-----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, Lf7vzKXw+Vo6QPDg27ZD/P+xA+nnQfzWz6BRV+3DIc6srjZmJjG6muQemVBCd0Xf nBZapktQcebXhO/2TkXkQA== /in/edgar/work/0000912057-00-049717/0000912057-00-049717.txt : 20001115 0000912057-00-049717.hdr.sgml : 20001115 ACCESSION NUMBER: 0000912057-00-049717 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 3 CONFORMED PERIOD OF REPORT: 20000930 FILED AS OF DATE: 20001114 FILER: COMPANY DATA: COMPANY CONFORMED NAME: PEGASYSTEMS INC CENTRAL INDEX KEY: 0001013857 STANDARD INDUSTRIAL CLASSIFICATION: [7374 ] IRS NUMBER: 042787865 STATE OF INCORPORATION: MA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: SEC FILE NUMBER: 001-11859 FILM NUMBER: 765166 BUSINESS ADDRESS: STREET 1: 101 MAIN ST CITY: CAMBRIDGE STATE: MA ZIP: 02142-1590 BUSINESS PHONE: 6173749600 MAIL ADDRESS: STREET 1: 101 MAIN ST CITY: CAMBRIDGE STATE: MA ZIP: 02142-1590 10-Q 1 a2030554z10-q.txt 10-Q SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (MARK ONE) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2000 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM ______ TO _____ Commission File Number: 1-11859 PEGASYSTEMS INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) MASSACHUSETTS 04-2787865 (STATE OR OTHER JURISDICTION OF (IRS EMPLOYER IDENTIFICATION NO.) INCORPORATION OR ORGANIZATION) 101 MAIN STREET CAMBRIDGE, MA 02142-1590 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE) (617) 374-9600 (REGISTRANT'S TELEPHONE NUMBER INCLUDING AREA CODE) Indicate by 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 Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ------- ------- Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. There were 29,438,310 shares of the Registrant's common stock, $.01 par value per share, outstanding on November 8, 2000.
PEGASYSTEMS INC. AND SUBSIDIARIES INDEX TO FORM 10-Q PAGE ---- PART I - FINANCIAL INFORMATION Item 1. Unaudited Condensed Consolidated Financial Statements Condensed Consolidated Balance Sheets at September 30, 2000 and December 31, 1999 3 Condensed Consolidated Statements of Operations for the three- and nine- month periods ended September 30, 2000 and September 30, 1999 4 Condensed Consolidated Statements of Cash Flows for the nine- month periods ended September 30, 2000 and September 30, 1999 5 Notes to Condensed Consolidated Financial Statements 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 11 Item 3. Quantitative and Qualitative Disclosures About Market Risk 19 PART II - OTHER INFORMATION Item 1. Legal Proceedings 19 Item 2. Changes in Securities and Use of Proceeds 20 Item 3. Defaults upon Senior Securities 20 Item 4. Submission of Matters to a Vote of Security Holders 20 Item 5. Other Information 20 Item 6. Exhibits and Reports on Form 8-K 20 SIGNATURES 21
Page 3 OF 21 FORM 10-Q PEGASYSTEMS INC. CONDENSED CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE-RELATED AMOUNTS) (UNAUDITED)
SEPTEMBER 30, December 31, 2000 1999 -------------------- ------------------- ASSETS Current assets: Cash and cash equivalents $25,258 $30,004 Trade and installment accounts receivable, net of allowance for doubtful accounts of $1,034 in 2000 and $1,026 in 1999 34,192 40,716 Prepaid expenses and other current assets 2,499 1,676 -------------------- ------------------- Total current assets 61,949 72,396 Long-term license installments 43,488 36,744 Equipment and improvements, net 6,127 8,335 Purchased software and other assets, net 5,705 7,516 -------------------- ------------------- Total assets $117,269 $124,991 ==================== =================== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable and accrued expenses $13,987 $13,643 Accrued litigation settlement 12,681 -- Deferred revenue 2,449 8,765 Current portion of capital lease obligations 212 198 -------------------- ------------------- Total current liabilities 29,329 22,606 Deferred income taxes 1,000 1,000 Capital lease obligations, net of current portion 93 253 Other long-term liabilities 60 87 -------------------- ------------------- Total liabilities 30,482 23,946 Commitments and contingencies (Note F) Stockholders' Equity: Preferred stock, $.01 par value, 1,000,000 shares authorized; no shares issued and outstanding -- -- Common stock, $.01 par value, 45,000,000 shares authorized; 29,327,570 shares and 28,995,821 shares issued and outstanding in 2000 and 1999, respectively 293 290 Additional paid-in capital 90,123 88,941 Deferred compensation (5) (18) Stock warrant 2,897 2,897 Retained (deficit) earnings (6,243) 9,079 Accumulated comprehensive loss (278) (144) -------------------- ------------------- Total stockholders' equity 86,787 101,045 -------------------- ------------------- Total liabilities and stockholders' equity $117,269 $124,991 ==================== ===================
See notes to condensed consolidated financial statements. Page 4 OF 21 PEGASYSTEMS INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) (UNAUDITED)
THREE MONTHS ENDED NINE MONTHS ENDED SEPT 30, SEPT 30, 2000 1999 2000 1999 -------------- ----------------- --------------- ------------------- REVENUE: Software license $12,946 $ 6,274 $28,210 $ 21,419 Services 9,718 14,235 33,740 35,502 -------------- ----------------- --------------- ------------------- Total revenue 22,664 20,509 61,950 56,921 -------------- ----------------- --------------- ------------------- COST OF REVENUE: Cost of software license 585 586 1,756 1,757 Cost of services 11,127 7,129 28,064 23,769 -------------- ----------------- --------------- ------------------- Total cost of revenue 11,712 7,715 29,820 25,526 -------------- ----------------- --------------- ------------------- GROSS PROFIT 10,952 12,794 32,130 31,395 OPERATING EXPENSES: Research and development 3,557 5,134 11,425 15,364 Selling and marketing 5,853 3,932 17,449 14,851 General and administrative 3,039 2,804 8,244 8,068 Litigation settlement, net of insurance -- -- 14,088 -- recovery -------------- ----------------- --------------- ------------------- Total operating expenses 12,449 11,870 51,206 38,283 -------------- ----------------- --------------- ------------------- (LOSS) INCOME FROM OPERATIONS (1,497) 924 (19,076) (6,888) Installment receivable interest income 900 900 2,743 2,565 Other interest income, net 451 274 1,339 601 Other income (expense), net -- 346 (179) 481 -------------- ----------------- --------------- ------------------- (LOSS) INCOME BEFORE PROVISION FOR (146) 2,444 (15,173) (3,241) INCOME TAXES Provision for income taxes 100 -- 150 -- -------------- ----------------- --------------- ------------------- NET (LOSS) INCOME ($246) $ 2,444 ($15,323) ($3,241) ============== ================= =============== =================== (LOSS) EARNINGS PER SHARE: Basic ($0.01) $0.08 ($0.53) ($0.11) ============== ================= =============== =================== Diluted ($0.01) $0.08 ($0.53) ($0.11) ============== ================= =============== =================== WEIGHTED AVERAGE NUMBER OF COMMON AND COMMON EQUIVALENT SHARES OUTSTANDING: Basic 29,454 28,861 29,173 28,858 ============== ================= =============== =================== Diluted 29,454 31,043 29,173 28,858 ============== ================= =============== ===================
See notes to condensed consolidated financial statements. Page 5 OF 21 PEGASYSTEMS INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) (UNAUDITED)
NINE MONTHS ENDED SEPT 30, 2000 1999 -------------- ---------------- CASH FLOWS FROM OPERATING ACTIVITIES: Net loss ($15,323) ($3,241) Adjustments to reconcile net loss to net cash provided by operating activities: Depreciation and amortization 4,700 5,161 Provision for doubtful accounts 190 2,060 Issuance of compensatory stock option - 85 Changes in operating assets and liabilities: Trade and installment accounts receivable (410) 15,490 Prepaid expenses and other current assets (823) 87 Other long term assets 56 (222) Accounts payable and accrued expenses 344 (1,441) Accrued litigation settlement 12,681 - Deferred revenue (6,316) (13,756) Other long term liabilities (27) 127 -------------- ---------------- Net cash provided by operating activities (4,928) 4,350 -------------- ---------------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of equipment and improvements (723) (1,792) -------------- ---------------- Net cash used in investing activities (723) (1,792) -------------- ---------------- CASH FLOWS FROM FINANCING ACTIVITIES: Payments of capital lease obligation (146) (77) Exercise of stock options 785 423 Sale of stock under employee stock purchase plan 400 414 -------------- ---------------- Net cash provided by financing activities 1,039 760 -------------- ---------------- Effect of exchange rate on cash and cash equivalents (134) 281 -------------- ---------------- NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS (4,746) 3,599 -------------- ---------------- CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 30,004 24,806 -------------- ---------------- CASH AND CASH EQUIVALENTS, END OF PERIOD $25,258 $28,405 ============== ================
See notes to condensed consolidated financial statements. Page 6 OF 21 PEGASYSTEMS INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 2000 NOTE A - BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements of Pegasystems Inc. (the "Company") presented herein have been prepared in accordance with the Securities and Exchange Commission's rules and regulations regarding interim financial reporting. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three- and nine-month periods ended September 30, 2000 are not necessarily indicative of the results that may be expected for the full year ending December 31, 2000. The Company suggests that these condensed consolidated financial statements be read in conjunction with the consolidated financial statements and notes thereto for the year ended December 31, 1999, included in the Company's 1999 Annual Report on Form 10-K/A filed with the Securities and Exchange Commission ("SEC".) NOTE B - REVENUE RECOGNITION The Company's revenue is derived from two sources: software license fees and services fees. Software license fees are generally payable on a monthly basis under license agreements, which generally have a five-year term and may be renewed for additional years at the customer's option. The present value of future license payments is generally recognized as revenue upon customer acceptance. A portion of the fee from each arrangement is deferred and recognized as interest income over the license term. In the case of software license agreement renewals, license fee revenue is recognized upon the commencement of the new license terms. The Company's services revenue is comprised of fees for maintenance, implementation, training and consulting services. Software license customers are offered the option to enter into an annual maintenance contract requiring the customer to pay a monthly maintenance fee renewable on a year-to-year basis. Prepaid maintenance fees are deferred based on the estimated fair value of all the elements of the arrangement and are recognized ratably over the term of the maintenance agreement. The Company's software implementation agreements typically require the Company to provide a specified level of implementation services for a specified fee, typically with additional implementation services available at an hourly rate. Implementation fees for time and material projects are recognized as incurred. Implementation fees for fixed price projects are recognized once the fair value of services and any other elements to be delivered under the arrangement can be determined. Costs associated with fixed price contracts are expensed as incurred. Prior to the point at which the fair value of the elements of a contract can be determined, revenue recognition is limited to amounts equal to costs incurred during the reporting period, resulting in no gross profit. Once the fair values of the elements of a contract are apparent, profit associated with the services elements will begin to be recognized. Training and consulting fees are generally recognized as the services are provided. The Company has adopted the provisions of the American Institute of Certified Public Accountants Statement of Position 98-9, "Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions." While such adoption did not have a material impact on the financial statements of the Company included in this report on Form 10-Q, it may in the future cause a greater portion of contract revenue to be classified as services revenue rather than license revenue. Page 7 of 21 NOTE C - EARNINGS (LOSS) PER SHARE
(in thousands, except per share data) Three Months Ended Nine Months Ended Sept 30, Sept 30, 2000 1999 2000 1999 ------------ ----------- ------------- ------------ Basic Net (loss) income ($246) $2,444 ($15,323) ($3,241) ============ =========== ============= ============ Weighted average common shares outstanding 29,454 28,861 29,173 28,858 ============ =========== ============= ============ Basic (loss) earnings per share ($0.01) $0.08 ($0.53) ($0.11) ============ =========== ============= ============ Diluted Net (loss) income ($246) $2,444 ($15,323) ($3,241) ============ =========== ============= ============ Weighted average common shares outstanding 29,454 28,861 29,173 28,858 Effect of : Assumed exercise of stock options -- 2,182 -- -- ------------ --------- ----------- ------------ Weighted average common shares outstanding, Assuming dilution 29,454 31,043 29,173 28,858 ============ =========== ============= ============ Diluted (loss) earnings per share ($0.01) $0.08 ($0.53) ($0.11) ============ =========== ============= ============
Basic earnings (loss) per share is computed based on the weighted average number of common shares outstanding during the period. Diluted earnings (loss) per share includes, to the extent inclusion of such shares would be dilutive to earnings per share, the effect of outstanding options and warrants, computed using the treasury stock method. For the three-month periods ended September 30, 2000 and 1999, 6,790,825 and 823,626 potential shares, respectively, have been excluded from the calculation, as such effect would be anti-dilutive. For the nine-month periods ended September 30, 2000 and 1999, 4,761,074 and 3,874,863 potential shares, respectively, have been excluded from the calculation, as their effect would be anti-dilutive. As stated in Note G to Notes to Consolidated Financial Statements, the Company entered into an agreement with a director of the Company pursuant to which such director has agreed to purchase 500,000 shares (the "Shares") of the Company's common stock for $2,345,000 from the escrow fund proposed to be established in connection with the settlement of the Chalverus Case (See Note F to Notes to Consolidated Financial Statements.) The Shares have been treated as though issued in August 2000 for purposes of determining weighted average common shares outstanding for computing basic loss per share, even though they were not actually issued as of September 30, 2000, because the Company was obligated in August 2000 to issue the Shares either to the Fund or directly to the director. NOTE D - COMPREHENSIVE INCOME (LOSS) The components of the Company's comprehensive income (loss) are as follows:
Three Months Ended Nine Months Ended Sept 30, Sept 30 (IN THOUSANDS) 2000 1999 2000 1999 - ----------- -------------- -------------- ------------ ------------------ Net (loss) income ($246) $2,444 ($15,323) ($3,241) -------------- -------------- ------------ ------------------ Other Comprehensive (Loss) Foreign currency translation adjustments, net of income taxes (58) 17 (134) 281 -------------- -------------- ------------ ------------------ Comprehensive (loss) income ($304) $2,461 ($15,457) ($2,960) ============== ============== ============ ==================
Page 8 of 21 NOTE E-NEW ACCOUNTING STANDARDS In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities". In June 2000, the FASB issued SFAS No. 138, which amends certain provisions of SFAS 133 to clarify four areas causing difficulties in implementation. The amendment included expanding the normal purchase and sale exemption for supply contracts, permitting the offsetting of certain intercompany foreign currency derivatives and thus reducing the number of third party derivatives, permitting hedge accounting for foreign-currency denominated assets and liabilities, and redefining interest rate risk to reduce sources of ineffectiveness. The Company will adopt SFAS 133 and the corresponding amendments under SFAS 138 on January 1, 2001. SFAS 133, as amended by SFAS 138, is not expected to have a material impact on the Company's financial position or results of operation. The Securities and Exchange Commission has released Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements," which sets forth its views regarding how revenue should be recognized in financial statements. The Company's revenue recognition practices are in conformity with accounting standards generally accepted in the United States of America, and the Company does not expect that this bulletin will have a material impact on the Company's financial position or results of operation. NOTE F - COMMITMENTS AND CONTINGENCIES COMPANY LITIGATION CLASS ACTION LITIGATION The Company has been involved in two matters involving litigation related to restatements of its financial statements (the Chalverus Case and the Gelfer Case). As described below, the Company has reached agreements with the plaintiffs to settle both cases and recorded a charge of $14.1 million (net of insurance reimbursements of $4.3 million) against operations in the quarter ended June 30, 2000, reflecting the estimated cost of the settlements and remaining legal costs. CHALVERUS CASE As a result of complaints filed in 1997 and 1998 in the United States District Court of Massachusetts, which were subsequently consolidated into a single complaint, (the "Amended Complaint" or the "Chalverus Case"), the Company has been engaged in litigating matters related to a restatement of its financial statements in 1997. The Amended Complaint alleged that the Company and two officers caused the issuance of false and misleading financial statements for the fiscal quarter ended June 30, 1997 by inappropriately including $5 million in revenue from a series of contracts with First Data Resources, Inc. The Amended Complaint alleged that as a result of the inclusion of such revenue in the Company's financial statements for that quarter, the market price of the Company's common stock was artificially inflated, causing damage to purchasers of the Company's common stock. Page 9 OF 21 The parties have agreed in writing to a settlement of the litigation, pursuant to which the Company will pay $5.25 million in shares of its common stock or in cash, at the Company's option, for the benefit of a stipulated class defined to include all purchasers of the Company's common stock between July 29, 1997 and October 29, 1997, inclusive, and the action will be dismissed with prejudice. The parties' settlement is subject to notice to class members and to approval by the United States District Court of Massachusetts (the "Court"). The Court has set December 18, 2000 as the date to consider such approval hearing. GELFER CASE In December 1998, a complaint also purporting to be a class action was filed with the Court after the Company's announcement on November 24, 1998 that it may be recording revenue adjustments to prior periods. In April 1999, the plaintiffs filed their First Amended Class Action Complaint (the "Gelfer Complaint") in that action following the January 20, 1999 restatement. The Gelfer Complaint involves the Company and two officers and alleges violations of the Exchange Act. The Complaint was filed on behalf of a purported class of persons who purchased the Company's common stock between April 2, 1998 through November 23, 1998. The parties entered a settlement by which the Company will pay a total of $12.25 million, of which at least $4.5 million is a cash payment and the remaining $7.75 million is a payment in shares of its common stock or in cash, at the Company's option. The settlement is for the benefit of stipulated class defined to include all purchasers of the Company's common stock between April 2,1998 and November 23,1998, inclusive, and the action will be dismissed with prejudice. The parties' settlement is subject to notice to class members and further approval by the Court. ERNST & YOUNG CASE On June 9, 2000, the Company and two of its officers filed a complaint against Ernst & Young LLP and Alan B. Levine (a former partner of Ernst & Young LLP) in a Massachusetts state court. The complaint alleges that the defendants committed professional malpractice, breached contractual and fiduciary duties owed to the Company, and issued false and misleading public statements in connection with accounting advice that Ernst & Young LLP rendered to the Company regarding the revenues in question in the Chalverus Case discussed above. The Company seeks compensatory damages, including contribution, for losses and other costs incurred in connection with the Chalverus Case. The defendants have moved to dismiss the complaint on the grounds that the matter should be arbitrated. FORMAL ORDER OF PRIVATE INVESTIGATION In May 1999, the Boston office of the SEC issued a Formal Order of Private Investigation of the Company and unidentified individuals, currently or formerly associated with the Company, concerning past accounting matters, financial reports, and other public disclosures and trading activity in the Company's securities during 1997 and 1998. The Company is cooperating fully with the investigation. NOTE G - SALE OF STOCK In August 2000, the Company entered into an agreement with a director of the Company pursuant to which such director has agreed to purchase 500,000 shares (the "Shares") of the Company's common stock for $2,345,000 from the escrow fund (the "Fund") proposed to be established in connection with the settlement of the Chalverus Case (See Note F to Notes to Consolidated Financial Statements). However, if (i) the case does not settle on or before December 31, 2000, (ii) the Fund is not established in connection with the settlement of the case, (iii) the court before which the case is pending does not approve the settlement on or before December 31, 2000 or (iv) the Fund does not sell Page 10 OF 21 the shares to such director, then the director has agreed to purchase, and the Company has agreed to sell, such number of shares at the same price. The Shares have been treated as though issued in August 2000 for purposes of determining weighted average common shares outstanding for computing basic loss per share, even though they were not actually issued as of September 30, 2000, because the Company was obligated in August 2000 to issue the Shares either to the Fund or directly to the director. Page ll of 21 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Company's business has historically experienced a lack of predictable revenues. The timing of revenue recognition is related to the completion of implementation services and acceptance of the licensed software by the customer, the timing of which has proven to be difficult to predict accurately. In 1999, there was a reduction in the size of the Company's sales force of almost 50%. Given the intense competition for qualified sales personnel and the significant amount of time required to train new sales personnel, this reduction may adversely affect the Company's ability to meet its future sales goals. In addition, because of the reduced size of the Company's sales force, the Company is more focused on closing larger but fewer license transactions than in the past. This may increase the volatility in the Company's quarterly operating results. The Company's independent public accountants have identified in connection with their audits of the Company's 1997, 1998, and 1999 financial statements material weaknesses in the Company's internal control environment. See Note 1 to the Consolidated Financial Statements included in the Company's 1999 Annual Report on Form 10-K/A. RESULTS OF OPERATIONS As of January 1, 1999, the Company refined its method of classifying costs and expenses by directly charging costs to their appropriate functional classification. During the third quarter of 1999, the Company further refined its methodology of classifying costs and expenses. Results for the first six months of 1999 have been reclassified to conform with the current methodology. THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2000 COMPARED TO THREE AND NINE MONTHS ENDED SEPTEMBER 30, 1999 REVENUE Total revenue for the three-month period ended September 30, 2000 (the "2000 Three Month Period") increased 10.5% to $22.7 million from $20.5 million for the three-month period ending September 30, 1999 (the "1999 Three Month Period"). Total revenue for the nine-month period ended September 30, 2000 (the "2000 Nine Month Period") increased 8.8% to $62.0 million from $56.9 million for the nine-month period ended September 30, 1999 (the "1999 Nine Month Period"). The increase in total revenue was due to an increase in software license revenue, partially offset by a decrease in services revenue. Software license revenue for the 2000 Three Month Period increased 106.3% to $12.9 million from $6.3 million for the 1999 Three Month Period. Software license revenue for the 2000 Nine Month Period increased 31.7% to $28.2 million from $21.4 million for the 1999 Nine Month Period. The increases were due primarily to a rise in software license renewals and acceptances by new and existing customers and less allocation of a portion of license revenue to services revenue in accordance with generally accepted accounting principles. Services revenue for the 2000 Three Month Period decreased 31.7% to $9.7 million from $14.2 million for the 1999 Three Month Period. The decrease was due primarily to the reduction of revenue recognized from previously deferred projects and a reduced allocation of software license revenue to services revenue under generally accepted accounting principles. Services revenue for the 2000 Nine Month Period decreased 5.0% to $33.7 million from $35.5 million for the 1999 Nine Month Period. The decrease in service revenue for the 2000 Nine Month Period was primarily attributable to a reduced allocation of software license revenue to services revenue in accordance with generally accepted accounting principles, partially offset by an increase in maintenance revenue during the nine months ended September 30, 2000. Page 12 OF 21 COST OF REVENUE Cost of software license revenue for the 2000 Three and Nine Month Periods and the 1999 Three and Nine Month Periods remained constant at $0.6 million and $1.8 million, respectively. Cost of software license relates to the amortization associated with a stock purchase warrant issued by the Company in June 1997, and the Company's acquisition of First Data Resources Corporation's ESP software product. These costs are being amortized through December 31, 2002. Cost of software license as a percentage of license revenue for the 2000 Three Month Period decreased to 4.5% from 9.3% in the 1999 Three Month Period. Cost of software license as a percentage of license revenue for the 2000 Nine Month Period decreased to 6.2% from 8.2% in the 1999 Nine Month Period. The lower percentages are due to the increase in license revenue. Cost of services consists primarily of the costs of providing implementation, consulting, maintenance, and training services. Cost of services for the 2000 Three Month Period increased 56.1% to $11.1 million from $7.1 million for the 1999 Three Month Period. Cost of services for the 2000 Nine Month Period increased 18.1% to $28.1 million from $23.8 million for the 1999 Nine Month Period. Cost of services as a percentage of services revenue increased to 114.5% for the 2000 Three Month Period from 50.1% for the 1999 Three Month Period. Cost of services as a percentage of services revenue increased to 83.2% for the 2000 Nine Month Period from 67.0% for the 1999 Nine Month Period. Services gross profit in the 1999 Three Month and Nine Month Periods had been favorably impacted due to recognition of service revenue that had been previously deferred; the costs associated with the deferred revenue had been recognized in prior periods. During the 2000 Three Month and Nine Month Periods, service margins declined due to a lower recovery rate on hours worked and costs associated with increased staffing - such as compensation, benefits, travel, and facilities. The lower recovery was also due to investing in field deployment of an eCRM template for new and existing customers, investing in partnership relationships, as well as a lower allocation of license revenue to service revenue as required by generally accepted accounting principles. OPERATING EXPENSES Research and development expenses for the 2000 Three Month Period decreased 30.7% to $3.6 million from $5.1 million for the 1999 Three Month Period. Research and development expenses for the 2000 Nine Month Period decreased 25.6% to $11.4 million from $15.4 million for the 1999 Nine Month Period. As a percentage of total revenue, research and development expenses decreased to 15.7% for the 2000 Three Month Period from 25.0% for the 1999 Three Month Period. As a percentage of total revenue, research and development expenses decreased to 18.4% for the 2000 Nine Month Period from 27.0% for the 1999 Nine Month Period. These decreases were due to decreased staffing costs - such as compensation, benefits, and travel. These cost reductions are not indicative of management's commitment to research and development projects. Management believes that the current level of staffing will enable the Company to successfully innovate. Selling and marketing expenses for the 2000 Three Month Period increased 48.9% to $5.9 million from $3.9 million for the 1999 Three Month Period. Selling and marketing expenses for the 2000 Nine Month Period increased 17.5% to $17.4 million from $14.9 million for the 1999 Nine Month Period. As a percentage of total revenue, selling and marketing expenses increased to 25.8% for the 2000 Three Month Period from 19.2% for the 1999 Three Month Period. As a percentage of total revenue, selling and marketing expenses increased to 28.2% for the 2000 Nine Month Period from 26.1% for the 1999 Nine Month Period. These increases were due to additional costs associated with marketing programs such as trade shows and additional employee related costs- such as compensation, benefits, and travel. General and administrative expenses for the 2000 Three Month Period increased 8.4% to $3.0 million from $2.8 million for the 1999 Three Month Period. General and administrative expenses for the 2000 Nine Month Period increased 2.2% to $8.2 million from $8.1 million for the 1999 Nine Month Period. These increased costs were due to costs associated with increased staffing - such as compensation, benefits, and travel. As a percentage of total revenue, general and administrative expenses decreased to 13.4% for the 2000 Three Month Period from 13.7% for the 1999 Three Month Period. As a percentage of total revenue, general and administrative expenses decreased to 13.3% for the 2000 Nine Month Period from 14.2% for the 1999 Nine Month Period. These decreases were due primarily to the increase in software license revenue. Page 13 OF 21 LITIGATION SETTLEMENT The Company has been involved in two matters involving litigation related to restatements of its financial statements (the Chalverus Case and the Gelfer Case). The Company has reached agreements in principle with the plaintiffs in both matters and has recorded a charge of $14.1 million (net of insurance reimbursements of $4.3 million) in the quarter ended June 30, 2000, reflecting the estimated cost of the settlements and the remaining legal costs. See Note F of Notes to Consolidated Financial Statements for additional information. INSTALLMENT RECEIVABLE INTEREST INCOME Installment receivable interest income, which consists of the portion of all license fees under long-term software license agreements that is attributable to the time value of money, remained constant at $0.9 million for the 2000 Three Month Period and the 1999 Three Month Period. Installment receivable interest income increased 6.9% to $2.7 million for the 2000 Nine Month Period from $2.6 million for the 1999 Nine Month Period. This change was primarily due to the increase in the Company's installment receivable balance. INTEREST INCOME, NET Interest income, net increased 64.6% to $0.5 million for the 2000 Three Month Period from $0.3 million for the 1999 Three Month Period. Interest income, net increased 122.8% to $1.3 million for the 2000 Nine Month Period from $0.6 million for the 2000 Nine Month Period. These increases were due primarily to additional interest income generated on cash and cash equivalents due to a larger average cash balance. OTHER INCOME (EXPENSE), NET Other income (expense), net, which consists primarily of reseller development funds received from third-party resellers of computer hardware products and unrealized currency exchange gains or losses on foreign denominated accounts receivable, was zero for the 2000 Three Month Period and $0.3 million of net income for the 1999 Three Month Period. Other income, net, decreased 137.2% to $0.2 million net expenses for the 2000 Nine Month Period from $0.5 million net income for the 1999 Nine Month Period. The decrease was due primarily to a larger unrealized currency exchange losses for foreign denominated accounts receivable. PROVISION FOR INCOME TAXES The tax provision for the 2000 Three and Nine Month Periods consisted of foreign taxes in the amount of $0.1 million and $0.2 million respectively. There was no tax provision for the 1999 Three and Nine Month Periods. No benefit was recorded for domestic losses incurred due to uncertainty regarding eventual utilization of these losses. LIQUIDITY AND CAPITAL RESOURCES Since its inception, the Company has funded its operations primarily through cash flow from operations, bank borrowings, and proceeds from the Company's public stock offerings. At September 30, 2000, the Company has cash and cash equivalents of approximately $25.3 million and working capital of approximately $32.6 million. The Company's approach of charging license fees payable in installments over the term of its license has historically deferred the receipt of cash and limits the availability of working capital in the short term while having a stabilizing effect on cash and working capital for the longer term. Net cash used by operating activities for the 2000 Nine Month Period was $4.9 million, as compared to $4.4 million of net cash provided during the 1999 Nine Month Period. This change was primarily due to an increase Page 14 OF 21 in operating expense during the 2000 Nine Month Period and the additional collection of long term outstanding receivables during the 1999 Nine Month Period. Net cash used in investing activities was approximately $0.7 million during the 2000 Nine Month Period, as compared to $1.8 million for the 1999 Nine Month Period. This change was primarily due to fewer purchases of property and equipment, consisting mainly of computer hardware and software, and furniture and fixtures. Net cash provided by financing activities was $1.0 million during the 2000 Nine Month Period, as compared, to $0.8 million used in the 1999 Nine Month Period. The increase in cash provided was primarily due to additional stock option exercises and the sale of stock under the Company's Employee Stock Purchase Plan. The Company anticipates, assuming the entry of Final Judgment in the Chalverus Case, that it will pay out $5 million in either cash or an amount in shares of the Company's common stock of equivalent value during the fourth quarter of 2000. (See Note F to Notes to Consolidated Financial Statements.) The Company anticipates, assuming the entry of Final Judgment in the Gelfer Case, that it will pay out $7.75 million in either cash or an amount in shares of the Company's common stock of equivalent value during the fourth quarter of 2000. (See Note F to Notes to Consolidated Financial Statements.) The Company has paid $4.5 million in accordance with the Gelfer settlement and $250,000 in accordance with the Chalverus settlement during the third quarter of 2000. The Company received $4.3 million in insurance settlement during the second Quarter of 2000. The Company has entered into an agreement with a director of the Company pursuant to which such director has agreed to purchase 500,000 shares of the Company's common stock for $2,345,000 from the escrow fund (the "Fund") proposed to be established in connection with the settlement of the Chalverus Case (See Note F to Notes to Consolidated Financial Statements). However, if (i) the case does not settle on or before December 31, 2000, (ii) the Fund is not established in connection with the settlement of the case, (iii) the court before which the case is pending does not approve the settlement on or before December 31, 2000 or (iv) the Fund does not sell the shares to such director, then the director has agreed to purchase, and the Company has agreed to sell, such number of shares at the same price. The Company believes that current cash and cash equivalents will be sufficient to fund the Company's operations for the near term. There can be no assurance that additional capital which may be required to support further revenue growth will not be required or that any such required additional capital will be available on reasonable terms, if at all, at such time as required by the Company. INFLATION Inflation has not had a significant impact on the Company's operating results to date, and the Company does not expect it to have a significant impact in the future. The Company's license and maintenance fees are typically subject to annual increases based on recognized inflation indexes. FORWARD-LOOKING STATEMENTS This report on Form 10-Q contains certain forward-looking statements. For this purpose, any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the generality of the foregoing, the words "believes", "anticipates", "plans" "expects", and similar expressions are intended to identify forward-looking statements. There are a number of important factors that could cause the Company's actual results to differ materially from those indicated by forward-looking statements made in this report and presented elsewhere by management from time to time. Some of the important risks and uncertainties that may cause the Company's operating results to differ materially and adversely are discussed below. THE COMPANY IS PRESENTLY A DEFENDANT IN TWO PRIVATE SECURITIES LITIGATION MATTERS. The Company has entered into a memorandum of understanding with plaintiffs' counsel in each of these cases with respect to proposed settlements, the financial impact of which are reflected in the Company's financial statements contained in this report on Form 10-Q. The proposed settlements are contingent, however, on final court approval. The failure to settle either of these cases on the proposed terms could result in the Company being required to pay substantial damages or higher settlement costs, incurring substantial defense costs and suffering diversion of management time and attention, any of which could have a material adverse effect on the Company's financial position or results of operation. THE COMPANY IS BEING INVESTIGATED BY THE SECURITIES AND EXCHANGE COMMISSION. In May of 1999, the Boston office of the SEC issued a Formal Order of Private Investigation of the Company Page 15 OF 21 and, as a result, the Company and certain individuals, currently or formerly associated with the Company, are presently being investigated by the SEC concerning past accounting matters, financial reports and other public disclosures and trading activity in the Company's securities during 1997 and 1998. Such investigation may result in the SEC imposing fines on the Company or taking other measures that may have a material adverse impact on the Company's financial position or results of operations. In addition, regardless of the outcome of the investigation, it is likely that the Company will incur substantial defense costs and that such investigation will cause a diversion of management time and attention. Finally, the negative publicity resulting from the investigation has made and may continue to make it more difficult for the Company to close sales, which in turn could have a material adverse impact on the Company's financial position or results of operations. THE COMPANY CONTINUED TO HAVE MATERIAL WEAKNESSES IN ITS FINANCIAL CONTROL ENVIRONMENT. The Company's independent public accountants have identified in connection with their audits of the Company's 1997, 1998, and 1999 financial statements material weaknesses in the Company's internal control environment. In connection with the completion of the 1999 audit, they informed the Company that their management letter would include a recommendation to, among other things, strengthen the resources of the Company's finance organization to improve financial accounting and internal controls. Although the Company is actively seeking to hire additional qualified personnel into such organization, these efforts have proved to be difficult and there can be no assurance that the Company will be successful in these efforts in the near term. The inability to hire such personnel could have a material adverse impact on the Company's reputation and on its financial condition and results of operations. THE COMPANY'S STOCK PRICE HAS BEEN VOLATILE. Quarterly results have and are likely to fluctuate significantly. The market price of Pegasystems' common stock has been and may continue to be highly volatile. Factors that are difficult to predict, such as quarterly revenues and operating results, statements and ratings by financial analysts, overall market performance and the outcome of litigation, will have a significant effect on the price for shares of Pegasystems' common stock. Revenues and operating results have varied considerably in the past from period to period and are likely to vary considerably in the future. The Company plans product development and other expenses based on anticipated future revenue. If revenue falls below expectations, financial performance is likely to be adversely affected because only a small portion of expenses vary with revenue. As a result, period-to-period comparisons of operating results are not necessarily meaningful and should not be relied upon to predict future performance. THE TIMING OF LICENSE REVENUES IS RELATED TO THE COMPLETION OF IMPLEMENTATION SERVICES AND PRODUCT ACCEPTANCE BY THE CUSTOMER, THE TIMING OF WHICH HAS BEEN DIFFICULT TO PREDICT ACCURATELY. There can be no assurance that Pegasystems will be profitable on an annual or quarterly basis or that earnings or revenues will meet analysts' expectations. Fluctuations may be particularly pronounced because a significant portion of revenues in any quarter is attributable to product acceptance or license renewal by a relatively small number of customers. Fluctuations also reflect a policy of recognizing license fee revenue upon product acceptance or license renewal in an amount equal to the present value of the total committed license payment due during the term. Customers generally do not accept products until the end of a lengthy sales cycle and an implementation period, typically ranging from one to six months but in some cases significantly longer. Risks over which the Company has little or no control, including customers' budgets, staffing allocation, and internal authorization reviews, can significantly affect the sales and acceptance cycles. Changes dictated by customers may delay product implementation and revenue recognition. The Company's business and financial and operating results have experienced and may continue to experience significant seasonality. THE COMPANY WILL NEED TO DEVELOP NEW PRODUCTS, EVOLVE EXISTING ONES, AND ADAPT TO TECHNOLOGICAL CHANGE. Technological developments, customer requirements, programming languages and industry standards change frequently in the Company's markets. As a result, success in current markets and new markets will depend upon the Company's ability to enhance current products, to develop and introduce new products that meet customer needs, keep pace with technological changes, respond to competitive products, and achieve market acceptance. Product development requires substantial investments for research, refinement and testing. There can be no assurance that the Company will Page 16 OF 21 have sufficient resources to make necessary product development investments. Pegasystems may experience difficulties that will delay or prevent the successful development, introduction or implementation of new or enhanced products. Inability to introduce or implement new or enhanced products in a timely manner would adversely affect future financial performance. The Company's products are complex and may contain errors. Errors in products will require the Company to ship corrected products to customers. Errors in products could cause the loss of or delay in market acceptance or sales and revenue, the diversion of development resources, injury to the Company's reputation, or increased service and warranty costs which would have an adverse effect on financial performance. THE COMPANY HAS HISTORICALLY SOLD TO THE FINANCIAL SERVICES MARKET. This market is consolidating rapidly, and faces uncertainty due to many other factors. The Company has historically derived a significant portion of its revenue from customers in the financial services market, and its future growth depends, in part, upon increased sales to this market. Competitive pressures, industry consolidation, decreasing operating margins within this industry, currency fluctuations, geographic expansion and deregulation affect the financial condition of the Company's customers and their willingness to pay. In addition, customers' purchasing patterns are somewhat discretionary. As a result, some or all of the factors listed above may adversely affect the demand by customers. The financial services market is undergoing intense domestic and international consolidation. In recent years, several customers have been merged or consolidated. Future mergers or consolidations may cause a decline in revenues and adversely affect the Company's future financial performance. THE COMPANY'S GROWTH STRATEGY REQUIRES EXPANSION INTO NEW VERTICAL MARKETS. The results of this strategy are uncertain. A critical part of the Company's growth strategy is to continue selling products to markets other than financial services, such as insurance, telecommunications, and health care. The Company will need to hire additional personnel with expertise in these other markets and otherwise invest in people and technologies to facilitate this expansion. Deterioration in economic or market conditions generally may also adversely affect the demand by customers in these other markets. There can be no assurance that the Company will be successful in selling products to these other markets or in continuing to attract and retain personnel with the necessary industry expertise. Inability to effectively penetrate these other markets could have an adverse effect on future financial performance. IF EXISTING CUSTOMERS DO NOT RENEW THEIR LICENSES, THE COMPANY'S FINANCIAL RESULTS MAY SUFFER. A significant portion of total revenue has been attributable to license renewals. While historically a significant number of customers have renewed their licenses, there can be no assurance that a significant number of customers will continue to renew expiring licenses. A decrease in license renewals absent offsetting revenue from other sources would have a material adverse effect on future financial performance. In addition, possible transition to a prepaid extended term license may have a material adverse impact on the amount of license renewal revenues in future periods. THE COMPANY DEPENDS ON CERTAIN KEY PERSONNEL AND MUST BE ABLE TO ATTRACT AND RETAIN QUALIFIED PERSONNEL IN THE FUTURE. The business is dependent on a number of key, highly skilled technical, managerial, consulting, sales and marketing personnel, including Mr. Trefler, the Company's Chief Executive Officer. The loss of key personnel could adversely affect financial performance. The Company does not have any significant key-man life insurance on any officers or employees and does not plan to put any in place. The Company's success will depend in large part on the ability to hire and retain qualified personnel. The number of potential employees who have the extensive knowledge of computer hardware and operating systems needed to develop, sell and maintain its products is limited, and competition for their services is intense and there can be no assurance that the Company will be able to attract and retain such personnel. If the Company is unable to do so, the Company's business, operating results, and financial condition could be materially adversely affected. THE MARKET FOR THE COMPANY'S OFFERINGS IS INCREASINGLY AND INTENSELY COMPETITIVE, RAPIDLY CHANGING, AND HIGHLY FRAGMENTED. The market for customer relationship management software and related consulting and training services is intensely competitive and highly fragmented. The Company currently encounters significant competition from internal information Page 17 OF 21 systems departments of potential or existing customers that develop custom software. It also competes with companies that target the customer interaction and workflow markets and professional services organizations that develop custom software in conjunction with rendering consulting services. Competition for market share and pressure to reduce prices and make sales concessions are likely to increase. Many competitors have far greater resources and may be able to respond more quickly and efficiently to new or emerging technologies, programming languages or standards or to changes in customer requirements or preferences. Competitors may also be able to devote greater managerial and financial resources to develop, promote and distribute products and provide related consulting and training services. There can be no assurance that the Company will be able to compete successfully against current or future competitors or that the competitive pressures faced by the Company will not materially adversely affect its business, operating results, and financial condition. THE COMPANY MUST MANAGE INCREASED BUSINESS COMPLEXITY AND GROWTH EFFECTIVELY. The business has grown in size, geographic scope and complexity and product offerings and the customer base have expanded. This growth and expansion have placed, and are expected to continue to place, a significant strain on management, operations and capital needs. Continued growth will require the Company to hire, train and retrain many employees in the United States and abroad, particularly additional sales and financial personnel. The Company will also need to enhance its financial and managerial controls and reporting systems. There can be no assurance that the Company will attract and retain the personnel necessary to meet its business challenges. Failure to manage growth effectively may adversely affect future financial performance. THE COMPANY SUFFERED RECENT ATTRITION IN ITS SALES FORCE. In 1999, there was a reduction in the size of the Company's sales force of almost 50%. Given the intense competition for qualified sales personnel and significant amount of time required to train new sales personnel, this reduction may adversely affect the Company's ability to meet its future sales goals. In addition, because of the reduced size of the Company's sales force, the Company is more focused on closing larger but fewer license transactions than in the past. This may increase the volatility in the Company's quarterly operating results. THE COMPANY RELIES ON CERTAIN THIRD PARTY RELATIONSHIPS. The Company has a number of relationships with third parties that are significant to sales, marketing and support activities and product development efforts. The Company relies on relational database management system applications and development tool vendors, software and hardware vendors, and consultants to provide marketing and sales opportunities for the direct sales force and to strengthen the Company's products through the use of industry-standard tools and utilities. The Company also has relationships with third parties that distribute its products. In particular, the Company relies on its relationship with First Data Corporation for the distribution of products to the credit card and mutual fund markets. There can be no assurance that these companies, most of which have significantly greater financial and marketing resources, will not develop or market products that compete with those of the Company in the future or will not otherwise end their relationships with or support of the Company. THE COMPANY MAY FACE PRODUCT LIABILITY AND WARRANTY CLAIMS. The Company's license agreements typically contain provisions intended to limit the nature and extent of the Company's risk of product liability and warranty claims. There is a risk that a court might interpret these terms in a limited way or could hold part or all of these terms to be unenforceable. Also, there is a risk that these contract terms might not bind a party other than the direct customer. Furthermore, some of the Company's licenses with its customers are governed by non-U.S. law, and there is a risk that foreign law might give the Company less or different protection. Although the Company has not experienced any material product liability claims to date, a product liability suit or action claiming a breach of warranty, whether or not meritorious, could result in substantial costs and a diversion of management's attention and the Company's resources. THE COMPANY FACES RISKS FROM OPERATIONS AND CUSTOMERS BASED OUTSIDE OF THE U.S. Sales to customers headquartered outside of the United States represented approximately 21.4%, 22.6%, Page 18 OF 21 and 16.5% of the Company's total revenue in 1999, 1998, and 1997, respectively. The Company, in part through its wholly-owned subsidiaries based in the United Kingdom, Singapore, Sweden, Canada, and Australia, markets products and renders consulting and training services to customers based in Canada, the United Kingdom, France, Switzerland, Ireland, Luxembourg, Mexico, Sweden, Australia, Austria, Hong Kong and Singapore. The Company has established offices in continental Europe and in Australia. The Company believes that its continued growth will necessitate expanded international operations requiring a diversion of managerial attention and financial resources. The Company anticipates hiring additional personnel to accommodate international growth, and the Company may also enter into agreements with local distributors, representatives, or resellers. If the Company is unable to do one or more of these things in a timely manner, the Company's growth, if any, in its foreign operations will be restricted, and the Company's business, operating results, and financial condition could be materially and adversely affected. In addition, there can be no assurance that the Company will be able to maintain or increase international market demand for its products. Most of the Company's international sales are denominated in U.S. dollars. Accordingly, any appreciation of the value of the U.S. dollar relative to the currencies of those countries in which the Company distributes its products may place the Company at a competitive disadvantage by effectively making its products more expensive as compared to those of its competitors. Additional risks inherent in the Company's international business activities generally include unexpected changes in regulatory requirements, increased tariffs and other trade barriers, the costs of localizing products for local markets and complying with local business customs, longer accounts receivable patterns and difficulties in collecting foreign accounts receivable, difficulties in enforcing contractual and intellectual property rights, heightened risks of political and economic instability, the possibility of nationalization or expropriation of industries or properties, difficulties in managing international operations, potentially adverse tax consequences (including restrictions on repatriating earnings and the threat of "double taxation"), enhanced accounting and internal control expenses, and the burden of complying with a wide variety of foreign laws. There can be no assurance that one or more of these factors will not have a material adverse effect on the Company's foreign operations, and, consequentially, the Company's business, operating results, and financial condition. THE COMPANY FACES RISKS RELATED TO INTELLECTUAL PROPERTY CLAIMS OR APPROPRIATION OF ITS INTELLECTUAL PROPERTY RIGHTS. The Company relies primarily on a combination of copyright, trademark and trade secrets laws, as well as confidentiality agreements to protect its proprietary rights. In October 1998, the Company was granted a patent by the United States Patent and Trademark Office relating to the architecture of the Company's systems. There can be no assurance that such patent will not be invalidated or circumvented or that rights granted thereunder or the description contained therein will provide competitive advantages to the Company's competitors or others. Moreover, despite the Company's efforts to protect its proprietary rights, unauthorized parties may attempt to copy aspects of the Company's products or to obtain the use of information that the Company regards as proprietary. In addition, the laws of some foreign countries do not protect the Company's proprietary rights to as great an extent as do the laws of the United States. There can be no assurance that the Company's means of protecting its proprietary rights will be adequate or that the Company's competitors will not independently develop similar technology. The Company is not aware that any of its products infringe the proprietary rights of third parties. There can be no assurance, however, that third parties will not claim infringement by the Company with respect to current or future products. The Company expects that software product developers will increasingly be subject to infringement claims as the number of products and competitors in the Company's industry segment grows and the functionality of products in different industry segments overlaps. Any such claims, with or without merit, could be time-consuming, result in costly litigation, cause product shipment delays, or require the Company to enter into royalty or licensing agreements. Such royalty or licensing agreements, if required, may not be available on terms acceptable to the Company or at all, which could have a material adverse effect upon the Company's business, operating results, and financial condition. Page 19 OF 21 PEGASYSTEMS INC. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Market risk represents the risk of loss that may affect the Company due to adverse changes in financial market prices and rates. The Company's market risk exposure is primarily the result of fluctuations in foreign exchange rates. The Company has not entered into derivative or hedging transactions to manage risk in connection with such fluctuations. Certain of the Company's international sales are denominated in foreign currencies. The price in dollars of products sold outside the United States in foreign currencies will vary as the value of the dollar fluctuates against such foreign currencies. Although the Company's sales denominated in foreign currencies in 1999 and the nine months ended September 30, 2000 were not material, there can be no assurance that such sales will not be material in the future and that there will not be increases in the value of the dollar against such currencies that will reduce the dollar return to the Company on the sale of its products in such foreign currencies. PART II - OTHER INFORMATION: Item 1. Legal Proceedings COMPANY LITIGATION CLASS ACTION LITIGATION The Company has been involved in two matters involving litigation related to restatements of its financial statements (the Chalverus Case and the Gelfer Case). As described below, the Company has reached agreements with the plaintiffs to settle both cases and has recorded a charge of $14.1 million (net of insurance reimbursements of $4.3 million) against operations in the quarter ended June 30, 2000, reflecting the estimated cost of the settlements and remaining legal costs. CHALVERUS CASE As a result of complaints filed in 1997 and 1998 in the United States District Court of Massachusetts, which were subsequently consolidated into a single complaint, (the "Amended Complaint" or the "Chalverus Case"), the Company has been engaged in litigating matters related to a restatement of its financial statements in 1997. The Amended Complaint alleged that the Company and two officers caused the issuance of false and misleading financial statements for the fiscal quarter ended June 30, 1997 by inappropriately including $5 million in revenue from a series of contracts with First Data Resources, Inc. The Amended Complaint alleged that as a result of the inclusion of such revenue in the Company's financial statements for that quarter, the market price of the Company's common stock was artificially inflated, causing damage to purchasers of the Company's common stock. The parties have agreed in writing to a settlement of the litigation, pursuant to which the Company will pay $5.25 million in shares of its common stock or in cash, at the Company's option, for the benefit of a stipulated class defined to include all purchasers of the Company's common stock between July 29, 1997 and October 29, 1997, inclusive, and the action will be dismissed with prejudice. The parties' settlement is subject to notice to class members and to approval by the United States District Court of Massachusetts (the "Court"). The Court has set December 18, 2000 as the date to consider such approval hearing. Page 20 OF 21 GELFER CASE In December 1998, a complaint also purporting to be a class action was filed with the Court after the Company's announcement on November 24, 1998 that it may be recording revenue adjustments to prior periods. In April 1999, the plaintiffs filed their First Amended Class Action Complaint (the "Gelfer Complaint") in that action following the January 20, 1999 restatement. The Gelfer Complaint involves the Company and two officers and alleges violations of the Exchange Act. The Complaint was filed on behalf of a purported class of persons who purchased the Company's common stock between April 2, 1998 through November 23, 1998. The parties entered a settlement by which the Company will pay a total of $12.25 million, of which at least $4.5 million is a cash payment and the remaining $7.75 million is a payment in shares of its shares of its common stock or in cash, at the Company's option. The Ssettlement is for the benefit of stipulated class defined to include all purchasers of the Company's common stock between April 2,1998 and November 23,1998, inclusive, and the action will be dismissed with prejudice. The parties' settlement is subject to notice to class members and further approval by the Court. FORMAL ORDER OF PRIVATE INVESTIGATION In May 1999, the Boston office of the SEC issued a Formal Order of Private Investigation of the Company and unidentified individuals, currently or formerly associated with the Company, concerning past accounting matters, financial reports, and other public disclosures and trading activity in the Company's securities during 1997 and 1998. The Company is cooperating fully with the investigation. Item 2. Changes in Securities and Use of Proceeds None. Item 3. Defaults upon Senior Securities Not applicable. Item 4. Submission of Matters to a Vote of Security Holders None. Item 5. Other Information None Item 6. Exhibits and Reports on Form 8-K (a) Exhibits: 10.1 Letter Agreement Between the Company and Alexander V. d'Arbeloff dated August 23, 2000 27.1 Financial Data Schedule Page 21 OF 21 PEGASYSTEMS INC. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. PEGASYSTEMS INC. Date: November 13, 2000 /s/ James P. O'Halloran ------------------------------ James P. O'Halloran Treasurer and Chief Financial Officer (principal financial officer and chief accounting officer) EX-10.1 2 a2030554zex-10_1.txt EXHIBIT 10.1 [LETTERHEAD] Mr. Alexander V. d'Arbeloff August 23, 2000 20 Dudley Street Brookline, MA 02445 Re: Agreement to Purchase Stock of Pegasystems Inc. (the "Company") Dear Mr. d'Arbeloff: Reference is made to (a) that certain lawsuit entitled Chalverus et al. v. Pegasystems Inc. et al. (the "Action"), (b) the Stipulation of Settlement (the "Stipulation") proposed to be entered into between the parties to the Action providing for the compromise and settlement, and (c) the escrow fund (the "Fund") proposed to be created in connection with the settlement of the Action pursuant to the Stipulation, into which Fund the Company would have the option to deposit shares of its Common Stock, $.01 par value per share ("Common Stock"), for sale for the benefit of the plaintiffs in the Action. Terms are used with the same definitions as used in the Stipulation unless the context requires otherwise. You have indicated your desire to purchase 500,000 shares of Common Stock (the "Shares") of the Company at a per share purchase price equal to the closing price of the Common Stock as reported on Nasdaq for the average of the five business days immediately prior to the date of this Agreement which was $4.69 (the "Purchase Price"). For good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, you and the Company hereby agree (a) that the Company will use commercially reasonable efforts to cause the Fund, if the final settlement of the Action provides for the creation, to sell the Shares to you for the Purchase Price per share at the Closing and (b) that you will buy the Shares from the Fund for the Purchase Price at the Closing. The closing of the above-described sale of the Shares (the "Closing") shall occur on the third business day following the entry by the court of a Judgment approving the settlement of the Action as fair, reasonable and in the best interests of the class, as provided for in the Stipulation (or such other date as shall be mutually agreed upon by you, the Company and the Fund). In the alternative, in the event (a) that the Action does not settle on or before December 31, 2000, (b) the Fund is not established in connection with the settlement of the Action, (c) the Court does not enter the Judgment on or before December 31, 2000, or (d) the Fund does not sell the Shares to you despite the Company's commercially reasonable efforts to cause it to do so or is otherwise not permitted to do so, then the Company shall issue and sell to you pursuant to a Stock Purchase Agreement in the form attached hereto as Exhibit "A," and you shall purchase from the Company the Shares at the Purchase Price. The closing of the above-described sale of the Shares (the "Alternative Closing") shall occur on the third business day after the conditions pursuant to which the failure of the Fund to sell shares to you shall have occurred (or such other date as shall be mutually agreed upon by you and the Company. Mr. Alexander V. d'Arbeloff August 23, 2000 Page 2 You represent and warrant to and agree with the Company that each of the following statements contained in paragraphs (a) and (b) is true and correct as of this date, and will be true and correct at and as of the Closing or the Alternative Closing as applicable. (a) Accredited Investor; Access to Data. You are an "accredited investor" as defined in Rule 501(a) of Regulation D promulgated under the Securities Act of 1933, as amended (the "Act") and have sufficient familiarity with the business and affairs of the Company to be able to evaluate the merits and risks of your investment in the Company through the purchase of the Shares. You have had the opportunity to ask questions of and receive answers from management of the Company concerning your acquisition of the Shares and to obtain any additional information, documents, contracts, records and books relative to the Company, its business, assets, financial condition, results of operation, liabilities (contingent or otherwise), and your investment in the company through the purchase of the Shares. You have reviewed the Company's filings with the Securities and Exchange Commission. You have sufficient experience in business, financial and investment matters to be able to evaluate the merits and risks involved in the acquisition of the Shares and to make an informed investment decision with respect to such acquisition. You understand an investment in the Shares involves a high degree of risk and can afford a complete loss of the value of the Shares and are able to bear the economic risk of holding the Shares for an indefinite period. (b) Restrictions on Transfer. You understand that, in the event you become an "affiliate" of the Company (as that term is defined under the Act), your ability to dispose of the Shares may be restricted, including, without limitation, pursuant to Rule 144 promulgated under the Act and Section 16 of the Securities Exchange Act of 1934, as amended. You agree, for the benefit of the Company, not to sell, transfer, or otherwise dispose of the Shares except in compliance with the Act and all applicable securities laws. This letter shall be governed by the laws of The Commonwealth of Massachusetts, without giving effect to its conflicts of laws provisions. By your signature below, you indicate your agreement and acceptance of the terms and conditions contained herein. PEGASYSTEMS INC. By: /s/ Alan Trefler -------------------------------- Name: Alan Trefler Title: Chairman and CEO Agreed to and accepted by: By: /s/ Alexander V. d'Arbeloff ------------------------------- Name: Mr. Alexander V. d'Arbeloff Date: Aug 23, 2000 ----------------- APPENDIX A STOCK PURCHASE AGREEMENT Dated August , 2000 --------- between PEGASYSTEMS INC. a Massachusetts corporation (the "Company"), and Alexander V. d'Arbeloff ("Investor") INTRODUCTION The Company wishes to issue and sell, and the Investor wishes to purchase from the Company 500,000 shares of the Common Stock, $.01 par value per share, of the Company (the "Shares"). TERMS AND CONDITIONS ARTICLE I. REPRESENTATIONS AND WARRANTIES OF THE COMPANY SECTION 1.01. CORPORATE EXISTENCE AND POWER. The Company is a corporation duly incorporated, validly existing and in good standing under the laws of The Commonwealth of Massachusetts and has full corporate and other power and authority to conduct its business and own its properties as now conducted and owned. SECTION 1.02. POWER AND AUTHORITY RELATIVE TO THIS TRANSACTION. The Company has full power and authority and has taken all required corporate and other action necessary to authorize and permit it to execute and deliver this Agreement and all other documents contemplated hereby or thereby, to issue and sell the Shares to be issued and sold by the Company hereunder and to otherwise carry out the terms of this Agreement and all other documents or instruments contemplated hereby, and none of such actions will violate any provision of the Restated Articles of Organization or By-Laws of the Company or any provision of law, rule or regulation or will result in the breach of or constitute a default under any material agreement or instrument to which the Company is a party or by which it is bound, or result in the creation or imposition of any lien, charge, restriction, claim or encumbrance of any nature whatsoever upon any of the properties or assets of the Company or upon the Shares. Each of this Agreement and all other documents contemplated, when executed and delivered by the Company, will constitute valid and legally binding obligations of the Company, enforceable against the Company in accordance with their respective terms. ARTICLE II. REPRESENTATIONS AND WARRANTIES OF THE INVESTOR The Investor represents and warrants to the Company that: SECTION 2.01. POWER AND AUTHORITY RELATIVE TO THIS TRANSACTION. The Investor has full power and authority and has taken all required action necessary to permit him to execute and deliver and to carry out the terms of this Agreement and all other documents or instruments required hereby. 1 SECTION 2.02. PURCHASE FOR INVESTMENT. The Investor is purchasing the Shares purchased by him hereunder for investment for the Investor's own account and not with a view to the distribution thereof in violation of the securities laws. The Investor understands that (i) the Shares must be held indefinitely unless they are registered under the 1933 Act or an exemption from such registration is available; (ii) sales of the Shares made in reliance upon Rule 144 under such Act can be made only in accordance with the terms and conditions of such Rule; (iii) there can be no assurance that the conditions precedent to making sales under such Rule will have been met, and that if such Rule is not available, compliance with another exemption from registration under such Act will be required prior to the disposition of the Shares and (iv) certificates representing the Shares will bear a restrictive legend referring to standard restrictions on transfer under the 1933 Act. SECTION 2.03. RECEIPT OF INFORMATION. The Investor has received all information that it has requested from the Company and believes that such information is sufficient to make an informed decision with respect to the purchase of the Shares. The Investor has had an opportunity to ask questions and receive answers from the Company regarding the financial condition of the Company and to obtain such additional information as he deemed necessary. SECTION 2.04. FINANCIAL RESOURCES; KNOWLEDGE AND EXPERIENCE; STATUS UNDER SECURITIES LAWS. The Investor: (a) possesses the financial resources to bear the risk of economic loss with respect to its purchase of the Shares; (b) has such knowledge and experience in financial and business matters that he is able to evaluate the merits and make an informed investment decision with respect to his purchase of the Shares; (c) qualifies as an "accredited investor" as such term is defined in Rule 501 under the 1933 Act; and (d) is experienced in investing in securities of companies in a similar stage of development as the Company and is able to fend for himself. SECTION 2.05. BROKERS, ETC. The Investor has dealt with no broker, finder, commission agent or person in connection with the offer or sale of the Shares and the transactions contemplated by this Agreement and is under no obligation to pay any broker's fee, finder's fee, or commission in connection with such transactions. ARTICLE III. THE INVESTMENT SECTION 3.01. THE SHARES. Subject to the terms and conditions hereof, and in reliance on the representations and warranties contained herein, the Company shall, subject to receipt of full payment therefor as contemplated by Section 3.02, issue and sell to the Investor, and the Investor shall purchase from the Company, 500,000 Shares at a purchase price equal to $4.69 per share (the "Purchase Price"). SECTION 3.02. CONSIDERATION FOR THE SHARES. The Investor shall pay the purchase price of the Shares purchased by him hereunder from the Company in full at the Closing referred to in Article IV by check or by wire transfer to accounts designated in writing by the Company. ARTICLE IV. THE CLOSING The purchase and sale of the Shares being purchased by the Investor shall take place at a closing (the "Closing") to be held at the offices of Choate, Hall & Stewart, Exchange Place, 53 State Street, Boston, Massachusetts at 10:00 a.m. local time on ________, 2000, or at such other place and time as may be mutually agreed upon in writing. 2 ARTICLE V. CONDITIONS OF THE CLOSING - INVESTOR The obligations of the Investor to purchase the Shares to be purchased by him at the Closing shall be subject to the satisfaction of the following conditions at and as of the time of the Closing: SECTION 5.01. SALE OF SHARES. The Company shall have issued in the name of the Investor a certificate for the Shares to be issued and sold by the Company hereunder. ARTICLE VI. CONDITIONS OF THE CLOSING-COMPANY SECTION 6.01. PAYMENT OF CONSIDERATION. The Investor shall have paid the Purchase Price of the Shares purchased by it hereunder. ARTICLE VII. DEFINED TERMS The terms defined in this Article VII, whenever used and capitalized in this Agreement, shall, unless the context otherwise requires, have the following respective meanings: CLOSING: shall have the meaning specified in Article IV. COMPANY: shall mean Pegasystems Inc., a Massachusetts corporation. INVESTOR: shall have the meaning specified at the beginning of this Agreement. SHARES: shall have the meaning specified in the Introduction. 1933 ACT: shall mean the Securities Act of 1933, as amended. ARTICLE VIII. MISCELLANEOUS SECTION 8.01. NOTICES. All notices to a party hereunder shall be in writing and shall be deemed to have been adequately given if delivered in person, upon facsimile transmission with receipt acknowledged by the recipient's facsimile transmission machine or by delivery by a recognized courier for overnight delivery, or three days after having been mailed, certified mail, return receipt requested, to such party at its address set forth below (or such other address as it may from time to time designate in writing to the other parties hereto). The Company: Pegasystems Inc. 101 Main Street Cambridge, MA 02142 Attn: June M. Morris, Esq. With a Copy to: Robert Jahrling, Esq. Choate, Hall & Stewart Exchange Place 53 State Street Boston, MA 02109 The Investor: Mr. Alexander V. d'Arbeloff 20 Dudley Street Brookline, MA 02445 3 SECTION 8.02. NO WAIVER. No failure to exercise and no delay in exercising, on the part of the Investor, any right, power or privilege hereunder shall operate as a waiver thereof; nor shall any single or partial exercise of any right, power or privilege hereunder preclude any other or further exercise or the exercise of any other right, power or privilege. The rights and remedies herein provided are cumulative and not exclusive of any rights or remedies provided by law. SECTION 8.03. AMENDMENTS AND WAIVERS. Except as hereinafter provided, this Agreement may be modified or amended or any term or provision may be waived by a writing signed by the Company and the Investor. No waiver of any term or provision shall be effective unless made in the same manner as an amendment of such term or provision. SECTION 8.04. SURVIVAL OF AGREEMENTS, ETC. All agreements, representations and warranties contained herein or made in writing by or on behalf of the Company, Investor or the Sellers in connection with the transactions contemplated shall, except where otherwise provided by their terms, survive the execution and delivery of this Agreement, the Closing pursuant to Article IV, and any investigation at any time made by or on behalf of the Investor. All statements contained in any certificate or other instrument delivered by or on behalf of the Company or the Sellers pursuant hereto or in connection with the transactions contemplated hereby shall be deemed representations and warranties by the Company. SECTION 8.05. CONSTRUCTION. This Agreement shall be governed by and construed in accordance with the law of The Commonwealth of Massachusetts. The descriptive headings of the several Sections are for convenience only and shall not control or affect the meaning or construction of any of the provisions. SECTION 8.06. BINDING EFFECT AND BENEFITS. This Agreement shall be binding upon and shall inure to the benefit of the parties and their respective heirs, successors and assigns, excluding assignees of the Shares, but not including any purchaser thereof in whose hands the Shares are not a restricted security as defined in Rule 144 under the 1933 Act. SECTION 8.07. ENTIRE AGREEMENT AND AMENDMENTS. This Agreement constitutes the entire agreement of the parties with respect to the subject matter and neither this Agreement nor any provision may be waived, modified, amended or terminated except by a written agreement signed by the parties, in accordance with the provisions of Section 8.03. To the extent any term or other provision of any other indenture, agreement or instrument by which any party is bound conflicts with this Agreement, this Agreement shall have precedence over such conflicting term or provision. SECTION 8.08. COUNTERPARTS. This Agreement may be executed in two or more counterparts, each of which shall be deemed an original, but all of which together shall constitute one and the same instrument. 4 IN WITNESS WHEREOF, the parties have executed this Agreement under seal as of the date first above written. PEGASYSTEMS INC. By: ________________________ Name: ________________________ Title: ________________________ PURCHASER: --------------------------------- Name: Mr. Alexander V. d'Arbeloff 5 EX-27.1 3 a2030554zex-27_1.txt EXHIBIT 27.1
5 1,000 6-MOS DEC-31-2000 JAN-01-2000 SEP-30-2000 25,258 0 78,714 1,034 0 61,949 21,166 15,034 117,269 29,329 0 0 0 293 86,494 117,269 61,950 61,950 29,820 29,820 51,206 0 0 (15,173) 150 (15,323) 0 0 0 (15,323) (0.53) (0.53)
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