-----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, NKavLpdtN89y5xye+AskfvzQwkj7h/NwKXWk5NvFpUG+47OKw6LA3YkR8+qA/QC8 Ed4DloyPl3Ks7lRQtPRgag== 0000950128-99-000608.txt : 19990325 0000950128-99-000608.hdr.sgml : 19990325 ACCESSION NUMBER: 0000950128-99-000608 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 9 CONFORMED PERIOD OF REPORT: 19981231 FILED AS OF DATE: 19990324 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: 99571669 BUSINESS ADDRESS: STREET 1: 493 NIXON RD CITY: CHESWICK STATE: PA ZIP: 15024 BUSINESS PHONE: 4122742156 10-K 1 TOLLGRADE COMMUNICATIONS 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, 1998 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 12, 1999, the aggregate market value of shares of the Registrant's Common Stock held by non-affiliates (excluding for purposes of this calculation only, 369,664 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 $87,963,024. As of March 12, 1999, the Registrant had outstanding 5,932,543 shares 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, 1998 II and IV Portions of the Proxy Statement to be distributed in connection with the 1999 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 1998 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 relate 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 test access and test extension products for the telecommunications and cable television industries. The Company's telecommunication proprietary products 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 Lucent (formerly part of 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 2 3 the DLC system manufacturer from which they are purchased. The Company maintains license agreements with and pays royalties to 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 1999 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 $1,893,000, $2,014,000 and $2,069,000 respectively in 1996, 1997 and 1998 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., Next Level Communications and SAGEM SA (a French corporation). The expiration dates of these agreements range at various times between May 1999 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%, 94% and 90% of the Company's sales in 1996, 1997 and 1998, respectively. The Company's cable products consist of a complete cable status monitoring system that provides a comprehensive testing solution for the Broadband Hybrid Fiber Coax distribution system. The status monitoring system consists of a host for user interface, control and configuration; a headend controller for managing network communications; and transponders that are strategically located within the cable network to gather status reports from power supplies, line amplifiers and fiber-optic nodes. The Company has entered into a license agreement with C-Cor Electronics, Inc. (a cable television systems developer) in which the Company provides its status monitoring transponder technology that is incorporated into C-Cor's cable network management system. In 1998, the Company, under certain other business arrangements, also shipped cable products to ANTEC and General Instrument. 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 1996, 1997 and 1998, research and development expenses were approximately $3,921,000, $5,945,000 and $6,880,000, 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 Tollgrade(SM)" is a service mark of the Company. The Company has also applied for trademark registration for "Lighthouse(TM)", "Digitest(TM)" and "Telaccord(TM)". 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 two U.S. provisional, two United States, one Canada and three 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 telecommunication 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. Historically, almost all of the Company's sales have been made to the RBOCs (79% in 1998). Bell Atlantic Corporation and BellSouth Corporation accounted for 29% and 25%, respectively, of the Company's total sales in 1998. The Company's primary cable product customers are Original Equipment Manufacturers ("OEM") cable equipment manufacturers such as C-Cor Electronics, Inc., ANTEC and General Instruments. Sales of the Company's cable products in 1998 were less than [2%] of total revenues. 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. The Company is ISO 9001 registered from the 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 develops and maintains internal documentation and processes to support the production of quality products to ensure customer satisfaction. The Company utilizes two key independent subcontractors to perform a majority of the circuit board assembly and in-circuit testing work on its products. The Company also utilizes other subassembly contractors on a more limited basis. 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, 1998 was approximately $0.6 million, as compared to approximately $1.6 million at December 31, 1997. At December 31, 1998, the composition of the backlog related primarily to one customer order, while backlog at December 31, 1997 consisted of several customer orders. 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. 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 telecommunications reform legislation has lifted the restrictions which previously prevented the RBOCs from manufacturing telecommunications equipment. Pursuant to this legislative 4 5 reform, the RBOCs, which are the Company's largest customers, may become competitors of the 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. In addition, the Wiltron Company, Inc. offers the Wiltron LoopMATE(R), a modular remote test head, which competes with the Company's POTS testing capabilities. 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 the Tau-Tron division of General Signal Corporation, which provides special services test systems, could also expand into POTS line testing. The alarm-related MCU product's primary competitor is the Turbo 2000 unit made by ANTEC Corporation. For the Company's cable products, the primary competitors for status monitoring are Cheetah Technologies and AM Communications, Inc. Employees. At December 31, 1998, the Company had 230 full-time employees, all in the United States. None of the Company's employees are 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 104,400 square feet. The Company occupies its current facilities under a lease that expires in December, 2001 with an option to renew the term of the lease for one additional period of three years. 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 1998, 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, 1999 is set forth below: Christian L. Allison Chairman of the Board, since April 1998; Chief Executive Officer since September 1995; Treasurer from May 1992 until April 1997; President since October 1993; prior thereto, Chief Operating Officer; Director since 1992; Age 38. 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 37. Robert L. Cornelia Executive Vice President, Operations since May 1996; prior thereto; Vice President, Manufacturing; Age 36. Bradley N. Dinger Controller since September 1996; prior thereto, Assistant Controller of AMSCO International, Inc. (manufacturer of health care equipment); Age 36. Herman Flaminio Executive Vice President, Marketing Services, Planning and Technical Support since July 1997; prior thereto, Senior Vice President, Marketing and Strategic Products; brother of Rocco L. Flaminio, Vice Chairman, Chief Technology Officer and a Director; Age 59. Rocco L. Flaminio Vice Chairman and Chief Technology Officer since October 1993; Director since December 1995; brother of Herman Flaminio, Executive Vice President; Age 74. Mark C. Frey Senior Vice President, Engineering since 1993; Age 45. 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; prior thereto, Director of Internal Audit at AMSCO; Age 43. 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 39. 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 38. 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 6 7 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 management; Age 38. Matthew J. Rosgone Senior Vice President, Purchasing/Manufacturing since July 1998; Vice President, Purchasing from July 1996 until July 1998; Director of Purchasing from July 1995 until July 1996; prior thereto, Buyer; Age 30. Roger A. Smith Senior Vice President, Test Systems since July 1998; Engineering Manager from June 1997 until July 1998; Senior Software Engineer from June 1996 until June 1997; prior thereto, Senior Software Development Engineer of Caldon Inc., (a manufacturer of ultrasonic flow meters for nuclear power industry); Age 38. 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 27 of the Company's 1998 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, 1998, is set forth under the caption "Selected Consolidated Financial Data" on page 7 of the Company's 1998 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 13 of the Company's 1998 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 PricewaterhouseCoopers LLP, are set forth on pages 15 through 26 of the Company's 1998 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 1999 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 1999 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 1999 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 1999 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 14 through 27 of the Company's 1998 Annual Report to Shareholders, which are incorporated herein by reference: Statement of Management's Responsibility for Financial Reporting, dated January 25, 1999 Report of Independent Accountants, dated January 25, 1999 Consolidated Balance Sheets at December 31, 1997 and 1998 Consolidated Statements of Operations for each of the three years in the period ended December 31, 1998 Consolidated Statements of Shareholders' Equity for the three years ended December 31, 1998 Consolidated Statements of Cash Flows for the three years ended December 31, 1998 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, as amended through May 6, 1998 (conformed copy), filed herewith. 3.1a Statement with Respect to Shares dated July 23, 1996 (conformed copy), filed herewith. 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 A to the Company's 1997 Proxy Statement 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 to the Annual Report of Tollgrade Communications, Inc. on Form 10 11 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 to 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 to 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 to 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, Herman Flaminio, Rocco Flaminio, Mark Frey, Samuel Knoch, and Matthew Rosgone, filed as Exhibit 10.1 to 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 to 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 to 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 to 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 to 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 as Exhibit 10.21 to the Annual Report of the Company on Form 10-K for the year ended December 31, 1997 (the "1997 Form 10-K"). 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 to 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 to 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 as Exhibit 10.24 to the 1997 Form 10-K. 10.25* Form of Non-employee Director Stock Option Agreement with respect to the Company's 1995 Long-Term Incentive Compensation Plan, filed as Exhibit 10.25 to the 1997 Form 10-K. 10.26* Change of Control Agreement, entered into July 17, 1997 between the Company and Roger A. Smith, filed herewith. 10.27* 1998 Employee Incentive Compensation Plan, filed herewith. 10.28* Amendment to Employment Agreement, dated as of December 30, 1998, between the Company and Christian L. Allison, filed herewith. 13.1 Company's 1998 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 PricewaterhouseCoopers LLP, 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, 1998. 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 24, 1999. TOLLGRADE COMMUNICATIONS, INC. By /s/ Christian L. Allison --------------------------------------- Christian L. Allison Chairman, President and 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 24, 1999.
SIGNATURE TITLE --------- ----- /s/Christian L. Allison Director, Chairman, President and Chief - -------------------------------------- Executive Officer, Christian L. Allison (Principal Executive Officer) /s/James J. Barnes Director - -------------------------------------- James J. Barnes /s/Daniel P. Barry Director - -------------------------------------- Daniel P. Barry /s/David S. Egan Director - -------------------------------------- David S. Egan /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 15 of the 1998 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/ PRICEWATERHOUSECOOPERS LLP Pittsburgh, Pennsylvania January 25, 1999 14 15 SCHEDULE II TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS For the Years Ended December 31, 1996, 1997 and 1998 (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, 1996 $120 $ 95 $ -- $ -- $215 Year ended December 31, 1997 215 -- -- (36) 179 Year ended December 31, 1998 179 88 -- -- 267 Allowance for doubtful accounts: Year ended December 31, 1996 $ -- $ -- $ -- $ -- $ -- Year ended December 31, 1997 -- 50 -- -- 50 Year ended December 31, 1998 50 50 -- -- 100 Warranty reserve: Year ended December 31, 1996 $ 45 $155 $ -- $ -- $200 Year ended December 31, 1997 200 100 -- -- 300 Year ended December 31, 1998 300 135 -- -- 435
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, as amended through May 6, 1998 (conformed copy), filed herewith. 3.1a Statement with Respect to Shares dated July 23, 1996 (conformed copy), filed herewith. 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 A to the Company's 1997 Proxy statement 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 to 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 to 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 to 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 to 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, Herman Flaminio, Rocco Flaminio, Mark Frey, Samuel Knoch, and Matthew Rosgone, filed as Exhibit 10.1 to the Report 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 to 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 to 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 to 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 as Exhibit 10.21 to the Annual Report of the Company on Form 10-K for the year ended December 31, 1997 (the "1997 Form 10-K"). * 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 to the Report on Form 10-Q of the Company filed on November 10, 1997. *
18 19
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 to 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 as Exhibit 10.24 to the 1997 Form 10-K. * 10.25 Form of Non-employee Director Stock Option Agreement with respect to the Company's Long-Term Incentive Compensation Plan, filed as Exhibit 10.25 to the 1997 Form 10-K. * 10.26 Change of Control Agreement, entered into July 17, 1997 between the Company and Roger A. Smith, filed herewith. 10.27 1998 Employee Incentive Compensation Plan, filed herewith. 10.28 Amendment to Employment Agreement, dated as of December 30, 1998, between the Company and Christian L. Allison, filed herewith. 13.1 Company's 1998 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 PricewaterhouseCoopers LLP, filed herewith. 27 Financial Data Schedule
- ---------------- * Incorporated by reference. 19 EX-3.1 2 TOLLGRADE COMMUNICATIONS 1 [CONFORMED COPY] Exhibit 3.1 AMENDED AND RESTATED ARTICLES OF INCORPORATION OF TOLLGRADE COMMUNICATIONS, INC. 1. Name. The name of the Corporation is Tollgrade Communications, Inc. 2. Address of Registered Office. The address of the Corporation's registered office in the Commonwealth of Pennsylvania is 493 Nixon Road, Cheswick, Allegheny County, PA 15024. 3. Capital Stock. (a) Generally. The authorized capital stock of the Corporation shall be: 25,000,000 shares of Common Stock, par value of $.20 per share, and 10,000,000 shares of Preferred Stock, par value of $1.00 per share. (b) Preferred Stock. The Board of Directors is authorized, at any time or from time to time, to divide any or all of the shares of Preferred Stock into one or more series, and in the resolution or resolutions establishing the series to fix and determine the number of shares and the designation of such series, so as to distinguish it from the shares of all other series and classes, and to fix and determine the voting rights, preferences, limitations, qualifications, privileges, options, conversion rights, restrictions and other special or relative rights of the Preferred Stock or of such series, to the fullest extent now or hereafter permitted by the laws of the Commonwealth of Pennsylvania including, but not limited to, the variations between different series in the following respects: (i) the distinctive designation of such series and the number of shares which shall constitute such series, which number may be increased or decreased (but not below the number of shares thereof then outstanding) from time to time by the Board of Directors; (ii) the annual dividend rate for such series, and the date or dates from which dividends shall commence to accrue; (iii) the price or prices at which, and the terms and conditions on which, the shares of such series may be made redeemable; (iv) the purchase or sinking fund provisions, if any, for the purchase of redemption of shares of such series; (v) the preferential amount or amounts payable upon shares of such series in the event of liquidation, dissolution, or winding up of the Corporation; (vi) the voting rights, if any, of shares of such series; (vii) the terms and conditions, if any, upon which shares of such series may be converted and the class or classes or series of shares of the Corporation or other securities into which such shares may be converted; (viii) the relative seniority, priority or junior rank of such series as to dividends or assets with respect to any other classes or series of stock then or thereafter to be issued; and (ix) such other terms, qualifications, privileges, limitations, options, restrictions, and special or relative rights and preferences, if any, of shares of such series as the Board of Directors may, at the time of such resolution or resolutions, lawfully fix or determine 1 2 under the laws of the Commonwealth of Pennsylvania. Unless otherwise provided in a resolution or resolutions establishing any particular series of Preferred Stock, the aggregate number of authorized shares of Preferred Stock may be increased by an amendment to the Articles approved solely by the holders of the Common Stock. The Common Stock shall be subject to the prior rights and preferences, if any, of any series of Preferred Stock outstanding according to the terms of such series. (c) No Cumulative Voting. Shareholders shall not be entitled to cumulative voting rights in the election of directors. 2 EX-3.1.A 3 STATEMENT W/RESPECT TO SHARES 1 [CONFORMED COPY] Exhibit 3.1a STATEMENT WITH RESPECT TO SHARES of SERIES A JUNIOR PARTICIPATING PREFERRED STOCK of TOLLGRADE COMMUNICATIONS, INC. (Pursuant to Section 1522 (c) of the Pennsylvania Business Corporation Law of 1998) - ------------------------------------------------------------------------------- In compliance with the requirements of Section 1522(c) of Pennsylvania Business Corporation Law of 1988 (the "BCL"), Tollgrade Communications, Inc., a corporation organized and existing under the BCL (the "Corporation"), hereby certifies that: 1. The name of the Corporation is Tollgrade Communications, Inc. 2. The resolution ("Resolution") duly adopted by the Board of Directors of the Corporation establishing and designating a series of the Corporation's Preferred Stock, par value $1.00 per share, and fixing and determining the relative rights and preferences thereof is as follows: RESOLVED, that pursuant to the authority granted to and vested in the Board of Directors of this Corporation (hereinafter called the "Board of Directors" or the "Board") in accordance with the provisions of the Amended and Restated Articles of Incorporation, the Board of Directors hereby creates a series of Preferred Stock, par value $1.00 per share (the "Preferred Stock"), of the Corporation and hereby states the designation and number of shares, and fixes the relative rights, preferences, and limitations thereof as follows: Series A Junior Participating Preferred Stock: Section 1. Designation and Amount. The shares of such series shall be designated as "Series A Junior Participating Preferred Stock" (the "Series A Preferred Stock"), and the number of shares constituting the Series A Preferred Stock shall be 100,000. Such number of shares may be increased or decreased by resolution of the Board of Directors; provided, that no decrease shall reduce the number of shares of Series A Preferred Stock to a number less than the number of shares then outstanding plus the number of shares reserved for issuance upon the exercise of outstanding options, rights or warrants or upon the conversion of any outstanding securities issued by the Corporation convertible into Series A Preferred Stock. 1 2 Section 2. Dividends and Distributions. (A) Subject to the rights of the holders of any shares of any series of Preferred Stock (or any similar stock) ranking prior and superior to the Series A Preferred Stock with respect to dividends, the holders of shares of Series A Preferred Stock, in preference to the holders of Common Stock, par value $0.20 per share (the "Common Stock"), of the Corporation, and of any other junior stock, shall be entitled to receive, when, as and if declared by the Board of Directors out of funds legally available for the purpose, quarterly dividends payable in cash on the first day of March, June, September and December in each year (each such date being referred to herein as a "Quarterly Dividend Payment Date"), commencing on the first Quarterly Dividend Payment Date after the first issuance of a share or fraction of a share of Series A Preferred Stock, in an amount per share (rounded to the nearest cent) equal to the greater of (a) $1 or (b) subject to the provision for adjustment hereinafter set forth, 100 times the aggregate per share amount of all cash dividends, and 100 times the aggregate per share amount (payable in kind) of all non-cash dividends or other distributions, other than a dividend payable in shares of Common Stock or a subdivision of the outstanding shares of Common Stock (by reclassification or otherwise), declared on the Common Stock since the immediately preceding Quarterly Dividend Payment Date or, with respect to the first Quarterly Dividend Payment Date, since the first issuance of any share or fraction of a share of Series A Preferred Stock. In the event the Corporation shall at any time declare or pay any dividend on the Common Stock payable in shares of Common Stock, or effect a subdivision or combination or consolidation of the outstanding shares of Common Stock (by reclassification or otherwise than by payment of a dividend in shares of Common Stock) into a greater or lesser number of shares of Common Stock, then in each such case the amount to which holders of shares of Series A Preferred Stock were entitled immediately prior to such event under clause (b) of the preceding sentence shall be adjusted by multiplying such amount by a fraction, the numerator of which is the number of shares of Common Stock outstanding immediately after such event and the denominator of which is the number of shares of Common Stock that were outstanding immediately prior to such event. (B) The Corporation shall declare a dividend or distribution on the Series A Preferred Stock as provided in subsection (A) of this Section immediately after it declares a dividend or distribution on the Common Stock (other than a dividend payable in shares of Common Stock); provided that, in the event no dividend or distribution shall have been declared on the Common Stock during the period between any Quarterly Dividend Payment Date and the next subsequent Quarterly Dividend Payment Date, a dividend of $1 per share on the Series A Preferred Stock shall nevertheless be payable on such subsequent Quarterly Dividend Payment Date. (C) Dividends shall begin to accrue and be cumulative on outstanding shares of Series A Preferred Stock from the Quarterly Dividend Payment Date next preceding the date of issue of such shares, unless the date of issue of such 2 3 shares is prior to the record date for the first Quarterly Dividend Payment Date, in which case dividends on such shares shall begin to accrue from the date of issue of such shares, or unless the date of issue is a Quarterly Dividend Payment Date or is a date after the record date for the determination of holders of shares of Series A Preferred Stock entitled to receive a quarterly dividend and before such Quarterly Dividend Payment Date, in either of which events such dividends shall begin to accrue and be cumulative from such Quarterly Dividend Payment Date. Accrued by unpaid dividends shall not bear interest. Dividends paid on the shares of Series A Preferred Stock in an amount less than the total amount of such dividends at the time accrued and payable on such shares shall be allocated pro rata on a share-by-share basis among all such shares at the time outstanding. The Board of Directors may fix a record date for the determination of holders of shares of Series A Preferred Stock entitled to receive payment of a dividend or distribution declared thereon, which record date shall be not more than 60 days prior to the date fixed for the payment thereof. Section 3. Voting Rights. The holders of shares of Series A Preferred Stock shall have the following voting rights: (A) Subject to the provision for adjustment hereinafter set forth, each share of Series A Preferred Stock shall entitle the holder thereof to 100 votes on all matters submitted to a vote of the shareholders of the Corporation. In the event the Corporation shall at any time declare or pay any dividend on the Common Stock payable in shares of Common Stock, or effect a subdivision or combination or consolidation of the outstanding shares of Common Stock (by reclassification or otherwise than by payment of a dividend in shares of Common Stock) into a greater or lesser number of shares of Common Stock, then in each such case the number of votes per share to which holders of shares of Series A Preferred Stock were entitled immediately prior to such event shall be adjusted by multiplying such number by a fraction, the numerator of which is the number of shares of Common Stock that were outstanding immediately prior to such event and the denominator of which is the number of shares of Common Stock that were outstanding immediately prior to such event. (B) Except as otherwise provided herein, in any other Statement With Respect to Shares creating a series of Preferred Stock or any similar stock, or by law, the holders of shares of Series A Preferred Stock and the holders of shares of Common Stock and any other capital stock of the Corporation having general voting rights shall vote together as one class on all matters submitted to a vote of shareholders of the Corporation. 3 4 (C) Except as set forth herein, or as otherwise provided by law, holders of Series A Preferred Stock shall have no special voting rights and their consent shall not be required (except to the extent they are entitled to vote with holders of Common Stock as set forth herein) for taking any corporate action. Section 4. Certain Restrictions. (A) Whenever quarterly dividends or other dividends or distributions payable on the Series A Preferred Stock as provided in Section 2 are in arrears, thereafter and until all accrued and unpaid dividends and distributions, whether or not declared, on shares of Series A Preferred Stock outstanding shall have been paid in full, the Corporation shall not: (i) declare or pay dividends, or make any other distributions, on any shares of stock ranking junior (either as to dividends or upon liquidation, dissolution or winding up) to the Series A Preferred Stock; (ii) declare or pay dividends, or make any other distributions, on any shares of stock ranking on a parity (either as to dividends or upon liquidation, dissolution or winding up) with the Series A Preferred Stock, except dividends paid ratably on the Series A Preferred Stock and all such parity stock on which dividends are payable or in arrears in proportion to the total amounts to which the holders of all such shares are then entitled; (iii) redeem or purchase or otherwise acquire for consideration shares of any stock ranking junior (either as to dividends or upon liquidation, dissolution or winding up) to the Series A Preferred Stock, provided that the Corporation may at any time redeem, purchase or otherwise acquire shares of any such junior stock in exchange for shares of any stock of the Corporation ranking junior (either as to dividends or upon dissolution, liquidation or winding up) to the Series A Preferred Stock; or (iv) redeem or purchase or otherwise acquire for consideration any shares of Series A Preferred Stock, or any shares of stock ranking on a parity with the Series A Preferred Stock, except in accordance with a purchase offer made in writing or by publication (as determined by the Board of Directors) to all holders of such shares upon such terms as the Board of Directors, after consideration of the respective annual dividend rates and other relative rights and preferences of the respective series and classes, shall determine in good faith will result in fair and equitable treatment among the respective series or classes. 4 5 (B) The Corporation shall not permit any subsidiary of the Corporation to purchase or otherwise acquire for consideration any shares of stock of the Corporation to purchase or otherwise acquire for consideration any shares of stock of the Corporation unless the Corporation could, under subsection (A) of this Section 4, purchase or otherwise acquire such shares at such time and in such manner. Section 5. Reacquired Shares. Any shares of Series A Preferred Stock purchased or otherwise acquired by the Corporation in any manner whatsoever shall be retired and cancelled promptly after the acquisition thereof. All such shares shall upon their cancellation become authorized but unissued shares of Preferred Stock and may be reissued as part of the same or a new series of Preferred Stock subject to the conditions and restrictions on issuance set forth herein, in the Amended and Restated Articles of Incorporation, or in any other Statement With Respect to Shares creating a series of Preferred Stock or any similar stock or as otherwise required by law. Section 6. Liquidation, Dissolution or Winding Up. Upon any liquidation, dissolution or winding up of the Corporation, no distribution shall be made (1) to the holders of shares of stock ranking junior (either as to dividends or upon liquidation, dissolution or winding up) to the Series A Preferred Stock unless, prior thereto, the holders of shares of Series A Preferred Stock shall have received $100 per share, plus an amount equal to accrued and unpaid dividends and distributions thereon, whether or not declared, to the date of such payment, provided that the holders of shares of Series A Preferred Stock shall be entitled to receive an aggregate amount per share, subject to the provision for adjustment hereinafter set forth, equal to 100 times the aggregate amount to be distributed per share to holders of shares of Common Stock, or (2) to the holders of shares of stock ranking on a parity (either as to dividends or upon liquidation, dissolution or winding up) with the Series A Preferred Stock, except distributions made ratably on the Series A Preferred Stock and all such parity stock in proportion to the total amounts to which the holders of all such shares are entitled upon such liquidation, dissolution or winding up. In the event the Corporation shall at any time declare or pay any dividend on the Common Stock payable in shares of Common Stock, or effect a subdivision or combination or consolidation of the outstanding shares of Common Stock (by reclassification or otherwise than by payment of a dividend in shares of Common Stock) into a greater or lesser number of shares of Common Stock, then in each such case the aggregate amount to which holders of shares of Series A Preferred Stock were entitled immediately prior to such event under the proviso in clause (1) of the preceding sentence shall be adjusted by multiplying such amount by a fraction the numerator of which is the number of shares of Common Stock outstanding immediately after such event and the denominator of which is the number of shares of Common Stock that were outstanding immediately prior to such event. Section 7. Consolidation, Merger, etc. In case the Corporation shall enter into any consolidation, merger, combination or other transaction in which the shares of Common combination or other transaction in which the shares of Common Stock are exchanged for or changed into other stock or securities, cash and/or any other property, then in any such case each share of Series A 5 6 Preferred Stock shall at the same time be similarly exchanged or changed into an amount per share, subject to the provision for adjustment hereinafter set forth, equal to 100 times the aggregate amount of stock, securities, cash and/or any other property (payable in kind), as the case may be, into which or for which each share of Common Stock is changed or exchanged. In the event the Corporation shall at any time declare or pay any dividend on the Common Stock payable in shares of Common Stock, or effect a subdivision or combination or consolidation of the outstanding shares of Common Stock (by reclassification or otherwise than by payment of a dividend in shares of Common Stock) into a greater or lesser number of shares of Common Stock, then in each such case the amount set forth in the preceding sentence with respect to the exchange or change of shares of Series A Preferred Stock shall be adjusted by multiplying much [sic] amount by a fraction, the numerator of which is the number of shares of Common Stock outstanding immediately after such event and the denominator of which is the number of shares of Common Stock that were outstanding immediately prior to such event. Section 8. No Redemption. The shares of Series A Preferred Stock shall not be redeemable. Section 9. Rank. Except as otherwise set forth in the Amended and Restated Articles of Incorporation or in the Statement With Respect to Shares creating another series of Preferred Stock or any other class or series of stock, the Series A Preferred Stock shall rank, with respect to the payment of dividends and the distribution of assets, junior to all other series of the Corporation's Preferred Stock and to any other class or series of stock other than the Common Stock, whether now existing or hereafter created. Section 10. Amendment. The Amended and Restated Articles of Incorporation of the Corporation shall not be amended in any manner which would materially alter or change the powers, preferences or special rights of the Series A Preferred Stock so as to affect them adversely without the affirmative vote of a majority of the votes cast at a meeting of shareholders by the holders of Series A Preferred Stock, voting together as a single class. 3. (i) The aggregate number of shares of the Series A Preferred Stock established and designated by the Resolution is 100,000; (ii) the number of shares of stock which the Corporation has previously established and designated pursuant to Section 1522 of the BCL or any corresponding provision of prior law is hereby reduced to zero; and (iii) the aggregate number of shares authorized under the Amended and Restated Articles of Incorporation of the Corporation is 35,000,000, of which 10,000,000 shares are Preferred Stock, par value $1.00 per share, issuable in one or more series, and 25,000,000 shares are Common Stock, par value $0.20 per share. 4. The Resolution was duly adopted at a meeting of the Board of Directors of the Corporation duly called and held on July 23, 1996, at which meeting a quorum was present and acted throughout. 6 7 IN WITNESS WHEREOF, this Statement with Respect to Shares is executed on behalf of the Corporation by its Chief Executive Officer and attested by its Secretary this 23rd day of July, 1996. /s/ Christian L. Allison --------------------------------------------- Christian L. Allison, Chief Executive Officer Attest: /s/ Sara M. Antol - ------------------------------ Sara M. Antol, Secretary 7 EX-10.26 4 AGREEMENT 1 Exhibit 10.26 AGREEMENT This Agreement, made as of the 17th day of July, 1997 by and between TOLLGRADE COMMUNICATIONS, INC., a Pennsylvania corporation (the "Corporation") and ROGER A. SMITH, 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, 1 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 2 3 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 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- 3 4 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; (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 4 5 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. "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 5 6 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 (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 6 7 (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 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 7 8 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 8 9 Option shall be automatically 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. 9 10 (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 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/ Jayne F. Smith /s/ Roger A. Smith - --------------------------- ------------------------------- 10 EX-10.27 5 1998 EMPLOYEE INCENTIVE COMPENSATION PLAN 1 Exhibit 10.27 Tollgrade Communications, Inc. 1998 Employee Incentive Compensation Plan ARTICLE 1. ESTABLISHMENT, OBJECTIVES AND DURATION. 1.1 ESTABLISHMENT OF THE PLAN. Tollgrade Communications, Inc., a Pennsylvania corporation (hereinafter referred to as the "Company"), hereby establishes an incentive compensation plan for all employees excluding officers and directors of the Company, to be known as the "Tollgrade Communications, Inc. 1998 Employee Incentive Compensation Plan" (hereinafter referred to as the "Plan"), as set forth in this document. The Plan permits the grant of Nonqualified Stock Options, Stock Appreciation Rights, Restricted Stock, Performance Shares and Performance Units. The Plan shall be effective as of January 29, 1998 (the "Effective Date") and shall remain in effect as provided in SECTION 1.3 hereof. 1.2 OBJECTIVES OF THE PLAN. The objectives of the Plan are to optimize the profitability and growth of the Company through incentives which are consistent with the Company's goals and which link the personal interests of Employees to those of the Company's stockholders; to provide Employees with an incentive for excellence in individual performance; and to promote teamwork among Employees. The Plan is further intended to provide flexibility to the Company in its ability to motivate, attract, and retain the services of Employees who make significant contributions to the Company's success and allow Employees to share in the success of the Company. 1.3 DURATION OF THE PLAN. The Plan was adopted by the Board of Directors on January 29, 1998, and shall commence on the Effective Date, as described in SECTION 1.1 hereof, and shall remain in effect, subject to the right of the Board of Directors to amend or terminate the Plan at any time pursuant to ARTICLE 14 hereof, until all Shares subject to it shall have been purchased or acquired according to the Plan's provisions. However, in no event shall an Award be granted under the Plan on or after January 29, 2008. ARTICLE 2. DEFINITIONS Whenever used in the Plan, the following terms shall have the meanings set forth below, and when the meaning is intended, the initial letter of the word shall be capitalized: 2.1 "AWARD" means, individually or collectively, a grant under this Plan of Nonqualified Stock Options, Stock Appreciation Rights, Restricted Stock, Performance Shares or Performance Units. 2.2 "AWARD AGREEMENT" means an agreement entered into by the Company and each Employee setting forth the terms and provisions applicable to Awards granted under this Plan. 2.3 "BENEFICIAL OWNER" OR "BENEFICIAL OWNERSHIP" shall have the meaning ascribed to such term in Rule 13d-3 of the General Rules and Regulations under the Exchange Act. 2.4 "BOARD" OR "BOARD OF DIRECTORS" means the Board of Directors of the Company. 2.5 "CHANGE IN CONTROL" of the Company shall be deemed to have occurred (as of a particular day, as specified by the Board) if the Board, by a majority vote, agrees 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 Company on the Effective Date (the "Current Owners") (or any individual or entity which received from a Current Owner an interest in the Company through will or the laws of descent and distribution) maintain more than a fifty percent (50%) interest in the resultant entity. 1 2 Regardless of the Board's vote, a Change in Control will be deemed to have occurred as of the first day any one (1) or more of the following paragraphs shall have been satisfied: (a) Any Person (other than the Person in control of the Company as of the Effective Date of the Plan, or other than a trustee or other fiduciary holding securities under an employee benefit plan of the Company, or a corporation owned directly or indirectly by the stockholders of the Company in substantially the same proportions as their ownership of stock in the Company), becomes the Beneficial Owner, directly or indirectly, of securities of the Company representing more than fifty percent (50%) of the combined voting power of the Company"s then outstanding securities; or (b) The stockholders of the Company approve: (i) A plan of complete liquidation of the Company; or (ii) An agreement for the sale or disposition of all or substantially all of the Company"s assets (other than one in which the stockholders of the Company, as determined immediately prior to such transaction, hold, directly or indirectly, as determined immediately following such transaction, a majority of the voting power of each surviving, resulting or acquiring corporation which, immediately following such transaction, holds more than 10% of the consolidated assets of the Company immediately prior to the transaction); or (iii) A merger, consolidation, or reorganization of the Company with or involving any other corporation, other than a merger, consolidation, or reorganization that would result in the voting securities of the Company outstanding immediately prior thereto continuing to represent (either by remaining outstanding or by being converted into voting securities of the surviving entity) at least fifty percent (50%) of the combined voting power of the voting securities of the Company (or such 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 a Employee, if that Employee is part of a purchasing group which consummates the Change in Control transaction. The Employee shall be deemed "part of a purchasing group" for purposes of the preceding sentence if the Employee 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 equity 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 nonemployee continuing Directors). 2.6 "CODE" means the Internal Revenue Code of 1986, as amended from time to time. 2.7 "COMMITTEE" means the Compensation Committee of the Board, as specified in ARTICLE 3 herein, or such other Committee appointed by the Board to administer the Plan with respect to grants of Awards. 2.8 "COMPANY" means Tollgrade Communications, Inc., a Pennsylvania corporation, any successor thereto as provided in ARTICLE 17 herein. 2.9 "DIRECTOR" means any individual who is a member of the Board of Directors of the Company. 2.10 "EFFECTIVE DATE" shall have the meaning ascribed to such term in SECTION 1.1 hereof. 2.11 "EMPLOYEE" means any full-time active employee of the Company who is not an Officer, as defined in SECTION 2.17 hereof. Directors shall not be considered employees under the Plan. 2.12 "EXCHANGE ACT" means the Securities Exchange Act of 1934, as amended from time to time, or any successor act thereto. 2 3 2.13 "FAIR MARKET VALUE" shall be the mean between the following prices, as applicable, for the date as of which fair market value is to be determined as quoted in The Wall Street Journal (or in such other reliable publication as the Committee, in its discretion, may determine to rely upon): (i) if the Common Stock is listed on the New York Stock Exchange, the highest and lowest sales prices per share of the Common Stock as quoted in the NYSE Composite Transactions listing for such date, (ii) if the Common Stock is not listed on such exchange, the highest and lowest sales prices per share of Common Stock for such date on (or on any composite index including) the principal united States securities exchange registered under the 1934 Act on which the Common Stock is listed or (iii) if the Common Stock is not listed on such exchange, the highest and lowest sales prices per share of the Common Stock for such date on the National Association of Securities Dealers Automated Quotations System or any successor system then in use ("NASDAQ"). If there are no such sale price quotations for the date as of which fair market value is to be determined but there are such sale price quotations within a reasonable period both before and after such date, then fair market value shall be determined by taking a weighted average of the means between the highest and lowest sales prices per share of the Common Stock as so quoted on the nearest date before and the nearest date after the date as of which fair market value is to be determined. The average should be weighted inversely by the respective number of trading days between the selling dates and the date as of which fair market value is to be determined. If there are no such sale prices quotations on or within a reasonable period both before and after the date as of which fair market value is to be determined, then fair market value of the Common Stock shall be the mean between the bona fide bid and asked prices per share of Common Stock as so quoted for such date on NASDAQ, or if none, the weighted average of the means between such bona fide bid and asked prices on the nearest trading date before and the nearest trading date after the date as of which fair market value is to be determined, if both such dates are within a reasonable period. The average is to be determined in the manner described above in this SECTION 2.13. If the fair market value of the Common Stock cannot be determined on any basis previously set forth in this SECTION 2.13 for the date as of which fair market value is to be determined, the Committee shall in good faith determine the fair market value of the Common Stock on such date. Fair market value shall be determined without regard to any restriction other than a restriction which, by its terms, will never lapse. 2.14 "FREESTANDING SAR" means an SAR that is granted independently of any Options, as described in ARTICLE 7 herein. 2.15 "INSIDER" shall mean an individual who, immediately prior to the grant of any Award, owns stock possessing more than ten percent (10%) of the total combined voting power of all classes of stock for the Company. For purposes of this SECTION 2.15, an individual (i) shall be considered as owning not only Shares of Stock owned individually but also all Shares of stock that are at the time owned, directly or indirectly, by or for the spouse, ancestors, lineal descendants and bothers and sisters (whether by whole or half blood) of such individual and (ii) shall be considered as owning proportionately any Shares owned, directly or indirectly, by or for any corporation, partnership, estate or trust in which such individual is a stockholder, partner or beneficiary. 2.16 "NONQUALIFIED STOCK OPTION" OR "NQSO" means an option to purchase Shares granted under ARTICLE 6 herein and which is not intended to meet the requirements of Code Section 422. 2.17 "OFFICER" means any person serving as an officer on behalf of the Company, as defined in the Company"s bylaws and by requirements of Pennsylvania corporate law, and by the requirements of the rules of the National Association of Securities Dealers, Inc. 2.18 "OPTION" means a Nonqualified Stock Option, as described in ARTICLE 6 herein. 2.19 "OPTION PRICE" means the price at which a Share may be purchased by a Employee pursuant to an Option. 2.20 "PERFORMANCE-BASED EXCEPTION" means the performance-based exception from the tax deductibility limitations of Code Section 162(m). 2.21 "PERFORMANCE SHARE" means an Award granted to an Employee, as described in ARTICLE 9 herein. 3 4 2.22 "PERFORMANCE UNIT" means an award granted to an Employee, as described in ARTICLE 9 herein. 2.23 "PERIOD OF RESTRICTION" means the period during which the transfer of Shares of Restricted Stock is limited in some way (based upon the passage of time, the achievement of performance goals, or upon the occurrence of other events as determined by the Committee, at its discretion), and the Shares are subject to a substantial risk of forfeiture, as provided in ARTICLE 8 herein. 2.24 "PERSON" shall have the meaning ascribed to such term in Section 3(a)(9) of the Exchange Act and used in Sections 13(d) and 14(d) thereof, including a "group" as defined in Section 13(d) thereof. 2.25 "RESTRICTED STOCK" means an award granted to an Employee pursuant to ARTICLE 8 herein. 2.26 "RETIREMENT" shall mean any voluntary termination of employment by an Employee following the attainment of age 65. 2.27 "SHARES" means the shares of Common Stock of the Company. 2.28 "STOCK APPRECIATION RIGHT" OR "SAR" means an Award, granted alone or in connection with a related Option, designated as an SAR, pursuant to the terms of ARTICLE 7 herein. 2.29 "TANDEM SAR" means an SAR that is granted in connection with a related Option pursuant to ARTICLE 7 herein, the exercise of which shall require forfeiture of the right to purchase a Share under the related Option (and when a Share is purchased under the Option, the Tandem SAR shall similarly be canceled). ARTICLE 3. ADMINISTRATION 3.1 THE COMMITTEE. Except as set forth in SECTION 3.5 below, the Plan shall be administered by the Compensation Committee of the Board, or by any other Committee appointed by the Board consisting of not less than two (2) Directors who (i) are "non-employee" directors and otherwise meet the "disinterested administration" rules of Rule 16b-3 under the Exchange Act and (ii) are "outside directors" under Section 162(m)(4)(C) of the Code, or any successor provision. The members of the Committee shall be appointed from time to time by, and shall serve at the discretion of, the Board of Directors. 3.2 AUTHORITY OF THE COMMITTEE. Except as set forth in SECTION 3.4 below, except as limited by law or by the Articles of Incorporation or Bylaws of the Company, and subject to the provisions herein, the Committee shall have full power to grant Options (with or without SARs) and to award Restricted Stock, Performance Shares and Performance Units as described herein and to determine the Employees to whom any such award shall be made and the number of Shares to be covered thereby; determine the sizes and types of Awards; determine terms and conditions of Awards in a manner consistent with the Plan; construe and interpret the Plan and any agreement or instrument entered into under the Plan as they apply to Employees; and (subject to the provisions of ARTICLE 14 herein) amend the terms and conditions of any outstanding Award to the extent such terms and conditions are within the discretion of the Committee as provided in the Plan. Further, the Committee shall make all other determinations which may be necessary or advisable for the administration of the Plan, as the Plan applies to Employees. As permitted by law the Committee may delegate its authority as identified herein. 3.3 DECISIONS BINDING. All determinations and decisions made by the Committee pursuant to the provisions of the Plan and all related orders and resolutions of the Board shall be final, conclusive and binding on all persons, including the Company, its stockholders, Employees, and their estates and beneficiaries. 3.4 NON-COMPETITION. If a grantee of an Option, Restricted Stock, Performance Units or Performance Shares (i) engages in the operation or management of a business (whether as owner, partner, officer, director, employee or otherwise and whether during or after employment) which is in competition with the Company, (ii) induces or attempts to induce any customer, supplier, licensee or other individual, corporation or other business organization having a 4 5 business relationship with the Company to cease doing business with the Company or any in any way interferes with the relationship between any such customer, supplier, licensee or other person and the Company or (iii) solicits any employee of the Company to leave the employment thereof or in any way interferes with the relationship of such employee with the Company, the Committee, in its discretion, may immediately terminate all outstanding Options held by the grantee, declare forfeited all Restricted Stock held by the grantee as to which the restrictions have not yet lapsed and/or immediately cancel any award of Performance Units or Performance Shares. Whether a grantee has engaged in any of the activities referred to in the preceding sentence which would cause the outstanding Options to be terminated, and/or the Restricted Stock to be forfeited and/or any award of Performance Units or Performance Shares to be canceled shall be determined, in its discretion, by the Committee, and any such determination by the Committee shall be final and binding. ARTICLE 4. SHARES SUBJECT TO THE PLAN 4.1 NUMBER OF SHARES AVAILABLE FOR GRANTS. Subject to adjustment as provided in SECTION 4.3 herein, the number of Shares hereby reserved for issuance to Employees under the Plan shall be 100,000; provided that, of that total, the maximum number of Shares of Restricted Stock granted pursuant to ARTICLE 8 herein, shall be 50,000. 4.2 LAPSED AWARDS. If any Award granted under this Plan is canceled, terminates, expires or lapses for any reason (with the exception of termination of a Tandem SAR upon exercise of the related Option, or the termination of a related Option upon exercise of the corresponding Tandem SAR), any Shares subject to such Award shall again be available for the grant of an Award under the Plan. 4.3 ADJUSTMENTS IN AUTHORIZED SHARES. In the event of any change in corporate capitalization, such as a stock split, or a corporate transaction, such as any merger, consolidation, separation, including a spin-off, or other distribution of stock or property of the Company, any reorganization (whether or nor such reorganization comes within the definition of such term in Code Section 368) or any partial or complete liquidation of the Company, such adjustment shall be made in the number and class of Shares which may be delivered under SECTION 4.1 and in the number and class of and/or price of Shares subject to outstanding Awards granted under the Plan, and in the number and class of and/or price of Shares subject to outstanding Awards granted under the Plan, as may be determined to be appropriate and equitable by the Committee, in its sole discretion, to prevent dilution or enlargement of rights; provided, however, that the number of Shares subject to any Award shall always be a whole number. ARTICLE 5. ELIGIBILITY AND PARTICIPATION 5.1 ELIGIBILITY. Persons eligible to participate in this Plan shall include all Employees of the Company, excluding Officers and Directors. 5.2 ACTUAL PARTICIPATION. Subject to the provisions of the Plan, the Committee may, from time to time, select from all eligible Employees those to whom Awards shall be granted and shall determine the nature and amount of each Award. ARTICLE 6. STOCK OPTIONS 6.1 GRANT OF OPTIONS. Subject to the terms and provisions of the Plan, the Committee may grant Nonqualified Stock Options in such number, and upon such terms, and at any time and from time to time as shall be determined by the Committee. 6.2 AWARD AGREEMENT. Each Option shall be evidenced by an Award Agreement that shall specify the Option Price, the duration of the Option, the number of Shares to which the Option pertains, and such other provisions as the Committee shall determine. 5 6 6.3 OPTION PRICE. The Option Price at which each Option may be exercised shall be no less than one hundred percent (100%) of the fair market value per share of the Common Stock covered by the Option on the date of grant. For purposes of this SECTION 6.3, the fair market value of the Common Stock shall be as determined in SECTION 2.14. 6.4 DURATION OF OPTIONS. Each Option granted to an Employee shall expire at such time as the Committee shall determine at the time of grant; provided, however, that no Option shall be exercisable after the expiration of ten years from the date of grant. 6.5 EXERCISE OF OPTIONS. Options granted under this Article 6 shall be exercisable at such times and be subject to such restrictions and conditions as the Committee shall in each instance approve, which need not be the same for each grant or for each Employee. 6.6 PAYMENT. Options granted under this Article 6 shall be exercised by the delivery of a written notice of exercise to the Company, setting forth the number of Shares with respect to which the Option is to be exercised, accompanied by full payment for the Shares. The Option Price upon exercise of the Option shall be payable to the Company in full either: (a) in cash in United States Dollars (including check, bank draft or money order), or (b) by tendering previously acquired Shares having an aggregate Fair Market Value at the time of exercise equal to the total Option Price, or (c) by a combination of (a) and (b). The Company will also cooperate with any person exercising an Option who participates in a cashless exercise program of a broker or other agent under which all or part of the Shares received upon exercise of the Option are sold through the broker or other agent or under which the broker or other agent makes a loan to such person. Notwithstanding the foregoing, unless the Committee, in its discretion, shall otherwise determine at the time of grant the exercise of the Option shall not be deemed to occur and no Shares of Common Stock will be issued by the Company upon exercise of the Option until the Company has received payment of the Option Price in full. 6.7 RESTRICTIONS ON SHARE TRANSFERABILITY. The Committee may impose restrictions on any Shares acquired pursuant to the exercise of an Option granted under this ARTICLE 6 as it may deem advisable, including, without limitation, restrictions under applicable Federal securities laws, under the requirements of any stock exchange or market upon which such Shares are then listed and/or traded, and under any blue sky or other state securities laws applicable to such Shares. 6.8 TERMINATION OF EMPLOYMENT. Unless the Committee, in its discretion, shall otherwise determine: (i) If the employment of an Employee who is not disabled within the meaning of Section 422(c)(6) of the Code (a "Disabled Grantee") is voluntarily terminated with the consent of the Company or an Employee retires under any retirement plan of the Company, any Option held by such Employee shall be exercisable by the Employee (but only to the extent exercisable by the Employee immediately prior to the termination of employment) at any time prior to the expiration date of such Option or within one year after the date of termination, whichever is the shorter period; (ii) If the employment of an Employee who is a Disabled Grantee is voluntarily terminated with the consent of the Company, any outstanding Option held by such Employee shall be exercisable by the Employee in full (whether or not so exercisable by the Employee immediately prior to the termination of employment) at any time prior to the expiration date of such Option or within one year after the date of termination of employment, whichever is the shorter period; 6 7 (iii) Following the death of an Employee during employment, any outstanding Option held by the Employee at the time of death shall be exercisable in full (whether or not so exercisable by the Employee immediately prior to the death of the Employee) by the person entitled to do so under the Will of the Employee, or, if the Employee shall fail to make testamentary disposition of the stock option or shall die intestate, by the legal representative of the Employee at any time prior to the expiration date of such stock option or within one year after the date of death of the Employee, whichever is the shorter period; (iv) Following the death of an Employee after termination of employment during the period when an Option is exercisable, the Option shall be exercisable by such person entitled to do so under the Will of the Employee by such legal representative (but only to the extent exercisable by the Employee immediately prior to the termination of employment) at any time prior to the expiration date of such Option or within one year after the date of death, whichever is the shorter period; (v) Unless the exercise period of a stock option following termination of employment has been extended as provided in SECTION 13.1, if the employment of an Employee terminates for any reason other than voluntary termination with the consent of the Company, retirement under any retirement plan of the Company or death, all outstanding Options held by the Employee at the time of such termination of employment shall automatically terminate. Whether termination of employment is a voluntary termination with the consent of the Company shall be determined, in its discretion, by the Committee and any such determination by the Committee shall be final and binding. 6.9 NONTRANSFERABILITY OF OPTIONS. No Option granted under the Plan may be sold, transferred, pledged, assigned, or otherwise alienated or hypothecated, other than by Will or if the Employee dies intestate by the laws of descent and distribution of the state of domicile of the Employee at the time of death. Further, all Options granted to an Employee under the Plan shall be exercisable during his or her lifetime only by the Employee. ARTICLE 7. STOCK APPRECIATION RIGHTS 7.1 GRANT OF SARS. Subject to the terms and conditions of the Plan, SARs may be granted to Employees at any time and from time to time as shall be determined by the Committee. The Committee may grant Freestanding SARs, Tandem SARs, or any combination of these forms of SARs. The Committee shall have complete discretion in determining the number of SARs granted to each Employee (subject to ARTICLE 4 herein) and, consistent with the provisions of the Plan, in determining the terms and conditions pertaining to such SARs. The grant price of a Freestanding SAR shall equal the Fair Market Value of a Share on the date of grant of the SAR. The grant price of Tandem SARs shall equal the Option Price of the related Option, as provided in SECTION 6.3. 7.2 EXERCISE OF TANDEM SARS. Tandem SARs may be exercised for all or part of the Shares subject to the related Option upon the surrender of the right to exercise the equivalent portion of the related Option. A Tandem SAR may be exercised only with respect to the Shares for which its related Option is then exercisable. 7.3 EXERCISE OF FREESTANDING SARS. Freestanding SARs may be exercised upon whatever terms the Committee, in its sole discretion, imposes upon them. 7.4 SAR AGREEMENT. Each SAR grant shall be evidenced by an Award Agreement that shall specify the grant price, the term of the SAR, and such other provisions as the Committee shall determine. 7 8 7.5 TERM OF SARs. The term of an SAR granted under the Plan shall be determined by the Committee, in its sole discretion; provided however, that such term shall not exceed ten (10) years. 7.6 PAYMENT OF SAR AMOUNT. Upon exercise of an SAR, an Employee shall be entitled to receive payment from the Company in an amount determined by multiplying: (a) the difference between the Fair Market Value of a Share on the date of exercise over the grant price; by (b) the number of Shares with respect to which the SAR is granted. At the discretion of the Committee, the payment upon SAR exercise may be in cash, in Shares of equivalent value, or in some combination thereof. 7.7 RULE 16b-3 REQUIREMENTS. Notwithstanding any other provision of the Plan, the Committee may impose such conditions on the exercise of an SAR as may be required to satisfy the requirements of Section 16 of the Exchange Act (or any successor rule). 7.8 TERMINATION OF EMPLOYMENT. Each SAR Award Agreement shall set forth the extent to which the Employee shall have the right to exercise the SAR following termination of the Employee's employment with the Company and/or its Subsidiaries. Such provisions shall be determined in the sole discretion of the Committee, shall be included in the Award Agreement entered into with Employees, need not be uniform among all SARs issued pursuant to the Plan, and may reflect distinctions based on the reasons for termination of such employment. 7.9 NONTRANSFERABILITY OF SARs. No SAR granted under the Plan may be sold, transferred, pledged, assigned, or otherwise alienated or hypothecated, other than by will or, if the grantee dies intestate, by the laws of descent and distribution of the state of domicile of the grantee at the time of death. Further, all SARs granted to an Employee under the Plan shall be exercisable during his or her lifetime only by such Employee. ARTICLE 8. RESTRICTED STOCK 8.1 GRANT OF RESTRICTED STOCK. Subject to the terms and provisions of the Plan, the Committee, at any time and from time to time, may grant Shares of Restricted Stock to Employees in such amounts as the Committee shall determine. 8.2 RESTRICTED STOCK AGREEMENT. Each Restricted Stock grant shall be evidenced by a Restricted Stock Award Agreement that shall specify the Period(s) of Restriction, the number of Shares of Restricted Stock granted, and such other provisions as the Committee shall determine. 8.3 TRANSFERABILITY. Except as provided in this ARTICLE 8, the Shares of Restricted Stock granted herein may not be sold, transferred, pledged, assigned or otherwise alienated or hypothecated until the end of the applicable Period of Restriction established by the Committee and specified in the Restricted Stock Award Agreement, or upon earlier satisfaction of any other conditions, as specified by the Committee in its sole discretion and set forth in the Restricted Stock Award Agreement. All rights with respect to the Restricted Stock granted to an Employee under the Plan shall be available during his or her lifetime only to such Employee. 8.4 OTHER RESTRICTIONS. Subject to ARTICLE 10 herein, the Committee shall impose such other conditions and/or restrictions on any Shares of Restricted Stock granted pursuant to the Plan as it may deem 8 9 advisable including, without limitation, a requirement that Employees pay a stipulated purchase price for each Share of Restricted Stock, restrictions based upon the achievement of specific performance goals (Company-wide, divisional, and/or individual), time-based restrictions on vesting following the attainment of the performance goals, and/or restrictions under applicable Federal or state securities laws. The Company shall retain the certificates representing Shares of Restricted Stock in the Company's possession until such time as all conditions and/or restrictions applicable to such Shares have been satisfied. Except as otherwise provided in this ARTICLE 8, Shares of Restricted Stock covered by each Restricted Stock grant made under the Plan shall become freely transferable by the Employee after the last day of the applicable Period of Restriction. 8.5 VOTING RIGHTS. During the Period of Restriction, Employees holding Shares of Restricted Stock granted hereunder may exercise full voting rights with respect to those Shares. 8.6 DIVIDENDS AND OTHER DISTRIBUTIONS. During the Period of Restriction, Employees holding Shares of Restricted Stock granted hereunder may be credited with regular cash dividends paid with respect to the underlying Shares while they are so held. The Committee may apply any restrictions to the dividends that the Committee deems appropriate. In the event that any dividend constitutes a "derivative security" or an "equity security" pursuant to Rule 16(a) under the Exchange Act, such dividend shall be subject to a vesting period equal to the remaining vesting period of the Shares of Restricted Stock with respect to which the dividend is paid. 8.7 TERMINATION OF EMPLOYMENT. Each Restricted Stock Award Agreement shall set forth the extent to which the Employee shall have the right to receive unvested Restricted Shares following termination of the Employee's employment with the Company. Such provisions shall be determined in the sole discretion of the Committee, shall be included in the Award Agreement entered into with each Employee, need not be uniform among all Shares of Restricted Stock issued pursuant to the Plan, and may reflect distinctions based upon the reasons for termination of such employment. ARTICLE 9. PERFORMANCE UNITS AND PERFORMANCE SHARES 9.1 GRANT OF PERFORMANCE UNITS/SHARES. Subject to the terms of the Plan, Performance Units and/or Performance Shares may be granted to Employees in such amounts and upon such terms, and at any time and from time to time, as shall be determined by the Committee. 9.2 VALUE OF PERFORMANCE UNITS/SHARES. Each Performance Unit shall have an initial value that is established by the Committee at the time of grant. Each Performance Share shall have an initial value equal to the Fair Market Value of a Share on the date of grant. The Committee shall set performance goals in its discretion which, depending upon the extent to which they are met, will determine the number and/or value of Performance Units/Shares that will be paid out to the Employee. For purposes of this ARTICLE 9, the time period during which the performance goals must be met shall be called a "Performance Period." 9.3 EARNING OF PERFORMANCE UNITS/SHARES. Subject to the terms of this Plan, after the applicable Performance Period has ended, the holder of Performance Units/Shares shall be entitled to receive payout on the number and value of Performance Units/Shares earned by the Employee over the Performance Period, to be determined as a function of the extent to which the corresponding performance goals have been achieved. 9.4 FORM AND TIMING OF PERFORMANCE UNITS/SHARES. Payment of earned Performance Units/Shares shall be made in a single lump sum within seventy-five (75) calendar days following the close of the applicable Performance Period. Subject to the terms of this Plan, the Committee, in its sole discretion, may pay 9 10 earned Performance Units/Shares in the form of cash or Shares (or a combination thereof) which have an aggregate Fair Market Value equal to the value of the earned Performance Units/Shares at the close of the applicable Performance Period. Such Shares may be granted subject to any restrictions deemed appropriate by the Committee. At the discretion of the Committee, Employees may be entitled to receive any dividends declared with respect to Shares which have been earned in connection with grants of Performance Units and/or Performance Shares which have been earned, but not yet distributed to Employees (such dividends shall be subject to the same accrual, forfeiture, and payout restrictions as apply to dividends earned with respect to Shares of Restricted Stock, as set forth in SECTION 8.6 herein). In addition, Employees may, at the discretion of the Committee, be entitled to exercise their voting rights with respect to such Shares. 9.5 TERMINATION OF EMPLOYMENT DUE TO DEATH, DISABILITY OR RETIREMENT. Unless otherwise determined by the Committee and set forth in the Employee's Award Agreement, in the event the employment of an Employee is terminated by reason of death, disability or Retirement during a Performance Period, the Employee shall receive a payout of the Performance Units/Shares which is prorated, as specified by the Committee in its discretion. Payment of earned Performance Units/Shares shall be made at a time specified by the Committee in its sole discretion and set forth in the Employee's Award Agreement. 9.6 TERMINATION OF EMPLOYMENT FOR OTHER REASONS. In the event that an Employee's employment terminates for any reason other than those reasons set forth in SECTION 9.5 herein, all Performance Units/Shares shall be forfeited by the Employee to the Company unless determined otherwise by the Committee, as set forth in the Employee's Award Agreement. 9.7 NONTRANSFERABILITY. Performance Units/Shares may not be sold, transferred, pledged, assigned or otherwise alienated or hypothecated, other than by will or if the grantee dies intestate by the laws of descent and distribution of the state of domicile of the grantee at the time of death. Further, an Employee's rights under the Plan shall be exercisable during the Employee's lifetime only by the Employee or the Employee's legal representative. ARTICLE 10. BENEFICIARY DESIGNATION Each Employee under the Plan may, from time to time, name any beneficiary or beneficiaries (who may be named contingently or successively) to whom any benefit under the Plan is to be paid in case of his or her death before he or she receives any or all of such benefit. Each such designation shall revoke all prior designations by the same Employee, shall be in a form prescribed by the Company, and will be effective only when filed by the Employee in writing with the Company during the Employee's lifetime. In the absence of any such designation, benefits remaining unpaid at the Employee's death shall be paid to the Employee's estate. ARTICLE 11. DEFERRALS The Committee may permit or require an Employee to defer such Employee's receipt of the payment of cash or the delivery of Shares that would otherwise be due to such Employee by virtue of the exercise of an Option or SAR, the lapse or waiver of restrictions with respect to Restricted Stock, or the satisfaction of any requirements or goals with respect to Performance Units/Shares. If any such deferral election is required or permitted, the Committee shall, in its sole discretion, establish rules and procedures for such payment deferrals. 10 11 ARTICLE 12. RIGHTS OF EMPLOYEES 12.1 EMPLOYMENT. Nothing in the Plan shall interfere with or limit in any way the right of the Company to terminate any Employee's employment at any time, nor confer upon any Employee any right to continue in the employ of the Company. 12.2 PARTICIPATION. No Employee shall be entitled to have the right to be selected to receive an Award under this Plan, or having been so selected, to be selected to receive a future Award. ARTICLE 13. CHANGE IN CONTROL 13.1 TREATMENT OF OUTSTANDING AWARDS. Upon the occurrence of a Change in Control, unless otherwise specifically prohibited under applicable laws, or by the rules and regulations of any governing governmental agencies or national securities exchanges: (a) Any and all Options and SARs granted hereunder shall become immediately exercisable, and shall remain exercisable throughout their entire term; (b) Any restriction periods and restrictions imposed on Restricted Shares shall lapse; (c) The target payout opportunities attainable under all outstanding Awards of Restricted Stock, Performance Units and Performance Shares shall be deemed to have been fully earned for the entire Performance Period(s) as of the effective date of the Change in Control. The vesting of all Awards denominated in Shares shall be accelerated as of the effective date of the Change in Control, and there shall be paid out in cash to Employees within thirty (30) days following the effective date of the Change in Control an amount equal to one hundred percent (100%) of all targeted cash payout opportunities associated with outstanding cash-based Awards; and (d) Subject to ARTICLE 14 herein, the Committee shall have the authority to make any modifications to the Awards as determined by the Committee to be appropriate before the effective date of the Change in Control. 13.2 ACCELERATION OF AWARD VESTING. Notwithstanding any provision of this Plan or any Award Agreement provision to the contrary, the Committee, in its sole and exclusive discretion, shall have the power at any time to accelerate the vesting of any Award granted under the Plan to any Employee, including without limitation acceleration to such a date that would result in said Awards becoming immediately vested. 13.3 TERMINATION, AMENDMENT AND MODIFICATIONS OF CHANGE IN CONTROL PROVISIONS. Notwithstanding any other provision of this Plan or any Award Agreement provision, the provisions of this ARTICLE 13 may not be terminated, amended or modified on or after the date of a Change in Control to affect adversely any Award theretofore granted under the plan without the prior written consent of the Employee with respect to said Employee's outstanding Awards; provided, however, the Board of Directors, upon recommendation of the committee, may terminate, amend, or modify this ARTICLE 13 at any time and from time to time prior to the date of a Change in Control. ARTICLE 14. AMENDMENT, MODIFICATION AND TERMINATION 14.1 ADMENDMENT, MODIFICATION AND TERMINATION. The Board may at any time and from time to time, alter, amend, suspend, or terminate the Plan in whole or in part. 14.2 ADJUSTMENT OF AWARDS UPON THE OCCURRENCE OF CERTAIN UNUSUAL OR NONRECURRING EVENTS. The Committee may make adjustments in the terms and conditions of, and the criteria included in, Awards in recognition of unusual or nonrecurring events (including, without limitation, the events described in SECTION 4.3 hereof) affecting the Company or the financial statements of the Company or of changes in 11 12 applicable laws, regulations, or accounting principles, whenever the Committee determined that such adjustments are appropriate in order to prevent dilution or enlargement of the benefits or potential benefits intended to be made available under the Plan; provided that no such adjustment shall be authorized to the extent that such authority would be inconsistent with the Plan's meeting the requirements of Section 162(m) of the Code, as from time to time amended. 14.3 AWARDS PREVIOUSLY GRANTED. No termination, amendment, or modification of the Plan shall adversely affect in any material way any Award previously granted under the Plan, without the written consent of the Employee holding such Award. 14.4 COMPLIANCE WITH CODE 162(m). At all times when Code Section 162(m) is applicable, all Awards granted under this Plan shall comply with the requirements of Code Section 162(m); provided, however, that in the event the Committee determines that such compliance is not desired with respect to any Award or Awards available for grant under the Plan, then compliance with Code Section 162(m) will not be required. In addition, in the event that any changes are made to Code Section 162(m) to permit greater flexibility with respect to any Award or Awards available under the Plan, the Committee may, subject to this ARTICLE 14, make any adjustments it deems appropriate. ARTICLE 15. WITHHOLDING 15.1 TAX WITHHOLDING. The Company shall have the power and the right to deduct or withhold, or require any Employee to remit to the Company, an amount sufficient to satisfy Federal, state and local taxes, domestic or foreign, required by law or regulation to be withheld with respect to any taxable event arising as a result of this Plan. 15.2 SHARE WITHHOLDING. With respect to withholding required upon the exercise of Options or SARs, upon the lapse of restrictions on Restricted Stock, or upon any other taxable event arising as a result of Awards granted hereunder, Employees may elect, subject to the approval of the Committee, to satisfy the withholding requirement, in whole or in part, by having the Company withhold Shares having a Fair Market Value on the date the tax is to be determined equal to the minimum statutory total tax which could be imposed on the action. All such elections shall be irrevocable, made in writing, signed by the Employee, and shall be subject to any restrictions or limitations that the Committee, in its sole discretion, may determine. ARTICLE 16. INDEMNIFICATION Each person who is or shall have been a member of the Committee, or of the Board, shall be indemnified and held harmless by the Company against and from any loss, cost, liability or expense that may be imposed upn or reasonably incurred by him or her in connection with or resulting from any claim, action, suit or proceeding to which he or she may be a party or in which he or she may be involved by reason of any action taken or failure to act under the Plan and against and from any and all amounts paid by him or her in settlement thereof, with the Company's approval, or paid by him or her in satisfaction of any judgment in any such action, suit or proceeding against him or her, provided he or she shall give the Company an opportunity at its own expense, to handle and defend the same before he or she undertakes to handle and defend it on his or her own behalf. The foregoing right of indemnification shall not be exclusive of any other right of indemnification to which such persons may be entitled under the Company's Articles of Incorporation or Bylaws, as a matter of law, or otherwise, or any power that the Company may have to indemnify them or hold them harmless. 12 13 ARTICLE 17. SUCCESSOR All obligations of the Company under the Plan with respect to Awards granted hereunder shall be binding upon any successor to the Company, whether the existence of such successor is the result of a direct or indirect purchase, merger, consolidation, or otherwise, of all or substantially all of the business and/or assets of the Company. ARTICLE 18. LEGAL CONSTRUCTION 18.1 GENDER AND NUMBER. Except where otherwise indicated by the context, any masculine term used herein shall also include the feminine; the plural shall include the singular and the singular shall include the plural. 18.2 SEVERABILITY. In the event any provision of the Plan shall be held illegal or invalid for any reason, the illegality or invalidity shall not affect the remaining parts of the Plan, and the Plan shall be construed and enforced as if the illegal or invalid provision had not been included. 18.3 REQUIREMENTS OF LAW. The granting of Awards and the issuance of Shares under the Plan shall be subject to all applicable laws, rules, and regulations, and to such approvals by governmental agencies or national securities exchanges as may be required. 18.4 SECURITIES LAW COMPLIANCE. With respect to (i) any person who is required to file reports pursuant to the rules promulgated under Section 16 of the Exchange Act and (ii) insiders, transactions under this Plan are intended to comply with all applicable conditions of Rule 16b-3 or its successors under the Exchange Act. To the extent any provision of the Plan or action by the Committee fails to so comply, it will be deemed null and void to the extent permitted by law and deemed advisable by the Committee. 18.5 GOVERNING LAW. To the extent not preempted by Federal law, the Plan and all agreements hereunder, shall be construed in accordance with and governed by the laws of the Commonwealth of Pennsylvania. 13 EX-10.28 6 AMENDMENT TO THE EMPLOYMENT AGREEMENT 1 Exhibit 10.28 AMENDMENT THIS AMENDMENT, dated as of December 30, 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 and January 8, 1998 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 $200,000 per annum, plus the cost of the Executive's annual long term disability premium, 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 1 EX-13.1 7 SELECTED CONSOLIDATED FINANCIAL DATA 1 Exhibit 13.1 SELECTED CONSOLIDATED FINANCIAL DATA The selected consolidated financial data of the Company as of December 31, 1994, 1995, 1996, 1997, 1998 and for the years then ended is derived from audited consolidated financial statements of the Company.
(In thousands, except per share data) Years Ended December 31, 1994 1995 1996 1997 1998 - --------------------------------------------------------------------------------------------------------------- STATEMENTS OF OPERATIONS DATA: Revenues(1) $ 14,722 $ 22,310 $ 37,490 $ 45,421 $ 46,277 Cost of product sales 8,168 11,329 18,322 20,104 19,620 ............................................................................................................... Gross profit 6,554 10,981 19,168 25,317 26,657 Operating expenses: Selling and marketing 1,903 2,953 4,767 5,446 5,704 General and administrative 1,268 1,471 2,552 3,768 4,128 Research and development 1,585 2,637 3,921 5,945 6,880 ............................................................................................................... Total operating expenses 4,756 7,061 11,240 15,159 16,712 Income from operations 1,798 3,920 7,928 10,158 9,945 Other income (expense), net (270) 20 845 899 1,062 ............................................................................................................... Income before income taxes 1,528 3,940 8,773 11,057 11,007 Provision (benefit) for income taxes (617) 1,418 3,176 4,174 4,040 - --------------------------------------------------------------------------------------------------------------- Net income $ 2,145 $ 2,522 $ 5,597 $ 6,883 $ 6,967 Net income applicable to common stock (2) $ 1,311 $ 2,522 $ 5,597 $ 6,883 $ 6,967 - --------------------------------------------------------------------------------------------------------------- Earnings per share: (3) Basic $ .49 $ .60 $ 1.02 $ 1.21 $ 1.19 Diluted .32 .56 .94 1.15 1.17 - --------------------------------------------------------------------------------------------------------------- Weighted average shares of common stock and equivalents: Basic 2,674 4,228 5,501 5,686 5,841 Diluted 4,159 4,504 5,940 5,962 5,967 - --------------------------------------------------------------------------------------------------------------- As of December 31, 1994 1995 1996 1997 1998 - --------------------------------------------------------------------------------------------------------------- BALANCE SHEET DATA: Working capital $ 3,195 $ 21,159 $ 27,232 $ 34,570 $ 40,539 Total assets 7,151 25,728 34,626 43,713 49,865 Long-term debt, less current portion 1,400 -- -- -- -- Shareholders' equity 1,387 22,609 30,006 38,101 45,696 - --------------------------------------------------------------------------------------------------------------- 1994 1995 1996 1997 1998 - --------------------------------------------------------------------------------------------------------------- OTHER DATA: (4) Number of employees at year end 96 126 184 205 230 Average revenue per employee $ 153 $ 177 $ 204 $ 222 $ 201 - ---------------------------------------------------------------------------------------------------------------
(1) Includes license fees of $250 and $150 for 1997 and 1998, respectively. (2) Net of accretion for redeemable warrants, all of which were redeemed in February 1995. (3) 1998 includes $.04 per share related to the after-tax effect of net key man life insurance proceeds associated with the death of the Company's former Chairman R. Craig Allison. (4) Data not derived from Company's audited financial statements. 6 2 Management's Discussion and Analysis of Results of Operations and Financial Condition The following discussion should be read in conjunction with the "Selected 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 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 Tollgrade Communications, Inc.'s (the "Company") present expectations or beliefs concerning future events. The Company cautions that such statements must be qualified by important factors that could cause actual earnings and other results to differ materially from those achieved in the past or those expected by the Company. These include rapid technological change, along with the need to continually develop new products; the Company's dependence on a single product line; competition; the Company's dependence on key employees; difficulties in managing the Company's growth; the Company's dependence upon a small number of large customers and certain suppliers; the Company's dependence upon proprietary rights; risks of third-party claims of infringement; and government regulation. OVERVIEW The Company was organized in 1986 and began operations in 1988. The Company designs, engineers, markets and supports test access and test extension products for the telecommunications and cable television industries. The Company's telecommunication proprietary products 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. The Company's MCU product line, which includes POTS line testing as well as alarm-related products, represented approximately 90% of the Company's revenue for the year ended December 31, 1998 and will continue to account for a majority of the Company's revenues for the foreseeable future. The Company's cable products consist of a complete cable status monitoring system that provides a comprehensive testing solution for the Broadband Hybrid Fiber Coax distribution system. The status monitoring system consists of a host for user interface, control and configuration; a headend controller for managing network communications; and transponders that are strategically located within the cable network to gather status reports from power supplies, line amplifiers and fiber-optic nodes. The Company's telecommunication product sales are primarily to the five Regional Bell Operating Companies (RBOCs) as well as major independent telephone companies such as Sprint and to certain digital loop carrier (DLC) equipment manufacturers. For the year ended December 31, 1998, approximately 79% of the Company's total revenue was generated from sales to these five RBOCs, the two largest of which comprised approximately 54% of revenues. The Company intends to market and sell its cable products directly, as well as through various Original Equipment Manufacturer (OEM) arrangements with cable network equipment manufacturers. The Company presently has one OEM arrangement under contract and works on less formal arrangements with several other OEM partners. Sales for the Company's cable products for the year ended December 31, 1998 were not material. 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. 7 3 This timing is particularly sensitive to various business factors within each of the RBOCs, including the RBOCs relationships with their various organized labor groups. During the third quarter of 1998, the Company's financial results were impacted by the effect of certain labor disputes at Bell Atlantic, USWest and Southern New England Telephone. These work stoppages, along with other factors, disrupted ongoing and established network expansion and maintenance programs and exacerbated seasonally lower sales. Certain contracts concerning the RBOCs organized employees were renegotiated during the third quarter of 1998. Refer to discussions on 1998 revenues for further comments. The Company believes that recent changes within the telecommunication marketplace, including industry consolidation, as well as the Company's ability to successfully penetrate certain new markets, have resulted in some discounting and more favorable terms granted to certain customers of the Company. In addition, the Company has recently experienced certain customer demands to consolidate product purchases which have translated into large bulk orders. Although the Company will continue to strive to meet the demands of its customers, which include delivery of quality products at an acceptable price and on acceptable terms, there are no assurances that the Company will be successful in negotiating acceptable terms and conditions pertaining to these large orders. Additionally, recent consolidations and potential future consolidations among the RBOCs, and their ability to consolidate their inventory and product procurement systems could cause fluctuations or delays in the Company's order patterns. The Company cannot predict such future events or business conditions, and the Company's results may be adversely affected by these industry trends in the primary markets its serves. Although international sales to date have not been significant, the Company believes the international markets offer opportunities. The international telephony markets differ from those found domestically due to the different types and configurations of equipment used by those international communication companies to provide services. Certain competitive elements also are found internationally which do not exist in the Company's domestic markets. The Company has, up to the present time, utilized the professional services of various marketing consultants to define the Company's international market opportunities. Markets that are the subject of continuing review are those markets in China, Europe and several countries in the Pacific Rim area. During the fourth quarter of 1998, the Company streamlined the structure responsible for its international efforts. The changes resulted in a more cost-effective structure that is now focused at the customer level. There continues to be a high level of interest expressed by certain potential customers in the international markets; however, there can be no assurance that these efforts will be successful or that the Company will achieve significant international sales. The Company 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 14.9% for the year ended December 31, 1998. The Company expects its research and development expenses to continue at significant levels. YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997 REVENUES Revenues for the year ended December 31, 1998 were $46.3 million and were $0.9 million, or 1.9%, higher than the revenues of $45.4 million for the year ended December 31, 1997. Revenues for both periods consisted almost entirely of product sales. Revenues for 1998 and 1997 include approximately $0.5 million and $0.9 million, respectively, for non-recurring engineering fees, royalty and license fees. The increase in revenues is primarily associated with new product revenues. During 1998, the Company generated revenues of approximately $2.2 million associated with new product introductions, including the Company's LIGHTHOUSE cable products, while same product sales between periods decreased $1.3 million, or 3.0%. This decrease occurred primarily in the second half of 1998, and the Company believes it was caused by several factors, including certain labor disputes at Bell Atlantic, USWest and Southern New England Telephone during the third quarter of 1998, higher than expected inventories at Ameritech, as well as slower than expected deployment of MCU products within certain regions of Bell Atlantic. Bell Atlantic's testability improvement initiatives migrated to more complex embedded DLC 8 4 architectures that require the provisioning of additional equipment and increased installation time. The Company is working to implement strategies designed to return product usage to historical levels for certain customers through comprehensive technical training and other testability improvement initiatives. The effectiveness of these programs from a timing point of view are highly dependent upon a number of factors outside of the Company's control, including the Company's customers' willingness to dedicate the appropriate levels of resources to see such initiatives through to their successful conclusion. Therefore, there can be no assurances as to the ultimate effectiveness of these programs in returning product deployment to historical levels. 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 there is a continuing possibility that the requirements for certain important MCU products which are utilized in legacy DLC systems may be satisfied in the near future, especially within one major customer. In order to reduce associated risks, the Company 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 1998 was $26.7 million compared to $25.3 million for 1997, representing an increase of $1.4 million, or 5.3%. Gross profit as a percentage of revenues increased to 57.6% for 1998 compared to 55.7% for 1997. The overall increase in gross profit 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 continuing gross margin levels will depend on its success in holding pricing, gaining further cost reductions, as well as the mix of products sold including the effect of the Company's cable products which carry lower gross margins than earned historically on the Company's telecommunication products. 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 1998 was $5.7 million, or 12.3% of revenues, compared to $5.4 million, or 12.0% of revenues for 1997. This increase of $0.3 million, or 4.7%, is primarily associated with additional personnel to support expanding product lines and increased consulting and travel expenses associated with international market development. 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 and the development of comprehensive technical training and other testability improvement initiatives. 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 1998 was $4.1 million, or 8.9% of revenues, compared to $3.8 million, or 8.3% of revenues for 1997. This increase of $0.3 million, or 9.5%, is primarily attributable to increased expenditures for legal and professional fees associated with business development activities as well as personnel recruiting costs. RESEARCH AND DEVELOPMENT EXPENSE Research and development expenses consist primarily of personnel costs and costs associated with the development of new products and technologies. Research and development expense for 1998 was $6.9 million, or 14.9% of revenues, compared to $5.9 million, or 13.1% of revenues for 1997. This increase of $1.0 million, or 15.7%, was principally due to costs associated with new product development and the addition of personnel to support these new product development activities. 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 $1.1 million for 1998 compared to $0.9 million for 1997. The increase of $0.2 million, or 18.2%, includes approximately $0.2 million of net key man life insurance proceeds associated with the death of the Company's former Chairman R. Craig Allison. Additionally, 1998 other income and expense included 9 5 interest expense of approximately $0.1 million related to settlements of issues with certain prior years' tax returns. PROVISION FOR INCOME TAXES The Company's effective tax rate for 1998 was 36.7% of income before income taxes, compared to the 37.7% rate in 1997. The decrease in the effective income tax rate primarily reflects the permanent effect of an increase in non-taxable interest income on the Company's short- and long-term investments related to individual municipal bonds. NET INCOME AND EARNINGS PER SHARE For the year ended December 31, 1998, net income was $7.0 million compared to $6.9 million for the year ended December 31, 1997, representing an increase of $0.1 million, or 1.2%. Diluted earnings per common share of $1.17 for 1998 increased by 1.7%, or $.02, from the $1.15 earned in 1997. Fiscal year 1998 includes approximately $0.2 million, or $.04 per share, related to the after-tax effect of net key man life insurance as previously discussed above. Excluding the effect of net key man life insurance proceeds, net income decreased $0.1 million, or 2.1% while diluted earnings per share for 1998 decreased 1.7% to $1.13 per share. Diluted weighted average shares of common stock and equivalents outstanding were 5,966,551 in 1998 compared to 5,961,540 in 1997. As a percentage of revenues, net income for 1998 decreased to 15.1% from 15.2% in 1997. 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 revenues included $250,000 of royalty and license fees, while similar fees for 1996 were immaterial. The increase in revenues was 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 included revenues of $0.7 million from six new products introduced in 1997. Overall, increased product demand was 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. 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 believed that during fiscal year 1998, there was a possibility that one of the Company's major customers would satisfy a substantial portion of its requirements for certain of the Company's important product lines. Management focused on the development of new product lines to attempt to meet the other requirements of this and other customers. Refer to discussions on 1998 revenues for further comments 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 has depended 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%, reflected 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's selling and marketing expenses have risen commensurate with increased revenues and selling efforts. The Company is continuing its efforts to expand its business 10 6 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%, was 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 reflected increases in state taxes offset by benefits from higher levels of tax-exempt interest and increased credits for research and development. LIQUIDITY AND CAPITAL RESOURCES The Company had working capital of $40.5 million as of December 31, 1998 compared to the working capital of $34.6 million as of December 31, 1997. The increase of $5.9 million, or 17.3%, can be attributed to operating cash flow (income from operations before depreciation and amortization) and proceeds from the exercise of stock options exceeding requirements for purchases of property and equipment and funding of the Company's stock buyback program. Significant components of the Company's change in working capital include an increase in cash and cash equivalents, which include the effect of cash received as a result of stock option exercises and net collections, an increase in inventories due to the investment required to introduce new products and to maintain sufficient inventory stocking levels. Most significantly offsetting these increases was a decrease in short-term investments of $1.4 million; the majority of such funds were invested in long-term investments and, as such, are still available for general corporate use upon maturity. These investments reflect the Company's strategy to migrate to individual municipal bonds with a maturity of more than one year and less than eighteen months and was undertaken to maximize investment income levels. As of December 31, 1998, the Company had $24.1 million of cash and cash equivalents, short-term and long-term investments which are available for acquisitions and other corporate requirements. The Company made capital expenditures of $1.7 million in 1998 and were primarily related to an upgrade of the MIS infrastructure, production test equipment and fixtures, as well as leasehold improvements made to the Company's facilities. Capital expenditures were $1.2 million and $2.0 million for 1997 and 1996, 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 1999 are anticipated to total approximately $2.4 million. These planned capital projects include test fixtures and development systems, computer and office equipment and leasehold improvements to the Company's facilities. As of May 31, 1998, the Company terminated its $2,500,000 bank line of credit. The Company believes that, based upon its current financial position, the line of credit is not necessary to be continued at the present time. On April 22, 1997, the Company's Board of Directors authorized a program to purchase up to 200,000 shares of its common stock over the 11 7 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, 1998, the Company had purchased 106,900 shares of common stock under this program. Subsequent to December 31, 1998 and through March 1, 1999, the Company purchased an additional 27,900 shares of 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 1998 results. The Company's financial position enables it to meet cash requirements for operations and capital expansion programs. 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 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. IMPACT OF THE YEAR 2000 ISSUE The Year 2000 issue exists because many computer systems and applications use two-digit rather than four-digit date fields to designate an applicable year. As a result, the systems and applications may not properly recognize the year 2000 or process data which include it, potentially causing data miscalculations or inaccuracies or operational malfunctions or failures. The Company has established a Year 2000 committee to transition the Company's business applications, computing infrastructure and communication systems into the next millennium. The objectives of the Year 2000 committee are to ensure all internal computer systems function correctly in the Year 2000, ensure data exchanged with external organizations conforms to Year 2000 standards and ensure all products sold by the Company conform to Year 2000 standards. The Company has developed an inventory of all Company business systems and corresponding software applications and is currently in the process of assessing the business priority of each system. Each system will be classified by mission criticality and a determination will be made to either replace or remediate the system, depending upon its importance. In addition, the Year 2000 project will include a review of the Year 2000 compliance efforts of the Company's key suppliers and other principal business partners and, as appropriate, the development of joint business support and continuity plans 12 8 for Year 2000 issues. While this initiative is broad in scope, it has been structured to identify and prioritize efforts for mission-critical systems, products and key business partners. The inventory and assessment phases have been substantially completed as of December 31, 1998. The Company has established a Year 2000 test center to certify all business applications and processes utilized throughout the Company. To date, more than 300 internal software applications or systems have been identified for testing. Initial results indicate less than 20% of these applications do not meet Year 2000 standards and, more importantly, less than 5% are business-critical. During the remainder of 1999, the Year 2000 committee will focus attention to remediation and testing of internal business systems and contingency planning. The Company's products with time-of-day (TOD) clocks in their design have been tested for successful Year 2000 operation. Products that do not have TOD clocks have no potential Year 2000 operational issues and, therefore, have not been tested. The Company believes that it will have no material exposure to contingencies related to the Year 2000 issue for the products it has sold. In order to ensure Year 2000 compliance among the Company's key suppliers and business partners, the Year 2000 committee developed surveys that were provided to the suppliers in addition to verifying compliance efforts via the suppliers' and business partners' Web sites for Year 2000 compliance-related information. The Company is currently examining where and how outside suppliers and business partners impact the business and apply the same mission-critical standard to suppliers and business partners that applies to the Company's own internal systems. Under the Company's current Year 2000 plan, the target date of June 30, 1999 has been established for completion of remediation, testing and implementation. The Company's ability to meet that target date is dependent upon the timely provision of necessary upgrades and modifications by the Company's suppliers and customers. 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. The Company currently estimates the expenses associated with the anticipated Year 2000 efforts to be approximately $0.1 million through 1999, with an additional $0.3 million for capital improvement costs to support this project. The costs expensed to date have been immaterial. The timing of the Company's expenses may vary and is not necessarily indicative of readiness efforts or progress to date. The Company anticipates that a portion of the Year 2000 expenses will not be incremental costs, but rather will represent the redeployment of existing Information Technology (IT) resources. As part of the Year 2000 initiative, the Company is evaluating scenarios that may occur as a result of the century change and is in the process of developing contingency and business plans that address potential Year 2000-related occurrences. These plans are expected to assess the potential for business disruption and to provide operational back-up, recovery and restoration alternatives. The above information is based on the Company's current best estimates. Given the complexity of the Year 2000 issues and risks, actual results may vary materially from those anticipated and discussed above. Specific factors that might cause such differences include, among others, the availability and cost of personnel trained in this area, the ability to locate and correct all affected computer systems, applications and products and the timing and success of remedial efforts of the Company's third party suppliers and business partners. BACKLOG The Company's backlog consists of firm customer purchase orders for the Company's various products. As of December 31, 1998, the Company had a backlog of $0.6 million, a $1.0 million decrease from the December 31, 1997 backlog of $1.6 million. At December 31, 1998, the composition of the backlog related primarily to one customer order, while backlog at December 31, 1997 consisted of several customer orders. 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. 13 9 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 PricewaterhouseCoopers LLP, Independent Accountants. As part of their audit of the Company's 1998 financial statements, PricewaterhouseCoopers LLP 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 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 Chairman, President and Chief Executive Officer /s/ Samuel C. Knoch -------------------------- Samuel C. Knoch Chief Financial Officer and Treasurer January 25, 1999 14 10 REPORT OF INDEPENDENT ACCOUNTANTS January 25, 1999 To the Board of Directors and Shareholders of Tollgrade Communications, Inc. and Subsidiaries: In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, of changes in shareholders' equity and of cash flows present fairly, in all material respects, the consolidated financial position of Tollgrade Communications, Inc. and subsidiaries at December 31, 1998 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, 1998, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which 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, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. /s/ PRICEWATERHOUSECOOPERS LLP ------------------------------- PricewaterhouseCoopers LLP Pittsburgh, Pennsylvania January 25, 1999 15 11 TOLLGRADE COMMUNICATIONS, INC., AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS
ASSETS December 31, 1997 DECEMBER 31, 1998 - ----------------------------------------------------------------------------------------------------------------- Current assets: Cash and cash equivalents $ 3,183,944 $ 8,311,353 Short-term investments 15,666,626 14,249,164 Accounts receivable: Trade 7,884,683 7,888,060 Other 517,090 300,680 Inventories 12,101,114 13,201,771 Prepaid expenses and deposits 409,252 352,413 Deferred tax assets 213,216 354,891 ................................................................................................................. Total current assets 39,975,925 44,658,332 Long-term investments 600,000 1,553,000 Property and equipment, net 3,001,824 3,314,522 Deferred tax assets 126,895 334,474 Patents and other assets 8,568 4,247 ................................................................................................................. Total assets $ 43,713,212 $ 49,864,575 - ----------------------------------------------------------------------------------------------------------------- LIABILITIES AND SHAREHOLDERS' EQUITY - ----------------------------------------------------------------------------------------------------------------- Current liabilities: Accounts payable $ 959,185 $ 687,079 Accrued expenses 1,091,990 1,128,421 Accrued salaries and wages 1,529,525 801,908 Royalties payable 878,780 712,971 Income taxes payable 946,233 788,479 ................................................................................................................. Total current liabilities 5,405,713 4,118,858 Deferred income -- 40,000 Deferred tax liabilities 206,116 9,950 ................................................................................................................. Total liabilities 5,611,829 4,168,808 Commitments Shareholders' equity: Preferred stock, $1.00 par value; authorized shares, 10,000,000; issued shares, -0- in 1997 and 1998, respectively -- -- Common stock, $.20 par value; authorized shares, 25,000,000; issued shares, 5,727,350 in 1997 and 5,920,464 in 1998 1,145,470 1,184,093 Additional paid-in capital 25,232,315 27,503,772 Treasury stock, at cost, 3,200 shares in 1997 and 109,100 shares in 1998 (70,355) (1,789,287) Unearned compensation (35,934) -- Retained earnings 11,829,887 18,797,189 ................................................................................................................. Total shareholders' equity 38,101,383 45,695,767 ................................................................................................................. Total liabilities and shareholders' equity $ 43,713,212 $ 49,864,575 - -----------------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial statements. 16 12 TOLLGRADE COMMUNICATIONS, INC., AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS
Years Ended December 31, 1996 1997 1998 - --------------------------------------------------------------------------------------------------------------- Revenues $ 37,489,949 $ 45,421,135 $ 46,277,409 Cost of product sales 18,321,677 20,104,202 19,620,226 ............................................................................................................... Gross profit 19,168,272 25,316,933 26,657,183 Operating expenses: Selling and marketing 4,767,339 5,446,102 5,704,323 General and administrative 2,551,959 3,767,925 4,127,580 Research and development 3,921,091 5,944,819 6,880,015 ............................................................................................................... Total operating expenses 11,240,389 15,158,846 16,711,918 ............................................................................................................... Income from operations 7,927,883 10,158,087 9,945,265 Other income (expense): Interest expense (3,076) (3,271) (107,694) Interest and other income 848,569 901,981 1,169,531 ............................................................................................................... Total other income (expense) 845,493 898,710 1,061,837 Income before income taxes 8,773,376 11,056,797 11,007,102 Provision for income taxes 3,176,753 4,173,649 4,039,800 ............................................................................................................... Net income $ 5,596,623 $ 6,883,148 $ 6,967,302 - --------------------------------------------------------------------------------------------------------------- EARNINGS PER SHARE INFORMATION: - --------------------------------------------------------------------------------------------------------------- Weighted average shares of common stock and equivalents: Basic 5,500,884 5,686,182 5,841,347 Diluted 5,939,662 5,961,540 5,966,551 ............................................................................................................... Net income per common share: (1) Basic $ 1.02 $ 1.21 $ 1.19 Diluted .94 1.15 1.17 - ---------------------------------------------------------------------------------------------------------------
(1) 1998 includes $.04 per share related to the after-tax effect of net key man life insurance proceeds associated with the death of the Company's former Chairman R. Craig Allison. The accompanying notes are an integral part of the consolidated financial statements. 17 13 TOLLGRADE COMMUNICATIONS, INC., AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
Additional Preferred Stock Common Stock Paid-in Treasury Shares Amount Shares Amount Capital Stock - --------------------------------------------------------------------------------------------- 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 (49,775) 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 (49,775) 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 -- -- -- -- -- (20,580) Net income -- -- -- -- -- -- ............................................................................................. Balance at December 31, 1997 -- -- 5,727,350 1,145,470 25,232,315 (70,355) EXERCISE OF COMMON STOCK OPTIONS -- -- 193,814 38,763 1,114,876 -- RESTRICTED STOCK - COMPENSATION CHARGED TO EXPENSE, NET -- -- -- -- -- -- SHARES FORFEITED -- -- (700) (140) (6,860) -- TAX BENEFIT FROM EXERCISE OF STOCK OPTIONS -- -- -- -- 1,163,441 -- PURCHASE OF TREASURY STOCK -- -- -- -- -- (1,718,932) NET INCOME -- -- -- -- -- -- ............................................................................................. BALANCE AT DECEMBER 31, 1998 -- $ -- 5,920,464 $1,184,093 $27,503,772 $(1,789,287) - ---------------------------------------------------------------------------------------------
Retained Earnings Unearned (Accumulated Compensation Deficit) Total - ----------------------------------------------------------------------- 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 -- -- 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 (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) Net income -- 6,883,148 6,883,148 ....................................................................... Balance at December 31, 1997 (35,934) 11,829,887 38,101,383 EXERCISE OF COMMON STOCK OPTIONS -- -- 1,153,639 RESTRICTED STOCK - COMPENSATION CHARGED TO EXPENSE, NET 28,934 -- 28,934 SHARES FORFEITED 7,000 -- -- TAX BENEFIT FROM EXERCISE OF STOCK OPTIONS -- -- 1,163,441 PURCHASE OF TREASURY STOCK -- -- (1,718,932) NET INCOME -- 6,967,302 6,967,302 ....................................................................... BALANCE AT DECEMBER 31, 1998 $ -- $18,797,189 $45,695,767 - -----------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial statements. 18 14 TOLLGRADE COMMUNICATIONS, INC., AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31, 1996 1997 1998 - -------------------------------------------------------------------------------------------------------------- Cash flows from operating activities: Net income $ 5,596,623 $ 6,883,148 $ 6,967,302 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 688,323 1,005,744 1,387,598 Deferred income taxes (77,990) 26,495 (545,420) Provision for losses on inventory 95,000 -- 88,000 Provision for allowance for doubtful accounts -- 50,000 50,000 Compensation expense for restricted stock 52,356 52,344 28,934 Changes in assets and liabilities: Increase in accounts receivable-trade (2,582,356) (2,781,094) (53,377) (Increase) decrease in accounts receivable-other (192,716) (212,656) 216,410 Increase in inventories (2,643,352) (3,531,296) (1,188,657) (Increase) decrease in prepaid expenses and deposits (398,302) 140,501 56,839 Decrease in accounts payable (275,517) (732,743) (272,106) Increase (decrease) in accrued expenses, salaries and wages, royalty payable and deferred income 1,679,404 911,508 (816,995) Increase (decrease) in income taxes payable 86,089 775,344 (157,754) .............................................................................................................. Net cash provided by operating activities 2,027,562 2,587,295 5,760,774 .............................................................................................................. Cash flows from investing activities: Purchase of investments (20,690,542) (19,567,255) (17,380,104) Redemption/maturity of investments 8,347,950 15,643,221 17,844,566 Capital expenditures (1,993,541) (1,230,910) (1,695,975) Patent expenditures (4,760) -- -- Purchase of treasury stock -- (20,580) (1,718,932) .............................................................................................................. Net cash used in investing activities (14,340,893) (5,175,524) (2,950,445) .............................................................................................................. Cash flows from financing activities: Proceeds from the exercise of stock options including related tax benefits 1,803,106 1,180,900 2,317,080 Issuance costs related to the initial public offering (55,889) -- -- .............................................................................................................. Net cash provided by financing activities 1,747,217 1,180,900 2,317,080 .............................................................................................................. Net increase (decrease) in cash and cash equivalents (10,566,114) (1,407,329) 5,127,409 Cash and cash equivalents at beginning of year 15,157,387 4,591,273 3,183,944 .............................................................................................................. Cash and cash equivalents at end of year $ 4,591,273 $ 3,183,944 $ 8,311,353 - -------------------------------------------------------------------------------------------------------------- Supplemental disclosure of cash flow information: Cash paid during the year for interest $ 3,076 $ 3,271 $ 107,694 Cash paid during the year for income taxes 2,013,981 2,420,460 3,596,079 - --------------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial statements. 19 15 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 test access and test extension products for the telecommunications and cable television industries. The Company's telecommunications proprietary products 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. The Company's cable products consist of a complete cable status monitoring system that provides a comprehensive testing solution for the Broadband Hybrid Fiber Coax distribution system. The status monitoring system consists of a host for user interface, control and configuration; a headend controller for managing network communications; and transponders that are strategically located within the cable network to gather status reports from power supplies, line amplifiers and fiber-optic nodes. 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 are 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, 1997 and 1998 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. Long-term investments are individual municipal bonds with a maturity of more than one year but less than eighteen months. The primary investment purposes are to provide a reserve for future business purposes, including possible acquisitions, capital expenditures and to meet working capital requirements. The Company classifies its investment in all debt securities as "held to maturity" in accordance with Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities." 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. 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. 20 16 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. RECLASSIFICATIONS Certain reclassifications have been made to the Company's 1997 financial statements to agree with current year classifications. 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:
Years Ended December 31, 1996 1997 1998 - --------------------------------------------------------------------------------------------------------------- Net Income $ 5,596,623 $ 6,883,148 $ 6,967,302 - --------------------------------------------------------------------------------------------------------------- Weighted average common shares outstanding 5,500,884 5,686,182 5,841,347 ............................................................................................................... Effect of dilutive securities - stock options 438,778 275,358 125,204 ............................................................................................................... 5,939,662 5,961,540 5,966,551 - --------------------------------------------------------------------------------------------------------------- Earnings per share: Basic $ 1.02 $ 1.21 $ 1.19 - --------------------------------------------------------------------------------------------------------------- Diluted $ .94 $ 1.15 $ 1.17 - ---------------------------------------------------------------------------------------------------------------
2. INVENTORIES Inventories consisted of the following:
December 31, 1997 DECEMBER 31, 1998 - ----------------------------------------------------------------------------------------------------------------- Raw materials $ 5,738,576 $ 6,135,743 Work in process 5,070,113 4,725,776 Finished goods 1,292,425 2,340,252 ................................................................................................................. $ 12,101,114 $ 13,201,771 - -----------------------------------------------------------------------------------------------------------------
3. PROPERTY AND EQUIPMENT Property and equipment consisted of the following:
December 31, 1997 DECEMBER 31, 1998 - ----------------------------------------------------------------------------------------------------------------- Test equipment and tooling $ 2,409,088 $ 3,289,767 Office equipment and fixtures 2,143,567 2,728,443 Leasehold improvements 921,049 1,127,904 ................................................................................................................. 5,473,704 7,146,114 Less accumulated depreciation and amortization 2,471,880 3,831,592 ................................................................................................................. $ 3,001,824 $ 3,314,522 - -----------------------------------------------------------------------------------------------------------------
21 17 4. SHAREHOLDERS' EQUITY COMMON STOCK The Company has 25,000,000 authorized shares which have a par value of $.20 per share. As of December 31, 1997 and 1998, there are 5,727,350 and 5,920,464 issued shares, respectively. 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, 1998, the Company had purchased 106,900 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. 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 1997 and 1998. 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 date of $10.00, as determined by the Board of Directors. Compensation expense was $52,356, $52,344 and $28,934 in 1996, 1997 and 1998, respectively. In 1996, 1997 and 1998, 2,440, 350 and 700 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 $9,487, $18,408 and $7,000 was reversed in 1996, 1997 and 1998, respectively. At December 31, 1998, all shares of restricted common stock granted had vested. 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, as defined. The options generally vest ratably over a two-year period, with one-third vested upon grant. The Company's option programs cover all employees and are used to attract and retain qualified personnel in all positions. 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 Company's Board of Directors adopted the 1998 Employee Incentive Compensation Plan on January 29, 1998 and further amended such plan on April 10, 1998. All full-time active employees of the Company, excluding officers and directors, are eligible to participate in the plan. The aggregate number of shares of the Company's common stock which may be issued under the plan is 600,000 shares, subject to proportionate adjustment in the event of stock splits and similar events. The shares authorized but not granted under these plans at December 31, 1997 and 1998 were as follows:
Shares Authorized But Not Granted December 31, 1997 DECEMBER 31, 1998 - ------------------------------------------------------------------------------------------------------ 1995 Long-Term Incentive Compensation Plan 357,973 64,073 1998 Employee Incentive Compensation Plan -- 389,333 ...................................................................................................... Total 357,973 453,406 - ------------------------------------------------------------------------------------------------------
22 18 Certain employees and directors of the Company were granted stock options under the 1995 Long-Term Incentive Compensation Plan and the 1998 Employee 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 1996, 1997 and 1998 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:
Years Ended December 31, 1996 1997 1998 - ------------------------------------------------------------------------------------------------------------ Net income As reported $ 5,596,623 $ 6,883,148 $ 6,967,302 Pro forma $ 4,687,153 $ 5,805,709 $ 5,159,610 ............................................................................................................ Diluted earnings per share As reported $ .94 $ 1.15 $ 1.17 Pro forma $ .79 $ .97 $ .86 - ------------------------------------------------------------------------------------------------------------
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 1996, 1997 and 1998: expected volatility of 46.5% in 1996, 40.4% in 1997 and 50.8% in 1998; a risk-free interest rate of 5.64% in 1996, 6.10% in 1997 and 4.82% in 1998; 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 1996, 1997 and 1998, is $10.71, $8.54 and $7.68, respectively. Transactions involving stock options under the Company's various stock option plans and otherwise are summarized below:
Weighted Average Number of Shares Range of Option Price Exercise Price - ----------------------------------------------------------------------------------------------------------- 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 Granted 540,000 14.5625 - 27.125 17.19 Exercised (193,714) 17.00 - 27.125 5.95 Cancelled (40,533) 12.00 - 27.125 20.66 - ----------------------------------------------------------------------------------------------------------- OUTSTANDING, DECEMBER 31, 1998 1,059,220 $ 12.00 - $27.125 $ 18.16 - -----------------------------------------------------------------------------------------------------------
Weighted Average Options exercisable at: Number of Shares Exercise Price - ----------------------------------------------------------------------------------------------------------- December 31, 1996 542,369 $ 10.33 December 31, 1997 615,289 14.17 DECEMBER 31, 1998 711,015 18.40 - -----------------------------------------------------------------------------------------------------------
23 19 The following table summarizes the status of the stock options, outstanding and exercisable, at December 31, 1998:
Stock Options Stock Options Outstanding Exercisable - ----------------------------------------------------------------------------------------------------------------- Weighted Average Weighted Weighted Range of Exercise Remaining Average Average Prices Shares Contractual Life Exercise Price Shares Exercise Price - ----------------------------------------------------------------------------------------------------------------- $12.0000 - $15.0000 312,597 7.78 $13.19 279,264 $13.03 ................................................................................................................. $15.1250 - $19.6250 390,704 9.62 16.84 128,229 16.77 ................................................................................................................. $20.6250 - $25.7500 333,252 8.34 23.76 296,519 23.96 ................................................................................................................. $27.1250 - $27.1250 22,667 9.54 27.13 7,003 27.13 ................................................................................................................. Total 1,059,220 8.67 $18.16 711,015 $18.40 - -----------------------------------------------------------------------------------------------------------------
Subsequent to December 31, 1998, the Board of Directors granted an additional 157,000 options to employees of the Company pursuant to the 1998 Employee Incentive Compensation Plan. 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 on 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 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%. 5. 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 $1,893,000, $2,014,000 and $1,903,701 were incurred in 1996, 1997 and 1998, respectively, and are included in cost of product sales in the accompanying consolidated statements of operations. 24 20 6. INCOME TAXES The provision for income taxes consisted of the following:
Years Ended December 31, 1996 1997 1998 - --------------------------------------------------------------------------------------------------------------- Current: Federal $ 2,938,491 $ 3,726,200 $ 4,030,841 State 316,252 421,000 554,379 ............................................................................................................... 3,254,743 4,147,200 4,585,220 - --------------------------------------------------------------------------------------------------------------- Deferred: Federal (111,056) (28,160) (475,494) State 33,066 54,609 (69,926) ............................................................................................................... (77,990) 26,449 (545,420) ............................................................................................................... $ 3,176,753 $ 4,173,649 $ 4,039,800 - ---------------------------------------------------------------------------------------------------------------
Reconciliations of the federal statutory rate to the effective tax rates are as follows:
Years Ended December 31, 1996 1997 1998 - --------------------------------------------------------------------------------------------------------------- Federal statutory tax rate 34% 34% 34% Research and development tax credit (1) (2) (1) State income taxes 2 3 3 Other 1 3 1 ............................................................................................................... Effective tax rate 36% 38% 37% - ---------------------------------------------------------------------------------------------------------------
The components of and changes in the deferred tax assets and liabilities recorded in the accompanying balance sheets at December 31, 1997 and 1998 were as follows:
Deferred Deferred December 31, Expense December 31, Expense DECEMBER 31, 1996 (Credit) 1997 (Credit) 1998 - ----------------------------------------------------------------------------------------------------------------- DEFERRED TAX ASSETS: Excess of tax basis over book basis for: Property and equipment $ -- $ -- $ -- $ (149,797) $149,797 Inventory 57,470 (16,328) 73,798 (130,980) 204,778 Reserves recorded for: Warranty 78,000 (39,000) 117,000 (52,650) 169,650 Obsolescence 83,850 14,040 69,810 (34,320) 104,130 Allowance for doubtful accounts -- (19,500) 19,500 (19,500) 39,000 Net operating loss carryforward - State 58,750 58,750 -- -- -- Other 50,829 (9,174) 60,003 37,993 22,010 ...................................................... ......... ........ Total deferred tax assets 328,899 340,111 689,365 - ------------------------------------------------------ --------- -------- DEFERRED TAX LIABILITIES: Excess of book basis over tax basis for: Property and equipment (111,777) 84,389 (196,166) (196,166) -- Other (56,678) (46,728) (9,950) -- (9,950) ...................................................... ......... ........ Total deferred tax liabilities (168,455) (206,116) (9,950) - ------------------------------------------------------ --------- -------- - ----------------------------------------------------------------------------------------------------------------- Net deferred taxes $ 160,444 $ 26,449 $ 133,995 $ (545,420) $679,415 Reconciliation to the consolidated balance sheets: Current portion of deferred tax assets 171,776 213,216 354,891 Current portion of deferred tax liabilities (168,455) (206,116) (9,950) ................................................................................................................. Long-term deferred taxes, net $ 157,123 $ 126,895 $334,474 - -----------------------------------------------------------------------------------------------------------------
The Company had a state tax operating loss carryforward at December 31, 1996 of approximately $500,000 which was utilized in 1997. 25 21 7. LEASE COMMITMENTS The Company leases office space and equipment under agreements which are accounted for as operating leases. The office lease expires December 31, 2001 and may be extended up to an additional 3 years. The equipment lease expires in September 2003. 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 $4,827, $4,727 and $1,619 in 1998, 1997 and 1996, respectively. Minimum annual future rental commitments under noncancelable leases as of December 31 are: 1999................................................................ $ 579,917 2000................................................................ 595,577 2001................................................................ 616,457 2002................................................................ 31,817 2003................................................................ 23,863
The rent expense for all lease commitments was approximately $335,000, $354,000 and $425,714 in 1996, 1997 and 1998, respectively. 8. MAJOR CUSTOMERS, REVENUE CONCENTRATION AND DEPENDENCE ON CERTAIN SUPPLIERS The Company sells primarily 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 90% of the Company's net product sales for 1998. 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 86%, 86% and 79% of the Company's net product sales for fiscal years 1996, 1997 and 1998, respectively. During fiscal years 1996, 1997 and 1998, sales to two RBOCs individually exceeded 10% of consolidated revenues and, on a combined basis, comprised 60%, 54% and 54%, respectively, of the Company's net product sales. At December 31, 1997 and 1998, accounts receivable-trade included in the consolidated balance sheets related to these two RBOCs was approximately $3,819,000 and $3,639,000, 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. The Company utilizes two key independent subcontractors to perform a majority of the circuit board assembly and in-circuit testing work on its products. The Company also utilizes other subassembly contractors on a more limited basis. The loss of the subcontractors could cause delays in the Company's ability to meet production obligations and could have 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. 9. 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 or not to exceed the regulatory imposed limit, as defined. The Company does not make any matching contributions to the plan. 26 22 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, 1997 1997 1997 1997 1998 1998 1998 1998 - ------------------------------------------------------------------------------------------------------------------ Revenues $ 8,619 $ 12,115 $ 11,363 $ 13,324 $ 10,764 $ 14,025 $ 10,120 $ 11,368 Cost of product sales 3,789 5,454 5,226 5,635 4,355 5,920 4,511 4,834 .................................................................................................................. Gross profit 4,830 6,661 6,137 7,689 6,409 8,105 5,609 6,534 Operating expenses: Selling and marketing 1,046 1,334 1,287 1,779 1,622 1,499 1,227 1,356 General and administrative 831 914 948 1,075 1,090 1,263 1,133 642 Research and development 1,241 1,425 1,517 1,762 1,628 1,542 1,587 2,123 .................................................................................................................. Total operating expenses 3,118 3,673 3,752 4,616 4,340 4,304 3,947 4,121 .................................................................................................................. Income from operations 1,712 2,988 2,385 3,073 2,069 3,801 1,662 2,413 Other income, net 177 239 221 261 189 417 103 353 .................................................................................................................. Income before income taxes 1,889 3,227 2,606 3,334 2,258 4,218 1,765 2,766 Provision for income taxes 710 1,194 999 1,270 813 1,575 655 997 .................................................................................................................. Net income $ 1,179 $ 2,033 $ 1,607 $ 2,064 $ 1,445 $ 2,643 $ 1,110 $ 1,769 - ------------------------------------------------------------------------------------------------------------------ Net income per common share (1) Basic $ .21 $ .36 $ .28 $ .36 $ .25 $ .45 $ .19 $ .30 Diluted $ .20 $ .34 $ .27 $ .35 $ .24 $ .44 $ .18 $ .30 Weighted average shares of common stock and equivalents: Basic 5,632 5,677 5,709 5,725 5,778 5,855 5,893 5,839 Diluted 5,976 5,942 5,955 5,975 5,956 6,008 6,048 5,890 - ------------------------------------------------------------------------------------------------------------------
(1) Second quarter 1998 includes $.04 per share related to the after-tax effect of net key man life insurance proceeds associated with the death of the Company's former Chairman R. Craig Allison. 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 sales prices for the Common Stock on such market:
High Low - ------------------------------------------------------------------------------------------------------------------ 1997: First Quarter $ 31-3/4 $ 17 Second Quarter 24-1/4 16-3/4 Third Quarter 24 20 Fourth Quarter 26-1/2 20-1/2 1998: FIRST QUARTER $ 23-3/4 $ 18-1/4 SECOND QUARTER 26-1/2 20-1/2 THIRD QUARTER 27-3/4 19-3/4 FOURTH QUARTER 21 11 - ------------------------------------------------------------------------------------------------------------------
At March 1, 1999, the Company had 352 holders of record of its Common Stock and 5,922,543 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. 27 EX-23.1 8 CONSENT OF PWC 1 Exhibit 23.1 CONSENT OF INDEPENDENT ACCOUNTANTS We consent to the incorporation by reference in the registration statements of Tollgrade Communications, Inc. and Subsidiaries on Form S-8 (Registration No. 333-4290 and Registration No. 333-52907) of our report dated January 25, 1999, on our audits of the consolidated financial statements and financial statement schedule of Tollgrade Communications Inc. and subsidiaries as of December 31, 1998 and 1997, and for each of the three years in the period ended December 31, 1998, which report is incorporated by reference or included in this Form 10-K. /s/ PRICEWATERHOUSECOOPERS LLP Pittsburgh, Pennsylvania March 25, 1999 EX-27 9 FDS
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 1998 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 0001002531 TOLLGRADE COMMUNICATIONS, INC. YEAR DEC-31-1998 JAN-01-1998 DEC-31-1998 8,311,353 14,249,164 8,288,740 100,000 13,201,771 44,658,332 7,146,114 3,831,592 49,864,575 4,118,858 0 0 0 1,184,093 44,511,674 49,864,575 45,767,409 510,000 19,620,226 19,620,226 0 50,000 0 11,007,102 4,039,800 0 0 0 0 6,967,302 1.19 1.17
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