-----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, GIUPTgO1/xTpUDG3o6bJYF6+RG6OhVTKuFamen8DU4hARCfGeCWVRPThN+oy3HWo RAoME1bXOa+YrMib5dzZsA== 0000927016-02-005015.txt : 20021023 0000927016-02-005015.hdr.sgml : 20021023 20021022215523 ACCESSION NUMBER: 0000927016-02-005015 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 4 CONFORMED PERIOD OF REPORT: 20020930 FILED AS OF DATE: 20021023 FILER: COMPANY DATA: COMPANY CONFORMED NAME: PEGASYSTEMS INC CENTRAL INDEX KEY: 0001013857 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-COMPUTER PROCESSING & DATA PREPARATION [7374] IRS NUMBER: 042787865 STATE OF INCORPORATION: MA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 001-11859 FILM NUMBER: 02795517 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 d10q.txt FORM 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, 2002 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 34,216,579 shares of the Registrant's common stock, $.01 par value per share, outstanding on October 17, 2002. 1 PEGASYSTEMS INC. AND SUBSIDIARIES Index to Form 10-Q
Page ---- Part I - Financial Information Item 1. Condensed Consolidated Financial Statements Condensed Consolidated Balance Sheets at September 30, 2002 and December 31, 2001 3 Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2002 and 2001 4 Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2002 and 2001 5 Notes to Condensed Consolidated Financial Statements 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 13 Item 3. Quantitative and Qualitative Disclosures About Market Risk 21 Item 4. Controls and Procedures 22 Part II - Other Information Item 1. Legal Proceedings 23 Item 2. Changes in Securities and Use of Proceeds 23 Item 3. Defaults upon Senior Securities 23 Item 4. Submission of Matters to a Vote of Security Holders 23 Item 5. Other Information 23 Item 6. Exhibits and Reports on Form 8-K 23 SIGNATURES 24 CERTIFICATIONS 25
2 PEGASYSTEMS INC. Condensed Consolidated Balance Sheets (in thousands, except share-related amounts)
September 30, December 31, 2002 2001 ------------- ------------ Assets Current assets Cash and cash equivalents .............................................. $ 52,263 $ 33,017 Trade accounts receivable, net of allowance for doubtful accounts of $858 in 2002 and $1,034 in 2001 (Note 4) ........................ 3,580 9,592 Short-term license installments ........................................ 35,008 31,359 Investments-held to maturity ........................................... 3,024 -- Prepaid expenses and other current assets .............................. 1,340 2,286 ----------- ----------- Total current assets .......................................... 95,215 76,254 Long-term license installments, net ............................................. 46,121 43,155 Investments-held to maturity .................................................... 1,776 -- Equipment and improvements, net ................................................. 2,087 3,053 Acquired technology, net (Note 3) ............................................... 1,167 -- Purchased software and other assets, net ........................................ 858 2,610 Goodwill (Note 3) ............................................................... 3,167 -- ----------- ----------- Total assets ........................................................... $ 150,391 $ 125,072 =========== =========== Liabilities and stockholders' equity Current liabilities Accrued payroll expenses ............................................... $ 8,228 $ 7,940 Accounts payable and accrued other expenses ............................ 4,417 4,900 Deferred revenue ....................................................... 9,997 6,176 Current portion of capital lease obligation ............................ -- 81 ----------- ----------- Total current liabilities ..................................... 22,642 19,097 Commitments and contingencies (Note 6) Deferred income taxes ........................................................... 1,000 1,000 Other long-term liabilities ..................................................... 284 17 ----------- ----------- Total liabilities ............................................. 23,926 20,114 Stockholders' equity Preferred stock, $0.01 par value, 1,000,000 share authorized; no shares issued and outstanding ....................................... -- -- Common stock, $0.01 par value, 45,000,000 shares authorized; 34,215,579 shares and 32,754,648 shares issued and outstanding in 2002 and 2001, respectively ...................................... 342 328 Additional paid-in capital ............................................. 108,665 101,318 Stock warrants ......................................................... 3,271 2,897 Retained earnings ...................................................... 13,625 757 Accumulated other comprehensive income (loss) .......................... 562 (342) ----------- ----------- Total stockholders' equity .................................... 126,465 104,958 ----------- ----------- Total liabilities and stockholders' equity ........... $ 150,391 $ 125,072 =========== ===========
See notes to condensed consolidated financial statements. 3 PEGASYSTEMS INC. Condensed Consolidated Statements of Operations (in thousands, except per share amounts)
Three Months Ended Nine Months Ended September 30, September 30, 2002 2001 2002 2001 -------- -------- -------- -------- Revenue Software license .......................................... $ 16,902 $ 10,629 $ 52,273 $ 30,163 Services .................................................. 8,663 13,258 24,170 40,845 -------- -------- -------- -------- Total revenue ........................................... 25,565 23,887 76,443 71,008 -------- -------- -------- -------- Cost of revenue Cost of software license .................................. 672 585 1,988 2,464 Cost of services .......................................... 7,352 9,293 22,245 29,438 -------- -------- -------- -------- Total cost of revenue ................................... 8,024 9,878 24,233 31,902 -------- -------- -------- -------- Gross profit 17,541 14,009 52,210 39,106 -------- -------- -------- -------- Operating expenses Research and development .................................. 5,349 5,386 16,703 15,372 Selling and marketing ..................................... 6,296 3,960 18,003 13,100 General and administrative ................................ 1,871 2,419 7,383 7,515 -------- -------- -------- -------- Total operating expenses ................................ 13,516 11,765 42,089 35,987 -------- -------- -------- -------- Income from operations ....................................... 4,025 2,244 10,121 3,119 -------- -------- -------- -------- Installment receivable interest income ....................... 1,258 1,450 3,774 4,350 Other interest income, net ................................... 218 211 541 658 Other (expense) income, net .................................. (373) 229 (816) 228 -------- -------- -------- -------- Income before provision for income taxes ..................... 5,128 4,134 13,620 8,355 Provision for income taxes ................................... 302 250 752 725 -------- -------- -------- -------- Net income ................................................... $ 4,826 $ 3,884 $ 12,868 $ 7,630 ======== ======== ======== ======== Earnings per share Basic ..................................................... $ 0.14 $ 0.12 $ 0.38 $ 0.23 ======== ======== ======== ======== Diluted ................................................... $ 0.13 $ 0.12 $ 0.35 $ 0.23 ======== ======== ======== ======== Weighted average number of common and common equivalent shares outstanding Basic ..................................................... 34,176 32,695 33,956 32,649 ======== ======== ======== ======== Diluted ................................................... 36,275 33,420 36,292 33,398 ======== ======== ======== ========
See notes to condensed consolidated financial statements. 4 PEGASYSTEMS INC. Condensed Consolidated Statements of Cash Flows (in thousands)
Nine Months Ended September 30, ------------------------- 2002 2001 ---- ---- Cash flows for operating activities Net income .................................................................................... $ 12,868 $ 7,630 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization ........................................................... 3,512 5,012 Non-cash compensation ................................................................... -- 73 Changes in operating assets and liabilities: Trade and installment accounts receivable .......................................... (306) (6,488) Prepaid expenses and other current assets .......................................... 974 (353) Accounts payable and accrued expenses .............................................. (151) 2,067 Deferred revenue ................................................................... 3,762 1,381 -------- -------- Net cash provided by operating activities ....................................... 20,659 9,322 -------- -------- Cash flows from investing activities Purchase of investments held to maturity ...................................................... (4,800) -- Acquisition of 1mind (Note 3) ................................................................. (573) -- Purchase of equipment and improvements ........................................................ (558) (432) Other long-term assets and liabilities ........................................................ (3) 302 -------- -------- Net cash used in investing activities ................................................ (5,934) (130) -------- -------- Cash flows from financing activities Payments of capital lease obligation .......................................................... (81) (240) Proceeds from sale of stock under employee stock purchase plan ................................ 177 164 Exercise of stock options ..................................................................... 3,887 55 -------- -------- Net cash provided by financing activities ............................................ 3,983 (21) -------- -------- Effect of exchange rate changes on cash and cash equivalents ....................................... 538 (259) -------- -------- NET INCREASE IN CASH AND CASH EQUIVALENTS .......................................................... 19,246 8,912 -------- -------- CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD ..................................................... 33,017 17,339 -------- -------- CASH AND CASH EQUIVALENTS, END OF PERIOD ........................................................... $ 52,263 $ 26,251 ======== ========
See notes to condensed consolidated financial statements. 5 PEGASYSTEMS INC. Notes to Condensed Consolidated Financial Statements September 30, 2002 Note 1 - Basis of presentation The unaudited condensed consolidated financial statements of Pegasystems Inc. (the "Company") have been prepared in accordance with accounting principles generally accepted in the United States of America and with the instructions to Form 10-Q and Article 10 of Regulation S-X. 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-month and nine-month periods ended September 30, 2002 are not necessarily indicative of the results that may be expected for the full year ending December 31, 2002. We suggest that these condensed consolidated financial statements be read in conjunction with the consolidated financial statements and notes thereto for the year ended December 31, 2001, included in our 2001 Annual Report on Form 10-K filed with the Securities and Exchange Commission ("SEC"). Certain amounts in the 2001 consolidated financial statements were reclassified to be consistent with the current presentation. Reimbursements received for out-of-pocket expenses have been reflected as services revenue, in compliance with Emerging Issues Task Force Abstract No. 01-14; in prior periods the reimbursements had been reflected as reduction of cost of services.
Three Months Nine Months Ended Ended September 30, September 30, (in thousands, except per share data) 2001 2001 ------------- ------------- Services revenue as reported previously ................ $12,478 $38,617 Add: reimbursements for out-of-pocket expenses ......... 780 2,228 ------- ------- Services revenue, reclassified ......................... $13,258 $40,845 ======= ======= Cost of services as reported previously ................ $ 8,513 $27,210 Add: reimbursements for out-of-pocket expenses ......... 780 2,228 ------- ------- Cost of services, reclassified ......................... $ 9,293 $29,438 ======= =======
Note 2 - Significant accounting policies (a) Business We develop, market, license and support software that enables transaction- intensive organizations to manage a broad array of customer interactions. We also offer consulting, training, maintenance and support services to facilitate the installation and use of our products. (b) Management estimates and reporting The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. Actual results could differ from those estimates. Estimates which effect significant assets and liabilities include estimates with respect to allowance for doubtful accounts, the relative fair value of deliverables under revenue contracts, deferred income taxes, and deferred revenue. 6 (c) Principles of consolidation The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries, Pegasystems Limited (a United Kingdom company), Pegasystems Company (a Canadian company), Pegasystems Worldwide Inc. (a United States corporation), Pegasystems Pty. Ltd. (an Australian company), Pegasystems Investment Inc. (a United States corporation), and Pegasystems Private Limited (a Singapore company). All intercompany accounts and transactions have been eliminated in consolidation. (d) Foreign currency translation The translation of assets and liabilities of our foreign subsidiaries is made at period-end exchange rates, while equity accounts are translated at historic exchange rates, and revenue and expense accounts are translated at the average exchange rates during the period transactions occurred. The resulting translation adjustments are reflected as a separate component of accumulated other comprehensive income (loss). Realized and unrealized exchange gains or losses from transactions and adjustments are reflected in other income (expense), net, in the accompanying consolidated statements of operations. (e) Revenue recognition Our revenue is derived from two primary sources: software license fees and service fees. We offer both perpetual and term software licenses. Perpetual license fees are generally payable at the time the software is delivered, and are generally recognized as revenue upon customer acceptance to the extent that payments are not subject to refund. Payments subject to refund are recognized as revenue as refund provisions lapse. Term software license fees are generally payable on a monthly basis under license agreements that 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 license fees payable under each term license agreement is treated as imputed interest deferred and recognized as installment receivable interest income over the license term. Many of our license agreements provide for license fee increases based on inflation. The present value of such increases is recognized when the inflation increases become known. For purposes of the present value calculations, the discount rates used are estimates of customers' borrowing rates at the time of recognition, typically below prime rate, and have varied between 3.25% and 8.0% for the past few years. As a result, revenue that we recognize relative to these types of license arrangements may be impacted by changes in market interest rates. For term license agreement renewals, license revenue is recognized when the customer becomes committed to the new license terms. In certain circumstances, such as when license fees are not fixed and determinable, some licenses are accounted for on a subscription basis, where revenue is recognized as payments become due over the term of the license. Our service revenue is comprised of fees for software implementation, consulting, maintenance, and training services. Our software implementation and consulting agreements typically require us to provide services for a fee, or at an hourly rate. Revenues for time and material projects are recognized as fees are billed. Revenues for fixed-price projects are recognized as services are delivered and once the fair value of services and any other elements to be delivered under the arrangement can be determined. All costs of services are expensed as incurred. Historically, we have had difficulty accurately estimating the time and resources needed to complete fixed-price service projects. As a result, determination of the fair value of the elements of the contract has generally occurred late in the implementation process, typically when implementation is complete and remaining services are no longer significant to the project. Until the fair value of the elements of a contract can be determined, revenue recognition for fixed-price projects is limited to amounts equal to costs incurred, resulting in no gross profit. Once the fair value of the elements of a contract are apparent, profit associated with the fixed-price services elements will begin to be recognized. Software license customers are offered the option to enter into a maintenance contract, which requires the customer to pay a monthly maintenance fee over the term of the maintenance agreement, typically renewable annually. Prepaid maintenance fees are deferred and are recognized evenly over the term of the maintenance agreement. We generally recognize training fees revenue as the services are provided. 7 We reduce revenue for estimates of the fair value of potential concessions, such as disputed services, when revenue is initially recorded. These estimated amounts are deferred or reserved until the related elements of the agreement are completed and provided to the customer. (f) Concentration of credit risk Financial instruments that potentially subject us to a concentration of credit risk consist of short-term cash investments, trade accounts receivable, and license installments receivable. We record long-term license installments in accordance with our revenue recognition policy, which results in receivables from customers due in periods exceeding one year from the reporting date, primarily from large organizations with strong credit ratings. We grant credit to customers who are located throughout the world. We perform credit evaluations of customers and generally do not request collateral from customers. Amounts due under license installments are expected to be received as follows: License Installments Years ending December 31, (in thousands) Remainder of 2002 ................. $ 12,035 2003 ................. 27,234 2004 ................. 20,184 2005 ................. 16,168 2006 ................. 11,480 2007 ................. 3,391 2008 ................. 982 --------- 91,474 Deferred license interest income .......... (10,345) ---------- Total license installments receivable ..... $ 81,129 ========= (g) Cash and cash equivalents and investments held-to-maturity We consider all highly liquid investments with remaining maturities of three months or less at the date of purchase to be cash equivalents. Cash equivalents principally consist of US Treasury bills and short-term debt securities. We account for investments under Statement for Financial Accounting Standards ("SFAS") No. 115, Accounting for Certain Investment in Debt and Equity Securities. Under SFAS No. 115, investments with remaining maturities of longer than three months when purchased and which we intend to hold until maturity are reported at amortized cost, which approximates fair market value. (h) Equipment and improvements Equipment and improvements are recorded at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, which are three years for equipment and five years for furniture and fixtures. Leasehold improvements and equipment under capital leases are amortized over the term of the lease or the useful life of the asset, whichever is less. Repairs and maintenance costs are expensed as incurred. (i) Impairment of long-lived assets We evaluate our long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the asset exceeds the fair value of the asset. 8 (j) Research and development and software costs Research and development costs, other than certain software related costs, are expensed as incurred. Capitalization of software costs begins upon the establishment of technical feasibility, generally demonstrated by a working model or an operative version of the computer software product that is completed in the same language and is capable of running on all of the platforms as the product to be ultimately marketed. Such costs have not been material to date and, as a result, no internal costs were capitalized during the three and nine months ended September 30, 2002 and 2001. Amortization of capitalized software is included in cost of software license revenue. No amortization expense for internally developed capitalized software costs was charged to cost of software license revenue during the three and nine months ended September 30, 2002 and 2001. (k) Net earnings per share Basic earnings per share are computed based on the weighted average number of common shares outstanding during the period. Diluted earnings 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.
Three Months Ended Nine Months Ended September 30, September 30, (in thousands, except per share data) 2002 2001 2002 2001 ----------- ------------ ------------ ------------ Basic - ----- Net income ..................................... $ 4,826 $ 3,884 $ 12,868 $ 7,630 =========== ============ ============ ============ Weighted average common shares outstanding ..... 34,176 32,695 33,956 32,649 =========== ============ ============ ============ Basic earnings per share ....................... $ 0.14 $ 0.12 $ 0.38 $ 0.23 =========== ============ ============ ============ Diluted - ------- Net income $ 4,826 $ 3,884 $ 12,868 $ 7,630 =========== ============ ============ ============ Weighted average common shares outstanding ..... 34,176 32,695 33,956 32,649 Effect of assumed exercise of stock options .... 2,099 725 2,336 749 ----------- ------------ ------------ ------------ Weighted average common shares outstanding, assuming dilution ........................... 36,275 33,420 36,292 33,398 =========== ============ ============ ============ Diluted earnings per share ..................... $ 0.13 $ 0.12 $ 0.35 $ 0.23 =========== ============ ============ ============ Outstanding options and warrant excluded as impact would be anti-dilutive ............... 4,454 7,914 4,115 7,605 =========== ============ ============ ============
9 (l) Segment reporting We currently operate in one operating segment - customer service software. We derive substantially all of our operating revenue from the sale and support of one group of similar products and services. Substantially all of our assets are located within the United States. For the three and nine months ending September 30, 2002 and 2001, we derived our operating revenue from the following geographic areas (sales outside the United States are principally through export from the United States):
Three Months Ended Nine Months Ended September 30, September 30, ------------ ------------ (in thousands) 2002 2001 2002 2001 ------ ------ ------ ------ United States ....... $ 19,205 75% $ 20,485 86% $ 59,787 78% $ 55,302 78% United Kingdom ...... 3,942 16% 1,492 6% 11,821 15% 8,420 12% Europe .............. 800 3% 970 4% 1,955 3% 4,708 7% Other ............... 1,618 6% 940 4% 2,880 4% 2,578 3% -------- -------- -------- -------- $ 25,565 100% $ 23,887 100% $ 76,443 100% $ 71,008 100% ======== ======== ======== ========
(m) Stock options We periodically grant stock options for a fixed number of shares to employees and directors with an exercise price equal to the fair value of the shares at the date of the grant. We account for such stock option grants using the intrinsic value method in accordance with APB Opinion No. 25, "Accounting for Stock Issued to Employees", and intend to continue to do so. Stock options granted to non-employee contractors are accounted for using the fair value method in accordance with SFAS No. 123, "Accounting for Stock-Based Compensation". We have adopted the disclosure provisions of SFAS No. 123, relative to the impact of the fair value method. (n) Fair value of financial instruments The principal financial instruments held consist of cash and cash equivalents, investments held to maturity, accounts receivable and payable, capital lease obligations, and license installment receivables arising from license transactions. The carrying values of cash and cash equivalents, investments held to maturity, accounts receivable, and accounts payable, approximate their fair value due to the relatively short-term nature of the accounts. Using current market rates, the fair value of license installment receivables approximates carrying value at September 30, 2002 and 2001. (o) New accounting standards We have adopted the SFAS No. 141, "Business Combinations," and SFAS No. 142, "Goodwill and Other Intangible Assets." These pronouncements provide guidance on how to account for the acquisition of businesses and intangible assets, including goodwill, which arise from such activities. SFAS No. 141 affirms that only one method of accounting may be applied to a business combination, the purchase method. SFAS No. 141 also provides guidance on the allocation of purchase price to the assets acquired. SFAS No. 142 provides that goodwill resulting from business combinations no longer be amortized to expense, but rather requires an annual assessment of impairment and, if necessary, adjustments to the carrying value of goodwill. We have adopted SFAS No. 143, "Accounting for Obligations Associated with the Retirement of Long-Lived Assets and SFAS No. 144 "Accounting for the Impairment of Disposal of Long-Lived Assets. SFAS No. 143 establishes accounting standards for the recognition and measurement of an asset retirement obligation and its associated asset retirement cost. It also provides guidance for legal obligations associated with the retirement of tangible long-lived assets. SFAS No. 144 establishes a single accounting model for the impairment or disposal of long-lived assets, including discontinued operations. Adoption of these pronouncements has not had a significant effect on our consolidated financial statements. 10 Note 3 - Acquisition On February 6, 2002, we acquired substantially all of the assets of 1mind Corporation ("1mind") for initial consideration value of $3.7 million. Depending upon the achievement of specified milestones by the acquired business in 2002 and validation of the negotiated value of 1mind, we may pay up to approximately $6 million in additional consideration substantially in the form of shares of our common stock. We believe that the acquisition will help increase our penetration of the healthcare and insurance markets, strengthen our management and delivery teams and deepen our product offerings. The acquisition of 1mind has been accounted for as purchase and the operations of 1mind have been included in our consolidated financial statements from the date of acquisition. Results of operations would not have changed materially for 2001 or the current year if 1mind had been acquired on January 1, 2001 and 2002, respectively. The cash flow impact of $573 thousand from this acquisition was transaction costs of $614 thousand less cash acquired of $41 thousand. The preliminary purchase price allocation is based on the report of an independent appraiser. The allocation of the purchase price in the condensed consolidated financial statements is based on estimates, and is subject to change. (in thousands) Shares issued (a) ..................................... $ 3,295 Warrants issued (b) ................................... 374 -------- Total purchase price .................................. $ 3,669 ======== Current assets, including cash of $41 ................. $ 339 Equipment and improvements ............................ 143 Acquired existing technology (c) ...................... 1,400 Goodwill and other intangibles (d) .................... 3,167 Current liabilities ................................... (571) Long-term liabilities ................................. (195) Transaction costs ..................................... (614) -------- $ 3,669 ======== (a) 569,949 common shares of Pegasystems Inc. valued at approximately $5.78 per share, the average of closing prices as reported by Nasdaq for the three days before and after January 29, 2002, the date of agreement. (b) Warrants to purchase, for nominal consideration, 83,092 common shares of Pegasystems Inc., valued at approximately $4.50 per warrant using a Black-Scholes model. (c) Acquired existing technology results from an appraisal report of 1mind intangible assets. This asset is being amortized over its expected useful life of four years. (d) Any additional consideration paid will be recorded as goodwill. These amounts are considered to have an indeterminate life and amortization is not provided. These assets will be subject to an annual impairment test. Note 4 - Valuation and qualifying accounts - allowance for doubtful accounts Our allowance for doubtful accounts was $858 thousand at September 30, 2002, down from $1.0 million at December 31, 2001. For the nine months ended September 30, 2002 and 2001, no provision for doubtful accounts was recorded. During the nine months ended September 30, 2002 we wrote off $180 thousand of receivables due from a bankrupt customer in South Africa. 11 Note 5 - Comprehensive income The components of comprehensive income are as follows:
(in thousands) Three Months Ended Nine Months Ended September 30, September 30, 2002 2001 2002 2001 -------- -------- -------- -------- Net income ....................................... $ 4,826 $ 3,884 $ 12,868 $ 7,630 Foreign currency translation adjustments, net of income taxes ........................... 265 4 904 (103) -------- -------- -------- -------- Comprehensive income ............................. $ 5,091 $ 3,888 $ 13,772 $ 7,527 ======== ======== ======== ========
Note 6 - Commitments and contingencies Litigation Qwest Arbitration. In August 2002, we settled our arbitration dispute with Qwest Corporation relating to Qwest's termination of a software license and service agreement with us described in our previous reports filed with the SEC. Pursuant to the settlement, Qwest paid us $2.4 million, the termination of the agreement was acknowledged and the parties entered into a mutual release agreement. We expect to recognize the cash received pursuant to the settlement as revenue in the fourth quarter of 2002. Ernst & Young Arbitration. On September 9, 2000, Pegasystems and two of its officers filed a complaint against Ernst & Young LLP and Alan B. Levine (a former partner of Ernst & Young) in Massachusetts state court, alleging, among other things, that the defendants committed professional malpractice in connection with advice that Ernst & Young rendered to us concerning the proper accounting treatment for revenue in the quarter ended June 30, 1997 under a series of contracts between us and First Data Resources, Inc. On April 5, 2001, the court dismissed the complaint, finding that it was subject to the dispute resolution procedures set forth in an engagement letter between us and Ernst & Young. The parties submitted this dispute to arbitration. On August 13, 2002, the arbitration panel denied Pegasystems' claims with respect to the allegations in the complaint. Acquisition Under the agreement for acquisition of 1mind, depending upon the achievement of specified milestones by the acquired business in 2002 and validation of the negotiated value of 1mind, we may pay up to approximately $6 million in additional consideration, substantially in the form of shares of our common stock. 12 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Critical Accounting Policies In connection with the discussion that follows, you are encouraged to read Note 2 of the notes to our condensed consolidated financial statements included elsewhere in this report. Our revenue is derived from two primary sources -- software license fees and service fees. We offer both perpetual and term software licenses. Perpetual license fees are generally payable at the time the software is delivered, and are generally recognized as revenue upon customer acceptance to the extent that payments are not subject to refund. Payments subject to refund are recognized as revenue as refund provisions lapse. Term software license fees are generally payable on a monthly basis under license agreements that 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 license fees payable under each term license agreement is treated as imputed interest and recognized as installment receivable interest income over the license term. Many of our license agreements provide for license fee increases based on inflation. The present value of such increases is recognized when the inflation increases become known. For purposes of the present value calculations, the discount rates used are estimates of customers' borrowing rates at the time of recognition, typically below prime rate, and have varied between 3.25% and 8.0% for the past few years. As a result, revenue that we recognize relative to these types of license arrangements may be impacted by changes in market interest rates. For term license agreement renewals, license revenue is recognized when the customer becomes committed to the new license terms. In certain circumstances, such as when license fees are not fixed and determinable, some licenses are accounted for on a subscription basis, where revenue is recognized as payments become due over the term of the license. Our service revenue is comprised of fees for software implementation, consulting, maintenance, and training services. Our software implementation and consulting agreements typically require us to provide services for a fixed fee or at an hourly rate. Revenues for time and material projects are recognized as fees are billed. Revenues for fixed-price projects are recognized as services are delivered and once the fair value of services and any other elements to be delivered under the arrangement can be determined. All costs of services are expensed as incurred. Historically, we have had difficulty accurately estimating the time and resources needed to complete fixed-price service projects. As a result, determination of the fair value of the elements of the contract has generally occurred late in the implementation process, typically when implementation is complete and remaining services are no longer significant to the project. Until the fair value of the elements of a contract can be determined, revenue recognition for fixed-price projects is limited to amounts equal to costs incurred, resulting in no gross profit. Once the fair value of the elements of a contract are apparent, profit associated with the fixed-price services elements will begin to be recognized. Software license customers are offered the option to enter into a maintenance contract, which requires the customer to pay a monthly maintenance fee over the term of the maintenance agreement, typically renewable annually. Prepaid maintenance fees are deferred and are recognized evenly over the term of the maintenance agreement. We generally recognize training fees revenue as the services are provided. We reduce revenue for estimates of the fair value of potential concessions, such as disputed services, when revenue is initially recorded. These estimated amounts are deferred or reserved until the related elements of the agreement are completed and provided to the customer. In addition, we maintain an allowance for doubtful accounts using estimates that we make based on factors such as 13 the composition of the accounts receivable aging, historical bad debts, changes in payment patterns, customer creditworthiness and current economic trends. If we used different estimates, or if the financial condition of customers were to deteriorate, resulting in an impairment of their ability to make payments, additional provisions for doubtful accounts would be required and would increase bad debt expense. Three and Nine Months Ended September 30, 2002 Compared to Three and Nine Months Ended September 30, 2001 Revenue Total revenue for the three-month period ended September 30, 2002 ("the third quarter of 2002") increased 7% to $25.6 million from $23.9 million for the three-month period ended September 30, 2001 ("the third quarter of 2001"). Total revenue for the nine months ended September 30, 2002 ("first nine months of 2002") increased 8% to $76.4 million from $71.0 million in the nine months ended September 30, 2001 ("first nine months of 2001"). The increases were due to increases in software license revenue, which were partially offset by decreases in services revenue. Signing of license contracts with new customers has slowed significantly since the latter part of 2001 due in large part, we believe, to continued weakness in spending by our target customers. Revenue from new customers was 11% of total revenue for the first nine months of 2002, compared with 13% for the first nine months of 2001. The decrease in license contracts with new customers has adversely impacted our services business because we derive a substantial portion of our services revenue from implementation of software licensed by new customers. The following table summarizes our revenue composition:
Three Months Ended Nine Months Ended (in millions) September 30, September 30, 2002 2001 2002 2001 --------- --------- --------- --------- License revenue --------------- Perpetual licenses and licenses accounted for on a subscription basis ....................... $ 10.1 $ 2.3 $ 28.9 $ 7.4 Term licenses, including renewals, extensions and additions (and not included above) ............ 6.8 8.3 23.3 22.8 ------ ------ ------ ------ Total license revenue .............................. 16.9 10.6 52.2 30.2 Services revenue ---------------- Implementation, consulting and training services ... 6.4 11.3 17.4 34.9 Maintenance ........................................ 2.3 2.0 6.8 5.9 ------ ------ ------ ------ Total services revenue ............................. 8.7 13.3 24.2 40.8 ------ ------ ------ ------ Total revenue ...................................... $ 25.6 $ 23.9 $ 76.4 $ 71.0 ====== ====== ====== ======
Software license revenue for the third quarter of 2002 increased 59% to $16.9 million from $10.6 million for the third quarter of 2001. Software license revenue for the first nine months of 2002 increased 73% to $52.3 million from $30.2 million for the same period in 2001. License revenue from new customers was 5% of total license revenue in the first nine months of 2002. The increase in perpetual license revenue for the third quarter of 2002 and for the first nine months of 2002 was primarily due to a perpetual license agreement entered into with First Data Resources ("FDR") in the first quarter of 2002. That perpetual license agreement replaced a prior term license agreement with FDR under which revenue was being recognized on a subscription basis and which was due to expire in December 2002. Of the $7.8 million increase in perpetual and subscription license revenue for the third quarter of 2002, $4.2 million was due to the FDR perpetual license agreement and $2.5 million was due to perpetual licenses to new customers. Of the $21.5 million increase in perpetual and subscription license revenue for the first nine months of 2002, $15.6 million was due to the FDR perpetual license agreement. The following table summarizes the revenue we have recognized under the FDR perpetual license and the prior agreements with FDR:
Three Months Ended Nine Months Ended (in millions) September 30, September 30, 2002 2001 2002 2001 --------- --------- --------- --------- Perpetual licenses and licenses accounted for on a subscription basis ........................ $ 5.9 $ 1.7 $ 20.3 $ 4.7 Implementation, consulting and training services .... - 1.5 0.7 4.5 Maintenance ......................................... 0.2 0.2 0.7 0.7 ----- ----- ------ ----- Total revenue ....................................... $ 6.1 $ 3.4 $ 21.7 $ 9.9 ===== ===== ====== =====
Under the terms of the FDR perpetual license agreement, FDR is required to make monthly payments through December 2003. These payments totaled $5.85 million in the third quarter of 2002 and will total $5.85 million in the fourth quarter of 2002 and $3.54 million in each of the four quarters of 2003. We recognize revenue three months in advance of receipt of payments, because the termination of the agreement requires three months advance notice. We expect to recognize as revenue from the FDR perpetual license $3.54 million in the fourth quarter of 2002 and each of the first three quarters of 2003. 14 In the future, we expect to enter into more perpetual license transactions, the effect of which may be to increase our license revenue and cash flow in the short term and to decrease the amount of revenue and cash flow from the renewal of term software license agreements. In recent history, a significant portion of our license revenue has been from renewals of term software license agreements. Revenues from term software licenses, renewals, extensions, and additions decreased by $1.5 million to $6.8 million from $8.3 million for the third quarter of 2001. Included in term software license revenue for the third quarter of 2002 is $2.4 million from a customer that converted to a term license from a license accounted for on a subscription basis, following revision of the license agreement to fix the amount of the license fee. Discount rates used to recognize term license revenue vary directly with market interest rates. The discount rates used to recognize term license revenue in the third quarter of 2002 averaged 3.40%. Decreases in the average discount rate resulted in an increase in license revenue of approximately $0.2 million for the third quarter of 2002 and approximately $1.1 million for the first nine months of 2002 versus comparable periods in 2001. If interest rates increase and in turn the discount rates we use to recognize term license revenue increase, we would be required to defer as installment receivable interest a greater portion of the revenue from such arrangements. Services revenue for the third quarter of 2002 decreased 35% to $8.7 million from $13.3 million for the third quarter 2001. Services revenue for the first nine months of 2002 decreased 41% to $24.2 million from $40.8 million in the first nine months of 2001. The decreases were due primarily to delayed customer spending and a decrease in new customer license transactions, which we believe were caused by the current generally weak economic conditions. Typically, we derive substantial revenue from services provided in connection with the implementation of software licensed by new customers. New customer implementations continue to be significantly below last year. The current rate of signing new customers indicates that growth in services revenue will continue to be a challenge. Deferred revenue balances increased to $10.0 million as of September 30, 2002, from $6.2 million as of December 31, 2001, due to $2.4 million received from a customer resolving a dispute which is subject to possible forfeiture, increases in advance maintenance fees and the unearned portion of services revenue. International revenues were 22% of total consolidated revenues for the first nine months of 2002 and 2001. Our international revenues may fluctuate in the future because such revenues generally result from a small number of product acceptances during a given period. Historically, most of our contracts have been denominated in U.S. dollars. However, more of our contracts in the future may be denominated in foreign currencies, thereby exposing us to increased currency exchange risk. Cost of revenue Costs of software license includes the amortization associated with purchased software and a stock purchase warrant we issued in September 1997, under an agreement with FDR and the amortization of the intellectual property we purchased from 1mind. Cost of software license revenue for the third quarter of 2002 increased 15% to $0.7 million from $0.6 million for the third quarter of 2001. As a percentage of software license revenue, cost of software license revenue decreased to 4% for the third quarter of 2002 from 6% for the third quarter of 2001. Cost of software licenses for the first nine months of 2002 decreased 19% to $2.0 million from $2.5 million for the first nine months of 2001. As a percentage of software license revenue, cost of software license revenue decreased to 4% for the first nine months of 2002 from 8% for the first nine months of 2001. Such decreases were attributable to a $0.6 million charge taken in the second quarter of 2001 and the increase in software license revenue. The charge was for software acquired by the Company in the 15 fourth quarter of 2000, which, after initially being amortized, was expensed in full in the second quarter of 2001 because the productive use of this software was no longer anticipated. Cost of services consists primarily of the costs of providing implementation, consulting, maintenance, and training services. Cost of services for the third quarter of 2002 decreased 21% to $7.4 million from $9.3 million for the third quarter of 2001, primarily due to reduced staff costs and reduced spending on consultants. Cost of services as a percentage of service revenue increased to 85% for the third quarter of 2002 from 70% for the third quarter of 2001. Cost of services for the first nine months of 2002 decreased 24% to $22.2 million from $29.4 million for the first nine months of 2001. Cost of services as a percentage of services revenue increased to 92% for the first nine months of 2002 from 72% for the first nine months of 2001. The increased percentages were primarily due to the reduction in services revenue, which was only partially offset by reduced staff costs. Service gross margin was $1.3 million for the third quarter of 2002. Due to our current expectation of future services revenues, based in part on expected move to partner-based sales of our PegaRULES product, we intend to reduce services headcount in the fourth quarter of 2002. We will continue to review resource requirements to ensure appropriate alignment with revenue expectations. Operating expenses Research and development expenses for the third quarter of 2002 decreased 1% to $5.3 million from $5.4 million for the third quarter of 2001. As a percentage of total revenue, research and development expenses decreased to 21% for the third quarter of 2002 compared to 23% for the third quarter of 2001. Research and development expenses for the first nine months of 2002 increased 9% to $16.7 million from $15.4 million for the first nine months of 2001. The increase in spending was primarily due to increased staff and staff related expenses. As a percentage of total revenue, research and development expenses held steady at 22% for the first nine months of 2002 compared to the first nine months of 2001. Selling and marketing expenses for the third quarter of 2002 increased 59% to $6.3 million from $4.0 million for the third quarter of 2001. As a percentage of total revenue, selling and marketing expenses increased to 25% for the third quarter of 2002 from 17% for the third quarter of 2001. Selling and marketing expenses for the first nine months of 2002 increased 37% to $18.0 million from $13.1 million for the first nine months of 2001. As a percentage of total revenue, selling and marketing expenses increased to 24% for the first nine months of 2002 from 18% for the first nine months of 2001. These increases were due to increased staff and marketing programs spending in our application business and investment in the emerging PegaRULES business. General and administrative expenses for the third quarter of 2002 decreased 23% to $1.9 million from $2.4 million for the third quarter of 2001. As a percentage of total revenue, general and administrative expenses decreased to 7% for the third quarter of 2002 from 10% for the third quarter of 2001. General and administrative expenses for the first nine months of 2002 decreased 2% to $7.4 million from $7.5 million for the first nine months of 2001. As a percentage of total revenue, general and administrative expenses decreased to 10% for the first nine months of 2002 from 11% of the first nine months of 2001. These decreases were due to reduced employee compensation related expenses. Installment receivable interest income Installment receivable interest income, which consists of the portion of all term license fees under software license agreements that is attributable to the time value of money, decreased in the third quarter of 2002 to $1.3 million from $1.5 million for the third quarter of 2001. Installment receivable interest income for the first nine months of 2002 decreased to $3.8 million from $4.4 million for the first nine months of 2001. The decreases were due to a lower average discount rate for our portfolio of term software licenses. A portion of the fee from each term license arrangement is initially deferred and recognized as installment receivable interest income over the remaining term of the license. For purposes of the present value calculations, the discount rates used are estimates of customers' borrowing rates, typically below prime rate, and have varied between 3.25% and 8.0% during the past few years. 16 Other interest income, net Other interest income, net increased 3% to $0.2 million for the third quarter of 2002 from $0.2 million for the third quarter of 2001. Other interest income, net, decreased to $0.5 million for the first nine months of 2002 from $0.7 million for the first nine months of 2001. The decrease was due to lower interest rates, partially offset by larger invested cash balances. Other income (expense), net Other income (expense), net, which consists primarily of currency exchange losses and reseller development funds received from third-party vendors of computer hardware products, was ($0.4) million for the third quarter of 2002 versus $0.2 million for the third quarter of 2001. Other income (expense), net was ($0.8) million for the first nine months of 2002 compared to $0.2 million for the first nine months of 2001. The decreases were due to greater currency exchange losses and lower reseller development funds. Income before provision for income taxes Income before provision for income taxes increased to $5.1 million for the third quarter of 2002 from $4.1 million for the third quarter of 2001. This $1.0 million improvement was due primarily to a $6.2 million improvement in software license gross margin from increased revenues, partially offset by a $2.7 million reduction in services gross margin due to lower services revenues, increased operating expenses of $1.8 million, greater currency losses and reduction in installment receivable interest income. Provision for income taxes The income tax provision for the third quarter of 2002 relates to the operations of our foreign subsidiaries. The tax provision for the first nine months of 2002 was $0.8 million, up from $0.7 million for the first nine months of 2001. Provisions have not been recorded for U.S. federal and state taxes due to the availability of net tax operating loss carryforwards. Liquidity and Capital Resources We have funded our operations primarily from cash flow from operations and the proceeds of our public stock offerings. At September 30, 2002, we had cash and cash equivalents of $52.3 million and working capital of $72.6 million. Net cash provided by operations for the first nine months of 2002 was $20.7 million compared with $9.3 million for the first nine months of 2001. The increase was due to a $6.2 million improvement in the collection of accounts receivable, primarily from perpetual licenses, and a $5.2 million improvement in profitability. Although we have been very successful in reducing receivables through collections activity, should services revenue increase or customer payments slow, it is reasonable to expect that receivables levels may increase to a more normal level by the end of the year. This increase, in combination with other working capital changes, could result in negative cash flow from operations in the fourth quarter of 2002. Net cash used in investing activities for the first nine months of 2002 was $5.9 million compared with $0.1 million for the first nine months of 2001. The increased use of cash was primarily due to a $4.8 million purchase of debt securities investments, which we intend to hold to maturity, and transaction costs associated with the 1mind acquisition. On February 6, 2002, we acquired substantially all of the assets of 1mind for initial consideration valued at $3.7 million, consisting of 569,949 shares of our common stock and warrants to purchase for nominal consideration 83,092 shares of our common stock. Depending upon the achievement of specified milestones by the acquired business in 2002 and validation of the negotiated value of 1mind, we may pay up to approximately $6 million in additional consideration substantially in the form of shares of our common stock. (See Note 3 of notes to condensed consolidated financial statements.) 17 Net cash provided by financing activities for the first nine months of 2002 was $4.0 million compared with $21 thousand used in the first nine months of 2001. The increase was primarily due to proceeds from employee stock option exercises. We believe that current cash, cash equivalents, and cash flow from ongoing operations will be sufficient to fund our operations for the coming year. Material risks to additional cash flow from operations include a further decline in services revenue and delayed or reduced cash payments accompanying sales of new licenses. There can be no assurance that changes in our plans or other events affecting our operations will not result in materially accelerated or unexpected expenditures. In addition, there can be no assurance that additional capital if needed will be available on reasonable terms, if at all, at such time as we require. Inflation Inflation has not had a significant impact on our operating results to date, and we do not expect it to have a significant impact in the future. Our agreements with customers typically provide for annual increases in term license and maintenance fees based on recognized inflation indexes. Forward-looking statements This Report 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 our 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 our operating results to differ materially or adversely are discussed below. We are having difficulty closing license transactions with new customers. Due in large part, we believe, to continued weakness in spending by our target customers, license transactions with new customers have decreased significantly since the latter part of 2001. License revenue from new customers was 5% of total license revenue in the first nine months of 2002. We believe that obtaining new license customers will continue to be a challenge at least in the near term. The decrease in license contracts with new customers has adversely impacted and may continue to adversely impact our services business because we derive a substantial portion of our services revenue from implementation of software licensed by new customers. Our stock price has been volatile. Quarterly results have fluctuated and are likely to continue to fluctuate significantly. The market price of our 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, and overall market performance, will have a significant effect on the price for shares of our 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. We plan 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 small portions 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 we 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 our policy of recognizing revenue upon product acceptance or license renewal in an amount equal to the present value of the total committed payments 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 six to 12 months but in some cases significantly longer. We are currently in the process of introducing new product technology and making material changes to our existing products. This may result in even lengthier sales and implementation cycles which may adversely affect our financial performance. In addition, we are more focused on closing larger but fewer license transactions than in the past. This may increase the volatility in our quarterly operating results. Risks over which we have little or no control, including customers' budgets, 18 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. If existing customers do not renew their term licenses, our financial results may suffer. Term license renewal negotiations have required more effort due to economic pressures and consolidation among our customers. A significant portion of total revenue has been attributable to term license renewals. While historically a majority of customers have renewed their term licenses, there can be no assurance that a majority of customers will continue to renew expiring term licenses. A decrease in term license renewals absent offsetting revenue from other sources would have a material adverse effect on future financial performance. In addition, we are currently entering into perpetual licenses with most of our new customers, the effect of which may be to increase our license revenue and cash flow in the short term but to decrease the amount of revenue and cash flow from the renewal of term licenses in the long term. We will need to develop new products, evolve existing ones, and adapt to technology change. Technical developments, customer requirements, programming languages and industry standards change frequently in our markets. As a result, success in current markets and new markets will depend upon our ability to enhance current products, to develop and introduce new products that meet customer needs, keep pace with technology 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 we will have sufficient resources to make necessary product development investments. We 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. Our products are complex and may contain errors. Errors in products will require us 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 our reputation, or increased service and warranty costs which would have an adverse effect on financial performance. We have historically sold to the financial services market. This market is continuing to consolidate, and faces uncertainty due to many other factors. We have historically derived a significant portion of our revenue from customers in the financial services market, and our 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 our 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 our future financial performance. We depend 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, our Chief Executive Officer. The loss of key personnel could adversely affect financial performance. We do not have any significant key-man life insurance on any officers or employees and do not plan to obtain any. Our 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 our products is limited, and competition for their services is intense, and there can be no assurance that we will be able to attract and retain such personnel. If we are unable to do so, our business, operating results, and financial condition could be materially adversely affected. The market for our offerings is increasingly and intensely competitive, rapidly changing, and highly fragmented. The market for customer relationship management software and related implementation, consulting and training services is intensely competitive and highly fragmented. We currently encounter significant competition from internal information systems departments of potential or existing customers that develop custom software. We also compete with companies that target the customer interaction and workflow 19 markets and professional service 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 we will be able to compete successfully against current or future competitors or that the competitive pressures faced by us will not materially adversely affect our business, operating results, and financial condition. We must manage increased business complexity and growth effectively. Our business has grown in size, geographic scope and complexity and we have expanded our product offerings and customer base. This growth and expansion has placed, and is expected to continue to place, a significant strain on management, operations and capital needs. Continued growth will require us to hire, train and retrain many employees in the United States and abroad, particularly additional sales and financial personnel. We will also need to enhance our financial and managerial controls and reporting systems to respond to significant growth. We cannot assure that we will attract and retain the personnel necessary to meet our business challenges. Failure to manage growth effectively may materially adversely affect future financial performance. We rely on certain third-party relationships. We have a number of relationships with third parties that are significant to sales, marketing and support activities, and product development efforts. We rely 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 our products through the use of industry-standard tools and utilities. We also have relationships with third parties that distribute our products. In particular, we rely on our relationship with First Data Resources for the distribution of products to the credit card market and with PFPC Inc. for distribution of products to the mutual fund market. 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 ours in the future or will not otherwise end their relationships with or support of us. We may face product liability and warranty claims. Our license agreements typically contain provisions intended to limit the nature and extent of our 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 our licenses with our customers are governed by non-U.S. law, and there is a risk that foreign law might give us less or different protection. Although we have 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 our resources. We face risks from operations and customers based outside of the U.S. Sales to customers headquartered outside of the United States represented approximately 23%, 26% and 21% of our total revenue in 2001, 2000 and 1999, respectively, and 22% for the nine months ended September 30, 2002. We, in part through our wholly-owned subsidiaries based in the United Kingdom, Singapore, Canada, and Australia, market products and render consulting and training services to customers based in Canada, the United Kingdom, France, Germany, the Netherlands, Belgium, Switzerland, Austria, Ireland, Sweden, South Africa, Mexico, Australia, Hong Kong, and Singapore. We have established offices in continental Europe, Australia, and Asia. We believe that growth will necessitate expanded international operations requiring a diversion of managerial attention and financial resources. We anticipate hiring additional personnel to accommodate international growth, and we may also enter into agreements with local distributors, representatives, or resellers. If we are unable to do one or more of these things in a timely manner, our growth, if any, in our foreign operations will be restricted, and our business, operating results, and financial condition could be materially and adversely affected. In addition, there can be no assurance that we will be able to maintain or increase international market demand for our products. Most of our 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 we distribute 20 our products may place us at a competitive disadvantage by effectively making our products more expensive as compared to those of our competitors. Additional risks inherent in our 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 our foreign operations, and, consequentially, our business, operating results, and financial condition. We face risks related to intellectual property claims or appropriation of our intellectual property rights. We rely primarily on a combination of copyright, trademark and trade secrets laws, as well as confidentiality agreements to protect our proprietary rights. In October 1998, we were granted a patent by the United States Patent and Trademark Office relating to the architecture of our systems. We cannot assure that such patent will not be invalidated or circumvented or that rights granted there under or the description contained therein will provide competitive advantages to our competitors or others. Moreover, despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain the use of information that we regard as proprietary. In addition, the laws of some foreign countries do not protect our proprietary rights to as great an extent as do the laws of the United States. There can be no assurance that our means of protecting our proprietary rights will be adequate or that our competitors will not independently develop similar technology. We are not aware that any of our products infringe the proprietary rights of third parties. There can be no assurance, however, that third parties will not claim infringement by us with respect to current or future products. We expect that software product developers will increasingly be subject to infringement claims as the number of products and competitors in our 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 us to enter into royalty or licensing agreements. Such royalty or licensing agreements, if required, may not be available on terms acceptable to us or at all, which could have a material adverse effect upon our business, operating results, and financial condition. We face risks related to the acquisition of 1mind. On February 6, 2002, we acquired substantially all of the assets and specified liabilities of 1mind Corporation and its wholly owned subsidiary (collectively, "1mind"). Following the acquisition of 1mind, we intend to intensify our focus on marketing and selling our products and services within the healthcare market. We face risks in connection with integrating 1mind's technology and personnel into the combined company. Additionally, we face risks involved with integrating and retaining key former 1mind personnel. Managing these risks may result in undue cost or delay and may require us to divert management time and attention from our primary business operations. The result could adversely affect our financial results. Item 3. Quantitative and Qualitative Disclosures about Market Risk Market risk represents the risk of loss that may affect us due to adverse changes in financial market prices and rates. Our market risk exposure is primarily fluctuations in foreign exchange rates and interest rates. We have not entered into derivative or hedging transactions to manage risk in connection with such fluctuations. We derived approximately 22% of our total revenue in the first nine months of 2002 from sales to customers based outside of the United States. Certain of our 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 our sales denominated in foreign currencies in the first nine months of 2002 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 us on the sale of our products in such foreign currencies. 21 We believe that at current market interest rates, the fair value of license installments receivable approximates carrying value as reported on our balance sheets. However, there can be no assurance that the fair value will approximate the carrying value in the future. Factors such as increasing interest rates can reduce the fair value of the license installments receivable. The carrying value reflects a weighted average of historic discount rates. The average rate changes with market rates as new license installment receivables are added to the portfolio, which mitigates exposure to market interest rate risk. Item 4. Controls and Procedures (a) Disclosure controls and procedures. Within 90 days before filing this report, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures. Our disclosure controls and procedures are the controls and other procedures that we designed to ensure that we record, process, summarize and report in a timely manner the information we must disclose in reports that we file with or submit to the SEC. Alan Trefler, our Chairman and Chief Executive Officer, and Christopher Sullivan, our Treasurer and Chief Financial Officer, reviewed and participated in this evaluation. Based on this evaluation, Messrs. Trefler and Sullivan concluded that, as of the date of their evaluation, our disclosure controls were effective. (b) Internal controls. Since the date of the evaluation described above, there have not been any significant changes in our internal accounting controls or in other factors that could significantly affect those controls. 22 Part II - Other Information: Item 1. Legal Proceedings Litigation Qwest Arbitration. In August 2002, we settled our arbitration dispute with Qwest Corporation relating to Qwest's termination of a software license and service agreement with us described in our previous reports filed with the SEC. Pursuant to the settlement, Qwest paid us $2.4 million, the termination of the agreement was acknowledged and the parties entered into a mutual release agreement. We expect to recognize the cash received pursuant to the settlement as revenue in the fourth quarter of 2002. Ernst & Young Arbitration. On September 9, 2000, Pegasystems and two of its officers filed a complaint against Ernst & Young LLP and Alan B. Levine (a former partner of Ernst & Young) in Massachusetts state court, alleging, among other things, that the defendants committed professional malpractice in connection with advice that Ernst & Young rendered to us concerning the proper accounting treatment for revenue in the quarter ended June 30, 1997 under a series of contracts between us and First Data Resources, Inc. On April 5, 2001, the court dismissed the complaint, finding that it was subject to the dispute resolution procedures set forth in an engagement letter between Pegasystems and Ernst & Young. The parties submitted this dispute to arbitration. On August 13, 2002, the arbitration panel denied Pegasystems' claims with respect to the allegations in the complaint. 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 The Company's chief executive officer and chief financial officer have furnished to the SEC the certification with respect to this Form 10-Q that is required by Section 906 of the Sarbanes-Oxley Act of 2002. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits: 10.1 Executive employment agreement dated July 25, 2002 between the Registrant and Henry Ancona 99.1 Certifying letter, Alan Trefler, Chairman and Chief Executive Officer 99.2 Certifying letter, Christopher Sullivan, Treasurer and Chief Financial Officer (b) Reports on Form 8-K: None. 23 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: October 22, 2002 /s/ Alan Trefler ----------------------------------- Chairman and Chief Executive Officer /s/ Christopher Sullivan ----------------------------------- Treasurer and Chief Financial Officer (principal financial officer and chief accounting officer) 24 I, Alan Trefler, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Pegasystems Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: October 22, 2002 /s/ Alan Trefler - -------------------------------- Chairman and Chief Executive Officer 25 I, Christopher Sullivan, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Pegasystems Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: October 22, 2002 /s/ Christopher Sullivan - ------------------------ Treasurer and Chief Financial Officer 26 EX-10.1 3 dex101.txt EXECUTIVE EMPLOYMENT AGREEMENT DATED JULY 25, 2002 BETWEEN THE REGISTRANT AND HENRY ANCONA Exhibit 10.1 EXECUTIVE EMPLOYMENT AGREEMENT THIS EXECUTIVE EMPLOYMENT AGREEMENT (the "Agreement"), made as of the 25th day of July, 2002, is entered into by Pegasystems Inc., a Massachusetts corporation with its principal place of business at 101 Main Street, Cambridge, Massachusetts 02142 (the "Company"), and Henry Ancona, residing at 180 Beacon Street, Boston, Massachusetts 02116 (the "Executive"). The Company desires to employ the Executive, and the Executive desires to be employed by the Company. In consideration of the mutual covenants and promises contained herein, and other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged by the parties hereto, the parties agree as follows: 1. Term of Employment. The Company hereby agrees to employ the Executive, and the Executive hereby accepts employment with the Company, upon the terms set forth in this Agreement, for the period (the "Employment Period") commencing on July 25, 2002 (the "Commencement Date") and ending when terminated in accordance with the provisions of Section 4. 2. Title; Capacity. (a) The Executive shall serve as President and Chief Operating Officer of the Company, subject to the general direction and control of the Company's Board of Directors (the "Board") and its Chief Executive Officer (the "CEO"). The Company will use its best efforts to cause the Executive to be elected to the Board prior to December 31, 2002. The Executive hereby accepts such employment and agrees to undertake the duties and responsibilities inherent in such position and such other executive duties and responsibilities as the Board or the CEO shall from time to time reasonably assign to him. (b) All employees of the Company other than the CEO and his administrative assistant shall report to the Executive. (c) The Executive agrees to devote his entire business time, attention and energies to the business and interests of the Company during the Employment Period provided, however, that Executive shall be allowed, to the extent that such activities do not materially interfere with the performance of his duties and responsibilities hereunder, to manage his personal and family financial and legal affairs and to serve on corporate, civic, not-for-profit, charitable and industry boards and advisory committees. Notwithstanding the foregoing, the Executive shall only serve on for-profit corporate boards of directors and advisory committees if approved in advance by the Board or the CEO. 3. Compensation and Benefits. 3.1 Salary. The Company shall pay the Executive an annual base salary of $325,000 during the Employment Period. Such base salary shall be subject to review by the Compensation Committee of the Board and, based on such review, may be changed by the Compensation Committee in its sole discretion. 3.2 Bonuses. The Company shall pay the Executive an annual cash bonus targeted at 50% of his annual base salary, with the actual bonus amount being dependent on the achievement of goals and objectives. Each such bonus shall be paid within 90 days after the end of the calendar year to which it relates, and, except as provided in Section 5 shall be conditioned upon the Executive's employment by the Company through the end of the calendar year to which it relates. 3.3 Fringe Benefits. The Executive shall be entitled to participate in all bonus and benefit programs (collectively, "Benefits") that the Company establishes and makes available to its senior executive employees, to the extent that the Executive's position, tenure, salary, age, health and other qualifications make him eligible to participate. 3.4 Vacation. The Executive shall be entitled to four (4) weeks paid vacation per year. 3.5 Reimbursement of Expenses. The Company shall reimburse the Executive for all reasonable travel, entertainment and other expenses incurred or paid by the Executive in connection with, or related to, the performance of his duties, responsibilities or services under this Agreement, subject to the Executive's compliance with the Company's standard expense reimbursement policies. 3.6 Stock Options. (a) On the Commencement Date, the Company will grant the Executive a nonqualified 10-year option under the Company's 1994 Long-Term, Incentive Plan (the "Plan") to purchase 500,000 shares of the Company's common stock, $.01 par value per share ("Common Stock"), at a price equal to the fair market value of the Common Stock on such date as determined in accordance with the Plan. Such option shall vest in equal quarterly installments over four (4) years. (b) In the event of a termination of the Executive's employment by the Company without Cause, by the Executive for Good Reason or as a result of the Executive's death (as each term is defined below), all vested stock options then held by the Executive shall remain exercisable for at least one (1) year after such termination, but in no event beyond the original term of the stock option. In the event of a termination of the Executive's employment as a result of Disability or "retirement" (as defined in the Plan), all vested stock options then held by the Executive shall remain exercisable for at least two (2) years after such termination, but in no event beyond the original term of the stock option. Upon any other termination, all vested stock options held by the Executive shall remain exercisable for at least 90 days after such termination, but in no event beyond the original term of the stock option. 2 4. Employment Termination. The employment of the Executive by the Company pursuant to this Agreement shall terminate upon the occurrence of any of the following: 4.1 At the election of the Company, for Cause, immediately upon written notice by the Company to the Executive given within 90 days after the Cause event becomes known to the Company. For the purposes of this Agreement, Cause shall mean: (A) a material breach by the Executive of this Agreement or a material breach by the Executive of the Company's Code of Conduct, in each case that is not cured within 10 days following receipt by the Executive of written notice from the Company specifying the details thereof, (B) Executive's willful failure to attempt in good faith to follow the legal written direction of the Board or the CEO, which is not cured within 10 days following receipt by the Executive of written notice from the Board or the CEO specifying the details thereof, (C) Executive's conviction of a felony (other than a felony involving a traffic violation or as a result of vicarious liability), (D) Executive's commission of an act constituting fraud, embezzlement, larceny or theft with regard to the Company that is of a material nature (other than good faith expense account reimbursement disputes) or (E) willful misconduct by the Executive with regard to the Company that has a material adverse effect on the Company. For purposes of this paragraph, no act, or failure to act, on Executive's part shall be considered "willful" unless done or omitted to be done, by him not in good faith and without reasonable belief that his action or omission was in the best interests of the Company. For purposes of clause (A) above, the Company's "Code of Conduct" shall mean such code as currently in effect and as it may hereafter be amended from time to time, provided that any such amendment is communicated to the Executive in writing or electronically. 4.2 Upon the death of the Executive, or upon 30 days' written notice from the Company after the Executive has incurred a Disability and remains disabled, unless he returns to the full-time performance of his duties within such 30-day period. As used in this Agreement, the term Disability shall mean the failure of the Executive, due to a physical or mental disability, to perform the services contemplated by this Agreement for a period of 120 days, whether or not consecutive, during any 360-day period. 4.3 At the election of the Company, without cause, immediately upon written notice by the Company to the Executive. 4.4 At the election of the Executive for Good Reason, provided that the Executive shall have given written notice to the Board within 90 days after he becomes aware of the occurrence of any event of Good Reason specifying such event, and such event shall be continued for a period of ten (10) days following such notice. For purposes of this Agreement, Good Reason means any of the following events (unless consented to by the Executive in writing): (i) a material diminution in the Executive's duties, responsibilities or authorities or the assignment to the Executive of duties or responsibilities that are materially adversely consistent with his then position; (ii) any individual appointed as the CEO other than the current CEO or the Executive; (iii) any material breach by the Company of this Agreement; (iv) failure of the Executive to be elected to the Board by September 1, 2003, or the Executive's removal from, or failure to be re-elected to the Board once elected thereto; (v) a reduction in the Executive's base salary or targeted bonus; (vi) a requirement by the Company that the Executive's principal place 3 of work to be moved to a location more than 35 miles away from Cambridge, Massachusetts; (vii) a requirement by the Company that the Executive report to a person other than the CEO; or (viii) a change in the Executive's title to a lesser title. 4.5 At the election of the Executive, without Good Reason, upon at least 60 days' prior written notice to the Company. 5. Effect of Termination. 5.1 Termination Pursuant to Section 4.2. In the event the Executive's employment is terminated by reason of the Executive's death or Disability, the Company shall pay or provide to the Executive (or his estate in the case of a termination due to the Executive's death) any compensation and Benefits accrued and otherwise payable to him under Section 3 through the last day of his actual employment by the Company (including, without limitation, any bonus if declared or earned but not yet paid for a completed fiscal year), and accrued vacation pay payable pursuant to the Company's policies, and any unreimbursed business expenses payable pursuant to Company policy (collectively the "Accrued Amounts"), which amounts shall promptly be paid in a lump sum. In addition, the Company shall: (i) continue to provide him and his dependents, for the twelve-month period commencing on the date of such termination, with the Benefits to which he would otherwise have been entitled hereunder had his employment not been terminated and (ii) pay to the Executive (or his estate in the case of his death) a pro-rata bonus for the year of termination equal to, the product of (x) the target annual bonus for the fiscal year of Executive's termination, multiplied by (y) a fraction, the numerator of which is the number of days of the current fiscal year during which Executive was employed by the Company, and the denominator of which is 365, which bonus shall be paid when bonuses for such period are paid to the other executives (the "Pro-Rata Bonus"). 5.2 Termination Pursuant to Sections 4.3 or 4.4. In the event the Executive's employment is terminated by the Company without cause or, by the Executive for Good Reason, the Company shall pay or provide the Executive with the following: (A) within thirty (30) days after the date of such termination, pay him a lump sum amount equal to his then current annual base salary; (B) continue to provide him, for the twelve-month period commencing on the date of such termination, with the Benefits to which he would otherwise have been entitled hereunder had his employment not been terminated; and (C) If the termination occurs at least twelve (12) months after the Commencement Date, then the Company will accelerate in full the vesting of the Executive's options to purchase shares of the Company's Common Stock so that such options are immediately exercisable; and (D) the Executive shall receive the Pro-Rata Bonus. 4 5.3 Termination Pursuant to Sections 4.1 or 4.5. If the Executive's employment is terminated by the Company for Cause or by the Executive without Good Reason, the Company shall pay to the Executive the Accrued Amounts. 6. Standards Letter. Concurrently with the execution and delivery of this Agreement, the Executive agrees to execute and deliver the Company's "standards letter" in the form most recently signed by an executive officer of the Company except that such letter shall be modified to provide that if the Executive's employment hereunder is terminated prior to the first anniversary of the Commencement Date by the Company without Cause or by the Executive for Good Reason then the non-competition covenants contained in such letter shall have no force or effect. The provisions of the standards letter executed by the Executive (the "Standards Letter") shall survive the termination of this Agreement. 7. Release. It will be a condition for receipt of the benefits described in Section 5 above (other than the Accrued Amounts) that the Executive: (i) return Company property, (ii) execute a general release (in the form attached hereto) regarding his employment and (iii) materially comply with the provisions of the Standards Letter. 8. Other Agreements. The Executive hereby represents and warrants that he is not bound by the terms of any agreement to refrain from competing, directly or indirectly, with the business of such previous employer or any other party. The Executive further represents and warrants that his performance of all the terms of this Agreement does not and will not breach any other agreement to which the Executive is a party or otherwise bound; provided that there are certain limitations with regard to confidentiality from prior employers. 9. No Mitigation; No Set-Off. In the event of any termination of employment hereunder, Executive shall be under no obligation to seek other employment and there shall be no offset against any amounts due Executive under this Agreement on account of any remuneration attributable to any subsequent employment that Executive may obtain. The Company's obligation to pay Executive the amounts provided and to make the arrangement provided hereunder shall not be subject to set-off, counterclaim or recoupment except for any amounts the Executive owes to the Company under any promissory note. 10. Indemnification. The Company shall indemnify and hold harmless Executive to the fullest extent permitted by law (including the advancement of legal fees) for any action or inaction of Executive while serving as an officer or director of the Company or, at the Company's request, as an officer or director of any other entity or as a fiduciary of any benefit plan, except for any activity by the Executive that constitutes gross negligence or is self-enriching. The Company shall cover the Executive under directors and officers liability insurance both during and, while potential liability exists, after the Employment Period in the same amount and to the same extent as the Company covers its other officers and directors. 11. Arbitration. All disputes and controversies arising under or in connection with this Agreement, other than the seeking of injunctive or other equitable relief pursuant to the Standards Letter, shall be settled by arbitration conducted before one arbitrator sitting in Boston, Massachusetts, or such other location agreed by the parties hereto, in accordance with the 5 National Rules for the Resolution of Employment Disputes of the American Arbitration Association then in effect. The determination of the arbitrator shall be final and binding on the parties. Judgment may be entered on the award of the arbitrator in any court having proper jurisdiction. 12. Notices. All notices required or permitted under this Agreement shall be in writing and shall be deemed effective upon personal delivery or upon deposit in the United States Post Office, by registered or certified mail, postage prepaid, addressed to the other party at the address shown above, or at such other address or addresses as either party shall designate to the other in accordance with this Section 12. 13. Entire Agreement. This Agreement constitutes the entire agreement between the parties and supersedes all prior agreements and understandings, whether written or oral, relating to the subject matter of this Agreement. 14. Amendment. This Agreement may be amended or modified only by a written instrument executed by both the Company and the Executive. 15. Governing Law. This Agreement shall be construed, interpreted and enforced in accordance with the laws of The Commonwealth of Massachusetts. 16. Successors and Assigns. This Agreement shall be binding upon and inure to the benefit of both parties and their respective successors and assigns, provided that the Company may assign the Agreement only to an acquiror of all or substantially all of its assets and business, and further provided, however, that the obligations of the Executive are personal and shall not be assigned by him. Any successor to the Company shall assume the obligations under this Agreement in a writing delivered to the Executive upon the assignee becoming such. 17. Miscellaneous. 17.1 No delay or omission by the Company in exercising any right under this Agreement shall operate as a waiver of that or any other right. A waiver or consent given by the Company on any one occasion shall be effective only in that instance and shall not be construed as a bar or waiver of any right on any other occasion. 17.2 The captions of the sections of this Agreement are for convenience of reference only and in no way define, limit or affect the scope or substance of any section of this Agreement. 17.3 In case any provision of this Agreement shall be invalid, illegal or otherwise unenforceable, the validity, legality and enforceability of the remaining provisions shall in no way be affected or impaired thereby. 6 IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of the day and year set forth above. PEGASYSTEMS INC. By: /s/ Alan Trefler -------------------------- Title: Chief Executive Officer /s/ Henry Ancona -------------------------- 7 CONFIDENTIAL RELEASE OF CLAIMS I, Henry Ancona, in consideration of certain separation payments that Pegasystems Inc. (the "Company") is agreeing to make to me upon the effectiveness of this Release, agree with the Company as follows: 1. General Release. On behalf of myself and my spouse, heirs, executors, --------------- administrators, trustees, legal representatives, and assigns, I hereby forever release and discharge the Company, its predecessors and successors, and each of its past and present parent corporations, divisions, subsidiaries, affiliates, assigns, officers, directors, employees, consultants, shareholders, partners, attorneys, and agents (any or all of which are referred to as the "Releasees") from any and all claims, demands, liabilities, actions, and causes of action of every name and nature, whether known or unknown, with regard to my employment with the Company and termination therefrom which could have been asserted from the beginning of the world to the date on which I sign this Release. This release includes, but is not limited to, (a) any claims for breach of contract, whether express or implied; (b) any claims for wrongful termination; (c) any claims for reemployment, salary, wages, bonuses, vacation pay, benefits, or other compensation of any kind; (d) any claims for harassment, discrimination, or retaliation in employment, including but not limited to any claims under Title VII of the Civil Rights of 1964, the Age Discrimination in Employment Act, Massachusetts General Laws Chapter 151B, the Employee Retirement Income Security Act, the Americans with Disabilities Act, the Family and Medical Leave Act, and any other federal, state, or local statute, ordinance, regulation, or common law relating to harassment, discrimination, or retaliation in employment; (e) any claims under any other federal, state, or local statutes, ordinances, or regulations; (f) any claims based in tort; (g) any other common-law claims; and (h) any claims for costs or attorneys' fees. Nothing herein shall release the Releasees from any claims based on: (i) my right to enforce this Release or the provisions of my employment agreement with the Company, (ii) any right I may have to vested or accrued benefits, (iii) any right to indemnification or (iv) any rights as a shareholder. 2. Company Property. I agree and acknowledge that I have returned to the ---------------- Company all originals and copies of Company documents and all other Company property that was in my possession at the time of my termination of employment, including without limitation, all keys, corporate credit cards, computer files, diskettes, database information, client information, sales documents, financial statements, budgets and forecasts, and any similar information. Notwithstanding the foregoing, I am permitted to retain my rolodex and similar address and telephone directories. 3. Non-Disparagement. I agree not to intentionally make any public ----------------- statement, written or oral, which disparages the Company, its services, or any of its directors, officers, employees, or agents. The Company shall cause its senior executive officers not to intentionally make any public statement, written or oral, which disparages me. 4. Confidentiality. I agree to keep the terms of this Release and the --------------- amount of separation payments paid to me in exchange for signing this Release completely confidential, and not to disclose any such matters to anyone, in words or in substance, except as set forth in 8 this section. Notwithstanding the foregoing, I may disclose such information (a) to my immediate family, attorney, and/or accountant, provided that I shall first obtain any such person's agreement to keep any such matters completely confidential and not to disclose any such matters to anyone; and (b) to the extent required by law or if compelled pursuant to the order of a court or governmental body or agency. 5. Notice and Right to Consider. I have been advised to consult with an ---------------------------- attorney before signing this Release. I acknowledge that I have been given the opportunity to consider this Release for 21 days before signing it. In the event that I have signed this Release within less than 21 days, I acknowledge that my decision was entirely voluntary and that I had the opportunity to consider this Release for the entire 21-day period. The Company acknowledges that for a period of seven days from the date on which I sign this Release, I will retain the right to revoke this Release by written notice that the Company receives before the end of that seven-day period, and that this Release will not become effective or enforceable until the expiration of such revocation period. 6. Miscellaneous. This Release is binding upon me and upon my heirs, ------------- administrators, representatives, executors, successors, and assigns. I agree that I have carefully read and understand all of the provisions of this Release and that I am voluntarily signing this Release. - ------------------------------- ----------------------------- Henry Ancona Date 9 EX-99.1 4 dex991.txt CERTIFYING LETTER CEO Exhibit 99.1 CERTIFICATION PERSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PERSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of Pegasystems Inc., (the Company) on Form 10-Q for the quarter ended September 30, 2002 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Alan Trefler, Chairman and Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of Section 13(a) or 15(d), as applicable, of the Securities Exchange Act of 1934, as amended; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ Alan Trefler ---------------- Chairman and Chief Executive Officer (Principal Executive Officer) October 22, 2002 27 EX-99.2 5 dex992.txt CERTIFYING LETTER CFO Exhibit 99.2 CERTIFICATION PERSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PERSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of Pegasystems Inc., (the Company) on Form 10-Q for the quarter ended September 30, 2002 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Christopher Sullivan, Treasurer and Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of Section 13(a) or 15(d), as applicable, of the Securities Exchange Act of 1934, as amended; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ Christopher Sullivan ------------------------ Treasurer and Chief Financial Officer (Principal Financial Officer and Chief Accounting Officer) October 22, 2002 28 -----END PRIVACY-ENHANCED MESSAGE-----