19 of the 1996 Form 10- K. 10.20* Amendment to Employment Agreements, dated as of December 13, 1996, between the Company and R. Craig Allison and Christian L. Allison, filed as Exhibit 10.20 of the 1996 Form 10-K. 10.21* Amendment to Employment Agreements, dated as of December 13, 1997, between the Company and R. Craig Allison and Christian L. Allison, filed herewith. 10.22* Change of Control Agreement, entered into July 17, 1997 between the Company and Timothy O'Brien, together with a schedule listing substantially a similar agreement with Joseph O'Brien incorporated by reference to Exhibit 10.1 of the Report on Form 10-Q of the Company filed on November 10, 1997.
11 12 10.23 Amendment, dated February 21, 1997, to Technical Information Agreement relating to Metallic Channel Units Types A and B, dated February 1, 1993, between American Telephone and Telegraph Company ("AT&T") (licensor) and the Company (licensee) incorporated by reference to Exhibit 10.3 of the Report on Form 10-Q of the Company filed on November 10, 1997. 10.24* Change of Control Agreement, entered into October 15, 1997 between the Company and Mark B. Peterson, filed herewith. 10.25* Form of Non-employee Director Stock Option Agreement with respect to the Company's 1995 Long-Term Incentive Compensation Plan, filed herewith. 11.1 Statement re: Computation of Per Share Earnings, filed herewith. 13.1 Company's 1997 Annual Report to Shareholders, filed herewith. 21.1 List of subsidiaries of the Company, filed as Exhibit 21.1 to the S-1 and incorporated herein by reference thereto. 23.1 Consent of Coopers & Lybrand L.L.P., filed herewith. 27 Financial Data Schedule
* Management contract or compensatory plan, contract or arrangement required to be filed by item 601(b)(10)(iii) of Regulation S-K. The Company agrees to furnish to the Commission upon request copies of all instruments not listed above which define the rights of holders of long-term debt of the Company. Copies of the exhibits filed as part of this Form 10-K are available at a cost of $.20 per page to any shareholder of record upon written request to the Secretary, Tollgrade Communications, Inc., 493 Nixon Road, Cheswick, Pennsylvania 15024. (b) Reports on Form 8-K filed during the quarter ended December 31, 1997. None 12 13 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized as of March 23, 1998. TOLLGRADE COMMUNICATIONS, INC. By /s/CHRISTIAN L. ALLISON --------------------- Christian L. Allison Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Company and in the capacities indicated as of March 23, 1998.
SIGNATURE TITLE --------- ----- /s/R. CRAIG ALLISON Chairman of the Board - ------------------------------------------------- R. Craig Allison /s/CHRISTIAN L. ALLISON Director, Chief Executive Officer, - ------------------------------------------------- (Principal Executive Officer) Christian L. Allison /s/JAMES J. BARNES Director - ------------------------------------------------- James J. Barnes /s/DANIEL P. BARRY Director - ------------------------------------------------- Daniel P. Barry /s/ROCCO L. FLAMINIO Director, Vice Chairman - ------------------------------------------------- and Chief Technology Officer Rocco L. Flaminio /s/RICHARD H. HEIBEL, M.D. Director - ------------------------------------------------- Richard H. Heibel, M.D. /s/ROBERT W. KAMPMEINERT Director - ------------------------------------------------- Robert W. Kampmeinert /s/SAMUEL C. KNOCH Chief Financial Officer and Treasurer - ------------------------------------------------- (Principal Financial Officer) Samuel C. Knoch /s/BRADLEY N. DINGER Controller - ------------------------------------------------- (Principal Accounting Officer) Bradley N. Dinger
13 14 Report of Independent Accountants To the Board of Directors Tollgrade Communications, Inc.: Our report on the consolidated financial statements of Tollgrade Communications, Inc. and subsidiaries has been incorporated by reference in this Form 10-K from page 13 of the 1997 Annual Report to Shareholders of Tollgrade Communications, Inc. and subsidiaries. In connection with our audits of such financial statements, we have also audited the related financial statement schedule listed in the index on page 9 of this Form 10-K. In our opinion, the financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, presently fairly, in all material respects, the information required to be included therein. /s/ COOPERS & LYBRAND L.L.P. Pittsburgh, Pennsylvania January 27, 1998 14 15 SCHEDULE II TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS For the Years Ended December 31, 1995, 1996 and 1997 (In thousands)
Col. A Col. B Col. C Col. D Col. E - ------ --------- ------ ------ ------ Additions Balance at --------------------------- Beginning Charged to Charged to Balance at of Year Expense Other Accounts Deductions End of Year ------- ------- -------------- ---------- ----------- Inventory reserve: Year ended December 31, 1995 $ 60 $ 60 $ -- $-- $120 Year ended December 31, 1996 120 95 -- -- 215 Year ended December 31, 1997 215 -- -- (36) 179 Allowance for doubtful accounts: Year ended December 31, 1995 $ -- $ -- $ -- $-- $ -- Year ended December 31, 1996 -- -- -- -- -- Year ended December 31, 1997 -- 50 -- -- 50
15 16 EXHIBIT INDEX (Pursuant to Item 601 of Regulation S-K)
Exhibit Number Description - ------ ----------- 3.1 Amended and Restated Articles of Incorporation of the Company, filed as Exhibit 3.1 to the Company's Registration Statement on Form S-1 (Reg. No. 33-98322) (as amended, the "S-1") and incorporated herein by reference thereto. * 3.2 Bylaws of the Company, filed as Exhibit 3.2 to the S-1 and incorporated herein by reference thereto. * 4.1 Rights Agreement dated as of July 23, 1996 between the Company and Chase Mellon Shareholder Services, L.L.C., filed as Exhibit 1 to the Company's Registration Statement on Form 8-A and incorporated herein by reference thereto. * 10.1 Common Stock Purchase Agreement dated November 7, 1994, between the Company and the investors listed on Schedule A thereto (attachments and exhibits omitted), filed as Exhibit 10.1 to the S-1 and incorporated herein by reference thereto. * 10.2 Credit Agreement, dated as of July 1, 1995, by and between the Company and Creditanstalt Corporate Finance, Inc. (schedules and exhibits omitted), filed as Exhibit 10.2 to the S-1 and incorporated herein by reference thereto. * 10.3 1995 Long-Term Incentive Compensation Plan, filed as Exhibit 10.3 to the S-1 and incorporated herein by reference thereto. * 10.4 License Agreement, dated August 24, 1993 between Fujitsu Network Transmission Systems, Inc. and the Company, filed as Exhibit 10.4 to the S-1 and incorporated herein by reference thereto. * 10.5 License Agreement, dated September 26, 1994 between NEC America, Inc. and the Company, filed as Exhibit 10.5 to the S-1 and incorporated herein by reference thereto. *
16 17 10.6 Interface License Agreement, dated March 22, 1995 between Northern Telecom Inc. and the Company, filed as Exhibit 10.7 to the S-1 and incorporated herein by reference thereto. * 10.7 Technical Information Agreement, dated February 1, 1993 between American Telephone and Telegraph Company and the Company, filed as Exhibit 10.8 to the S-1 and incorporated herein by reference thereto. * 10.8 Technology License Agreement, dated November 16, 1994 between DSC Technologies Corporation and the Company, filed as Exhibit 10.12 to the S-1 and incorporated herein by reference thereto. * 10.9 License Agreement, dated August 24, 1993 between Reliance Comm/Tec Corporation and the Company, filed as Exhibit 10.13 to the S-1 and incorporated herein by reference thereto. * 10.10 Employment Agreement, dated as of December 13, 1995, between the Company and R. Craig Allison, filed as Exhibit 10.10 of the Annual Report of Tollgrade Communications, Inc. on Form 10-K for the year ended December 31, 1995 (the "1995 Form 10-K"). * 10.11 Employment Agreement, dated as of December 13, 1995, between the Company and Christian L. Allison, filed as Exhibit 10.11 of the 1995 Form 10-K. * 10.12 Stock Option Agreement entered into January 1, 1994 between the Company and Frederick Kiko, together with a schedule listing substantially identical agreements with Christian L. Allison and Rocco L. Flaminio, filed as Exhibit 10.12 of the 1995 Form 10-K. * 10.13 Stock Option Agreement entered into July 7, 1994 between the Company and R. Craig Allison, together with a schedule listing substantially identical agreements with Gordon P. Anderson, John H. Guelcher, Richard H. Heibel and Joseph T. Messina, filed as Exhibit 10.13 of the 1995 Form 10-K. *
17 18 10.14 Stock Option Agreement entered into December 14, 1995 between the Company and R. Craig Allison, together with a schedule listing substantially identical agreements with Gordon P. Anderson, Jeffrey Blake, John H. Guelcher, Richard H. Heibel, Joseph T. Messina and Douglas T. Halliday, filed as Exhibit 10.14 of the 1995 Form 10-K. * 10.15 Form of Stock Option Agreement dated December 14, 1995 and December 29, 1995 for Non-Statutory Stock Options granted under the 1995 Long-Term Incentive Compensation Plan, filed as Exhibit 10.15 of Form 10-K for the year ended December 31, 1996 ("the 1996 Form 10-K"). * 10.16 Change in Control Agreement, entered into May 30, 1996 between the Company and Sara M. Antol, together with a schedule listing substantially identical agreements with Robert Cornelia, Ruth Dilts, Herman Flaminio, Rocco Flaminio, Mark Frey, Joseph Giannetti, Samuel Knoch, Goeffrey Lea, Gregory Nulty and Matthew Rosgone, filed as Exhibit 10.1 of the Report on Form 10-Q of the Company filed on August 13, 1996. * 10.17 Change in Control Agreement, entered into September 9, 1996 between the Company and Bradley N. Dinger, filed as Exhibit 10.1 of the Report on Form 10-Q of the Company filed on November 12, 1996. * 10.18 Form of Stock Option Agreement for Non-Statutory Stock Options granted under the 1995 Long-Term Incentive Compensation Plan, filed as Exhibit 10.2 of the Report on Form 10-Q of the Company filed on November 12, 1996. * 10.19 Form of Non-employee Stock Option Agreement entered into December 13, 1996 and December 30, 1997 between the Company and Lawrence Arduini, filed as Exhibit 10.19 of the 1996 Form 10-K. * 10.20 Amendment to Employment Agreements, dated as of December 13, 1996, between the Company and R. Craig Allison and Christian L. Allison, filed as Exhibit 10.20 of the 1996 Form 10-K. * 10.21 Amendment to Employment Agreements, dated as of December 13, 1997, between the Company and R. Craig Allison and Christian L. Allison, filed herewith. 10.22 Change of Control Agreement, entered into July 17, 1997 between the Company and Timothy O'Brien, together with a schedule listing substantially a similar agreement with Joseph O'Brien incorporated by reference to Exhibit 10.1 of the Report on Form 10-Q of the Company filed on November 10, 1997. * 10.23 Amendment, dated February 21, 1997, to Technical Information Agreement
18 19 relating to Metallic Channel Units Types A and B, dated February 1, 1993, between American Telephone and Telegraph Company ("AT&T") (licensor) and the Company (licensee) incorporated by reference to Exhibit 10.3 of the Report on Form 10-Q of the Company filed on November 10, 1997. * 10.24 Change of Control Agreement, entered into October 15, 1997 between the Company and Mark B. Peterson, filed herewith. 10.25 Form of Non-employee Director Stock Option Agreement with respect to the Company's Long-Term Incentive Compensation Plan, filed herewith. 11.1 Statement re: Computation of Per Share Earnings, filed herewith. 13.1 Company's 1997 Annual Report to Shareholders, filed herewith. 21.1 List of subsidiaries of the Company, filed as Exhibit 21.1 to the S-1 and incorporated herein by reference thereto. * 23.1 Consent of Coopers & Lybrand L.L.P., filed herewith. 27 Financial Data Schedule
- ---------- * Incorporated by reference. 19 EX-10.21 2 TOLLGRADE COMMUNICATIONS, INC. 1 Exhibit 10.21 AMENDMENT THIS AMENDMENT, dated as of January 10, 1998 (herein called the "Amendment"), is entered into by and between TOLLGRADE COMMUNICATIONS, INC. (herein referred to "Tollgrade") and R. CRAIG. ALLISON (herein referred to as the "Executive"). AMENDMENT TO AGREEMENT WHEREAS, Tollgrade and the Executive entered into an Agreement effective dated the 13th day of December, 1995 and amended effective January 14, 1997 governing the employment of the Executive and certain benefits to be received by the Executive in the event his employment is terminated (herein referred to as the "Agreement"); and WHEREAS, Tollgrade and the Executive desire to amend the Agreement upon the terms and conditions stated in this Amendment. NOW, THEREFORE, in consideration of the promises and the faithful performance of the mutual covenants herein contained, and intending to be legally bound hereby, Tollgrade and the Executive agree as follows: 1. Capitalized terms used herein and not otherwise defined in this Amendment shall have the meaning assigned to them in the Agreement. 2. The Agreement shall be amended such that the Executive's base salary, as specified in Section 2(b) of the Agreement, shall be increased to $193,000 per annum, effective as of the anniversary date of the Agreement. 3. Except as modified by this Amendment, the provisions of the Agreement will remain in full force and effect. IN WITNESS WHEREOF, the parties have executed this Amendment as of the date first above written. TOLLGRADE COMMUNICATIONS, INC. By: /s/ SARA M. ANTOL ------------------------------- Title: Chief Counsel & Secretary --------------------------- /s/ R. CRAIG ALLISON ---------------------------------- R. Craig Allison 20 2 AMENDMENT THIS AMENDMENT, dated as of January 8, 1998 (herein called the "Amendment"), is entered into by and between TOLLGRADE COMMUNICATIONS, INC. (herein referred to "Tollgrade") and CHRISTIAN L. ALLISON (herein referred to as the "Executive"). AMENDMENT TO AGREEMENT WHEREAS, Tollgrade and the Executive entered into an Agreement effective dated the 13th day of December, 1995 and amended effective January 14, 1997 governing the employment of the Executive and certain benefits to be received by the Executive in the event his employment is terminated (herein referred to as the "Agreement"); and WHEREAS, Tollgrade and the Executive desire to amend the Agreement upon the terms and conditions stated in this Amendment. NOW, THEREFORE, in consideration of the promises and the faithful performance of the mutual covenants herein contained, and intending to be legally bound hereby, Tollgrade and the Executive agree as follows: 1. Capitalized terms used herein and not otherwise defined in this Amendment shall have the meaning assigned to them in the Agreement. 2. The Agreement shall be amended such that the Executive's base salary, as specified in Section 2(b) of the Agreement, shall be increased to $193,000 per annum, effective as of the anniversary date of the Agreement. 3. Except as modified by this Amendment, the provisions of the Agreement will remain in full force and effect. IN WITNESS WHEREOF, the parties have executed this Amendment as of the date first above written. TOLLGRADE COMMUNICATIONS, INC. By: /s/ SARA M. ANTOL -------------------------------- Title: Chief Counsel & Secretary ---------------------------- /s/ CHRISTIAN L. ALLISON ----------------------------------- Christian L. Allison 21 EX-10.24 3 TOLLGRADE COMMUNICATIONS, INC. 1 Exhibit 10.24 AGREEMENT This Agreement, made as of the 30th day of December, 1997 by and between TOLLGRADE COMMUNICATIONS, INC., a Pennsylvania corporation (the "Corporation") and Mark B. Peterson, an individual residing in the Commonwealth of Pennsylvania and an employee of the Corporation (the "Executive"). WITNESSETH: WHEREAS, the Board of Directors of the Corporation has determined that it is in the best interests of the Corporation to enter into this Agreement with the Executive to provide for compensation of the Executive upon termination of employment under certain circumstances relating to a change in control of the Corporation; and WHEREAS, the Executive desires to obtain such benefits in the event the Executive's employment is terminated under the circumstances provided herein. NOW, THEREFORE, in consideration of the covenants and premises contained herein, and intending to be legally bound hereby, the parties hereto agree as follows: 1. DEFINITION OF TERMS. The following terms when used in this Agreement shall have the meaning hereafter set forth: "ANNUAL SALARY ADJUSTMENT PERCENTAGE" shall mean the mean average percentage increase in base salary for all elected officers of the Corporation during the two full calendar years immediately preceding the time to which such percentage is being applied; provided however, that if after a Change-in-Control, as hereinafter defined, there should be a significant change in the number of elected officers of the Corporation or in the manner in which they are compensated, then the foregoing definition shall be changed by substituting for the phrase "elected officers of the Corporation" the phrase "persons then performing the functions formerly performed by the elected officers of the Corporation." "CAUSE FOR TERMINATION" shall mean: (a) the deliberate and intentional failure by the Executive to devote substantially his entire business time and best efforts to the performance of his duties (other than any such failure resulting from the Executive's incapacity due to physical or mental illness or disability) after a demand for substantial performance is delivered to the Executive by the Board of Directors which specifically identifies the manner in which the Board of Directors believes that the Executive has not substantially performed his duties, 22 2 or (b) wilfully engaging by the Executive in conduct which constitutes a fraud against the Corporation or a material breach of this Agreement, or (c) the Executive's conviction of any crime which constitutes a felony. For purposes of this definition, no act, or failure to act, on the Executive's part shall be considered "deliberate and intentional" or "willfully" unless done, or omitted to be done, by the Executive not in good faith and without reasonable belief that his action or omission was in the best interests of the Corporation. "CHANGE-IN-CONTROL" shall mean the determination (which may be made effective as of a particular date specified by the Board of Directors of the Corporation) by the Board of Directors of the Corporation, made by a majority vote that a change in control has occurred, or is about to occur. Such a change shall not include, however, a restructuring, reorganization, merger, or other change in capitalization in which the Persons who own an interest in the Corporation on the date hereof (the "Current Owners")(or any individual or entity which receives from a Current Owner an interest in the Corporation through will or the laws of descent and distribution) maintain more than a sixty-five percent (65%) interest in the resultant entity. Regardless of the Board's vote or whether or not the Board votes, a Change-in-Control will be deemed to have occurred as of the first day any one (1) or more of the following subparagraphs shall have been satisfied: (a) Any Person (other than the Person in control of the Corporation as of the date of this Agreement, or other than a trustee or other fiduciary holding securities under an employee benefit plan of the Corporation, or a corporation owned directly or indirectly by the stockholders of the Corporation in substantially the same proportions as their ownership of stock of the Corporation), becomes the beneficial owner, directly or indirectly, of securities of the Corporation representing more than thirty five percent (35%) of the combined voting power of the Corporation's then outstanding securities; or (b) The stockholders of the Corporation approve: (i) A plan of complete liquidation of the Corporation; (ii) An agreement for the sale or disposition of all or substantially all of the Corporation's assets; or (iii) A merger, consolidation, or reorganization of the Corporation with or involving any other corporation, other than a merger, consolidation, or reorganization that would result in the voting securities of the Corporation outstanding immediately prior thereto continuing to represent (either by remaining outstanding or by being converted into voting securities of the surviving entity) at least sixty-five percent (65%) of the combined voting power of the voting securities of the Corporation (or such 23 3 surviving entity) outstanding immediately after such merger, consolidation, or reorganization. However, in no event shall a Change in Control be deemed to have occurred, with respect to the Executive, if the Executive is part of a purchasing group which consummates the Change-in-Control transaction. The Executive shall be deemed "part of the purchasing group" for purposes of the preceding sentence if the Executive is an equity participant or has agreed to become an equity participant in the purchasing company or group (except for (i) passive ownership of less than five percent (5%) of the voting securities of the purchasing company; or (ii) ownership of equity participation in the purchasing company or group which is otherwise deemed not to be significant, as determined prior to the Change-in-Control by a majority of the non-employee continuing Directors of the Board of Directors of the Corporation). "DATE OF TERMINATION" shall mean: (a) if the Executive's employment is terminated for Disability, the date that a Notice of Termination is given to the Executive; (b) if the Executive terminates due to his death or Retirement, the date of death or Retirement, respectively; (c) if the Executive decides to terminate employment upon Good Reason for Termination, the date following such decision specified by the Corporation after it has been notified of the Executive's decision to terminate employment; or (d) if the Executive's employment is terminated for any other reason, the date on which such termination becomes effective pursuant to a Notice of Termination. "DISABILITY" shall mean such incapacity due to physical or mental illness or injury as causes the Executive to be unable to perform his duties with the Corporation during 180 consecutive days. "GOOD REASON FOR TERMINATION" shall mean the occurrence of: (a) without the Executive's express written consent, the assignment to the Executive of any duties materially and substantially inconsistent with his positions, duties, responsibilities and status with the Corporation immediately prior to a Change-in-Control, or a material change in his reporting responsibilities, titles or offices as in effect immediately prior to a Change-in-Control, or any removal of the Executive from or any failure to re-elect the Executive to any of such positions, except in connection with the termination of the Executive's employment due to Cause for Termination, Disability or Retirement (as hereinafter defined) or as a result of the Executive's death; (b) (i) a reduction by the Corporation prior to a Change-in-Control in the Executive's base salary unless such reduction is the result of the Board of Directors of the Corporation determining that the Executive has not adequately discharged his duties; 24 4 (ii) a reduction by the Corporation after a Change-in-Control in the Executive's base salary as in effect immediately prior to any Change-in-Control or a failure by the Corporation after a Change-in-Control to increase the Executive's base salary by the Annual Salary Adjustment Percentage; (c) a failure by the Corporation to continue to provide incentive compensation comparable to that provided by the Corporation immediately prior to any Change-in-Control; (d) a failure by the Corporation after a Change-in-Control to continue in effect any benefit or compensation plan, stock option plan, pension plan, life insurance plan, health and accident plan or disability plan in which the Executive is participating immediately prior thereto (provided, however, that there shall not be deemed to be any such failure if the Corporation substitutes for the discontinued plan, a plan providing the Executive with substantially similar benefits) or the taking of any action by the Corporation which would adversely affect the Executive's participation in or materially reduce the Executive's benefits under any of such plans or deprive the Executive of any material fringe benefit enjoyed by the Executive immediately prior to a Change-in-Control (provided, however, that any act or failure to act by the Corporation that is on a plan-wide basis, i.e., it similarly affects all employees of the Corporation or all employees eligible to participate in any such plan, as the case may be, shall not constitute Good Reason for Termination); (e) the failure of the Corporation to obtain the assumption of this Agreement by any successor as contemplated in SECTION 10(c) hereof; (f) any purported termination of the employment of the Executive by the Corporation which is not (i) due to the Executive's Disability, Retirement (as hereinafter defined) or Cause for Termination, or (ii) effected as a Notice of Termination, as defined herein; or (g) the Corporation's requiring the Executive to be based anywhere other than the Corporation's executive offices at which the Executive has his principal office immediately prior to a Change-in-Control or executive offices located within 50 miles of the location of the Corporation's executive offices immediately prior to a Change-in-Control, except for required travel on the Corporation's business to an extent substantially consistent with the Executive's present business travel obligations. "NOTICE OF TERMINATION" shall mean a written statement which sets forth the specific reason for termination and, if such is claimed to be a Cause for Termination or Good Reason for Termination, in reasonable detail the facts and circumstances which indicate that such is Cause for Termination or Good Reason for Termination. "OPTIONS" shall mean any stock options issued pursuant to any present or future stock option plan of the Corporation. "PERSON" shall have the meaning ascribed to such term in Section 3(a)(9) of the Securities Exchange Act of 1934, as in effect on the date hereof and used in Sections 13(d) and 14(d) thereof, including a "group" as defined in Section 13(d) thereof. 25 5 "RETIREMENT" shall mean the termination of the Executive's employment after age 65 or in accordance with any mandatory retirement arrangement with respect to an earlier age agreed to by the Executive. "STOCK APPRECIATION RIGHT" shall mean any stock appreciation rights issued pursuant to any stock option plan of the Corporation or any future stock appreciation rights plan. 2. TERMS OF EMPLOYMENT. The Executive acknowledges that this Agreement does not constitute an employment contract and that the Executive's employment relationship with the Corporation is at-will and not for any particular period. Rather, this Agreement is only intended to set forth certain liquidated damages to be paid in the event of termination of the Executive upon the terms and conditions specified herein. 3.TERM OF AGREEMENT. The initial term of this Agreement shall be for a period of four (4) years. Upon expiration of the initial term, the Company shall, in its sole discretion, determine whether this Agreement shall be renewed upon such terms it deems advisable. 4. PAYMENTS FOLLOWING TERMINATION OF EMPLOYMENT UPON A CHANGE-IN-CONTROL. (a) If the Executive's employment with the Corporation shall be terminated: (i) due to the Executive's death, (ii) by the Executive other than the Executive's having terminated for Good Reason for Termination following a Change-in-Control, or (iii) by the Corporation due to Cause for Termination or for Disability or Retirement, then the Corporation shall have no obligations to the Executive other than to pay the Executive any unpaid portion of base salary due until the Date of Termination and any other sums due in accordance with the then various policies, practices and benefit plans of the Corporation. (b) If the Executive's employment with the Corporation shall have terminated during the period commencing six months prior to the date of a Change-in-Control and ending on the third anniversary of a Change-in-Control other than in the circumstances described in subsection (a) above, then the Corporation shall pay on or before the fifth day following the Date of Termination (or if the Date of Termination preceded the date of the Change-in-Control, on or before the fifth day following the date of the Change-in-Control), to the Executive the following sums: (i) in cash any unpaid portion of the Executive's full base salary for the period from the last period for which the Executive was paid to the Date of Termination, or the date of the Change-in-Control, as the case may be; and (ii) an amount in cash as liquidated damages for lost future renumeration equal to the product obtained by multiplying 26 6 (A) the lesser of (1) two, or (2) a number equal to the number of calendar months remaining from the Date of Termination to the date on which the Executive is 65 years of age (or, if earlier, the age agreed to by the Executive pursuant to any prior arrangement) divided by twelve, or (3) a number equal to the greater of (i) one (1.0) and (ii) thirty six (36) less the number of completed months commencing after the date of the Change-in-Control during which the Executive was employed by the Corporation and did not have Good Reason for Termination times (iii) one-twelfth (1/12) times (B) the sum of (1) the greater of (i) the Executive's annual base salary for the year in effect on the Date of Termination (provided that in the case of Termination for Good Reason by the Executive the date immediately preceding the date of the earliest event which gave rise to the Termination for Good Reason by the Executive shall be used instead of the Date of Termination) or (ii) the Executive's annual base salary for the year in effect on the date of the Change-in-Control; plus (2) the greater of (i) the average annual cash award received by the Executive as incentive compensation or bonus for one calendar year immediately preceding the Date of Termination (provided that in the case of Termination for Good Reason by the Executive the date immediately preceding the date of the event which gave rise to the Termination for Good Reason by the Executive shall be used instead of the Date of Termination) or (ii) the average annual cash award received by the Executive as incentive compensation or bonus for one calendar year immediately preceding the date of the Change-in-Control. 5.OUTPLACEMENT SERVICES. If the Executive's employment with the Corporation should terminate under circumstances as to entitle the Executive to receive payment hereunder, the Corporation shall reimburse 27 7 the Executive for any reasonable fees or other costs incurred by the Executive during the two (2) years following the Date of Termination in retaining executive placement agencies, up to a maximum dollar amount not to exceed fifteen percent (15%) of the Executive's base salary at the time of such termination. Such reimbursement shall be made within five (5) days following the Executive's presentment of bills or other evidence of the costs incurred with executive placement agencies. 6.TAX IMPLICATIONS. If any payment due to the Executive pursuant to this Agreement result in a tax being imposed on the Executive pursuant to Section 4999 of the Internal Revenue Code of 1954, as amended, or any successor provision ("Section 4999"), then the Corporation shall, at the Executive's option, either (i) reduce the total payments payable to the Executive to the maximum amount payable without incurring the Section 4999 tax, or (ii) pay to the Executive the total amount payable, with the understanding that Section 4999 tax will be due on that total amount. 7.BENEFITS. If the Executive's employment with the Corporation should terminate under circumstances as to entitle the Executive to receive payment hereunder, the Executive shall also be deemed, for purposes of medical insurance, pension and other benefits of the Corporation, to have remained in the continuous employment of the Corporation for the two (2) year period following the Date of Termination and shall be entitled to all of the medical insurance, pension or other benefits provided by the Corporation as if the Executive had so remained in the employment of the Corporation. If, for any reason, whether by law or provisions of the Corporation's employee medical insurance, pension or other benefit plans, or otherwise any benefits which the Executive would be entitled to under this SECTION 6 cannot be paid pursuant to such employee benefit plans, then the Corporation contractually agrees to pay the Executive the difference between the benefits which the Executive would have received in accordance with this Section if the relevant employee medical insurance, pension or other benefit plan could have paid such benefit and the amount of benefits, if any, actually paid by such employee medical insurance, pension or other benefit plan. The Corporation shall not be required to fund its obligation to pay the foregoing difference. 8.OTHER EMPLOYMENT. In the event of termination under the circumstances contemplated in SECTION 4(b) hereunder, the Executive shall have no duty to seek any other employment after termination of his employment with the Corporation and the Corporation hereby waives and agrees not to raise or use any defense based upon the position that the Executive had a duty to mitigate or reduce the amounts due him hereunder by seeking other employment whether suitable or unsuitable and should the Executive obtain other employment, then the only effect of such on the obligations of the Corporation shall be that the Corporation shall be entitled to credit against any payments that would otherwise be made pursuant to SECTION 7 hereof, any comparable payments to which the executive is entitled under the employee benefit plans maintained by the Executive's other employer or employers in connection with services to such employer or employers after termination of this employment with the Corporation. 9.STOCK APPRECIATION RIGHTS AND OPTIONS. If the Executive's employment should terminate under circumstances as to entitle the Executive to receive payment hereunder, then with respect to any standing Stock Appreciation Rights and/or Options which did not immediately become exercisable upon the occurrence of a Change-in-Control, such Stock Appreciation Right or Option shall be automatically 28 8 vested and remain outstanding in accordance with its terms and be exercisable thereafter until the stated expiration date of such Stock Appreciation Right or Option. 10.MISCELLANEOUS. (a)This Agreement shall be construed under the laws of the Commonwealth of Pennsylvania. (b)This Agreement constitutes the entire understanding of the parties hereto with respect to the subject matter hereof and may only be amended or modified by written agreement signed by the parties hereto. (c)The Corporation will require any successor (whether direct or indirect, by purchase, merger, consolidation or otherwise) to all or substantially all of the business and/or assets of the Corporation, by agreement in form and substance satisfactory to the Executive, to expressly assume and agree to perform this Agreement in the same manner required of the Corporation and to perform it as if no such succession had taken place. As used in this Agreement, "Corporation" shall mean the Corporation as hereinbefore defined and any successor to its business and/or assets as aforesaid which executes and delivers the agreement provided for in this subsection (c) or which otherwise becomes bound by all of the terms and provisions of this Agreement by operation of law. (d)This Agreement shall inure to the benefit of and be enforceable by the Executive and the Corporation and their respective legal representatives, executors, administrators, successors, heirs, distributees, devisees and legatees. If the Executive should die while any amounts would still be payable to him hereunder if he had continued to live, all such amounts, unless otherwise provided herein, shall be paid in accordance with the terms of this Agreement to his devisee, legatee or other designee or, if there be no such designee, to his estate. (e)Any notice or other communication provided for in this Agreement shall be in writing and, unless otherwise expressly stated herein, shall be deemed to have been duly given if mailed by United States registered mail, return receipt requested, postage prepaid, addressed in the case of the Executive to his office at the Corporation with a copy to his residence and in the case of the Corporation to its principal executive offices, attention to the Chief Executive Officer. (f)No provision of this Agreement may be modified, waived or discharged unless such waiver, modification or discharge is agreed to in writing signed by the Executive and approved by resolution of the Board of Directors of the Corporation. No waiver by either party hereto at any time of any breach by the other party hereto of, or compliance with, any condition or provision of this Agreement to be performed by such other party shall be deemed a waiver of similar or dissimilar provisions or conditions at the same or at any prior or subsequent time. No agreements or representations, oral or otherwise, express or implied, with respect to the subject matter hereof have been made by either party which are not set forth expressly in this Agreement. (g)The invalidity or unenforceability of any provisions of this Agreement shall not affect the validity or unenforceability of any other provision of this Agreement, which shall remain in full force and effect. If any provision hereof shall be deemed invalid or unenforceable, either in whole or in part, this 29 9 Agreement shall be deemed amended to delete or modify, as necessary, the offending provision and to alter the bounds thereof in order to render it valid and enforceable. (h)This Agreement may be executed in one or more counterparts, each of which shall be deemed to be an original but all of which taken together will constitute one and the same instrument. (i)If litigation should be brought to enforce, interpret or challenge any provision contained herein, the prevailing party shall be entitled to its reasonable attorney's fees and disbursements and other costs incurred in such litigation and, if a money judgment be rendered in favor of the Executive, to interest on any such money judgment obtained calculated at the prime rate of interest in effect from time to time at Mellon Bank, N.A., from the date that the payment should have been made or damages incurred under this Agreement. IN WITNESS WHEREOF, this Agreement has been executed on the date first above written. ATTEST: TOLLGRADE COMMUNICATIONS, INC. /s/ SARA M. ANTOL By: /s/ CHRISTIAN L. ALLISON - ------------------ ------------------------ WITNESS: /s/ SARA M. ANTOL /s/ MARK B. PETERSON - ------------------ ------------------------ Mark B. Peterson 30 EX-10.25 4 TOLLGRADE COMMUNICATIONS, INC. 1 Exhibit 10.25 TOLLGRADE COMMUNICATIONS, INC. 1995 LONG-TERM INCENTIVE COMPENSATION PLAN NON-EMPLOYEE DIRECTOR NONSTATUTORY STOCK OPTION AGREEMENT THIS AGREEMENT is made and entered into this _____ day of _______, 199__, by and between TOLLGRADE COMMUNICATIONS, INC., a Pennsylvania corporation (the "Company") and ____________________, an individual (the "Holder"). WHEREAS, the Company desires to issue, and the Holder desires to receive, an option to purchase shares of the common stock of the Company, pursuant to the terms described herein. NOW, THEREFORE, in consideration of the terms and conditions contained herein and intending to be legally bound hereby, the parties agree as follows: 1.Grant of Option.The Company hereby confirms the grant to the Holder on _________________ (the "Date of Grant") of an option (the "Option") to purchase, from time to time in accordance with the terms hereof ___________ (________) shares of common stock of the Company, par value $.20 per share (the "Common Stock") at an option price of $____________ per share, under and subject to the terms and conditions of the Company's 1995 Long-Term Incentive Compensation Plan, as amended (the "Plan") and this Agreement. The Plan is incorporated herein by reference and made a part hereof as though set forth in full herein. Terms which are capitalized herein but which are not defined herein have the same meaning as in the Plan unless the context otherwise requires. The Option confirmed hereby is a nonstatutory stock option as that term is defined in Section 2.20 of the Plan. The Option will expire at the close of business on ____________________. 2.Acceptance of Grant of Option.The Holder accepts the grant of the Option confirmed hereby, acknowledges having received a copy of the Plan and agrees to be bound by the terms and provisions of the Plan, as the Plan may be amended from time to time; provided, however, that no alteration, amendment, revocation or termination of the Plan shall, without the written consent of the Holder, adversely affect the rights of the Holder with respect to the Option. 3.Non-Transferability.This Option shall not be transferrable otherwise than by Will or the laws of descent or distribution, and the Option shall be exercisable during the lifetime of the Holder only by the Holder. 4.Procedure for Exercise of Option. The Option may be exercised only by (a) execution and delivery by the 31 2 Holder to the Company of an exercise form or forms prescribed by the Committee; and (b) surrender of this Agreement at the principal office of the Company. Each exercise form must set forth the number of shares of Common Stock for which the Option is exercised and must be dated and signed by the person exercising the Option. Subject to the last paragraph of this Section 4, the exercise is not effective until the Company receives payment of the full option price for the number of shares of Common Stock for which the Option is exercised. The Option Price shall be paid to the Company in full in the manner specified in Section 6.6 of the Plan. To the extent the Holder pays the Option Price in whole or in part by shares of already-owned Common Stock, as permitted by the Plan, the Company shall advise any person exercising the Option in such manner as to the amount of any cash required to be paid to the Company for any shares representing a fraction of a share, and such person will be required to pay any such cash directly to the Company before any distribution of certificates representing shares of Common Stock will be made. The person exercising the Option should execute the form of assignment on the back of the certificate or should deliver an executed Assignment Separate from Certificate with respect to each stock certificate delivered in payment of the Option Price. If any person other than the Holder exercises the Option, the exercise material must include proof satisfactory to the Company of the right of such person to exercise the Option, and the signature on all certificates or stock powers must be guaranteed by a commercial bank or trust company or by a firm having membership in the New York Stock Exchange, Inc., the American Stock Exchange, Inc., or the National Association of Securities Dealers, Inc. The date of exercise of the Option is the date on which the exercise form or forms, proof of right to exercise (if required) and payment of the Option Price are received by the Company. For purposes of determining the date of exercise where payment of the Option Price is made in shares of already-owned Common Stock, any cash required to be paid to the Company with respect to a fraction of a share shall not be taken into account when determining whether payment of the Option Price has been made. 5.Issuance of Certificates.Subject to Section 4 above and this Section 5, the Company will issue a certificate or certificates representing the number of shares of Common Stock for which the Option is exercised as soon as practicable after the date of exercise. Unless otherwise directed, the certificate(s) will be registered in the name of the person exercising the Option and delivered to such person. If the Option Price is paid in whole or in part with shares of already-owned Common Stock, the Company will issue at the same time and return to the person exercising the Option a certificate representing the number of any excess shares included in any certificate or certificates delivered to the Company at the time of exercise. The obligation of the Company to issue shares on exercise of an option is subject to the effectiveness of a Registration Statement under the Securities Act of 1933, as amended, with respect to such shares, if deemed necessary or appropriate by counsel to the Company. The Company is not obligated to file such a Registration Statement. If at the time of exercise of the Option, no such Registration Statement is in effect, the issuance of shares on exercise of the Option may also be made subject to restrictions on the transfer of the shares, including the placing of an appropriate legend on the certificates restricting the transfer thereof, and to such other restrictions as the Committee, on the advice of counsel, may deem necessary or appropriate to prevent a violation of applicable securities laws. 32 3 6.Withholding of Taxes.The Holder will be advised by the Company as the amount of any Federal income, employment or excise taxes required to be withheld by the Company on any compensation income resulting from the exercise of the Option, and the Holder will pay such taxes directly to the Company upon request. State, local or foreign income or employment taxes may also be required to be withheld by the Company and the Holder will also be required to pay such taxes directly to the Company upon request. If the Holder does not pay any taxes required to be withheld directly to the Company within ten (10) days after any such request, the Company may withhold such taxes from any other compensation to which the Holder is entitled from the Company. The Holder will hold the Company harmless in acting to satisfy its withholding obligations in this manner if it becomes necessary to do so. 7.Interpretation of Plan and Agreement.This Agreement is an award agreement referred to in Section 6.2 of the Plan. If there is any conflict between the Plan and this Agreement, the provisions of the Plan shall control. However, there may be provisions in this Agreement not contained in the Plan, which provisions shall nonetheless be effective. In addition, to the extent that provisions of the Plan are expressly modified for purposes of this Agreement pursuant to authorization in the Plan, the provisions of this Agreement shall control. Any dispute or disagreement which shall arise under or in any way relate to the construction or interpretation of the Plan or this Agreement shall be resolved by the Committee, and the decision of the Committee shall be final, binding and conclusive for all purposes. 8.Effect of Agreement on Rights of Company and Holder.This Agreement does not confer any rights on the Holder to continue as a Director. 9.Indemnification.The Holder indemnifies and holds harmless the Company from and against any and all loss, damages, liability or expense, including costs and reasonable attorneys' fees, to which the Company may be put or may incur by reason of or in connection with any misrepresentation made by the Holder, any breach of the Holder's warranties, or the Holder's failure to fulfill any of his or her covenants or agreements set forth herein. 10.Binding Effect.This Agreement shall be binding upon the successors and assigns of the Company and upon the legal representatives, heirs and legatees of the Holder. 11.Entire Agreement.This Agreement constitutes the entire agreement between the parties and supersedes all prior agreements and understandings, oral or written, between the parties with respect to the subject matter of this Agreement. 12.Amendment.This Agreement may be amended only a written instrument signed by the Company and the Holder. 13.Governing Law.This Agreement shall be governed by and construed and enforced in accordance with the laws of the Commonwealth of Pennsylvania. 33 4 IN WITNESS WHEREOF, the Company and the Holder have executed this Agreement as of the date first written above. TOLLGRADE COMMUNICATIONS, INC. By:_________________________ Title: _____________________ WITNESS: HOLDER: ____________________________ ___________________________ 34 EX-11.1 5 TOLLGRADE COMMUNICATIONS, INC. 1 Exhibit 11.1 Tollgrade Communications, Inc. and Subsidiaries Calculation of Earnings Per Share For the Years Ended December 31, 1995, 1996, and 1997
December 31, ------------------------------------------------ 1995 1996 1997 Net income. . . . . . . . . . . . . . . . . . . . . . . . . $2,521,827 $5,596,623 $6,883,148 ========== ========== ========== Common and common equivalent shares: Weighted average number of common shares outstanding during the period . . . . . . . 4,227,648 5,500,884 5,686,182 Common shares issuable upon exercise of outstanding stock options Diluted . . . . . . . . . . . . . . . . . . . . . . 276,064 438,778 275,358 -------- ------- ------- Common and common equivalent shares outstanding during the period Diluted . . . . . . . . . . . . . . . . . . . . . . 4,503,712 5,939,662 5,961,540 ---------- --------- ---------- Earnings per share data: Net income per common and common equivalent shares Basic . . . . . . . . . . . . . . . . . . . . . . . $ .60 $ 1.02 $ 1.21 Diluted . . . . . . . . . . . . . . . . . . . . . . $ .56 $ .94 $ 1.15
35 EX-13.1 6 TOLLGRADE COMMUNICATIONS, INC. 1 Exhibit 13.1 SELECTED CONSOLIDATED FINANCIAL DATA The selected consolidated financial data of the Company as of December 31, 1993, 1994, 1995, 1996 and 1997 is derived from audited consolidated financial statements of the Company.
(In thousands, except per share data) Year Ended December 31, 1993 1994 1995 1996 1997 - ------------------------------------------------------------------------------------------------------------------------------------ STATEMENTS OF OPERATIONS DATA: Revenues(1) $ 10,089 $ 14,722 $22,310 $37,490 $45,421 Cost of product sales 5,860 8,168 11,329 18,322 20,104 - ------------------------------------------------------------------------------------------------------------------------------------ Gross profit 4,229 6,554 10,981 19,168 25,317 Operating expenses: Selling and marketing 1,409 1,903 2,953 4,767 5,446 General and administrative 1,079 1,268 1,471 2,552 3,768 Research and development 769 1,585 2,637 3,921 5,945 - ------------------------------------------------------------------------------------------------------------------------------------ Total operating expenses 3,257 4,756 7,061 11,240 15,159 - ------------------------------------------------------------------------------------------------------------------------------------ Income from operations 972 1,798 3,920 7,928 10,158 Other income (expense), net (295) (270) 20 845 899 - ------------------------------------------------------------------------------------------------------------------------------------ Income before income taxes 677 1,528 3,940 8,773 11,057 Provision (benefit) for income taxes 76 (617) 1,418 3,176 4,174 - ------------------------------------------------------------------------------------------------------------------------------------ Net income $ 601 $ 2,145 $ 2,522 $ 5,597 $ 6,883 - ------------------------------------------------------------------------------------------------------------------------------------ Net income applicable to common stock (2) $ 432 $ 1,311 $ 2,522 $ 5,597 $ 6,883 - ------------------------------------------------------------------------------------------------------------------------------------ Earnings per share: Basic $ .25 $ .49 $ .60 $ 1.02 $ 1.21 Diluted .12 .32 .56 .94 1.15 - ------------------------------------------------------------------------------------------------------------------------------------ Weighted average shares of common stock and equivalents: Basic 1,707 2,674 4,228 5,501 5,686 Diluted 3,465 4,159 4,504 5,940 5,962 - ------------------------------------------------------------------------------------------------------------------------------------
As of December 31, 1993 1994 1995 1996 1997 - ------------------------------------------------------------------------------------------------------------------------------------ BALANCE SHEET DATA: Working capital $ 896 $3,195 $21,159 $27,232 $34,570 Total assets 3,590 7,151 25,728 34,626 43,713 Long-term debt, less current portion 1,800 1,400 -- -- -- Shareholders' equity (deficit) (911) 1,387 22,609 30,006 38,101 1993 1994 1995 1996 1997 - ------------------------------------------------------------------------------------------------------------------------------------ OTHER DATA: (3) Number of employees at year end 71 96 126 184 205 Average revenue per employee $ 142 $ 153 $ 177 $ 204 $ 222
(1) Includes royalty and license fees of $75 and $250 for 1993 and 1997, respectively. (2) Net of accretion for redeemable warrants, all of which were redeemed in February 1995. (3) Data not derived from Company's audited financial statements. 6 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with the "Selected Consolidated Financial Data" and the Consolidated Financial Statements and notes thereto appearing elsewhere in this Annual Report to Shareholders. CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995. The statements contained in this Annual Report to Shareholders, specifically including those contained in the following Management's Discussion and Analysis of Results of Operations and Financial Condition, which are not historical are "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements represent the Company's present expectations or beliefs concerning future events. The Company cautions that such statements are qualified by important factors that could cause actual results to differ materially from those in the forward looking statements. Results actually achieved may differ materially from expected results included in these statements. Reference is made to a discussion of the important risk factors detailed from time to time in the Company's SEC reports, including the report on Form 10-K for the year ended December 31, 1997, a copy of which may be obtained from the Company upon written request and without charge (except for the exhibits thereto). OVERVIEW Tollgrade Communications, Inc. (the "Company") was organized in 1986 and began operations in 1988. The Company designs, engineers, markets and supports proprietary products which enable local telephone companies to use their existing line test systems to remotely diagnose problems in Plain Old Telephone Service ("POTS") lines containing both copper and fiber optics. The Company's metallic channel unit ("MCU") product line, which includes POTS line testing as well as alarm-related products, represented more than 94% of the Company's revenue for the year ended December 31, 1997 and will continue to account for a majority of Tollgrade's revenues for the foreseeable future. The Company's revenues include product sales as well as license and royalty fees paid to the Company for the use of its proprietary technology. The Company's product sales are primarily to the five Regional Bell Operating Companies ("RBOCs"), as well as major independent telephone companies such as Sprint. For the year ended December 31, 1997, 86% of revenue was from the five RBOCs, the two largest of which comprised 54% of revenues. The Company's operating results have fluctuated and may continue to fluctuate as a result of various factors, including the timing of orders from and shipments to the RBOCs. Although international sales to date have not been significant, the Company believes the international markets offer opportunities. The Company intends to focus additional sales, marketing and development resources on increasing its international presence; however, there can be no assurance that these efforts will be successful or that the Company will achieve significant international sales. Tollgrade believes that continued growth will depend on its ability to design and engineer new products and therefore spends a significant amount on research and development. Research and development expenses as a percent of revenues were approximately 13% for the year ended December 31, 1997. The Company expects its research and development expenses to continue at significant levels. YEAR ENDED DECEMBER 31, 1997 COMPARED TO YEAR ENDED DECEMBER 31, 1996 REVENUES Revenues for the year ended December 31, 1997 were $45.4 million, and were $7.9 million, or 21.2%, higher than revenues of $37.5 million for the year ended December 31, 1996. Revenues for both periods consisted almost entirely of product sales. 1997 7 3 revenues included $250,000 of royalty and license fees while similar fees for 1996 were immaterial. The increase in revenues is primarily associated with the increase in unit volume sales of the MCU product line as a result of increased market penetration and customer acceptance. The increase includes revenues of $0.7 million from six new products introduced in 1997. Overall, increased product demand is at least partly attributable to technology licensing agreements and/or joint venture relationships with certain major Digital Loop Carrier ("DLC") vendors, as well as continued expansion of a marketing program to train customers in advanced line test system trouble-shooting. Periodic fluctuations in customer orders and backlog result from a variety of factors, including but not limited to the timing of significant orders and shipments, and are not necessarily indicative of long-term trends in sales of the Company's products. Management believes that during fiscal year 1998 there is a possibility that one of the Company's major customers will have satisfied a substantial portion of its requirements for certain of the Company's important product lines. Management is focusing on the development of new product lines to attempt to meet the other requirements of this and other customers. GROSS PROFIT Gross profit for 1997 was $25.3 million compared to $19.2 million for 1996, representing an increase of $6.1 million, or 32.1%. Gross profit as a percentage of revenues increased to 55.7% for 1997 compared to 51.1% for 1996. The overall increase in gross profit margin resulted primarily from the increased sales levels, while improvements in gross margin as a percentage of sales were a result of increased sales volumes and increased manufacturing efficiencies. The Company's ability to sustain current gross margin levels will depend on its success in gaining further cost reductions as well as experiencing a similar mix of products sold and maintaining current pricing levels. SELLING AND MARKETING EXPENSE Selling and marketing expenses consist primarily of personnel costs as well as commissions and travel expenses of direct sales and marketing personnel, and costs associated with marketing programs. Selling and marketing expense for 1997 was $5.4 million, or 12.0% of revenues, compared to $4.8 million, or 12.7% of revenues for 1996. This increase of $0.6 million, or 14.2%, reflects additional salaries and benefits associated with increased staffing levels to support expanding product lines and increased consulting and travel expenses associated with the planned expansion into international markets. The Company expects selling and marketing expenses to rise commensurate with increased revenues and selling efforts. The Company is continuing its efforts to expand its business by marketing new products, developing additional customer training programs and expanding its international presence. GENERAL AND ADMINISTRATIVE EXPENSE General and administrative expenses consist primarily of personnel costs for finance, administrative and general management personnel as well as accounting and legal expenses. General and administrative expense for 1997 was $3.8 million, or 8.3%, of revenues, compared to $2.6 million, or 6.8%, of revenues for 1996. This increase of $1.2 million, or 47.6%, is primarily attributable to additional salaries and benefits associated with increased staffing levels to support the expanded business operations and increased travel and business development activities. RESEARCH AND DEVELOPMENT EXPENSE Research and development expenses consist primarily of personnel costs and costs associated with the development of new products. Research and development expense for 1997 was $5.9 million, an increase of $2.0 million, or 51.6%, compared to $3.9 million for 1996. The increase was principally due to costs associated with additional personnel to support new product introductions. As a percentage of revenues, research and development expense was 13.1% for 1997 compared to 10.5% for 1996. The Company expenses all research and development costs as they are incurred. OTHER INCOME AND EXPENSE Other income, which consists primarily of interest income, was $0.9 million for 1997 compared to $0.8 million for 1996. The increase in other income was primarily attributable to increased interest income, which resulted from the increased levels of investable funds. PROVISION FOR INCOME TAXES The Company's effective tax rate for 1997 was 37.7% of income before income taxes, compared to the 36.2% rate in 1996. The slight increase reflects increases in state taxes offset by benefits from higher levels of tax-exempt interest and increased credits for research and development. 8 4 YEAR ENDED DECEMBER 31, 1996 COMPARED TO YEAR ENDED DECEMBER 31, 1995 REVENUES Revenues for the year ended December 31, 1996 were $37.5 million, and were $15.2 million, or 68.0%, higher than revenues of $22.3 million for the year ended December 31, 1995. Revenues for both periods consisted almost entirely of product sales. Royalty and license fees were not material for either period. The increase in revenues is primarily associated with the increase in unit volume sales of the MCU product line as a result of increased market penetration and customer acceptance. The increase includes revenues of $5.6 million from eight new products introduced in 1996. Overall, increased product demand is at least partly attributable to technology licensing agreements and/or joint venture relationships with certain major DLC vendors, as well as continued expansion of a marketing program to train customers in advanced line test system trouble-shooting. In addition, revenues in the first quarter of 1996 included $1.3 million associated with the completion of a one-time project for a major customer. This project was not related to the Company's core MCU line testing product line. GROSS PROFIT Gross profit for 1996 was $19.2 million compared to $11.0 million for 1995, representing an increase of $8.2 million, or 74.6%. Gross profit as a percentage of revenues increased to 51.1% for 1996 compared to 49.2% for 1995. The overall increase in gross profit margin resulted primarily from the increased sales levels, while improvements in gross margin as a percentage of sales were a result of increased sales of certain higher-margin products within the MCU product line as well as reduced unit costs from suppliers and manufacturing efficiencies. The Company's ability to sustain current gross margin levels will depend on its success in gaining further cost reductions as well as experiencing a similar mix of products sold. SELLING AND MARKETING EXPENSE Selling and marketing expenses consist primarily of personnel costs as well as commissions and travel expenses of direct sales and marketing personnel, and costs associated with marketing programs. Selling and marketing expense for 1996 was $4.8 million, or 12.7% of revenues, compared to $3.0 million, or 13.2% of revenues for 1995. This increase of $1.8 million, or 61.4%, reflects additional salaries and benefits associated with increased staffing levels to support expanding product lines and increased consulting and travel expenses associated with the planned expansion into international markets. GENERAL AND ADMINISTRATIVE EXPENSE General and administrative expenses consist primarily of personnel costs for finance, administrative and general management personnel as well as accounting and legal expenses. General and administrative expense for 1996 was $2.6 million, or 6.8%, of revenues, compared to $1.5 million, or 6.6%, of revenues for 1995. This increase of $1.1 million, or 73.5%, is primarily attributable to additional salaries and benefits associated with increased staffing levels to support the expanded business operations, as well as additional costs associated with being a public company. RESEARCH AND DEVELOPMENT EXPENSE Research and development expenses consist primarily of personnel costs and costs associated with the development of new products. Research and development expense for 1996 was $3.9 million, an increase of $1.3 million, or 48.7%, compared to $2.6 million for 1995. The increase was principally due to costs associated with additional personnel to support new product introductions. As a percentage of revenues, research and development expense was 10.5% for 1996 compared to 11.8% for 1995. The Company expenses all research and development costs as they are incurred. OTHER INCOME AND EXPENSE Other income, which consists primarily of interest income, was $845,000 for 1996 compared to $20,000 for 1995. The increase in other income was primarily attributable to increased interest income, which resulted from the investment of the initial public offering proceeds for the entire year of 1996 versus only a portion of 1995. PROVISION FOR INCOME TAXES The Company's effective tax rate for 1996 was 36.2% of income before income taxes, which was comparable to the 36.0% rate in 1995. LIQUIDITY AND CAPITAL RESOURCES The Company had working capital of $34.6 million as of December 31, 1997 compared to working capital of $27.2 million as of December 31, 1996. The increase in working capital can be attributed to operating cash flow (income from operations before depreciation and amortization) exceeding the requirements for purchases of property and equipment. Cash provided by oper- 9 5 ations was $2.6 million and $2.0 million for 1997 and 1996, respectively. Net income was the primary source of cash provided by operations for 1997 and 1996, offset by increased levels in accounts receivable and inventories due to increased product sales. Inventories increased 41.2% during the period due to the investment required to support increased sales of existing products, introduce new products and to maintain sufficient inventory stocking levels. As of December 31, 1997, the Company had $19.5 million of cash and cash equivalents, short-term and long-term investments which are available for acquisitions and other corporate requirements. Capital expenditures were $1.2 million for 1997 and were primarily related to prototype tooling, test fixtures and development systems, computer and office equipment for increased staff, as well as leasehold improvements made to the Company's facilities. Capital expenditures were $2.0 million and $1.0 million for 1996 and 1995, respectively, and were primarily related to office equipment, test fixtures and development systems, tooling and leasehold improvements. The Company presently has no material capital expenditure commitments. Planned capital expenditures for 1998 are anticipated to total approximately $2.0 million. These planned capital projects include test fixtures and development systems, computer and office equipment and leasehold improvements to the Company's facilities. On July 1, 1995, the Company entered into a Credit Agreement with the U.S. branch of Creditanstalt-Bankverein (the "Bank"), a banking corporation of the Republic of Austria, replacing an earlier agreement between the Company and the Bank. Under the Credit Agreement, the Company may borrow up to an amount equal to 90% of the amount of eligible accounts receivable plus the lesser of $750,000 and 40% of the amount of eligible inventory. Borrowings accrue interest at .5% above the higher of the Bank's prime rate or the federal funds rate plus .5%. Loans may not in any event exceed $2.5 million. The Credit Agreement is collateralized by substantially all of the Company's assets, including accounts receivable and inventory. The Credit Agreement contains a variety of restrictive covenants, including prohibitions on the incurrence of additional indebtedness for borrowed money, dividends and stock repurchases. The Credit Agreement also requires the Company to be in compliance with certain financial ratios and other financial requirements. At December 31, 1997, there was $2.5 million available under the Credit Agreement and there were no outstanding borrowings under the Credit Agreement. The agreement expires on June 30, 1998, however, the Company believes its financial position will enable it to negotiate any further credit agreements on comparable or more favorable terms. On July 23, 1996, the Board of Directors of the Company declared a dividend of one preferred stock purchase right for each outstanding share of the Company's common stock. The rights will be exercisable only if a person or group acquires or announces a tender or exchange offer for 20% or more of the Company's common stock. In such an event, each right will entitle shareholders to buy one-hundredth of a share of a new series of preferred stock at an exercise price of $115.00. Each one-hundredth of a share of the new preferred stock has terms designed to make it the economic and voting equivalent of one share of common stock. If a person or group acquires 20% or more of the Company's outstanding common stock, each right not owned by the person or group will entitle its holder to purchase at the right's exercise price a number of shares of the Company's common stock (or, at the option of the Company, the new preferred stock) having a market value of twice the exercise price. Further, at any time after a person or group acquires 20% or more (but less than 50%) of the outstanding common stock, the Board of Directors may at its option, exchange part or all of the rights (other than rights held by the acquiring person or group) for shares of the Company's common or preferred stock on a one-for-one basis. If after a person or group acquires 20% or more of the outstanding common stock, each right will entitle its holder to purchase, at the right's exercise price, a number of the acquiring company's common shares having a market value at that time of twice the exercise price. The Board of Directors is entitled to redeem the rights for one cent per right at any time before a 20% position has been acquired. The Board of Directors is also authorized to reduce the 20% thresholds referred to above to not less than 10%. The rights were not distributed in response to any specific effort to acquire control of the Company, nor is the Company presently aware of any such effort. The distribution of the rights will not affect the 10 6 Company's reported earnings and is not taxable to shareholders or to the Company. Shareholders will not receive any documents evidencing their rights unless and until the rights become exercisable. Until that time, the rights will not trade separately from the common stock. The rights will expire on August 15, 2006. On April 22, 1997 the Company's Board of Directors authorized a program to repurchase up to 200,000 shares of its common stock over the next two years. The shares will be utilized to provide stock under certain employee benefit programs. The number of shares that the Company intends to purchase and the time of such purchases will be determined by the Company, at its discretion. The Company plans to use existing cash and short-term investments to finance the repurchases. To date, the Company has purchased 12,800 shares of the Company's common stock under this program. The impact of inflation on both the Company's financial position and the results of operations has been minimal and is not expected to adversely affect 1997 results. The Company's financial position enables it to meet cash requirements for operations and capital expansion programs. IMPACT OF THE YEAR 2000 ISSUE The Year 2000 Issue is the result of computer programs being written using two digits rather than four to define the applicable year. Any of the Company's computer programs that have date-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in a system failure or miscalculations causing disruption of operations, including among other things, a temporary inability to process transactions, send invoices, or engage in similar normal business activities. The Company is currently assessing whether its existing computer systems will properly utilize dates beyond December 31, 1999. If modifications are required for its existing systems and the modifications are not completed on a timely basis, the Year 2000 Issue could have a material impact on the operations of the Company. The Company believes that it has no exposure to contingencies related to the Year 2000 Issue for the products it has sold. The Company plans to engage in formal communication with all of its significant suppliers and large customers to determine the extent to which the Company is vulnerable to those third parties' failure to remediate their own Year 2000 Issue. There can be no guarantee that the systems of other companies on which the Company's systems rely will be timely converted, or that a failure to convert by another company, or a conversion that is incompatible with the Company's systems, would not have a material adverse effect on the Company. Presently, the Company does not have an estimate for the costs of the project and the date on which the Company plans to complete the Year 2000 modifications, if any. However, based upon the Company's initial assessment, the Company believes that the costs of the project will not be material. ACCOUNTING PRONOUNCEMENTS In June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income," which establishes standards for reporting and displaying comprehensive income and its components in a full set of general-purpose financial statements. This Statement, which is effective for financial statements for fiscal years beginning after December 15, 1997, requires that all items that are required to be recognized under accounting standards as components of comprehensive income be reported in a financial statement that is displayed with the same prominence as other financial statements. Additionally, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information," which establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports. This Statement, which is effective for financial statements for fiscal years beginning after December 15, 1997, also establishes standards for related disclosures about products and services, geographic areas and major customers. Management is currently evaluating the implication of these statements from both an operations and financial reporting perspective. BACKLOG The Company's backlog consists of firm customer purchase orders for the Company's various products. At December 31, 1997 the Company had backlog of $1.6 million, a $0.7 million increase from the December 31, 1996 backlog of $0.9 million. The increase was due largely to the receipt of certain orders under Original Equipment Manufacturer ("OEM") arrangements scheduled for shipment in the first quarter of 1998 and beyond. 11 7 TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES STATEMENT OF MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL REPORTING The accompanying consolidated financial statements of Tollgrade Communications, Inc. and Subsidiaries have been prepared by management, who are responsible for their integrity and objectivity. The statements have been prepared in conformity with generally accepted accounting principles and include amounts based on management's best estimates and judgements. Financial information elsewhere in this Annual Report is consistent with that in the financial statements. Management has established and maintains a system of internal control designed to provide reasonable assurance that assets are safeguarded and that the financial records reflect the authorized transactions of the Company. The system of internal control includes widely communicated statements of policies and business practices that are designed to require all employees to maintain high ethical standards in the conduct of Company affairs. The internal controls are augmented by organizational arrangements that provide for appropriate delegation of authority and division of responsibility. The financial statements have been audited by Coopers & Lybrand L.L.P., Independent Public Accountants. As part of their audit of the Company's 1997 financial statements, Coopers & Lybrand L.L.P. considered the Company's system of internal control to the extent they deemed necessary to determine the nature, timing and extent of their audit tests. The Independent Public Accountants' Report follows. The Board of Directors pursues its responsibility for the Company's financial reporting through its Audit Committee, which is composed entirely of outside directors. The Audit Committee has met periodically with the Independent Public Accountants and management. The Independent Public Accountants had direct access to the Audit Committee, with and without the presence of management representatives, to discuss the results of their audit work and their comments on the adequacy of internal accounting controls and the quality of financial reporting. /s/ CHRISTIAN L. ALLISON ------------------------ Christian L. Allison Chief Executive Officer /s/ SAMUEL C. KNOCH ------------------------------------- Samuel C. Knoch Chief Financial Officer and Treasurer January 27, 1998 12 8 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors of Tollgrade Communications, Inc.: We have audited the accompanying consolidated balance sheets of Tollgrade Communications, Inc. and subsidiaries as of December 31, 1996 and 1997, and the related consolidated statements of operations, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1997. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Tollgrade Communications, Inc. and subsidiaries as of December 31, 1996 and 1997, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1997 in conformity with generally accepted accounting principles. /s/ COOPERS & LYBRAND L.L.P. ---------------------------- COOPERS & LYBRAND L.L.P. Pittsburgh, Pennsylvania January 27, 1998 13 9 TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS
ASSETS December 31, 1996 December 31, 1997 - -------------------------------------------------------------------------------------------------------------- Current assets: Cash and cash equivalents $ 4,591,273 $ 3,183,944 Short-term investments 12,342,592 15,666,626 Accounts receivable: Trade 5,153,589 7,884,683 Other 304,434 517,090 Inventories 8,569,818 12,101,114 Prepaid expenses and deposits 549,753 409,252 Deferred tax asset 171,776 213,216 - -------------------------------------------------------------------------------------------------------------- Total current assets 31,683,235 39,975,925 Long-term investments -- 600,000 Property and equipment, net 2,769,657 3,001,824 Deferred tax asset 157,169 126,895 Patents and other assets 15,569 8,568 - -------------------------------------------------------------------------------------------------------------- Total assets $34,625,630 $43,713,212 - -------------------------------------------------------------------------------------------------------------- LIABILITIES AND SHAREHOLDERS' EQUITY - -------------------------------------------------------------------------------------------------------------- Current liabilities: - -------------------------------------------------------------------------------------------------------------- Accounts payable $ 1,691,928 $ 959,185 Accrued expenses 1,077,151 1,091,990 Accrued salaries and wages 769,855 1,529,525 Royalty payable 741,781 878,780 Income taxes payable 170,889 946,233 - -------------------------------------------------------------------------------------------------------------- Total current liabilities 4,451,604 5,405,713 Deferred tax liability 168,455 206,116 - -------------------------------------------------------------------------------------------------------------- Total liabilities 4,620,059 5,611,829 Commitments Shareholders' equity: Preferred stock, $1.00 par value; authorized shares, 10,000,000 issued shares, -0- in 1996 and 1997, respectively -- -- Common stock, $.20 par value; authorized shares, 7,000,000; issued shares, 5,620,417 in 1996 and 5,727,350 in 1997 1,124,083 1,145,470 Additional paid-in capital 24,091,210 25,232,315 Treasury stock, at cost, 2,200 shares in 1996 and 3,200 in 1997 (49,775) (70,355) Unearned compensation (106,686) (35,934) Retained earnings 4,946,739 11,829,887 - -------------------------------------------------------------------------------------------------------------- Total shareholders' equity 30,005,571 38,101,383 - -------------------------------------------------------------------------------------------------------------- Total liabilities and shareholders' equity $34,625,630 $43,713,212 - --------------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial statements. 14 10 TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS
Years Ended December 31, 1995 1996 1997 - -------------------------------------------------------------------------------------------------------------------------------- Revenues $ 22,309,629 $ 37,489,949 $ 45,421,135 Cost of product sales 11,328,660 18,321,677 20,104,202 Gross profit 10,980,969 19,168,272 25,316,933 - -------------------------------------------------------------------------------------------------------------------------------- Operating expenses: Selling and marketing 2,953,223 4,767,339 5,446,102 General and administrative 1,471,222 2,551,959 3,767,925 Research and development 2,636,770 3,921,091 5,944,819 - -------------------------------------------------------------------------------------------------------------------------------- Total operating expenses 7,061,215 11,240,389 15,158,846 - -------------------------------------------------------------------------------------------------------------------------------- Income from operations 3,919,754 7,927,883 10,158,087 Other income (expense): Interest expense (58,583) (3,076) (3,271) Interest and other income 78,656 848,569 901,981 - -------------------------------------------------------------------------------------------------------------------------------- 20,073 845,493 898,710 - -------------------------------------------------------------------------------------------------------------------------------- Income before income taxes 3,939,827 8,773,376 11,056,797 Provision for income taxes 1,418,000 3,176,753 4,173,649 - -------------------------------------------------------------------------------------------------------------------------------- Net income $ 2,521,827 $ 5,596,623 $ 6,883,148 - -------------------------------------------------------------------------------------------------------------------------------- EARNINGS PER SHARE INFORMATION: Weighted average shares of common stock and equivalents: Basic 4,227,648 5,500,884 5,686,182 Diluted 4,503,712 5,939,662 5,961,540 - -------------------------------------------------------------------------------------------------------------------------------- Net income per common share: Basic $ .60 $ 1.02 $ 1.21 Diluted .56 .94 1.15 - --------------------------------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial statements. 15 11 TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
Additional Preferred Stock Common Stock Paid-in Shares Amount Shares Amount Capital - -------------------------------------------------------------------------------------------------------------- Balance at December 31, 1994 958,721 $958,721 2,591,427 $ 518,286 $ 3,834,386 Receipt of stock subscriptions -- -- -- -- -- Issuance of common stock through private placement offering, net of offering costs -- -- 463,337 92,667 2,054,255 Conversion of preferred stock to common stock (958,721) (958,721) 958,721 191,744 766,977 Restricted stock: Issuance of common stock -- -- 18,960 3,792 185,803 Compensation charged to expense, net -- -- -- -- -- Tax benefit from vesting of restricted stock -- -- -- -- 29,200 Cancellation of treasury stock -- -- (74,200) (14,840) (13,360) Issuance of common stock through initial public offering, net of offering costs -- -- 1,485,585 297,117 15,481,761 Net income -- -- -- -- -- - -------------------------------------------------------------------------------------------------------------- Balance at December 31, 1995 -- -- 5,443,830 1,088,766 22,339,022 Issuance costs for initial public offering in 1995 -- -- -- -- (55,889) Exercise of common stock options -- -- 179,027 35,805 439,005 Restricted stock - compensation charged to expense, net -- -- -- -- -- Shares forfeited -- -- (2,440) (488) (8,999) Tax benefit from exercise of stock options -- -- -- -- 1,378,071 Net income -- -- -- -- -- - -------------------------------------------------------------------------------------------------------------- Balance at December 31, 1996 -- -- 5,620,417 1,124,083 24,091,210 EXERCISE OF COMMON STOCK OPTIONS -- -- 107,283 21,457 456,759 RESTRICTED STOCK - COMPENSATION CHARGED TO EXPENSE, NET -- -- -- -- -- SHARES FORFEITED -- -- (350) (70) (18,338) TAX BENEFIT FROM EXERCISE OF STOCK OPTIONS -- -- -- -- 702,684 PURCHASE OF TREASURY STOCK -- -- -- -- -- NET INCOME -- -- -- -- -- BALANCE AT DECEMBER 31, 1997 -- $ -- 5,727,350 $1,145,470 $25,232,315 - --------------------------------------------------------------------------------------------------------------
Retained Earnings Subscriptions Treasury Unearned (Accumulated Receivable Stock Compensation Deficit) Total - ------------------------------------------------------------------------------------------------------------------- Balance at December 31, 1994 $(681,830) $(28,200) $(42,873) $( 3,171,711) $ 1,386,779 Receipt of stock subscriptions 681,830 -- -- -- 681,830 Issuance of common stock through private placement offering, net of offering costs -- -- -- -- 2,146,922 Conversion of preferred stock to common stock -- -- -- -- -- Restricted stock: Issuance of common stock -- -- (189,595) -- -- Compensation charged to expense, net -- -- 63,939 -- 63,939 Tax benefit from vesting of restricted stock -- -- -- -- 29,200 Cancellation of treasury stock -- 28,200 -- -- -- Issuance of common stock through initial public offering, net of offering costs -- -- -- -- 15,778,878 Net income -- -- -- 2,521,827 2,521,827 - ------------------------------------------------------------------------------------------------------------------- Balance at December 31, 1995 -- -- (168,529) (649,884) 22,609,375 Issuance costs for initial public offering in 1995 -- -- -- -- (55,889) Exercise of common stock options -- (49,775) -- -- 425,035 Restricted stock - compensation charged to expense, net -- -- 52,356 -- 52,356 Shares forfeited -- -- 9,487 -- -- Tax benefit from exercise of stock options -- -- -- -- 1,378,071 Net income -- -- -- 5,596,623 5,596,623 - ------------------------------------------------------------------------------------------------------------------- Balance at December 31, 1996 -- (49,775) (106,686) 4,946,739 30,005,571 EXERCISE OF COMMON STOCK OPTIONS -- -- -- -- 478,216 RESTRICTED STOCK - COMPENSATION CHARGED TO EXPENSE, NET -- -- 52,344 -- 52,344 SHARES FORFEITED -- -- 18,408 -- -- TAX BENEFIT FROM EXERCISE OF STOCK OPTIONS -- -- -- -- 702,684 PURCHASE OF TREASURY STOCK -- (20,580) -- -- (20,580) NET INCOME -- -- -- 6,883,148 6,883,148 BALANCE AT DECEMBER 31, 1997 $ -- $(70,355) ($35,934) $ 11,829,887 $38,101,383 - -------------------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial statements. 16 12 TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS
Year Ended December 31, 1995 1996 1997 - ------------------------------------------------------------------------------------------------------------------------------------ Cash flows from operating activities: Net income $ 2,521,827 $ 5,596,623 $ 6,883,148 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 342,310 688,323 1,005,744 Deferred income taxes 692,000 (77,990) 26,495 Provision for losses on inventory 60,000 95,000 -- Compensation expense for restricted stock 63,939 52,356 52,344 Changes in assets and liabilities: Increase in accounts receivable-trade (892,290) (2,582,356) (2,731,094) Decrease (increase) in accounts receivable-other 29,222 (192,716) (212,656) Increase in inventories (3,250,474) (2,643,352) (3,531,296) (Increase) decrease in prepaid expenses and deposits (109,982) (398,302) 140,501 Increase (decrease) in accounts payable 457,809 (275,517) (732,743) Increase in accrued expenses and royalty payable 389,048 1,679,404 911,508 Increase in income taxes payable 66,194 86,089 775,344 - ------------------------------------------------------------------------------------------------------------------------------------ Net cash provided by operating activities 369,603 2,027,562 2,587,295 - ------------------------------------------------------------------------------------------------------------------------------------ Cash flows from investing activities: Purchase of short-term investments -- (20,690,542) (19,567,255) Redemption/maturity of short-term investments 74,219 8,347,950 15,643,221 Capital expenditures (1,040,062) (1,993,541) (1,230,910) Patent expenditures (3,405) (4,760) -- Purchase of treasury stock -- -- (20,580) - ------------------------------------------------------------------------------------------------------------------------------------ Net cash used in investing activities (969,248) (14,340,893) (5,175,524) - ------------------------------------------------------------------------------------------------------------------------------------ Cash flows from financing activities: Net Repayments under line of credit (865,719) -- -- Payments on long-term debt (1,800,000) -- -- Purchase of stock warrants (1,253,708) -- -- Proceeds from issuance of common stock, net of issuance costs 2,146,922 -- -- Proceeds from the exercise of stock options including related tax benefits -- 1,803,106 1,180,900 Proceeds from initial public offering, net of issuance costs 16,107,694 (55,889) -- Receipt of stock subscriptions 681,830 -- -- - ------------------------------------------------------------------------------------------------------------------------------------ Net cash provided by financing activities 15,017,019 1,747,217 1,180,900 - ------------------------------------------------------------------------------------------------------------------------------------ Net increase (decrease) in cash and cash equivalents 14,417,374 (10,566,114) (1,407,329) Cash and cash equivalents at beginning of year 740,013 15,157,387 4,591,273 - ------------------------------------------------------------------------------------------------------------------------------------ Cash and cash equivalents at end of year $ 15,157,387 $ 4,591,273 $ 3,183,944 - ------------------------------------------------------------------------------------------------------------------------------------ Supplemental disclosure of cash flow information: Cash paid during the year for interest $ 79,101 $ 3,076 $ 3,271 Cash paid during the year for income taxes 658,765 2,013,981 2,420,460 Noncash financing and operating activities: Issuance of restricted common stock at no cost 189,595 -- -- Tax benefit from vesting of restricted stock 29,200 -- -- Conversion of preferred stock to common stock 951,721 -- -- Conversion of preferred stock to common stock in treasury 7,000 -- -- Issuance costs for initial public offering in accounts payable 328,816 -- -- - ------------------------------------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial statements. 17 13 TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: ORGANIZATION AND BASIS OF PRESENTATION: Tollgrade Communications, Inc. (the "Company") designs, engineers, markets and supports its proprietary electronic equipment for use by telephone companies to use their existing line test systems to remotely diagnose problems in Plain Old Telephone Service ("POTS") lines containing both copper and fiber optics. The Company was organized in 1986 and began operations in 1988. USE OF ESTIMATES: The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of income and expense during the reporting period. Actual results could differ from those estimates. PRINCIPLES OF CONSOLIDATION: The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany transactions have been eliminated. CASH AND CASH EQUIVALENTS: The Company considers highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. Substantially all of the Company's cash and cash equivalents is maintained at one financial institution. No collateral or security is provided on these deposits, other than $100,000 of deposits per financial institution insured by the Federal Deposit Insurance Corporation. INVESTMENTS: Short-term investments at December 31, 1996 and 1997 consist of a treasury note and/or individual municipal bonds stated at cost, which approximated market value. These securities have a maturity of one year or less at date of purchase and/or contain a callable provision in which the bonds can be called within one year from date of purchase. The primary investment purpose is to provide a reserve for future business purposes, including possible acquisitions, capital expenditures and to meet working capital requirements. Long-term investments are individual municipal bonds with a maturity of more than one year but less than eighteen months. In May 1993, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities." The Company adopted the new accounting and disclosure rules for this standard in the first quarter of 1996. The Company classifies its investment in all debt securities as "held-to-maturity." INVENTORIES: Inventories are stated at the lower of cost or market, with cost determined on the first-in, first-out method. The Company provides appropriate reserves for any inventory deemed slow moving or obsolete. PROPERTY AND EQUIPMENT: Property and equipment is stated at cost. Property and equipment is depreciated on a straight-line method over their estimated useful lives ranging from 3 to 7 years. Leasehold improvements are amortized over the related lease period or the estimated useful life, whichever is shorter. The cost of renewals and betterments that extend the lives or productive capacities of properties is capitalized. Expenditures for normal repairs and maintenance are charged to operations as incurred. The cost of property and equipment retired or otherwise disposed of and the related accumulated depreciation or amortization are removed from the accounts and any resulting gain or loss is reflected in current operations. PATENTS: The costs of patents are being amortized on a straight-line method over a period of five years. 18 14 PRODUCT WARRANTY: The Company records estimated warranty costs on the accrual basis of accounting. These reserves are based on applying historical returns and cost experience to the current level of product shipments. REVENUE RECOGNITION: Revenue from product sales is recognized at the time of shipment. Revenue for license and royalty fees is recognized when earned. RESEARCH AND DEVELOPMENT COSTS: Research and development costs are charged to operations in the year incurred. INCOME TAXES: The Company follows the provisions of SFAS No. 109, "Accounting for Income Taxes" (SFAS 109). Under SFAS 109, deferred tax liabilities and assets are determined based on the "temporary differences" between the financial statement carrying amounts and the tax basis of assets and liabilities using enacted tax rates in effect in the years in which the differences are expected to reverse. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. PER SHARE INFORMATION: Net income per share has been computed in accordance with the provisions of SFAS No. 128, "Earnings Per Share" for all periods presented. The statement requires companies with complex capital structures to report earnings per share on a basic and diluted basis, as defined. Basic earnings per share are calculated on the actual number of weighted average common shares outstanding for the period, while diluted earnings per share must include the effect of any dilutive securities. All prior periods have been restated in accordance with SFAS No. 128. A reconciliation of earnings per share is as follows:
December 31, 1995 1996 1997 - --------------------------------------------------------------------------------------------------------------------------- Net Income $ 2,521,827 $ 5,596,623 $ 6,883,148 - --------------------------------------------------------------------------------------------------------------------------- Weighted average common shares outstanding 4,227,648 5,500,884 5,686,182 - --------------------------------------------------------------------------------------------------------------------------- Effect of dilutive securities - stock options 276,064 438,778 275,358 - --------------------------------------------------------------------------------------------------------------------------- 4,503,712 5,939,662 5,961,540 - --------------------------------------------------------------------------------------------------------------------------- Earnings per share: Basic $ .60 $ 1.02 $ 1.21 - --------------------------------------------------------------------------------------------------------------------------- Diluted $ .56 $ .94 $ 1.15 - ---------------------------------------------------------------------------------------------------------------------------
Pursuant to the requirements of the Securities and Exchange Commission, common, restricted and convertible preferred shares issued by the Company during the twelve months immediately preceding the initial public offering (See Note 2) plus the number of shares issuable upon exercise of stock options and warrants granted during this period, have been included in the calculation of the shares used in computing net income per share as if they were outstanding for 1995 through the date of the initial public offering (using the treasury stock method and the public offering price in calculating equivalent shares). 2. INITIAL PUBLIC OFFERING: On December 14, 1995, the Company completed an initial public offering of common stock, receiving net proceeds (after deduction of underwriting discounts and other offering costs of $2,048,142) of $15,778,878 from the sale of 1,485,585 shares of common stock at the initial public offering price of $12 per share. 3. STOCK SPLIT: On October 16, 1995, the Board of Directors approved a seven-for-ten reverse split of its common stock which was ratified on November 12, 1995 by the shareholders. All references in the accompanying consolidated financial statements to the number of shares of common stock and convertible preferred stock were retroactively restated to reflect the seven-for-ten reverse stock split. 19 15 4. INVENTORIES: Inventories consisted of the following:
December 31, 1996 DECEMBER 31, 1997 - --------------------------------------------------------------------------------------------------------------------------- Raw materials $ 3,816,242 $ 5,738,576 Work in process 3,808,842 5,070,113 Finished goods 944,734 1,292,425 - --------------------------------------------------------------------------------------------------------------------------- $ 8,569,818 $ 12,101,114 - ---------------------------------------------------------------------------------------------------------------------------
5. PROPERTY AND EQUIPMENT: Property and equipment consisted of the following:
December 31, 1996 DECEMBER 31, 1997 - --------------------------------------------------------------------------------------------------------------------------- Test equipment and tooling $ 1,715,227 $ 2,409,088 Office equipment and fixtures 1,672,929 2,143,567 Leasehold improvements 854,637 921,049 - --------------------------------------------------------------------------------------------------------------------------- 4,242,793 5,473,704 Less accumulated depreciation and amortization 1,473,136 2,471,880 - --------------------------------------------------------------------------------------------------------------------------- $ 2,769,657 $ 3,001,824 - ---------------------------------------------------------------------------------------------------------------------------
In March 1995, the Financial Accounting Standards Board issued SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of." This statement requires review and measurement methods to calculate impairment of long-lived assets whenever events or circumstances indicate that the carrying amount of an asset may not be recoverable. The Company adopted this standard in 1996 and the standard did not impact the financial position and results of operations of the Company in 1996 or 1997. 6. DEBT: FINANCING AGREEMENT: During 1994, the Company maintained a financing agreement with the U.S. branch of Creditanstalt-Bankverein, a banking corporation of the Republic of Austria. At December 31, 1994, the financing agreement, as amended on July 8, 1994, provided for a revolving line of credit up to $1,000,000 and for a $2,000,000 term loan. Balances outstanding as of December 31, 1994 were $865,719 under the line of credit and $2,000,000 under the term loan. During April 1995, the Company repaid the entire balance outstanding of $865,719 on the line of credit. In addition, on February 9, 1995, the Company used the proceeds from a private placement and rights offerings to repay the balance outstanding on the term loan of $1,800,000 (refer to Note 7). On July 1, 1995, the Company entered into a new credit agreement with the U.S. Branch of Creditanstalt-Bankverein providing for maximum borrowing of $2,500,000 under a revolving line of credit. This agreement has been extended to June 30, 1998. Borrowings under the line are limited to 90% of eligible accounts receivable plus the lesser of $750,000 and 40% of eligible inventory and accrue interest at .5% above the higher of the bank's prime rate or the federal funds rate plus .5%. The financing agreement is collateralized by substantially all of the Company's assets, including accounts receivable and inventory, and contains certain financial covenants including the prohibition on the incurrence of additional indebtedness for borrowed money and the payment of dividends. At December 31, 1997, there were no outstanding borrowings under the credit agreement. 7. SHAREHOLDERS' EQUITY: PREFERRED STOCK: The non-voting preferred stock, issued prior to 1994, was redeemable at the option of the Company, at a price equal to the issuance price, plus 13% of the issuance price for each year the shares are outstanding, limited to 165% of the issuance price. The preferred stock had a liquidation value equal to the issuance price reduced by the amount of preferred stock dividends paid. In addition, the preferred stock was convertible into shares of common stock at any time, on a one-for-one basis. 20 16 In 1994, 367,938 shares of preferred stock were converted to common stock. During 1995, the remaining shares of preferred stock were converted into 958,721 shares of common stock. COMMON STOCK: The Company has 7,000,000 authorized shares which have a par value of $ .20 per share. As of December 31, 1996 and 1997, there are 5,620,417 and 5,727,350 issued shares, respectively. RIGHTS OFFERING: On September 19, 1994, the Company offered for sale to every common or preferred shareholder non-transferable rights to subscribe to one share of common stock at a purchase price of $5 per share for every four shares of common or preferred stock held on that date. During September 1994, the Company sold 140,944 shares of common stock under the rights offering for an aggregate price of $704,720. As of December 31, 1994, the rights offering was closed. Subscriptions receivable related to this offering totaled $129,566 at December 31, 1994, which were collected in 1995. The proceeds from the offering were reduced by $34,188 for costs incurred in connection with the offering. PRIVATE PLACEMENT OFFERING: During January and February 1995, the Company sold 463,337 shares of common stock at an issue price of $5 per share in a private placement offering for an aggregate price of $2,316,685. These proceeds were reduced by $201,503 for costs incurred in connection with the offering, of which $31,740 was incurred in 1994. STOCK REPURCHASE PROGRAM: On April 22, 1997, the Company's Board of Directors authorized a program to repurchase up to 200,000 shares of its common stock over the next two years. The shares will be utilized to provide stock under certain employee benefit programs. The number of shares that the Company intends to purchase and the time of such purchases will be determined by the Company, at its discretion. The Company plans to use existing cash and short-term investments to finance the purchases. As of December 31, 1997, the Company had purchased 1,000 shares of the Company's common stock under this program. RESTRICTED STOCK: In May 1989, the Company adopted the Tollgrade Communications, Inc. Restricted Stock Employee Incentive Plan (the "Plan"), which provides for the granting of restricted common stock to key employees. A maximum of 140,000 shares were issuable under the Plan. During 1995, 18,960 shares of restricted stock under the Plan were issued. Additionally, prior to 1995, the Company had granted a total of 193,134 shares of restricted common stock to certain key employees, of which 22,403 were granted under the provisions of the Plan. Effective upon approval by the Company's Board of Directors of the 1995 Long-Term Incentive Compensation Plan, the Plan was terminated. No shares of restricted stock were granted under the 1995 Long-Term Incentive Compensation Plan in 1996 and 1997. All shares of restricted stock were issued at no cost. Generally, the recipients of the restricted stock are required to continue in the employment of the Company for three to five years after the date of issuance for ownership to vest. The unearned compensation related to the restricted stock is being charged to expense over the vesting period using the market value at the issuance dates, ranging from $.571 to $10.00, as determined by the Board of Directors. Compensation expense was $63,939, $52,356 and $52,344 in 1995, 1996 and 1997, respectively. In 1995, 1996 and 1997, -0-, 2,440 and 350 shares of restricted stock, respectively, were forfeited due to the termination of certain employees. Accordingly, the compensation expense recorded for these shares in prior periods amounting to $-0-, $9,487 and $18,408 was reversed in 1995, 1996 and 1997, respectively. At December 31, 1997, all shares of restricted common stock granted had vested with the exception of the 18,960 shares granted under the Plan in 1995, which vest in August 1998. STOCK COMPENSATION PLANS: Under the Company's stock compensation plans, officers and other employees may be granted options to purchase shares of the Company's common stock. The option price on all outstanding options is equal to the fair market value of the stock at the date of the grant. 21 17 On April 22, 1997, the shareholders of the Company approved an amendment of the 1995 Long-Term Incentive Compensation Plan to increase the number of shares authorized for issuance under the plan by 375,000 and to allow for inclusion of non-employee directors under the plan. The shares authorized but not granted under the Company's stock option plans were 126,168 at December 31, 1996 and 357,973 at December 31, 1997. Prior to and during 1995, 1996 and 1997, certain employees of the Company were granted stock options under the 1995 Long-Term Incentive Compensation Plan and various other agreements. The Company has adopted the disclosure-only provisions of SFAS No. 123 "Accounting for Stock-based Compensation," but applies Accounting Principles Board Opinion No. 25 and related interpretations in accounting for its plans. If the Company had elected to recognize compensation cost for these stock options based on the fair value at the grant dates for awards granted under those plans in 1995, 1996 and 1997 consistent with the method prescribed by SFAS No. 123, net income and earnings per share would have been changed to the pro forma amounts indicated below:
Year Ended December 31, 1995 December 31, 1996 DECEMBER 31, 1997 - --------------------------------------------------------------------------------------------------------------------------- Net income As reported $ 2,521,827 $ 5,596,623 $ 6,883,148 Pro forma $ 2,113,201 $ 4,687,153 $ 5,805,709 - --------------------------------------------------------------------------------------------------------------------------- Diluted earnings per share As reported $ .56 $ .94 $ 1.15 Pro forma $ .47 $ .79 $ .97
The fair value of the stock options used to compute pro forma net income and earnings per share disclosures is the estimated present value at grant date using the Black-Scholes option-pricing model with the following weighted average assumptions for 1995, 1996 and 1997: expected volatility of 40.4%; a risk free interest rate of 5.44% in 1995, 5.64% in 1996 and 6.10% in 1997; and an expected holding period of 4 years. The weighted average fair value of stock options, calculated using the Black-Scholes option-pricing model, granted during the year ended 1995, 1996 and 1997 is $5.40, $10.71 and $8.54, respectively. Transactions involving stock options under the Company's various stock option plans and otherwise are summarized below:
Number of Shares Range of Option Price Weighted Average Exercise Price - --------------------------------------------------------------------------------------------------------------------------- Outstanding, December 31, 1994 481,600 $ .957 - $ 5.50 $ 2.52 Granted 333,982 12.00 - 15.00 12.65 Exercised ---- ---- ---- Cancelled (105,000) 4.41 4.41 - --------------------------------------------------------------------------------------------------------------------------- Outstanding, December 31, 1995 710,582 .957 - 15.00 7.00 Granted 201,500 21.75 - 25.75 25.33 Exercised (179,027) 1.43 - 15.00 2.67 Cancelled (3,000) 12.00 12.00 - --------------------------------------------------------------------------------------------------------------------------- Outstanding, December 31, 1996 730,055 .957 - 25.75 13.10 Granted 135,750 17.50 - 25.13 21.50 Exercised (107,283) .957 - 17.50 4.42 Cancelled (5,055) 12.00 - 15.00 13.81 - --------------------------------------------------------------------------------------------------------------------------- OUTSTANDING, DECEMBER 31, 1997 753,467 $ .957 - $ 25.75 $ 15.84 - ---------------------------------------------------------------------------------------------------------------------------
Options exercisable at: Number of Shares Weighted Average Exercise Price - --------------------------------------------------------------------------------------------------------------------------- December 31, 1995 578,694 $ 5.61 December 31, 1996 542,369 10.33 DECEMBER 31, 1997 615,289 14.17
22 18 The following table summarizes the status of the stock options, outstanding and exercisable at December 31, 1997:
Stock Options Outstanding Stock Options Exercisable - --------------------------------------------------------------------------------------------------------------------------- Weighted Average Range of Exercise Remaining Weighted Average Weighted Average Prices Shares Contractual Life Exercise Price Shares Exercise Price - --------------------------------------------------------------------------------------------------------------------------- $.957 89,000 1 year $ .957 89,000 $ .957 - --------------------------------------------------------------------------------------------------------------------------- $2.14 30,100 1 year $ 2.14 30,100 $ 2.14 - --------------------------------------------------------------------------------------------------------------------------- $12.00 to $17.50 302,617 8 years $ 12.76 298,949 $ 12.70 - --------------------------------------------------------------------------------------------------------------------------- $21.00 to $25.75 331,750 9.3 years $ 23.89 197,240 $ 24.20 - --------------------------------------------------------------------------------------------------------------------------- Total 753,467 $ 15.84 615,289 $ 14.17 - ---------------------------------------------------------------------------------------------------------------------------
Subsequent to December 31, 1997, the Board of Directors granted an additional 86,000 options to officers of the Company pursuant to the 1995 Long-Term Incentive Compensation Plan, as well as an additional 81,000 options to non-officers of the Company pursuant to a separate plan established by the Board of Directors on January 29, 1998. REDEEMABLE WARRANTS: In association with the bank financing agreement (refer to Note 6), the Company issued to the bank over a four year period, at no cost, warrants to purchase shares of common stock in the amount of 438,798 shares. The warrants were exercisable by the bank up to six years from the termination date of the financing agreement. The $250,738 value assigned to the warrants was recorded as a discount on the related debt. The warrants contained an anti-dilutive provision if additional shares of stock (other than through a stock split) were issued for a consideration per share less than market value. In addition, the warrants granted the bank, at its sole option, the right to require the Company to repurchase all or any portion of the warrants on or after April 30, 1994. The repurchase price was the fair market value of the common stock purchasable with the warrants, as defined in the financing agreement. On July 8, 1994, the Company entered into an agreement with the bank under which the repurchase provisions of the warrants were eliminated and a stock redemption agreement was established. Under the stock redemption agreement, the consideration to be paid per share would be the market value of the shares on the day of the offer. In December 1994, the bank offered to sell all of its warrants to the Company at $2.86 per warrant through February 15, 1995. On February 9, 1995, the Company repurchased all of the warrants from the bank at the price of $2.86 per warrant for an aggregate purchase price of $1,253,708. As a result of such repurchase, the stock redemption agreement was terminated. SERIES A JUNIOR PARTICIPATING PREFERRED STOCK PURCHASE RIGHTS: In order to protect shareholder value in the event of an unsolicited offer to acquire the Company, on July 23, 1996, the Board of Directors of the Company declared a dividend of one preferred stock purchase right for each outstanding share of the Company's common stock. The dividend was payable on August 15, 1996 to shareholders of record as of that date. The aforementioned rights are exercisable only if a person or group acquires or announces an offer to acquire 20% or more of the Company's common stock. In such an event, each right will entitle shareholders to buy one-hundredth of a share of a new series of preferred stock at an exercise price of $115.00. Each one-hundredth of a share of the new preferred stock has terms designed to make it the economic and voting equivalent of one share of common stock. If a person or group acquires 20% or more of the Company's outstanding common stock, each right not owned by the person or group will entitle its holder to purchase at the right's exercise price a number of shares of the Company's common stock (or, at the option of the Company, the new preferred stock) having a market value of twice the exercise price. Further, at any time after a person or group acquires 20% or more (but less than 50%) of the outstanding common stock, the Board of Directors may at its option, exchange part or all of the rights (other than rights held by the acquiring person or group) for shares of the Company's common or preferred stock for a one-for-one basis. Each right further provides that if the Company is acquired in a merger or other business transaction, each right will entitle its 23 19 holder to purchase, at the right's exercise price, a number of the acquiring company's common shares having a market value at that time of twice the exercise price. The Board of Directors is entitled to redeem the rights for one cent per right at any time before a 20% position has been acquired. The Board of Directors is also authorized to reduce the 20% thresholds referred to above to not less than 10%. 8. LICENSE AND ROYALTY FEES: The Company has entered into several technology license agreements with certain major Digital Loop Carrier ("DLC") vendors under which the Company has been granted access to the licensor's patent technology and the right to manufacture and sell the patent technology in the Company's product line. The Company is obligated to pay royalty fees, as defined, through the terms of these license agreements. Royalty fees of $1,075,800, $1,893,000 and $2,014,000 were incurred in 1995, 1996 and 1997, respectively, and are included in cost of product sales in the accompanying consolidated statements of operations. 9. INCOME TAXES: The provision for income taxes consisted of the following:
December 31, 1995 1996 1997 - --------------------------------------------------------------------------------------------------------------------------- Current: Federal $ 641,400 $ 2,938,491 $ 3,726,200 State 84,600 316,252 421,000 - --------------------------------------------------------------------------------------------------------------------------- 726,000 3,254,743 4,147,200 - --------------------------------------------------------------------------------------------------------------------------- Deferred: Federal 640,000 (111,056) (28,160) State 52,000 33,066 54,609 - --------------------------------------------------------------------------------------------------------------------------- 692,000 (77,990) 26,449 - --------------------------------------------------------------------------------------------------------------------------- $ 1,418,000 $ 3,176,753 $ 4,173,649 - ---------------------------------------------------------------------------------------------------------------------------
Reconciliations of the federal statutory rate to the effective tax rates are as follows:
December 31, 1995 1996 1997 - --------------------------------------------------------------------------------------------------------------------------- Federal statutory tax rate 34% 34% 34% Research and development tax credit (3) (1) (2) State income taxes 5 2 3 Other ---- 1 3 - --------------------------------------------------------------------------------------------------------------------------- Effective tax rate 36% 36% 38% - ---------------------------------------------------------------------------------------------------------------------------
The components of net deferred tax assets and liabilities were as follows:
December 31, 1996 1997 - --------------------------------------------------------------------------------------------------------------------------- State net operating loss carryforwards $ 58,750 $ ---- Other, net 101,740 133,995 - --------------------------------------------------------------------------------------------------------------------------- Total net deferred tax assets $ 160,490 $ 133,995 - ---------------------------------------------------------------------------------------------------------------------------
The Company had a state tax operating loss carryforward at December 31, 1996 of approximately $500,000 which was utilized in 1997. 24 20 10. LEASE COMMITMENTS: The Company leases office space and equipment under agreements which are accounted for as operating leases. The office lease expires December 31, 1998 and may be extended up to an additional 12 years. The equipment lease expires in May 2002. The Company is also involved in various month-to-month leases for research and development equipment. In addition, the office lease includes provisions for possible adjustments in annual future rental commitments relating to excess taxes and excess maintenance costs that may occur. The Company made additional rental payments of $4,727 and $1,619 in 1997 and 1996, respectively, and no additional rental payments in 1995.
Minimum annual future rental commitments under noncancelable leases as of December 31 are: 1998.........................................................$397,985 1999...........................................................26,578 2000...........................................................26,578 2001...........................................................26,578 2002............................................................8,859 The rent expense for all lease commitments was approximately $273,000, $335,000 and $354,000 in 1995, 1996 and 1997, respectively.
11. MAJOR CUSTOMERS, REVENUE CONCENTRATION AND DEPENDENCE ON CERTAIN SUPPLIERS: The Company sells precision electronic equipment to companies in the telecommunications industry primarily in the United States. Sales are concentrated primarily with the five Regional Bell Operating Companies (RBOCs) as well as major independent telephone companies such as Sprint. Sales are primarily from the Company's metallic channel unit ("MCU") product line. The MCU product line accounted for more than 94% of the Company's net product sales for 1997. The Company expects that revenues from MCU products will continue to account for a majority of the Company's revenues for the foreseeable future. Sales to the RBOCs accounted for approximately 95%, 86% and 86% of the Company's net product sales for fiscal years 1995, 1996 and 1997, respectively. During fiscal years 1995, 1996 and 1997, sales to two RBOCs comprised 65%, 60% and 54%, respectively, of the Company's net product sales. At December 31, 1996 and 1997, accounts receivable-trade included in the consolidated balance sheets related to these two RBOCs was approximately $3,034,000 and $3,819,000, respectively. Due to the Company's present dependency on the RBOCs, the loss of one or more of the RBOCs as a customer, or the reduction of orders for the Company's products by the RBOCs, could materially and adversely affect the Company. For a portion of 1997 and prior years, the Company utilized one key independent subcontractor to perform a majority of the circuit board assembly and in-circuit testing work on its products. The Company also utilized other subassembly contractors on a more limited basis. During the third quarter, 1997, the key subassembly subcontractor notified the Company that, due to a change in its business strategy, only customers that provide certain volume levels of business would be sought or retained. As a result of this evaluation, the key subassembly subcontractor notified the Company that its services would be phased out, at the latest, during early 1998. The Company is in the process of phasing out the use of the subcontractor, and is now utilizing two other subassembly subcontractors that had been utilized by the Company on a more limited basis in the past. In addition, proprietary design integrated circuits, which are a key component of certain products, are the design and property of the manufacturer from which they are purchased. The license agreements under which the proprietary design integrated circuits are supplied can be terminated on relatively short notice. The loss of such license agreements or a reduction in the capacity for any reason of the Company's key subassembly contractors could cause a delay in manufacturing and a possible loss of sales, which would affect operating results adversely. 12. EMPLOYEE BENEFIT PLANS: The Company adopted a 401(k) benefit plan effective March 1, 1996. Eligible employees, as defined in the plan, may contribute up to 20% of eligible compensation, as defined. The Company does not make any matching contributions to the plan. 25 21 STATEMENTS OF OPERATIONS DATA BY QUARTER: The following table presents unaudited quarterly operating results for each of the Company's last eight fiscal quarters. This information has been prepared by the Company on a basis consistent with the Company's audited financial statements and includes all adjustments (consisting only of normal recurring adjustments) that the Company considers necessary for a fair presentation of the data. Such quarterly results are not necessarily indicative of the future results of operations.
(In thousands, except per share data) Quarter Ended (Unaudited) March 31, June 30, Sept. 30, Dec. 31, MARCH 31, JUNE 30, SEPT. 30, DEC. 31, 1996 1996 1996 1996 1997 1997 1997 1997 - --------------------------------------------------------------------------------------------------------------------------- Revenues $6,849 $10,182 $10,080 $10,379 $8,619 $12,115 $11,363 $13,324 Cost of product sales 3,463 4,971 5,000 4,888 3,789 5,454 5,226 5,635 - --------------------------------------------------------------------------------------------------------------------------- Gross profit 3,386 5,211 5,080 5,491 4,830 6,661 6,137 7,689 Operating expenses: Selling and marketing 892 1,259 1,234 1,382 1,046 1,334 1,287 1,779 General and administrative 480 596 672 804 831 914 948 1,075 Research and development 713 878 1,044 1,286 1,241 1,425 1,517 1,762 - --------------------------------------------------------------------------------------------------------------------------- Total operating expenses 2,085 2,733 2,950 3,472 3,118 3,673 3,752 4,616 - --------------------------------------------------------------------------------------------------------------------------- Income from operations 1,301 2,478 2,130 2,019 1,712 2,988 2,385 3,073 Other income, net 204 184 90 367 177 239 221 261 - --------------------------------------------------------------------------------------------------------------------------- Income before income taxes 1,505 2,662 2,220 2,386 1,889 3,227 2,606 3,334 Provision for income taxes 548 1,050 824 754 710 1,194 999 1,270 - --------------------------------------------------------------------------------------------------------------------------- Net income $ 957 $ 1,612 $ 1,396 $ 1,632 $1,179 $2,033 $ 1,607 $ 2,064 - --------------------------------------------------------------------------------------------------------------------------- Net income per common share Basic $ .18 $ .30 $ .25 $ .29 $ .21 $ .36 $ .28 $ .36 Diluted $ .16 $ .27 $ .23 $ .27 $ .20 $ .34 $ .27 $ .35 Weighted average shares of common stock and equivalents: Basic 5,444 5,446 5,504 5,612 5,632 5,677 5,709 5,725 Diluted 5,858 5,942 5,940 5,978 5,976 5,942 5,955 5,975
COMMON STOCK MARKET PRICES The Company's Common Stock has been included for quotation on the Nasdaq National Market System under the Nasdaq symbol "TLGD" since the Company's initial public offering in December 1995. The following table sets forth, for the periods indicated, the high and low closing sale prices for the Common Stock on such market:
High Low - ---------------------------------------------------------------- 1996: First Quarter $18-1/4 $14-1/2 Second Quarter 27 17-7/8 Third Quarter 24-1/2 20-3/4 Fourth Quarter 31 22-1/2 1997: FIRST QUARTER $30-3/4 $18-1/4 SECOND QUARTER 24 17 THIRD QUARTER 23-1/2 20 FOURTH QUARTER 26-3/8 20-1/2
At March 3, 1998, the Company had 410 holders of record of its Common Stock and 5,837,766 shares outstanding. The Company has never paid any dividends on its common stock and does not expect to pay cash dividends in the foreseeable future. In addition, the Company is prohibited from paying dividends under the terms of a credit agreement with Creditanstalt Corporate Finance. (See Note 6 in the accompanying consolidated financial statements). 26 EX-23.1 7 TOLLGRADE COMMUNICATIONS, INC. 1 Exhibit 23.1 CONSENT OF INDEPENDENT ACCOUNTANTS We consent to the incorporation by reference in the registration statement of Tollgrade Communications, Inc. and Subsidiaries on Form S-8 (Registration No. 333-4290) of our report dated January 27, 1998, on our audits of the consolidated financial statements and financial statement schedule of Tollgrade Communications Inc. and Subsidiaries as of December 31, 1997 and 1996, and for each of the three years in the period ended December 31, 1997, which report is incorporated by reference or included in this Form 10-K. /s/ COOPERS & LYBRAND L.L.P. Pittsburgh, Pennsylvania March 18, 1998 37 EX-27 8 TOLLGRADE COMMUNICATIONS, INC.
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 1997. 0001002531 TOLLGRADE COMMUNICATIONS, INC. YEAR DEC-31-1997 JAN-01-1997 DEC-31-1997 3,183,944 15,666,626 8,451,773 50,000 12,101,114 39,975,925 5,473,704 2,471,880 43,713,212 5,405,713 0 0 0 1,145,470 36,955,913 43,713,212 44,546,135 45,421,135 20,104,202 20,104,202 0 50,000 0 11,056,797 4,173,649 0 0 0 0 6,883,148 1.21 1.15
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