10-Q/A 1 f71251e10-qa.txt FORM 10-Q/A 1 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ------------------------ FORM 10-Q/A (Amendment No. 1) ------------------------ [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2000 [ ] 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 CRITICAL PATH, INC. A CALIFORNIA CORPORATION I.R.S. EMPLOYER NO. 91-1788300 532 FOLSOM STREET SAN FRANCISCO, CALIFORNIA 94105 415-808-8800 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. [X] Yes [ ] No As of October 31, 2000, the company had outstanding 73,651,212 shares of common stock, $0.001 par value per share. -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- 2 CRITICAL PATH, INC. INDEX
PAGE ---- PART I Explanatory Note ........................................... ii Item 1. Consolidated Financial Statements (Unaudited) Consolidated Balance Sheet.................................. 1 Consolidated Statement of Operations........................ 2 Consolidated Statement of Cash Flows........................ 3 Notes to Consolidated Financial Statements.................. 4 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations................................... 18 Supplemental Pro Forma Financial Data (Unaudited)........... 40 Item 3. Quantitative and Qualitative Disclosures About Market Risk........................................................ 41 PART II Item 1. Legal Proceedings........................................... 42 Item 2. Changes in Securities and Use of Proceeds................... 42 Item 3. Defaults Upon Senior Securities............................. 42 Item 4. Submission of Matters to a Vote of Security Holders......... 42 Item 5. Other Information........................................... 42 Item 6. Exhibits and Reports on Form 8-K............................ 42
i 3 EXPLANATORY NOTE REGARDING THIS AMENDMENT ON FORM 10-Q/A This quarterly report on Form 10-Q/A is being filed as a result of the restatement of our consolidated financial statements for the quarterly period ended September 30, 2000 as further described in Note 1 -- Basis of Presentation and Summary of Significant Accounting Policies of this Form 10-Q/A and in Note 22 of Notes to Consolidated Financial Statements--Quarterly Financial Data (Unaudited) included in our Annual Report on Form 10-K for the year ended December 31, 2000. This report still speaks as of the original filing date and, except as expressly stated, no attempt has been made to update this report to reflect events occurring subsequent to the date of the original filing. ii 4 PART I ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CRITICAL PATH, INC. CONSOLIDATED BALANCE SHEET (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) ASSETS
DECEMBER 31, SEPTEMBER 30, 1999 2000 ------------ ------------- (UNAUDITED) Current assets Cash and cash equivalents................................. $ 75,932 $ 242,458 Restricted cash........................................... 325 325 Accounts receivable, net.................................. 10,147 37,438 Other current assets...................................... 40,800 9,688 --------- ---------- Total current assets............................... 127,204 289,909 Investments................................................. 18,426 32,669 Notes receivable from officers.............................. 669 1,107 Property and equipment, net................................. 52,517 82,719 Intangible assets, net...................................... 474,297 1,493,478 Other assets................................................ 692 9,202 --------- ---------- Total assets....................................... $ 673,805 $1,909,084 ========= ========== LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities Accounts payable.......................................... $ 35,621 $ 39,549 Accrued expenses.......................................... 7,120 12,887 Deferred revenue.......................................... 1,818 16,532 Capital lease and other obligations, current.............. 6,585 9,681 --------- ---------- Total current liabilities.......................... 51,144 78,649 Convertible subordinated notes payable...................... -- 300,000 Capital lease and other obligations, long-term.............. 5,669 5,958 --------- ---------- Total liabilities.................................. 56,813 384,607 --------- ---------- Minority interest in consolidated subsidiary................ -- 526 Commitments and contingencies Shareholders' Equity Preferred Stock and paid-in-capital, $0.001 par value Shares authorized: 5,000 Shares issued and outstanding: none..................... -- -- Common Stock and paid-in-capital, $0.001 par value Shares authorized: 150,000 Shares issued and outstanding: 46,937 and 73,392........ 864,699 2,132,237 Notes receivable from shareholders........................ (1,154) (1,192) Unearned compensation..................................... (124,906) (128,507) Accumulated deficit, including other comprehensive loss... (121,647) (478,587) --------- ---------- Total shareholders' equity......................... 616,992 1,523,951 --------- ---------- Total liabilities and shareholders' equity......... $ 673,805 $1,909,084 ========= ==========
The accompanying notes are an integral part of these Consolidated Financial Statements. 1 5 CRITICAL PATH, INC. CONSOLIDATED STATEMENT OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
THREE MONTHS ENDED NINE MONTHS ENDED ------------------------------ ------------------------------ SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, 1999 2000 1999 2000 ------------- ------------- ------------- ------------- (UNAUDITED) (UNAUDITED) Net revenues License.............................. $ -- $ 12,365 $ -- $ 37,332 Service.............................. 4,913 22,977 7,968 56,058 -------- --------- -------- --------- Total net revenues........... 4,913 35,342 7,968 93,390 -------- --------- -------- --------- Cost of net revenues License.............................. -- 634 -- 2,378 Service.............................. 4,681 19,076 9,829 50,154 Amortization of purchased technology........................ -- 4,434 -- 10,969 Acquisition-related retention bonuses........................... 130 260 130 1,040 Stock-based expenses................. 2,712 381 3,901 1,257 -------- --------- -------- --------- Total cost of net revenues... 7,523 24,785 13,860 65,798 -------- --------- -------- --------- Gross profit (loss).................... (2,610) 10,557 (5,892) 27,592 -------- --------- -------- --------- Operating expenses Sales and marketing.................. 3,557 16,128 8,760 47,075 Research and development............. 1,895 7,853 4,705 23,389 General and administrative........... 3,678 6,568 7,919 20,666 Amortization of intangible assets.... 9,263 94,160 9,813 230,645 Acquisition-related retention bonuses........................... 570 1,028 570 7,400 Stock-based expenses................. 5,425 10,388 25,244 29,033 Acquired in-process research and development....................... -- 3,500 -- 3,700 Employee severance expenses.......... -- 6,695 -- 6,695 -------- --------- -------- --------- Total operating expenses..... 24,388 146,320 57,011 368,603 -------- --------- -------- --------- Loss from operations................... (26,998) (135,763) (62,903) (341,011) Interest and other income (expense), net.................................. 2,841 4,905 5,074 10,859 Interest expense....................... (167) (5,214) (411) (10,747) Equity in net loss of joint venture.... -- (640) -- (640) Minority interest in net income of consolidated subsidiary.............. -- (201) -- (526) -------- --------- -------- --------- Loss before income taxes............... (24,324) (136,913) (58,240) (342,065) Provision for income taxes............. -- (2,534) -- (4,333) -------- --------- -------- --------- Net loss............................... $(24,324) $(139,447) $(58,240) $(346,398) ======== ========= ======== ========= Net loss per share -- basic and diluted.............................. $ (0.65) $ (2.26) $ (2.26) $ (6.09) ======== ========= ======== ========= Weighted average shares -- basic and diluted.............................. 37,158 61,614 25,715 56,925 ======== ========= ======== =========
The accompanying notes are an integral part of these Consolidated Financial Statements. 2 6 CRITICAL PATH, INC. CONSOLIDATED STATEMENT OF CASH FLOWS (IN THOUSANDS)
NINE MONTHS ENDED SEPTEMBER 30 ---------------------- 1999 2000 --------- --------- (UNAUDITED) Operations Net loss.................................................. $ (58,240) $(346,398) Provision for doubtful accounts........................... 135 1,169 Depreciation and amortization............................. 14,017 24,915 Amortization of intangible assets......................... -- 241,614 Amortization of stock-based costs and expenses............ 29,299 33,737 Acquired in-process research and development.............. -- 3,700 Minority interest in net income of consolidated subsidiary............................................. -- 526 Equity in net loss of unconsolidated affiliate............ -- 640 Accounts receivable....................................... (1,562) (10,901) Other assets.............................................. (3,997) (3,738) Accounts payable.......................................... 2,928 (11,364) Accrued expenses.......................................... 2,018 856 Deferred revenue.......................................... (438) (799) --------- --------- Net cash used in operating activities.................. (15,840) (66,043) --------- --------- Investing Notes receivable from officers, net....................... (122) (371) Property and equipment purchases.......................... (21,843) (39,939) Investments in unconsolidated entities, net............... (4,500) (27,895) Payments for acquisitions, net of cash acquired........... (78,223) (15,269) Promissory note receivable................................ (15,000) 10,000 --------- --------- Net cash used in investing activities.................. (119,688) (73,474) --------- --------- Financing Proceeds from issuance of Preferred Stock, net............ 12,496 -- Proceeds from issuance of Common Stock, net............... 257,372 29,414 Proceeds from convertible debt offering, net.............. -- 289,181 Proceeds from payments of shareholder notes receivable.... 97 -- Repayment of note payable................................. -- (6,000) Principal payments on lease obligations................... (2,166) (4,710) Repurchase of common stock................................ (229) (113) --------- --------- Net cash provided by financing activities.............. 267,570 307,772 --------- --------- Net change in cash and cash equivalents..................... 132,042 168,255 Effect of exchange rates on cash and cash equivalents....... -- (1,729) Cash and cash equivalents at beginning of period............ 14,791 75,932 --------- --------- Cash and cash equivalents at end of period.................. $ 146,833 $ 242,458 ========= =========
The accompanying notes are an integral part of these Consolidated Financial Statements. 3 7 CRITICAL PATH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) NOTE 1 -- BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The Company Critical Path, Inc. was incorporated in California on February 19, 1997. In connection with the Annual Shareholders meeting held in June 2000, the shareholders approved the re-incorporation of Critical Path, Inc. in Delaware, as well as an increase in the authorized shares of Common Stock from 150 million to 500 million. Management expects that these changes will become effective in the fourth quarter of 2000. The unaudited Consolidated Financial Statements ("Financial Statements") of Critical Path, Inc. and Subsidiaries (the "Company" or "Critical Path") furnished herein reflect all adjustments that are, in the opinion of management, necessary to present fairly the financial position and results of operations for each interim period presented. All adjustments are normal recurring adjustments. The Financial Statements should be read in conjunction with the consolidated financial statements and notes thereto, together with management's discussion and analysis of financial condition and results of operations, presented in the Company's 1999 Annual Report on Form 10-K/A. The results of operations for the interim periods presented herein are not necessarily indicative of the results to be expected for the entire year. Restatement of Financial Results On February 2, 2001, we issued a press release announcing that we believed that our previously announced unaudited financial results for the fourth quarter of 2000 may have been materially misstated, that the Board of Directors had formed a special committee to conduct an investigation into the matter, and that our president and vice president of worldwide sales had been placed on administrative leave related to the matter. On February 15, 2001, we announced that, based on the preliminary results of the investigation being conducted we were reviewing certain specific transactions that were reported as revenue during the third quarter of 2000. During February and March 2001, the investigation by the special committee of the Board of Directors was completed, we completed our internal review, and our auditors completed the annual audit. As a result, our financial results for the third quarter of 2000 were materially restated. The third quarter financial results were restated. Adjustments to the Company's third quarter results for the year 2000 are as follows (in thousands):
2000 -------------- THIRD QUARTER -------------- (IN THOUSANDS) Matters impacting revenues: - Software licensing and hosted messaging transactions for which revenues were recognized and it was subsequently determined that revenues, if any, should have been recognized in a later quarter................... $(3,948) - Software licensing transactions for which no revenue will be recognized primarily as a result of re-evaluating the judgment that management used in the application of accounting principles to these transactions............. (5,685) ------- Total revenue decrease...................................... (9,633) ------- Matters impacting costs and expenses: - Miscellaneous selling, general and administrative expense adjustments..................................... 1,565 ------- Total net loss increase..................................... $(8,068) =======
Basis of presentation The consolidated financial statements include the accounts of the Company, its wholly-owned and majority-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. Cash equivalents and restricted cash The Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents. Cash equivalents consist primarily of deposits in money market funds. Restricted cash is composed of amounts held on deposit that are required as collateral for Company issued credit cards. Investments Marketable securities are classified as available-for-sale as of each balance sheet date and are reported at fair value, with unrealized gains and losses, net of tax, recorded in shareholders' equity. Realized gains or losses and charges for permanent declines in value, if any, on available-for-sale securities will be reported in other income or expense as incurred. The equity method is used to account for investments in unconsolidated entities if the Company has the ability to exercise significant influence over financial and operating matters, but does not have the ability to control such entities. The cost method is used to account for equity investments in unconsolidated entities where the Company does not have the ability to exercise significant influence over financial and operating matters. The Company periodically evaluates these investments for other-than-temporary impairment. Concentration of credit risk Financial instruments that potentially subject the Company to a concentration of credit risk consist of cash and cash equivalents, restricted cash, and accounts receivable. Cash and cash equivalents and restricted cash are deposited with financial institutions that management believes are creditworthy. The Company's accounts receivable are derived from product and service transactions with geographically dispersed companies that operate in a number of horizontal markets. At September 30, 2000, approximately 10% of the Company's net accounts receivable were collectible from over 270 publicly-held and private companies operating Internet portal and other on-line businesses. Approximately 8% of the Company's net accounts receivable were collectible from over 80 Internet service providers. Due to the large representative customer 4 8 CRITICAL PATH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) base, management does not believe that these industry concentrations expose the Company to material credit risk. The Company performs ongoing credit evaluations of its customers and maintains allowances for potential credit losses. To date, such losses have been within management's expectations. Fair value of financial instruments The Company's financial instruments, including cash and cash equivalents, restricted cash, accounts and notes receivable, accounts payable and capital lease obligations, are carried at cost, which approximates fair value due to the short maturity of these instruments. Property and equipment Property and equipment are stated at cost less accumulated depreciation. Depreciation is computed using the straight-line method over the shorter of the estimated useful lives of the assets, generally three to five years, or the lease term, if applicable. Gains and losses on disposals are included in income at amounts equal to the difference between the net book value of the disposed assets and the proceeds received upon disposal. Expenditures for replacements and improvements are capitalized, while expenditures for maintenance and repairs are charged to operations as incurred. Internally developed software Statement of Position ("SOP") 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use," requires that certain costs for the development of internal use software should be capitalized, including the costs of coding, software configuration, upgrades and enhancements. SOP 98-1 provides guidance on capitalization of costs incurred for computer software developed or obtained for internal use. The Company capitalizes internally developed software costs in accordance with SOP 98-1; these costs primarily include purchased software and external consulting fees. SOP 98-1 was adopted during 1999, and did not have a material effect on the Company's 1999 financial results. Intangible assets Identifiable intangible assets result from the application of the purchase method of accounting for the Company's acquisitions and are composed of the amounts allocated to the acquisition date fair value of assembled workforce, customer base and acquired technology. The excess of the purchase price paid over the fair value of tangible and identifiable intangible net assets acquired is allocated to goodwill. Intangible assets are stated net of accumulated amortization and are amortized on a straight-line basis over their expected useful lives ranging from two to eight years. The Company periodically evaluates the reasonableness of the remaining useful lives of intangible assets based upon an analysis of current operating contributions and business plans. Valuation of long-lived assets In accordance with Statement of Financial Accounting Standards ("SFAS") No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of," the Company periodically evaluates the carrying value of long-lived assets and certain identifiable intangibles for impairment, when events and circumstances indicate that the carrying amount of an asset may not be recoverable. An impairment loss is recognized whenever the evaluation demonstrates that the carrying amount of a long-lived asset is not recoverable. Since February 19, 1997 (inception) through September 30, 2000, no impairment losses have been identified. 5 9 CRITICAL PATH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) Revenue recognition The Company's revenue recognition policies are in compliance with all applicable accounting standards and regulations, and subsequent amendments and interpretations issued by the American Institute of Certified Public Accountants ("AICPA") and the Securities and Exchange Commission ("SEC"), including SOP 97-2, "Software Revenue Recognition," SOP 98-9 "Modification of SOP 97-2, Software Revenue Recognition with Respect to Certain Transactions," and the SEC's Staff Accounting Bulletin ("SAB") No. 101, "Revenue Recognition." SOP 97-2 provides guidance on generally accepted accounting principles for recognizing revenue on software transactions. SOP 97-2 requires that revenue recognized from software arrangements be allocated to each element of the arrangement based on the relative fair values of the elements, such as software products, specified upgrades and enhancements, post contract customer support, installation, training or other services. Under SOP 97-2, the determination of fair value is based on Company-specific objective evidence. If objective evidence of fair value for each element of the arrangement does not exist, all revenue from the arrangement is deferred until such time that evidence of fair value does exist or until all elements of the arrangement are delivered. License Revenue. License revenue is derived from perpetual and term licenses for the Company's messaging, directory, collaborative and enterprise application integration technologies. License revenues are recognized when persuasive evidence of an arrangement exists, delivery of the licensed software to the customer has occurred and the collection of a fixed or determinable license fee is considered probable. The Company also receives license fees from resellers under arrangements that do not provide product return, exchange or upgrade rights. Revenue from reseller agreements may include a nonrefundable, advance royalty which is payable upon the signing of the contract and license fees based on the contracted value of the Company's products purchased by the reseller. Guaranteed license fees from resellers, where no right of return exists, are recognized when persuasive evidence of an arrangement exists, delivery of the licensed software has occurred and the collection of a fixed or determinable license fee is considered probable. Non-guaranteed per-copy license fees from resellers are initially deferred and are recognized when they are reported as sold to end users by the reseller. Service Revenue. The Company derives service revenues from the delivery of hosted messaging and collaboration services, professional services associated with both hosted services and licensed products and from post-contract customer support agreements associated with product licenses. Fees for hosted messaging services are primarily based upon monthly contractual per unit rates for the services involved, which are recognized on a ratable monthly basis over the term of the contract beginning with the month in which service delivery starts. Amounts billed or received in advance of service delivery are initially deferred and subsequently recognized on a ratable monthly basis over the term of the contract beginning with the month in which service delivery starts. Fees from with post-contract customer support agreements associated with product licenses are recognized ratably over the term of the support contract, generally one year. Other services revenue, composed primarily of training, installation and configuration services, are recognized in the period in which the services are performed. Research and development Research and development costs include expenses incurred by the Company to develop and enhance its portfolio of secure messaging, directory, wireless, data integration and collaboration solutions. Research and development costs, including acquired in-process research and development costs, are recognized as an expense as incurred. 6 10 CRITICAL PATH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) Advertising expense Advertising and promotion costs are generally expensed as incurred. Costs associated with the development of print or other media campaigns are deferred until the period that includes the first commercial use of the media campaign. Costs associated with industry trade shows and customer conferences are deferred until the period that includes the applicable trade show or conference. Stock-based compensation The Company accounts for stock-based employee compensation arrangements in accordance with the provisions of Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees" and complies with the disclosure provisions of Statement of Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based Compensation." Under APB No. 25, compensation expense is based on the difference, if any, on the date of the grant, between the fair value of the Company's stock and the exercise price of the option. The Company accounts for equity instruments issued to non-employees in accordance with the provisions of SFAS No. 123 and Emerging Issues Task Force ("EITF") 96-18, "Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services." In March 2000, the Financial Accounting Standards Board ("FASB") issued FASB Interpretation ("FIN") No. 44, "Accounting for Certain Transactions Involving Stock Compensation, an Interpretation of APB Opinion No. 25" (the "Interpretation"). The Interpretation was intended to clarify certain issues that have arisen in practice since the issuance of Accounting Principals Board No. 25, "Accounting for Stock Issued to Employees." The Company implemented the provisions of FIN No. 44 in the quarter ended June 30, 2000. Management does not believe that the adoption of FIN No. 44 will have a significant impact on future results. Income taxes Income taxes are computed using an asset and liability approach, which requires the recognition of taxes payable or refundable for the current year and deferred tax assets and liabilities for the future tax consequences of events that have been recognized in the Company's consolidated financial statements or tax returns. The measurement of current and deferred tax assets and liabilities are based on provisions of the enacted tax law; the effects of future changes in tax laws or rates are not anticipated. The measurement of deferred tax assets is reduced, if necessary, by the amount of any tax benefits that, based on available evidence, are not expected to be realized. Net loss per share Net loss per share is calculated in accordance with SFAS No. 128, "Earnings per Share" and SAB No. 98. Under the provisions of SFAS No. 128 and SAB No. 98, basic net loss per share is computed by dividing the net loss available to common shareholders for the period by the weighted average number of common shares outstanding during the period. Shares subject to repurchase by the Company and shares held in escrow in connection with certain acquisition agreements, are excluded from the basic calculation. Diluted net loss per share is computed by dividing the net loss for the period by the weighted average number of common and potential common shares outstanding during the period if the effect of each class of potential common shares is dilutive. Potential common shares include restricted Common Stock, shares held in escrow, and incremental Common and Preferred shares issuable upon the exercise of stock options and warrants and upon conversion of Series A and Series B Convertible Preferred Stock and the convertible notes. 7 11 CRITICAL PATH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) Comprehensive income In accordance with SFAS No. 130, "Reporting Comprehensive Income" the Company accounts for and reports comprehensive income or loss and its components in its financial statements. Comprehensive income or loss, as defined, includes the Company's net income or loss and all other changes in equity (net assets) during the period from non-owner sources. Foreign currency translation Assets and liabilities recorded in foreign currencies are translated at the exchange rate on the balance sheet date. Revenue and expenses are translated at average rates of exchange prevailing during the period. Translation adjustments are charged or credited to other comprehensive income, a component of shareholders' equity. Realized gains and losses on foreign currency transactions are included in "Interest and other income (expense), net." Segment and geographic information In June 1997, the Financial Accounting Standards Board issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." This Statement establishes standards for the way companies report information about operating segments in annual financial statements. It also establishes standards for related disclosures about products and services, geographic areas and major customers. In accordance with the provisions of SFAS No. 131, the Company has determined that it does not have separately reportable operating segments. The Company operates in one principle business segment across domestic and international markets. NOTE 2 -- ACQUISITIONS AND JOINT VENTURE ISOCOR Corporation On January 19, 2000, the Company acquired ISOCOR Corporation ("ISOCOR"), a leading supplier of Internet messaging, directory and meta-directory software solutions. The acquisition was accounted for using the purchase method of accounting and accordingly, the purchase price was allocated to the tangible and intangible net assets acquired on the basis of their respective fair values on the acquisition date. The fair value of intangible assets was determined based upon an independent valuation using a combination of methods, including an income approach for the acquired in-process research and development and existing technologies and the customer base, and a replacement cost approach for the value of the assembled workforce. The total purchase price of approximately $274.9 million consisted of $226.7 million of the Company's Common Stock (5,043,054 shares), assumed stock options with a fair value of $37.2 million, and other acquisition related expenses of approximately $11.0 million, consisting primarily of payments for legal and financial advisory services. Of the total purchase price, $18.7 million was allocated to net tangible assets, and the remainder was allocated to intangible assets, including in-process research and development ($200,000), existing technology ($18.3 million), customer base ($9.8 million), assembled workforce ($3.4 million) and goodwill ($224.5 million). The acquired in-process research and development was recognized as research and development expense in the period the transaction was consummated. The fair value of other acquired intangible assets, excluding goodwill, was capitalized and is being amortized over their estimated useful lives of three years. Goodwill is being amortized using the straight-line method over three years. 8 12 CRITICAL PATH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) The ISOCOR acquisition was recognized as follows:
(IN THOUSANDS) Fair value of assets acquired.......................... $ 290,176 Liabilities assumed.................................... (15,291) Fair value of Common Stock and options issued.......... (263,885) --------- Cash paid, including acquisition costs................. 11,000 Less: cash acquired.................................... 18,989 --------- Net cash acquired...................................... $ 7,989 =========
The docSpace Company On March 8, 2000, the Company acquired all outstanding stock of The docSpace Company ("docSpace"), a provider of Web-based services for secure file delivery, storage and collaboration. The acquisition was accounted for using the purchase method of accounting and accordingly, the purchase price was allocated to the tangible and intangible assets acquired on the basis of their respective fair values on the acquisition date. The fair value of intangible assets was determined based upon an independent valuation using a combination of methods, including a cost approach for the acquired existing technology, and the replacement cost approach for the value of the assembled workforce. The total purchase price of $258.0 million consisted of $30.0 million cash, Common Stock (3,805,820 shares) valued at $218.0 million, and other acquisition related expenses of approximately $10.0 million, consisting primarily of payments for legal and financial advisory services. Of the total purchase price, approximately $7.1 million was allocated to net tangible liabilities and the remainder was allocated to intangible assets, including assembled workforce ($500,000), existing technology ($21.5 million), and goodwill ($243.1 million). The fair value of acquired intangible assets, excluding goodwill, was capitalized and is being amortized over their estimated useful lives of three years. Goodwill is being amortized using the straight-line method over three years. The docSpace acquisition was recognized as follows:
(IN THOUSANDS) Fair value of assets acquired.......................... $ 266,128 Liabilities assumed.................................... (8,154) Fair value of Common Stock issued...................... (217,979) --------- Cash paid, including acquisition costs................. 39,995 Less: cash acquired.................................... 153 --------- Net cash paid.......................................... $ 39,842 =========
RemarQ Communities, Inc. On March 30, 2000, the Company acquired RemarQ Communities, Inc. ("RemarQ"), a provider of Internet collaboration services for corporations, Web portals and Internet service providers. The acquisition was accounted for using the purchase method of accounting and accordingly, the purchase price was allocated to the tangible and intangible net assets acquired on the basis of their respective fair values on the acquisition date. The fair value of intangible assets was determined based upon an independent valuation using a combination of methods, including cost and royalty savings approaches for the value of the acquired existing technology, cost and income approaches for the value of the customer base, and a cost approach for the value of the assembled workforce. 9 13 CRITICAL PATH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) The total purchase price of approximately $267.6 million, consisted of Common Stock (3,868,450 shares) valued at $259.3 million, assumed stock options with an estimated fair market value of $7.7 million, and other acquisition related expenses of approximately $600,000, consisting primarily of payments for legal and financial advisory services. Of the total purchase price, approximately $7.8 million was allocated to net tangible assets, and the remainder was allocated to intangible assets, including existing technology ($4.5 million), assembled workforce ($3.3 million), customer base ($5.9 million), and goodwill ($246.1 million). The fair value of the acquired intangible assets, excluding goodwill, was capitalized and is being amortized over their estimated useful lives of two to three years. Goodwill is being amortized using the straight-line method over three years. The RemarQ acquisition was recognized as follows:
(IN THOUSANDS) Fair value of assets acquired.......................... $ 279,033 Liabilities assumed.................................... (11,453) Fair value of Common Stock and options issued.......... (267,000) --------- Cash paid, including acquisition costs................. 580 Less: cash acquired.................................... 11,203 --------- Net cash acquired...................................... $ 10,623 =========
Netmosphere, Inc. On June 26, 2000, the Company acquired Netmosphere, Inc. ("Netmosphere"), a provider of e-business solutions for project collaboration and communications. The acquisition was accounted for using the purchase method of accounting and accordingly, the purchase price was allocated to the tangible and intangible net assets acquired on the basis of their respective fair values on the acquisition date. The fair value of intangible assets was determined based upon an independent valuation using a combination of methods, including an income approach for the acquired technologies and customer base, and a replacement cost approach for the value of the assembled workforce. The total purchase price was approximately $41.3 million, which consisted of the Company's Common Stock (1,007,835 shares) valued at $33.0 million, assumed stock options with an estimated fair market value of $5.7 million, assumed warrants with an estimated fair value of $1.0 million, and other acquisition related expenses of approximately $1.6 million, consisting primarily of payments for legal and financial advisory services. Of the total purchase price, approximately $1.0 million was allocated to net tangible liabilities, and the remainder was allocated to intangible assets, including existing technology ($3.6 million), assembled workforce ($1.4 million), customer base ($9.0 million), and goodwill ($28.3 million). The fair value of the acquired intangible assets, excluding goodwill, was capitalized and is being amortized over their estimated useful lives of four years. Goodwill is being amortized using the straight-line method over four years. The Netmosphere acquisition was recognized as follows:
(IN THOUSANDS) Fair value of assets acquired.......................... $ 43,089 Liabilities assumed.................................... (1,749) Fair value of Common Stock, options and warrants issued............................................... (39,726) -------- Cash paid, including acquisition costs................. 1,614 Less: cash acquired.................................... 23 -------- Net cash paid.......................................... $ 1,591 ========
10 14 CRITICAL PATH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) PeerLogic, Inc. On September 26, 2000, the Company acquired PeerLogic, Inc. ("PeerLogic"), a vendor of directory and enterprise application integration software. The acquisition was accounted for using the purchase method of accounting and accordingly, the purchase price was allocated to the tangible and intangible net assets acquired on the basis of their respective fair values on the acquisition date. The fair value of intangible assets was determined based upon an independent valuation using a combination of methods, including an income approach for the acquired in-process research and development and existing technologies and the customer base, and a replacement cost approach for the value of the assembled workforce. Upon consummation of the PeerLogic acquisition, the Company recognized $3.5 million representing the value attributable to acquired in-process research and development in certain enterprise application integration software that had not yet reached technological feasibility and had no alternative future use. The value was determined using an income approach, by estimating the future net cash flows of the acquired in-process research and development over its estimated useful life and discounting the net cash flows back to their present value. The discount rate included a factor that took into account the uncertainty surrounding the successful development of the acquired in-process research and development. The acquired in-process research and development is expected to become commercially available in 2001. The total purchase price of approximately $445.1 million consisted of $374.7 million of the Company's Common Stock (6.1 million shares), assumed stock options with a fair value of $63.4 million, other acquisition related expenses of approximately $4.0 million, consisting primarily of payments for legal and financial advisory services, and the Company's previous $3.0 million minority investment in PeerLogic. Of the total purchase price, approximately $18.7 million was allocated to the net tangible liabilities, approximately $28.3 million was allocated to unearned compensation related to the unvested portion of assumed stock options, and the remainder was allocated to intangible assets, including acquired in-process research and development ($3.5 million), existing technology ($30.3 million), assembled workforce ($7.4 million), customer base ($5.5 million), and goodwill ($388.8 million). The unvested portion of the assumed stock options was capitalized and is being amortized over the estimated remaining service period of two years. The fair value of other acquired intangible assets, excluding goodwill, was capitalized and is being amortized over their estimated useful lives of three years. Goodwill is being amortized using the straight-line method over three years. The PeerLogic acquisition was recognized as follows:
(IN THOUSANDS) Fair value of assets acquired.......................... $ 472,824 Liabilities assumed.................................... (27,704) Fair value of Common Stock, options and warrants issued............................................... (438,120) --------- Cash paid, including acquisition costs................. 7,000 Less: cash acquired.................................... -- --------- Net cash paid.......................................... $ 7,000 =========
11 15 CRITICAL PATH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) ProForma Results The following unaudited pro forma information presents the Company's consolidated results of operations for the nine months ended September 30, 1999 and 2000, as if the acquisitions had been consummated at the beginning of each period. The pro forma consolidated results of operations include certain pro forma adjustments, including the amortization of intangible assets and the accretion of the acquisition-related retention bonuses.
NINE MONTHS ENDED SEPTEMBER 30, ---------------------- 1999 2000 --------- --------- (IN THOUSANDS, EXCEPT PER SHARE DATA) Net revenues................................. $ 34,577 $ 112,119 Net loss..................................... (398,840) (544,596) Net loss per share -- basic and diluted...... (9.12) (7.74)
The pro forma results are not necessarily indicative of those that would have actually occurred had the acquisition taken place at the beginning of the periods presented. Critical Path Pacific The Company established a joint venture, Critical Path Pacific ("CP Pacific"), with Mitsui and Co., Ltd., NTT Communications Corporation and NEC Corporation to deliver advanced Internet messaging solutions to Asia/Pacific businesses. The Company has invested $7.5 million and holds a 40% ownership interest in the joint venture. This investment is being accounted for using the equity method. During the three-and nine-month periods ended September 30, 2000, the Company recorded equity in net loss of joint venture of $640,000. NOTE 3 -- ACQUISITION-RELATED RETENTION BONUSES In connection with the acquisitions of dotOne Corporation ("dotOne"), Amplitude Software Corporation ("Amplitude"), Xeti, Inc. ("Xeti"), FaxNet Corporation ("FaxNet"), ISOCOR, and docSpace, the Company established a retention bonus program in the aggregate amount of $20.7 million to provide incentives for certain former employees of these companies to continue their employment with Critical Path. Payment of bonuses to the listed employees will occur one year following the date of acquisition, unless the listed employees voluntarily terminate their employment with the Company prior to the respective acquisition's one-year anniversary. The aggregate amount of the eligible bonuses is reduced for the bonus amount allocated to each former dotOne, Amplitude, Xeti, FaxNet, ISOCOR, and docSpace employee that chooses to terminate his or her employment with the Company. A ratable share of the adjusted eligible bonus amount will be accrued and charged to compensation expense over the respective twelve-month period commencing on the date the bonuses are granted. As of September 30, 2000, the aggregate, adjusted eligible bonus amount was $18.3 million, and the amount recognized as compensation expense was $3.1 million and $10.3 million during the three- and nine-month periods then ended, respectively. Additionally, during the three-month period ended September 30, 2000, approximately $790,000 was recognized as employee severance expense, resulting from acceleration of the required one year vesting period (Note 4). Based on the functions of the employees scheduled to receive acquisition-related retention bonuses, $260,000 and $1.0 million of the compensation charge was allocated to cost of net revenues, and the remaining $2.9 million and $9.3 million was allocated to operating expenses, for the three-and nine-month periods ended September 30, 2000, respectively. Acquisition-related retention bonuses during both the three- and nine-month periods ended September 30, 1999, amounted to $700,000. 12 16 CRITICAL PATH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) During the three- and nine-months ended September 30, 2000, of which $130,000 was allocated to cost of net revenues and the remaining $570,000 was allocated to operating expenses. NOTE 4 -- EMPLOYEE SEVERANCE EXPENSES On July 19, 2000, the Company announced its plan to reduce its worldwide employee headcount by approximately 13%. This employee reduction plan was executed with the intent to realize various synergies gained through the nine acquisitions the Company completed in 1999 and the first half of 2000. During the quarter ended September 30, 2000, the Company recognized a one-time charge for severance-related costs totaling $6.7 million, composed of $3.3 million in cash charges and $3.4 million in stock-based compensation expense. During the quarter ended September 30, 2000, the Company paid approximately $2.6 million related to employee severance and expects to make the remaining severance related payments in the quarter ending December 31, 2000. Any differences between the amounts accrued and amounts actually incurred will be recognized in the quarter ending December 31, 2000. The Company recognized stock-based compensation expense resulting from the acceleration of certain employee stock options in connection with the Company's employee reduction plan. These charges totaled $3.4 million and have been included in employee severance expense for the quarter ended September 30, 2000. NOTE 5 -- INVESTMENTS The Company's investments in unconsolidated entities consist of the following:
DECEMBER 31, SEPTEMBER 30, 1999 2000 ------------ ------------- (IN THOUSANDS) Marketable securities.............................. $10,926 $ 2,201 Non-marketable securities, at cost................. 7,500 23,600 Investments, at equity............................. -- 6,868 ------- ------- Total Investments........................ $18,426 $32,669 ======= =======
The Company made strategic equity investments totaling $13.1 million during the three months ended September 30, 2000 in four private entities, which are being accounted for using the cost method of accounting. See Subsequent Events -- Note 13. NOTE 6 -- INTANGIBLE ASSETS
DECEMBER 31, SEPTEMBER 30, 1999 2000 ------------ ------------- (IN THOUSANDS) Goodwill........................................... $475,368 $1,610,413 Customer base...................................... 12,800 42,950 Assembled workforce................................ 6,960 22,960 Existing technology................................ 9,940 89,540 Patent license..................................... 1,488 1,488 -------- ---------- 506,556 1,767,351 Less: accumulated amortization..................... (32,259) (273,873) -------- ---------- Intangible assets, net................... $474,297 $1,493,478 ======== ==========
Amortization of intangible assets totaled $98.6 million and $241.6 million during the three- and nine-month periods ended September 30, 2000, respectively. During the three- and nine-month periods ended September 30, 1999, amortization of intangible assets totaled $9.3 million and $9.8 million, respectively. 13 17 CRITICAL PATH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) Based on the functionality of the purchased technology, amortization expense for the three- and nine-month periods ended September 30, 2000, of $4.4 million and $11.0 million, respectively, was allocated to cost of net revenues. The remaining $94.2 million and $230.6 million was allocated to operating expenses. NOTE 7 -- BORROWINGS On September 26, 2000, in connection with the PeerLogic acquisition, the Company assumed a $6.0 million unsecured convertible note payable to International Computers Limited ("ICL") (the "ICL Note Payable"). The ICL Note Payable was issued by PeerLogic in April 1999, accrued interest at a rate of 7.5% per annum and was payable in equal, principal and interest, monthly installments commencing on August 1, 1999 until June 30, 2002, when the balance of the unpaid principal and accrued interest shall be due and payable in full. On September 29, 2000, the Company retired the ICL Note Payable through the payment of $6.0 million to ICL. On March 30, 2000, the Company issued $300.0 million of five-year, 5.75% Convertible Subordinated Notes ("Notes") due April 2005, to qualified institutional buyers in reliance on Rule 144A under the Securities Act of 1933. Holders may convert the Notes into shares of Critical Path's Common Stock at any time before their maturity or the business day before their redemption or repurchase of Critical Path. The conversion rate is 9.8546 shares per $1,000 principal amount of Notes, subject to adjustment in certain circumstances This rate is equivalent to a conversion price of approximately $101.48 per share. The Company incurred approximately $10.8 million in debt issuance costs, consisting primarily of payments for an underwriting discount and legal and other professional fees. These costs have been capitalized and will be recognized as a component of interest expense on a straight-line basis over the five-year term of the Notes. Interest is payable on April 1 and October 1 of each year with the first interest payment due on October 1, 2000. The Notes subordinated in right of payment to all senior debt of Critical Path and effectively subordinated to all existing and future debt and other liabilities of Critical Path's subsidiaries. On or after the third business day after April 1, 2003, through March 31, 2004, the Company has the option to redeem all or a portion of the Notes that have not been previously converted at the redemption price equal to 102.30% of the principal amount. During the period from April 1, 2004 through March 31, 2005, the Company has the option to redeem all or a portion of the Notes that have been previously converted at the redemption price equal to 101.15% of the principal amount. Thereafter the redemption price is equal to 100% of principal amount. The Notes are non-callable for three years. In the event of a "Change in Control," as defined in Notes' Offering Circular, the Holders have the option of requiring the Company to repurchase any Notes held at a price of 100% of the principal amount of the Notes plus accrued interest to the date of repurchase. NOTE 8 -- COMMITMENTS AND CONTINGENCIES On March 8, 2000, the Company acquired docSpace, which is involved in a patent infringement action with Tumbleweed Communications Corp. The lawsuit relates to a Tumbleweed patent that describes an apparatus for delivering documents via the Internet. The Company has denied the allegations of infringement and has counterclaimed for violations of the antitrust laws and related state law claims. Both parties have moved for summary judgment. This case is in the initial discovery phase and the Company is not currently able to assess the impact, if any, on its financial position or results of operations. The Company is party to various legal proceedings in the ordinary course of its business. The Company believes that the ultimate outcome of these matters will not have a material adverse impact on its financial position or results of operations. 14 18 CRITICAL PATH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) In the ordinary course of business, the Company has issued letters of credit and refundable security deposits totaling $1.7 million associated primarily with operating leases for office facilities. NOTE 9 -- MINORITY INTEREST IN SUBSIDIARY The Company owns a 72.87% interest in CP Italia, a consolidated subsidiary. In addition, in the event certain performance levels are achieved, the Company has agreed to purchase the remaining 27.13% minority interest it doesn't own on or before January 31, 2001, for a purchase price ranging from $2.7 million to $4.2 million, based upon the achievement of future performance milestones. NOTE 10 -- SHAREHOLDERS' EQUITY WARRANTS America Online/ICQ In January 1999, the Company entered into an agreement with ICQ, Inc., a subsidiary of America Online, Inc. ("ICQ"), pursuant to which the Company provides email hosting services that are integrated with ICQ's instant messaging service provided to ICQ's customers. As part of the agreement, ICQ agreed to provide sub-branded advertising for the Company in exchange for warrants to purchase 2,442,766 shares of the Company's Common Stock, issuable upon attainment of each of five milestones. As of April 9, 2000, all five milestones had been attained. Aggregate charges to stock-based expenses of $798,000 and $5.9 million were recorded during the three-month periods ended September 30, 1999 and 2000, respectively, and $12.2 million and $13.6 million were recorded during the nine-month periods ended September 30, 1999 and 2000, respectively, related to these warrants. At April 9, 2000, the final revised aggregate fair value of all vested warrants was $93.8 million. On September 8, 2000, AOL executed a net exercise of warrants to purchase 766,674 shares related to the attainment of the first of five milestones (the related gross number of warrants to purchase shares of the Company's Common Stock were 814,254 shares). On September 18, 2000, AOL executed a net exercise of warrants to purchase 1,441,067 shares related to the attainment of the remaining four milestones (the related gross number of warrants to purchase shares of the Company's Common Stock were 1,628,512 shares). Qwest Communications Corporation In October 1999, the Company entered into an agreement with Qwest Communications Corporation ("Qwest"), a telecommunications company, pursuant to which the Company provides email hosting services to Qwest's customers. As part of the agreement, Qwest agreed to provide sub-branded advertising for Critical Path in exchange for warrants to purchase up to a maximum of 3,534,540 shares of Common Stock upon attainment of each of six milestones. As of September 30, 2000, only the first of the six milestones had been attained. None of the remaining milestones are considered probable and as a result, the fair value of the warrants relating to the shares underlying the second through sixth milestones has not been recognized. During the three- and nine-month periods ended September 30, 2000, $1.9 million and $5.6 million, respectively, was charged to stock-based expense related to the vested warrants. Worldsport Network Ltd. In December 1999, the Company entered into an agreement with Worldsport Network Ltd. ("Worldsport"), exclusive provider of Internet solutions for the General Association of International Sports Federations ("GAISF") and a majority of the international federations it recognizes. Worldsport offers Critical 15 19 CRITICAL PATH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) Path's advanced Web-based email and calendaring services to the entire GAISF network and its members. As part of the agreement, Worldsport agreed to provide sub-branded advertising for the Company in exchange for warrants to purchase up to a 1.25% equity interest in the Company on a fully diluted basis upon attainment of each of five milestones. As of September 30, 2000, none of the milestones were considered probable and as a result, the fair value associated with these warrants has not been recognized. Telco In January of 2000, docSpace entered into an agreement with a major telecommunications company ("Telco") pursuant to which docSpace would provide secure messaging services to the Telco's customers. As part of the agreement, Telco agreed to provide marketing, publicity, and promotional services to docSpace. As a result of the completion of the Company's acquisition of docSpace, Critical Path assumed warrants that allowed Telco to purchase up to a maximum of 349,123 shares of Common Stock upon attainment of each of three milestones. Subsequent to the acquisition, the Company entered into discussions with Telco to modify their relationship. Accordingly, the vesting provisions of the proposed agreement are being modified to reflect the requirements of the new relationship. As of September 30, 2000, none of the vesting milestones had been attained; however, the Company believes that all shares underlying these warrants are probable of issuance. As a result, the shares underlying these milestones were remeasured using the September 30, 2000, closing price of the Company's Common Stock of $60.75, resulting in a revised fair value of the warrants of $17.6 million. The fair value of the warrants will be recognized on a straight-line basis over the greater of the term of the contract or the expected period of benefit of the strategic relationship. During the three- and nine-month periods ended September 30, 2000, no amount was recognized as stock-based expense related to these warrants. NOTE 11 -- COMPREHENSIVE LOSS The components of comprehensive loss, net of tax, are as follows:
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, --------------------- --------------------- 1999 2000 1999 2000 -------- --------- -------- --------- (IN THOUSANDS) Net loss...................................... $(24,324) $(139,447) $(58,240) $(346,398) Unrealized investment gains (losses).......... (7,475) (3,117) 7,014 (9,233) Foreign currency translation adjustments...... -- (1,177) -- (1,308) -------- --------- -------- --------- Comprehensive loss............................ $(31,799) $(143,741) $(51,226) $(356,939) ======== ========= ======== =========
Accumulated other comprehensive loss consists of unrealized gains (losses) on available-for-sale securities, net of tax, and cumulative translation adjustments, as presented on the accompanying consolidated balance sheet. 16 20 CRITICAL PATH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) NOTE 12 -- NET LOSS PER SHARE Net loss per share is calculated as follows:
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, --------------------- --------------------- 1999 2000 1999 2000 -------- --------- -------- --------- (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) Net loss...................................... $(24,324) $(139,447) $(58,240) $(346,398) Weighted average shares outstanding........... 39,990 64,405 28,768 60,061 Weighted average shares subject to repurchase agreements.................................. (2,574) (1,214) (2,967) (1,637) Weighted average shares held in escrow related to acquisitions............................. (258) (1,577) (86) (1,499) -------- --------- -------- --------- Shares used in computation of basic and diluted net loss per share.................. 37,158 61,614 25,715 56,925 ======== ========= ======== ========= Net loss per share -- basic and diluted....... $ (0.65) $ (2.26) $ (2.26) $ (6.09) ======== ========= ======== =========
For the three- and nine-month periods ended September 30, 1999, approximately 19.2 million and 16.9 million, potential common shares, respectively, were excluded from the determination of diluted net loss per share, as the effect of such shares on a weighted average basis is anti-dilutive. For the three- and nine-month periods ended September 30, 2000, approximately 18.4 million and 19.4 million potential common shares, respectively, were excluded. NOTE 13 -- SUBSEQUENT EVENT In October 2000 the Company made a strategic equity investment totaling $600,000 in a private entity and is committed to increase this investment to $4.2 million upon the investee's attainment of certain future performance milestones. 17 21 CRITICAL PATH, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis of Critical Path, Inc., and Subsidiaries ("Company" or "Critical Path") should be read in conjunction with the Consolidated Financial Statements and Notes thereto of the Company included herein, as well as the Company's 1999 Annual Report on Form 10-K/A. The following discussion contains forward-looking statements. The Company's actual results may differ significantly from those projected in these forward-looking statements. Factors that might cause future results to differ materially from those projected in the forward-looking statements include, but are not limited to, failure to expand our sales and marketing activities, unplanned system interruptions and capacity constraints that could reduce our ability to provide messaging services and harm our business and our reputation, potential difficulties associated with strategic relationships and investments, ability to respond to rapid technological change of the Internet messaging industry, competition, foreign currency fluctuations, failure to maintain or reduce operating expense levels, delays in customer orders, recognition of revenue from customers, problems related to managing the Company's expected growth, including the ability to maintain or improve upon cost efficiencies, and the failure to realize savings due to perceived synergies of acquired businesses, including PeerLogic, and those discussed in "Additional Factors That May Affect Future Operating Results" and elsewhere in this report. Readers are cautioned not to place undue reliance on these forward-looking statements. The Company has no obligation to publicly release the results of any revisions to these forward-looking statements to reflect events or circumstances after the date of this filing. OVERVIEW Critical Path Inc. is a leading global provider of Internet messaging infrastructure products and services. The Company is a single resource that provides solutions to manage the flow of mission-critical information through an integrated portfolio of secure messaging, directory, wireless, data integration and collaboration solutions. Critical Path was founded in 1997, and is headquartered in San Francisco with offices in eleven countries throughout the world. Restatement of Financial Results On February 2, 2001, we issued a press release announcing that we believed that our previously announced unaudited financial results for the fourth quarter of 2000 may have been materially misstated, that the Board of Directors had formed a special committee to conduct an investigation into the matter, and that our president and vice president of worldwide sales had been placed on administrative leave related to the matter. On February 15, 2001, we announced that, based on the preliminary results of the investigation being conducted we were reviewing certain specific transactions that were reported as revenue during the third quarter of 2000. During February and March 2001, the investigation by the special committee of the Board of Directors was completed, we completed our internal review, and our auditors completed the annual audit. As a result, our financial results for the third quarter 2000 were materially restated (also see Note 1 of Notes to Consolidated Financial Statements -- Basis of Presentation and Summary of Significant Accounting Policies). Acquisitions and Joint Venture ISOCOR Corporation. On January 19, 2000, the Company acquired ISOCOR Corporation ("ISOCOR"), a leading supplier of Internet messaging, directory and meta-directory software solutions. The acquisition was accounted for using the purchase method of accounting and accordingly, the purchase price was allocated to the tangible and intangible net assets acquired on the basis of their respective fair values on the acquisition date. The fair value of intangible assets was determined based upon an independent valuation using a combination of methods, including an income approach for the acquired in-process research and development and existing technologies and the customer base, and a replacement cost approach for the value of the assembled workforce. The total purchase price of approximately $274.9 million consisted of $226.7 million of the Company's Common Stock (5,043,054 shares), assumed stock options with a fair value of $37.2 million, and other acquisition related expenses of approximately $11.0 million, consisting primarily of payments for legal and financial advisory services. Of the total purchase price, $18.7 million was allocated to net tangible assets, and the remainder was allocated to intangible assets, including in-process research and development ($200,000) existing technology ($18.3 million), customer base ($9.8 million), assembled workforce ($3.4 million) and goodwill ($224.5 million). The acquired in-process research and development was recognized as research and development expense in the period the transaction was consummated. The fair value of the other acquired intangible assets, excluding goodwill, was capitalized and is being amortized over their estimated useful lives of three years. Goodwill is being amortized using the straight-line method over three years. 18 22 CRITICAL PATH, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) The docSpace Company. On March 8, 2000, the Company acquired all outstanding stock of The docSpace Company ("docSpace"), a provider of Web-based services for secure file delivery, storage and collaboration. The acquisition was accounted for using the purchase method of accounting and accordingly, the purchase price was allocated to the tangible and intangible assets acquired on the basis of their respective fair values on the acquisition date. The fair value of intangible assets was determined based upon an independent valuation using a combination of methods, including a cost approach for the acquired existing technology, and the replacement cost approach for the value of the assembled workforce. The total purchase price of $258.0 million consisted of $30.0 million cash, Common Stock (3,805,820 shares) valued at $218.0 million, and other acquisition related costs of approximately $10.0 million, consisting primarily of payments for legal and financial advisory services. Of the total purchase price, approximately $7.1 million has been allocated to net tangible liabilities and the remainder has been allocated to intangible assets, including existing technology ($21.5 million), assembled workforce ($500,000), and goodwill ($243.1 million). The fair value of the acquired intangible assets, excluding goodwill, was capitalized and is being amortized over their estimated useful lives of three years. Goodwill is being amortized using the straight-line method over three years. RemarQ Communities, Inc. On March 30, 2000, the Company acquired all outstanding stock of RemarQ Communities, Inc. ("RemarQ"), a provider of Internet collaboration services for corporations, Web portals and Internet service providers. The acquisition was accounted for using the purchase method of accounting and accordingly, the purchase price was allocated to the tangible and intangible assets acquired on the basis of their respective fair values on the acquisition date. The fair value of intangible assets was determined based upon an independent valuation using a combination of methods, including cost and royalty savings approaches for the value of the acquired existing technology, cost and income approaches for the value of the customer base, and a cost approach for the value of the assembled workforce. The total purchase price of approximately $267.6 million consisted of Common Stock (3,868,450 shares) valued at $259.3 million, assumed stock options valued at approximately $7.7 million, and other acquisition related expenses of approximately $600,000, consisting primarily of payments for legal and financial advisory services. Of the total purchase price, approximately $7.8 million has been allocated to net tangible assets and the remainder was allocated to intangible assets, including existing technology ($4.5 million), assembled workforce ($3.3 million), customer base ($5.9 million), and goodwill ($246.1 million). The fair market of the acquired intangible assets, excluding goodwill, was capitalized and is being amortized over the estimated useful lives of two to three years. Goodwill is being amortized using the straight-line method over three years. Netmosphere, Inc. On June 26, 2000, the Company acquired Netmosphere, Inc. ("Netmosphere"), a provider of e-business solutions for project collaboration and communications. The acquisition was accounted for using the purchase method of accounting and accordingly, the purchase price was allocated to the tangible and intangible net assets acquired on the basis of their respective fair values on the acquisition date. The fair value of intangible assets was determined based upon an independent valuation using a combination of methods, including an income approach for the acquired technologies and customer base, and a replacement cost approach for the value of the assembled workforce. The total purchase price was approximately $41.3 million, which consisted of the Company's Common Stock (1,007,835 shares) valued at $33.0 million, assumed stock options with an estimated fair market value of $5.7 million, assumed warrants with an estimated fair value of $1.0 million, and other acquisition related expenses of approximately $1.6 million, consisting primarily of payments for legal and financial advisory services. Of the total purchase price, approximately $1.0 million was allocated to net tangible liabilities, and the remainder was allocated to intangible assets, including existing technology ($3.6 million), assembled workforce ($1.4 million), customer base ($9.0 million), and goodwill ($28.3 million). The fair value of the 19 23 CRITICAL PATH, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) acquired intangible assets, excluding goodwill, was capitalized and is being amortized over their estimated useful lives of four years. Goodwill is being amortized using the straight-line method over four years. PeerLogic, Inc. On September 26, 2000, the Company acquired PeerLogic, Inc. ("PeerLogic"), a vendor of directory and enterprise application integration software. The acquisition was accounted for using the purchase method of accounting and accordingly, the purchase price was allocated to the tangible and intangible net assets acquired on the basis of their respective fair values on the acquisition date. The fair value of intangible assets was determined based upon an independent valuation using a combination of methods, including an income approach for the acquired in-process research and development and existing technologies and the customer base, and a replacement cost approach for the value of the assembled workforce. Upon consummation of the PeerLogic acquisition, the Company recognized $3.5 million representing the value attributable to acquired in-process research and development in certain enterprise application integration software that had not yet reached technological feasibility and had no alternative future use. The value was determined using an income approach, by estimating the future net cash flows of the acquired in-process research and development over its estimated useful life and discounting the net cash flows back to their present value. The discount rate included a factor that took into account the uncertainty surrounding the successful development of the acquired in-process research and development. The acquired in-process research and development is expected to become commercially available in 2001. The total purchase price of approximately $445.1 million consisted of $374.7 million of the Company's Common Stock (6.4 million shares), assumed stock options with a fair value of $63.4 million, other acquisition related expenses of approximately $4.0 million, consisting primarily of payments for legal and financial advisory services, and the Company's previous $3.0 million minority investment in PeerLogic. Of the total purchase price, approximately $19.7 million was allocated to the net tangible liabilities, approximately $28.3 million was allocated to unearned compensation related to the unvested portion of assumed stock options, and the remainder was allocated to intangible assets, including acquired in-process research and development ($3.5 million), existing technology ($30.3 million), assembled workforce ($7.4 million), customer base ($5.5 million), and goodwill ($389.8 million). The unvested portion of the assumed stock options was capitalized and is being amortized over the estimated remaining service period of two years. The fair value of other acquired intangible assets, excluding goodwill, was capitalized and is being amortized over their estimated useful lives of three years. Goodwill is being amortized using the straight-line method over three years. Critical Path Pacific. The Company established a joint venture, Critical Path Pacific ("CP Pacific"), with Mitsui and Co., Ltd., NTT Communications Corporation and NEC Corporation to deliver advanced Internet messaging solutions to Asia/Pacific businesses. The Company has invested $7.5 million and holds a 40% ownership interest in the joint venture. This investment is being accounted for using the equity method. During the three- and nine-month periods ended September 30, 2000, the Company recorded equity in net loss of joint venture of $640,000. Warrants America Online/ICQ. In January of 1999, the Company entered into an agreement with ICQ, Inc., a subsidiary of America Online, Inc. ("ICQ"), pursuant to which the Company provides email hosting services that are integrated with ICQ's instant messaging service provided to ICQ's customers. As part of the agreement, ICQ agreed to provide sub-branded advertising for the Company in exchange for warrants to purchase 2,442,766 shares of the Company's Common Stock, issuable upon attainment of each of five milestones. 20 24 CRITICAL PATH, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) As of April 9, 2000, all five milestones had been attained. Aggregate charges to stock-based expenses of $798,000 and $5.9 million were recorded during the three-month periods ended September 30, 1999 and 2000, respectively, and $12.2 million and $13.6 million were recorded during the nine-month periods ended September 30, 1999 and 2000, respectively, related to these warrants. At April 9, 2000, the final revised aggregate fair value of all vested warrants was $93.8 million. On September 8, 2000, AOL executed a net exercise of warrants to purchase 766,674 shares related to the attainment of the first of five milestones (the gross number of warrants to purchase shares of the Company's Common Stock amounted to 814,254 shares). On September 18, 2000, AOL executed a net exercise of warrants to purchase 1,441,067 shares related to the attainment of the remaining four milestones (the gross number of warrants to purchase shares of the Company's Common Stock amounted to 1,628,512 shares). Qwest Communications Corporation. In October 1999, the Company entered into an agreement with Qwest Communications Corporation ("Qwest"), a telecommunications company, pursuant to which the Company provides email hosting services to Qwest's customers. As part of the agreement, Qwest agreed to provide sub-branded advertising for Critical Path in exchange for warrants to purchase up to a maximum of 3,534,540 shares of Common Stock upon attainment of each of six milestones. As of September 30, 2000, only the first of the six milestones had been attained. None of the remaining milestones are considered probable and as a result, the fair value of the warrants relating to the shares underlying the second through sixth milestones has not been recognized. During the three-and nine-month periods ended September 30, 2000, $1.9 million and $5.6 million, respectively, was charged to stock-based expense related to these vested warrants. Worldsport Network Ltd. In December 1999, the Company entered into an agreement with Worldsport Network Ltd. ("Worldsport"), the sole and exclusive provider of Internet solutions for the General Association of International Sports Federations ("GAISF") and a majority of the international federations it recognizes. Worldsport offers Critical Path's advanced Web-based email and calendaring services to the entire GAISF network and its members. As part of the agreement, Worldsport agreed to provide sub-branded advertising for the Company in exchange for warrants to purchase up to a 1.25% equity interest in the Company on a fully diluted basis upon attainment of each of five milestones. As of September 30, 2000, none of the milestones were considered probable and as a result, the fair value associated with these warrants has not been recognized. Telco. In January 2000, The docSpace Company ("docSpace") entered into an agreement with a major telecommunications company ("Telco") pursuant to which docSpace would provide secure messaging services to the Telco's customers. As part of the agreement, Telco agreed to provide marketing, publicity, and promotional services to docSpace. As a result of the completion of the Company's acquisition of docSpace, Critical Path assumed warrants that allowed Telco to purchase up to a maximum of 349,123 shares of Common Stock upon attainment of each of three milestones. Subsequent to the acquisition, the Company entered into discussions with Telco to modify its relationship. Accordingly, the vesting provisions of the proposed agreement are being modified to reflect the requirements of the new relationship. As of September 30, 2000, none of the vesting milestones had been attained; however, the Company believes that all shares underlying these warrants are probable of issuance. As a result, the shares underlying these milestones were remeasured using the September 30, 2000, closing price of the Company's Common Stock of $60.75, resulting in a revised fair value of the warrants of $17.6 million. The fair value of the warrants will be recognized on a straight-line basis over the greater of the term of the contract or the expected period of 21 25 CRITICAL PATH, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) benefit of the strategic relationship. During the three-and nine-month periods ended September 30, 2000, no amount was recognized as stock-based expense related to these warrants. The Company believes that each of its warrant agreements could have a significant current and potential future impact on the Company's results of operations. The Company expects that future changes in the trading price of the Company's Common Stock at the end of each quarter, and at the time certain milestones are considered probable and achieved, may cause additional substantial changes in the ultimate amount of the related stock-based charges. RESULTS OF OPERATIONS In view of the rapidly evolving nature of the Company's business, recent acquisitions, and limited operating history, the Company believes that period-to-period comparisons of revenues and operating results, including gross profit margin and operating expenses as a percentage of total net revenues, are not meaningful and should not be relied upon as indications of future performance. At September 30, 2000, the Company had 1,028 employees, in comparison with 488 employees at December 31, 1999 and 369 at September 30, 1999. The Company does not believe that its historical growth rates for revenue, expenses, or personnel are indicative of future results. Net Revenues The Company's revenue recognition policies are in compliance with all applicable accounting standards and regulations, and subsequent amendments and interpretations issued by the American Institute of Certified Public Accountants ("AICPA") and the Securities and Exchange Commission ("SEC"), including SOP 97-2, "Software Revenue Recognition," SOP 98-9 "Modification of SOP 97-2, Software Revenue Recognition with Respect to Certain Transactions," and the SEC's Staff Accounting Bulletin ("SAB") No. 101, "Revenue Recognition." SOP 97-2 provides guidance on generally accepted accounting principles for recognizing revenue on software transactions. SOP 97-2 requires that revenue recognized from software arrangements be allocated to each element of the arrangement based on the relative fair values of the elements, such as software products, specified upgrades and enhancements, post contract customer support, installation, training or other services. Under SOP 97-2, the determination of fair value is based on Company-specific objective evidence. If objective evidence of fair value for each element of the arrangement does not exist, all revenue from the arrangement is deferred until such time that evidence of fair value does exist or until all elements of the arrangements are delivered. License Revenue. License revenue is derived from perpetual and term licenses for the Company's messaging, directory, collaborative and enterprise application integration technologies. License revenues are recognized when persuasive evidence of an arrangement exists, delivery of the licensed software to the customer has occurred and the collection of a fixed or determinable license fee is considered probable. The Company also receives license fees from resellers under arrangements that do not provide product return, exchange or upgrade rights. Revenue from reseller agreements may include a nonrefundable, advance royalty which is payable upon the signing of the contract and license fees based on the contracted value of the Company's products purchased by the reseller. Guaranteed license fees from resellers, where no right of return exist, are recognized when persuasive evidence of an arrangement exists, delivery of the licensed software to the customer has occurred and the collection of a fixed or determinable license fee is considered probable. Non-guaranteed per-copy license fees from resellers are initially deferred and are recognized when they are reported as sold to end users by the reseller. Service Revenue. The Company derives service revenues from the delivery of hosted messaging and collaboration services, professional services associated with both hosted services and licensed products and from post-contract customer support agreements associated with product licenses. Fees for hosted messaging services 22 26 CRITICAL PATH, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) are primarily based upon monthly contractual per unit rates for the services involved, which are recognized on a ratable monthly basis over the term of the contract beginning with the month in which service delivery starts. Amounts billed or received in advance of service delivery are initially deferred and subsequently recognized on a ratable monthly basis over the term of the contract beginning with the month in which service delivery starts. Fees from post-contract customer support agreements associated with product licenses are recognized ratably over the term of the support contract, generally one year. Other services revenue, composed primarily of training, installation and configuration services, are recognized in the period in which the services are performed. License. The Company recognized $12.4 million and $37.3 million in license revenues during the three-and nine-month periods ended September 30, 2000, respectively, as compared to no license revenues in the first three quarters of 1999. These increases over 1999 levels were attributed to the introduction of new product offerings as a result of several acquisitions and to increasing demand for the Company's messaging, directory, meta-directory and calendar applications. Service. The Company recognized $23.0 million and $56.1 million in services revenues during the three-and nine-month periods ended September 30, 2000, respectively, as compared to $4.9 million and $8.0 million during the three- and nine-months ended September 30, 1999. These increases over 1999 levels were attributed to the introduction of new product offerings as a result of several acquisitions, continued penetration of the hosted messaging services market, including continued increases in the number of email boxes hosted and the number of new hosted enterprise customers, and continued demand for value-added outsourced services including InScribe Fax Messaging, InSchedule Calendaring, InScribe Secure File Services and InScribe Message Boards. The Company's international operations accounted for approximately 35% and 39% of net revenues during the three-and nine-month periods ended September 30, 2000, respectively. Revenues from international operations were insignificant in 1999. Cost of Net Revenues Licenses. Cost of net license revenues consists primarily of product media duplication, manuals and packaging materials, personnel and facility costs associated with the assembly operation, and third-party royalties. During the quarter ended September 30, 2000, cost of license revenues benefited from the elimination of a royalty agreement for directory technology with PeerLogic, Inc., which was acquired on September 26, 2000. Royalties incurred under the then existing agreement for the three months ended June 30, 2000, approximated $700,000. Services. Cost of net services revenues consists primarily of costs incurred in the delivery and support of messaging services, including depreciation of capital equipment used in network infrastructure, amortization of purchased technology, Internet connection charges, accretion of acquisition-related retention bonuses, personnel costs incurred in operations, customer support functions and professional services including custom engineering, installation and training services, and other direct and allocated indirect costs. During the three months ended September 30, 2000, total cost of net revenues was $24.8 million, or 70% of net revenues, in comparison with costs of $7.5 million, or 153% of net revenues, for the comparable period of 1999. For the nine months ended September 30, 2000, total cost of net revenues was $65.8 million, or 70% of net revenues, in comparison with costs of $13.9 million, or 174% of net revenues in the comparable period of 1999. The Company added 15 new hosted messaging clusters to its data centers during the first three quarters of 2000, expanding the capacity of its hosting network to manage current customer requirements and anticipated growth. Additional costs were incurred during the first three quarters of 2000 to add technology platforms for new service offerings. As a result of these significant acquisitions of equipment and related support resources, 23 27 CRITICAL PATH, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) depreciation and other costs and expenses during the first three quarters of 2000 increased substantially in comparison with the same quarters in 1999. Cost of net revenues was also impacted by the increased compensation and other personnel costs resulting from the additional headcount added through the Company's ten acquisitions completed during 1999 and the first three quarters of 2000, and through its continued efforts to enhance its portfolio of secure messaging, directory, data integration and collaboration solutions. Operations, customer support, and professional services staff increased from 102 employees at September 30, 1999, to 338 employees at September 30, 2000. During the three- and nine-month periods ended September 30, 2000, the Company recognized charges associated with amortization of acquired technology in the amounts of $4.4 million and $11.0 million, respectively. Additionally, the Company recognized charges related to acquisition-related retention bonuses and stock-based charges associated with employee stock options in cost of net revenues. During the three- and nine-month periods ended September 30, 2000, acquisition-related retention bonuses were $260,000 and $1.0 million, respectively. During both the three- and nine-month periods ended September 30, 1999, acquisition-related retention bonuses were $130,000. Additionally, for the three- and nine-month periods ended September 30, 2000, the Company recognized stock-based charges associated with employee stock options in the amounts of $381,000 and $1.3 million, respectively. For the three- and nine-month periods ended September 30, 1999, the Company recognized stock-based charges of $2.7 million and $3.9 million, respectively. Operating Expenses Sales and Marketing. Sales and marketing expenses consist primarily of compensation for sales and marketing personnel, advertising, public relations, other promotional costs, and, to a lesser extent, related overhead. Sales and marketing expenses during the three- and nine-month periods ended September 30, 2000, amounted to $16.1 million, or 46% of net revenues, and $47.1 million, or 50% of net revenues, respectively, in comparison with approximately $3.6 million, or 72% of net revenues, and $8.8 million, or 110% of net revenues, respectively, during the comparable periods of 1999. Increases in marketing and promotional expenses, incentive compensation payments to sales personnel, and increases in compensation associated with additional headcount resulted in the increase in sales and marketing expenses. Sales and marketing staff increased from 120 employees to 298 employees at September 30, 1999 and 2000, respectively. Research and Development. Research and development expenses consist primarily of compensation for technical staff, payments to outside contractors, depreciation of capital equipment associated with research and development activities, and, to a lesser extent, related overhead. The Company recognizes research and development expenses, including in-process research and development costs, as they are incurred. Research and development expenses amounted to $7.9 million, or 22% of net revenues, and $23.4 million, or 25% of net revenues during the three- and nine-month periods ended September 30, 2000, respectively, in comparison with approximately $1.9 million, or 39% of net revenues, and $4.7 million, or 59% of net revenues, during the comparable periods of 1999, respectively. These significant increases resulted primarily from increases in personnel as the Company continues to develop and enhance its portfolio of secure messaging, directory, wireless, data integration and collaboration solutions. Research and development staff increased from 109 employees to 239 employees at September 30, 1999 and 2000, respectively. General and Administrative. General and administrative expenses consist primarily of compensation for personnel, fees for outside professional services, occupancy costs and, to a lesser extent, related overhead. General and administrative expenses amounted to approximately $6.6 million, or 19% of net revenues, and $20.7 million, or 22% of net revenues, during the three- and nine-month periods ended September 30, 2000, 24 28 CRITICAL PATH, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) respectively, in comparison with approximately $3.7 million, or 75% of net revenues, and $7.9 million, or 99% of net revenues, during the comparable periods of 1999, respectively. These increases were attributable primarily to increases in compensation associated with additional headcount and higher fees for outside professional services. General and administrative staff increased from 38 employees to 153 employees at September 30, 1999 and 2000, respectively. Acquisition-Related Retention Bonuses In connection with the acquisitions of dotOne Corporation ("dotOne"), Amplitude Software Corporation ("Amplitude"), Xeti, Inc. ("Xeti"), FaxNet Corporation ("FaxNet"), ISOCOR, and docSpace, the Company established a retention bonus program in the aggregate amount of $20.7 million to provide incentives for certain former employees of these companies to continue their employment with Critical Path. Payment of bonuses to the listed employees will occur one year following the date of acquisition, unless the listed employees voluntarily terminate their employment with the Company prior to the respective acquisition's one-year anniversary. The aggregate amount of the eligible bonuses is reduced for the bonus amount allocated to each former dotOne, Amplitude, FaxNet, ISOCOR and docSpace employee that chooses to terminate his or her employment with the Company. A ratable share of the adjusted eligible bonus amount will be accrued and charged to compensation expense over the respective twelve-month period commencing on the date the bonuses are granted. As of September 30, 2000, the aggregate, adjusted eligible bonus amounted to $18.3 million, and the amount recognized as compensation expense was $1.3 million and $8.4 million during the three- and nine-month periods ended September 30, 2000, respectively. Based on the functions of the employees scheduled to receive acquisition-related retention bonuses, for the three months ended September 30, 2000, $260,000 of the compensation charge was allocated to cost of net revenues and the remaining $1.0 million was allocated to operating expenses. During the nine months ended September 30, 2000, $1.0 million of the compensation charge was allocated to cost of net revenues and the remaining $7.4 million was allocated to operating expenses. Additionally, during the three-month period ended September 30, 2000, approximately $790,000, in acquisition-related retention bonuses, was recognized as employee severance expense, resulting from the acceleration of certain employees' required one year vesting period. These accelerations resulted from the Company's employee reduction plan, which was executed in the third quarter of 2000. Compensation charges recognized related to acquisition-related retention bonuses during the three- and nine-month periods ended September 30, 1999, amounted to $700,000. During the three- and nine-months ended September 30, 2000, $130,000 of the compensation charge was allocated to cost of net revenues and the remaining $570,000 was allocated to operating expenses. Amortization of Intangible Assets In connection with its acquisitions of the Connect Service business of Fabrik Communications ("Fabrik"), dotOne, Amplitude, Xeti, FaxNet, ISOCOR, docSpace, RemarQ, Netmosphere and PeerLogic, which are accounted for under the purchase method of accounting, the Company recorded goodwill and other intangible assets representing the excess of the purchase price paid over the fair value of net assets acquired. Other intangible assets primarily include assembled workforce, customer base, in-process technology and existing technology. The aggregate amortization of these intangibles was $98.6 million and $241.6 million during the three- and nine- month periods ended September 30, 2000. Amortization expense for the three-and nine-month periods ended September 30, 2000, of $4.4 million and $11.0 million, respectively, was allocated to cost of net revenues and the remaining $94.2 million and $230.6 million was allocated to operating expenses. There were no acquisitions during the first quarter of 1999 and charges to operating expenses related 25 29 CRITICAL PATH, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) to amortization of intangibles amounted to $9.3 million and $9.8 million for the three- and nine-month periods ended September 30, 1999. The Company anticipates that future amortization of intangible assets associated with its acquisitions which occurred in 1999 and the first three quarters of 2000 will continue to be amortized on a straight-line basis over their expected useful lives ranging from two to eight years. It is likely that the Company will continue to expand its business through acquisitions and internal development. Any additional acquisitions or impairment of goodwill and other purchased intangibles could result in additional merger and acquisition related costs. Acquired In-Process Research and Development In connection with the acquisitions of ISOCOR and PeerLogic, the Company recognized $200,000 and $3.5 million, respectively, representing the value attributable to acquired in-process research and development that had not yet reached technological feasibility and had no alternative future use. These values were determined by estimating the future net cash flows of the acquired in-process research and development over their respective estimated useful life and discounting the net cash flows back to their present value. Stock-Based Expenses In connection with certain stock option grants and Common Stock issuances during the years ended December 31, 1998 and 1999, the Company recognized unearned compensation totaling $19.9 million and $22.3 million, respectively, which is being amortized over the vesting periods of the related options. Amortization expense recognized during the three- and nine-month periods ended September 30, 2000, totaled approximately $3.0 million and $11.0 million, respectively. Approximately $381,000 and $2.6 million of amortized unearned compensation was allocated to cost of net revenues, and the remaining $1.3 million and $9.7 million was amortized to operating expenses for the three- and nine-month periods ended September 30, 2000, respectively. In addition, during the three- and nine-month periods ended September 30, 1999, amortization expense totaled $6.7 million and $15.2 million, respectively. Approximately $2.7 million and $3.9 million of amortized unearned compensation was allocated to cost of net revenues, and the remaining $4.0 million and $11.3 million was amortized to operating expenses for the three- and nine-month periods ended September 30, 1999, respectively. The Company incurred stock-based expenses for warrants the Company granted to ICQ, Qwest, Telco, i2, a lessor and for Common Stock issued to one other strategic partner. Amortization of the fair value of these warrants and Common Stock resulted in stock-based expenses of approximately $1.4 million and $7.8 million for the three-month periods ended September 30, 1999 and 2000, respectively. During the nine-month periods ended September 30, 1999 and 2000, approximately $13.9 million and $19.3 million was recognized as stock-based expenses as a result of these warrants. Employee Severance Expenses On July 19, 2000, the Company announced its plan to reduce its worldwide employee headcount by approximately 13%. This employee reduction plan was executed with the intent to realize various synergies gained through the nine acquisitions the Company completed in 1999 and the first half of 2000. During the quarter ended September 30, 2000, the Company recognized a one-time charge for severance-related costs totaling $6.7 million, composed of $3.3 million in cash charges and $3.4 million in stock-based compensation expense. During the quarter ended September 30, 2000, the Company paid approximately $2.6 million related to employee severance and expects to make the remaining severance related payments in the quarter ending December 31, 2000. Any differences between the amounts accrued and amounts actually incurred will be recognized in the quarter ending December 31, 2000. The Company recognized stock-based compensation 26 30 CRITICAL PATH, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) expense resulting from the acceleration of certain employee stock options in connection with the Company's employee reduction plan. These charges totaled $3.4 million and have been included in employee severance expense for the quarter ended September 30, 2000. Interest and Other Income (Expense) and Interest Expense Interest and other income (expense) consists primarily of interest earnings on cash and cash equivalents as well as net realized gains (losses) on foreign exchange transactions. The Company completed private placements of equity securities in April 1998, September 1998, and January 1999, and closed public offerings of Common Stock in April 1999 and June 1999. In addition, on March 30, 2000, the Company issued $300.0 million of five-year, 5.75% Convertible Subordinated Notes due April 1, 2005 (the "Notes"). As a result, interest income increased significantly during the latter half of 1999 and into 2000 in comparison with early 1999 due to higher cash balances available for investing. Interest income amounted to $2.8 million and $4.0 million during the three-month periods ended September 30, 1999 and 2000, respectively, and $5.1 million and $9.9 million for the nine-month periods ended September 30, 1999 and 2000, respectively. The Company recognized a net realized gain from foreign exchange transactions associated with its international operations in the amount of $884,000 and $963,000 during the three- and nine-month periods ended September 30, 2000. There was no foreign exchange transaction gain or loss during the nine-month period ended September 30, 1999. Interest expense consists primarily of the interest related to the Notes and the amortization of related issuance costs. The Company incurred approximately $4.3 million and $8.6 million in interest on the Notes, and approximately $540,000 and $1.1 million related to amortization of debt issuance costs for the three- and nine-month periods ended September 30, 2000, respectively. Additionally, during the three- and nine-month periods ended September 30, 2000, the Company incurred interest expense of $327,000 and $975,000, respectively, comprised of interest on capital lease obligations, stock-based charges, and interest on other long-term debt obligations. For the three- and nine-month periods ended September 30, 2000, amortization of stock-based charges was $16,000 and $48,000, respectively, and interest charges on capital lease obligations amounted to $311,000 and $927,000, respectively. For the three- and nine-month periods ended September 30, 1999, amortization of stock-based charges was $16,000 and $48,000, respectively, and interest charges on capital lease obligations amounted to $151,000 and $363,000, respectively. Minority Interest in Net Income of Consolidated Subsidiary The Company owns a 72.87% interest in CP Italia, a consolidated subsidiary. During the three- and nine-month periods ended September 30, 2000, the Company recorded minority interest in net income of consolidated subsidiary of $201,000 and $526,000, respectively. Provision for Income Taxes No provision for U.S. federal or state income taxes has been recorded as the Company has incurred net operating losses from its inception through September 30, 2000. The Company recognized a provision for foreign income taxes during the three- and nine-month periods ended September 30, 2000 in the amount of $2.5 million and $4.3 million, respectively, as certain of the Company's European operations generated income taxable in certain European jurisdictions. As of December 31, 1999, the Company had approximately $94.9 million of U.S. federal and state net operating loss carryforwards, which expire in varying amounts through 2019 and 2005, respectively, available to offset future taxable income. Under the Tax Reform Act of 1986, the amounts of and benefits from net operating loss carryforwards may be impaired or limited in certain circumstances. For example, the amount of net operating losses that the Company may utilize in any one year would be limited in the presence of a cumulative ownership change of more than 50% over a three-year period. 27 31 CRITICAL PATH, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) At December 31, 1999, the Company also had research and development credit carryforwards of approximately $1.2 million and $717,000 for U.S. federal and state, respectively. These research and development credit carryforwards begin to expire in varying amounts through 2019 for U.S. federal purposes, and do not expire for U.S. state purposes. There is significant doubt as to whether the Company will realize any benefit from these deferred tax assets, and accordingly, the Company has established a full valuation allowance as of December 31, 1999, and September 30, 2000. LIQUIDITY AND CAPITAL RESOURCES The Company invests excess cash primarily in money market funds and other highly liquid securities with maturities of less than 90 days with the intent to make such funds readily available for operating purposes. During the nine months ended September 30, 2000, cash and cash equivalents increased $166.5 million to $242.5 million. For the nine months ended September 30, 2000, the Company used $69.0 million in cash to fund operating activities primarily due to its net loss adjusted for non-cash charges, notably the amortization of intangibles resulting from the Company's acquisitions and depreciation, and approximately $11.5 million in one-time severance and acquisition-related retention bonus payments made in the third quarter of 2000. For the nine months ended September 30, 1999, the Company used $15.8 million to fund operating activities. Cash used in investing activities during the nine months ended September 30, 2000, was approximately $70.5 million. During the nine months ended September 30, 2000, the Company disbursed $37.0 million to purchase property and equipment, consisting of approximately $30.7 million in expenditures related to customer network infrastructure and approximately $6.3 million related to the Company's general operations. Installation of network infrastructure equipment in the Company's data centers, licenses of new software platforms, and purchases of furniture and equipment for new employees accounted for the significant increase in capital expenditures. The Company expects that investments in property and equipment will continue to be a significant use of cash as the Company seeks to increase its capacity to provide messaging infrastructure to support our customers' new and existing business initiatives. In addition, the Company completed its acquisitions of ISOCOR, docSpace, RemarQ, Netmosphere and PeerLogic during the first nine months of 2000, and as a result, expended approximately $15.3 million, net of cash received. Furthermore, the Company made strategic investments totaling $20.4 million in several private entities and made an initial capital contribution of $7.5 million to fund its interest in the Critical Path Pacific joint venture. The Company also advanced approximately $371,000 to certain officers pursuant to promissory notes. These uses of cash were offset by the receipt of $10.0 million previously advanced to a private company pursuant to a promissory note. During the first nine months of 1999, the Company issued $122,000 in notes to certain officers of the Company, net of repayments, advanced $15.0 million to two strategic partners, made capital expenditures which totaled $21.8 million, completed investments in two privately held strategic corporate partners totaling $4.5 million and expended approximately $78.2 million in net cash proceeds and other acquisition costs related to the acquisitions of Fabrik, dotOne and Amplitude. Cash from financing activities during the nine months ended September 30, 2000, totaled $307.8 million. The Company received $289.2 million in net proceeds from the sale of its $300.0 million Notes, as well as approximately $29.4 million from the exercise of employee stock options. These increases were offset by a payment of $6.0 million to retire a note payable assumed in the PeerLogic acquisition, payments totaling $4.7 million to retire principal on capital lease obligations and $113,000 to repurchase the Company's common stock. During the nine months ended September 30, 1999, the Company completed the second round of the Series B Convertible Preferred Stock financing through the issuance of approximately 3.2 million shares, including 454,544 shares issued pursuant to outstanding stock purchase rights, for net proceeds of $12.5 million. Also in January 1999, the Company sold 1,090,909 shares of Common Stock for net proceeds of $2.4 million. In April 28 32 CRITICAL PATH, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) 1999, the Company received approximately $114.1 million in net proceeds upon the closing of its initial public offering of Common Stock. In June 1999, Critical Path received approximately $140.7 million in net proceeds upon the closing of its secondary offering of Common Stock. In addition, the Company paid $2.2 million to retire principal on capital lease obligations and $229,000 to purchase treasury stock. These payments were offset by the repayment of $97,000, by a shareholder, on a previously outstanding note receivable. The Company has experienced a substantial increase in its capital expenditures and operating lease arrangements since its inception and anticipates that this expenditure level will continue in the future. The Company expects to incur capital expenditures of approximately $15.0 million during the remaining three months of 2000 to purchase network infrastructure equipment and to develop and implement its automated billing application. In October 2000 the Company made a strategic equity investment, totaling $600,000, in a private entity and is committed to increase this investment to $4.2 million, upon the investee's attainment of certain future performance milestones. Additionally, the Company will continue to evaluate possible acquisitions of, or investments in, businesses, products and technologies that are complementary to those of the Company, which may require the use of cash. In the first nine months of 2000, the Company completed its acquisitions of ISOCOR, docSpace, RemarQ, Netmosphere and PeerLogic and as a result, expended approximately $60.2 million in cash consisting of approximately $33.0 million in acquisition consideration and $27.2 million for other acquisition costs, consisting primarily of financial advisory and other professional services. The Company expects that future acquisitions of businesses and other strategic assets will require considerable outlays of capital. Management believes that existing capital resources will enable it to maintain current and planned operations for at least the next 12 months. However, operating and investing activities on a long-term basis may require the Company to seek additional equity or debt financing. ADDITIONAL FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS WE HAVE A LIMITED OPERATING HISTORY UPON WHICH YOU CAN EVALUATE OUR BUSINESS AND FACE RISKS ASSOCIATED WITH EARLY STAGE COMPANIES THAT MAY ADVERSELY AFFECT OUR BUSINESS. Because we have had a limited operating history, it is difficult to evaluate our business and we may face various risks, expenses and difficulties associated with early stage companies. You should consider the risks, expenses and difficulties that we may encounter when making your investment decision. These risks include our ability to: - Acquire businesses and technologies; - Integrate the operations of the companies that we have recently acquired; - Manage growing domestic and international operations; - Create and maintain strategic relationships; - Expand sales and marketing activities; - Expand our customer base and retain key clients; - Introduce new products and services; - Compete in a highly competitive market; - Upgrade our systems and infrastructure to handle any increases in messaging traffic; - Reduce service interruptions; and - Recruit and retain key personnel. 29 33 CRITICAL PATH, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) WE HAVE A HISTORY OF LOSSES, EXPECT CONTINUING LOSSES AND MAY NEVER ACHIEVE PROFITABILITY. As of September 30, 2000, we had an accumulated deficit, including other comprehensive loss, of approximately $478.9 million. We have not achieved profitability in any period, and expect to continue to incur net losses in accordance with generally accepted accounting principles for the foreseeable future. We expect that our operating expenses will increase as we spend resources on building our business and that this increase may have a negative effect on operating results and financial condition in the near term. We have spent heavily on technology and infrastructure development. We expect to continue to spend substantial financial and other resources on developing and introducing new end-to-end Internet messaging and collaboration solutions, and expanding our sales and marketing organizations, strategic relationships and operating infrastructure. We expect that our cost of revenues, sales and marketing expenses, general and administrative expenses, operations and customer support expenses, and depreciation and amortization expenses will continue to increase in absolute dollars and may increase as a percent of revenues. If revenues do not correspondingly increase, our operating results and financial condition could be negatively affected. Should we continue to incur net losses in future periods, we may not be able to increase the number of employees or investment in capital equipment, sales and marketing programs, and research and development in accordance with our present plans. We may never obtain sufficient revenues to achieve profitability. If we do achieve profitability, we may not sustain or increase profitability in the future. This may, in turn, cause our stock price to decline. DUE TO OUR LIMITED OPERATING HISTORY AND THE EMERGING NATURE OF THE INTERNET MESSAGING AND COLLABORATION SOLUTIONS MARKET, FUTURE REVENUES ARE UNPREDICTABLE, AND OUR QUARTERLY OPERATING RESULTS MAY FLUCTUATE. We cannot accurately forecast our revenues as a result of our limited operating history and the emerging nature of the Internet messaging and collaboration solutions market. Our revenues could fall short of expectations if we experience delays or cancellations of even a small number of orders. We often offer volume-based pricing, which may affect operating margins. A number of factors are likely to cause fluctuations in operating results, including, but not limited to: - Continued growth of the Internet in general and of messaging and collaboration usage in particular; - Demand for outsourced messaging services; - Demand for licensing of messaging, directory, and other products; - Our ability to attract and retain customers and maintain customer satisfaction; - Our ability to upgrade, develop and maintain our systems and infrastructure; - The amount and timing of operating costs and capital expenditures relating to expansion of business and infrastructure; - Technical difficulties or system outages; - The announcement or introduction of new or enhanced services by competitors; - Our ability to attract and retain qualified personnel with Internet industry expertise, particularly sales and marketing personnel; - The pricing policies of competitors; - Failure to increase international sales; and - Governmental regulation surrounding the Internet and messaging in particular. In addition to the factors set forth above, operating results will be impacted by the extent to which we incur non-cash charges associated with stock-based arrangements with employees and non-employees. In 30 34 CRITICAL PATH, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) particular, we have incurred and expect to continue to incur substantial non-cash charges associated with the grant of warrants to our customers and other parties with which we have commercial relationships. Period-to-period comparisons of operating results are not a good indication of future performance. It is likely that operating results in some quarters will be below market expectations. In this event, the price of our Common Stock is likely to decline. FURTHER ACQUISITIONS COULD RESULT IN DILUTION, OPERATING DIFFICULTIES AND OTHER CONSEQUENCES. We expect to acquire or invest in additional businesses, products, services and technologies that complement or augment our service offerings and customer base. Since January 1999, we have completed the acquisition of ten companies for an aggregate consideration consisting of cash, Common Stock and the assumption of stock options and warrants totaling approximately $1.8 billion. We are currently engaged in discussions with a number of companies regarding strategic acquisitions or investments. Although these discussions are ongoing, we have not signed any definitive agreements and cannot assure you that any of these discussions will result in actual acquisitions. To be successful, we will need to identify suitable acquisition candidates, integrate disparate technologies and corporate cultures and manage a geographically dispersed company. We cannot assure you that we will be able to do this successfully. Acquisitions could divert attention from other business concerns and could expose us to unforeseen liabilities. In addition, we may lose key employees while integrating any new companies. We expect to pay for acquisitions by issuing additional Common Stock, which would dilute current shareholders. We may also use cash to make acquisitions. It may be necessary for us to raise additional funds through public or private financings. We cannot assure you that we will be able to raise additional funds at any particular point in the future or on favorable terms. In addition, we may be required to amortize significant amounts of goodwill and other intangible assets in connection with future acquisitions, which would materially increase operating expenses. WE WILL FACE TECHNICAL, OPERATIONAL AND STRATEGIC CHALLENGES THAT MAY PREVENT US FROM SUCCESSFULLY CONTINUING THE INTEGRATION OF ANY ACQUIRED BUSINESS. Acquisitions involve risks related to the integration and management of acquired technology, operations and personnel. The integration of businesses that we have acquired into our business has been and will be a complex, time consuming and expensive process and may disrupt our business if not completed in a timely and efficient manner. For example, on July 19, 2000, we reduced employee headcount in order to eliminate duplicative positions totaling approximately 11% of our worldwide workforce that were created by our acquisitions. The elimination was necessary to achieving synergies with our acquisitions, but it may negatively affect employee morale. We must operate as a combined organization utilizing, common information and communication systems, operating procedures, financial controls and human resources practices. In particular, we are currently evaluating, upgrading or replacing our financial information systems and establishing uniformity among the systems of the acquired businesses. We may encounter substantial difficulties, costs and delays involved in integrating the operations of our subsidiaries, including: - potential incompatibility of business cultures; - perceived adverse changes in business focus; - potential conflicts in sponsor, advertising or strategic relationships; and - the loss of key employees and diversion of the attention of management from other ongoing business concerns. 31 35 CRITICAL PATH, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) Consequently, we may not be successful in integrating acquired businesses or technologies and may not achieve anticipated revenue and cost benefits. We also cannot guarantee that these acquisitions will result in sufficient revenues or earnings to justify our investment in, or expenses related to, these acquisitions or that any synergies will develop. If we fail to execute our acquisition strategy successfully for any reason, our business will suffer significantly. WE HAVE EXPERIENCED RAPID GROWTH THAT HAS PLACED A STRAIN ON RESOURCES AND OUR FAILURE TO MANAGE GROWTH COULD CAUSE OUR BUSINESS TO SUFFER. We have expanded our operations rapidly and intend to continue this expansion. The number of our employees increased from 93 on December 31, 1998 to 1,028 on September 30, 2000. This expansion has placed, and is expected to continue to place, a significant strain on managerial, operational and financial resources. To manage any further growth, we will need to improve or replace our existing operational, customer service and financial systems, procedures and controls. Any failure to properly manage these systems and procedural transitions could impair our ability to attract and service customers, and could cause us to incur higher operating costs and delays in the execution of our business plan. We will also need to continue the expansion of our operations and employee base. Our management may not be able to hire, train, retain, motivate and manage required personnel. In addition, our management may not be able to successfully identify, manage and exploit existing and potential market opportunities. However, in the third quarter of 2000, we eliminated approximately 13% of our worldwide employees to operational synergies that were observed due to the acquisitions we have completed. If we cannot manage growth effectively, our business and operating results could suffer. IF WE FAIL TO EXPAND SALES AND MARKETING ACTIVITIES, WE MAY BE UNABLE TO EXPAND OUR BUSINESS. Our ability to increase revenues will depend on our ability to successfully recruit, train and retain sales and marketing personnel. We plan to continue to invest significant resources to expand our sales and marketing organizations. Competition for additional qualified personnel is intense and we may not be able to hire and retain personnel with relevant experience. The complexity and implementation of our Internet messaging services require highly trained sales and marketing personnel to educate prospective customers regarding the use and benefits of our services. Current and prospective customers, in turn, must be able to educate their end-users. With our relatively brief operating history and our plans for expansion, we have considerable need to recruit, train and retain qualified staff. Any delays or difficulties encountered in these staffing efforts would impair our ability to attract new customers and to enhance our relationships with existing customers. This in turn would adversely impact the timing and extent of revenues. Because the majority of our sales and marketing personnel have recently joined us and have limited experience working together, our sales and marketing organizations may not be able to compete successfully against the larger and more experienced sales and marketing organizations of our competitors. If we do not successfully expand sales and marketing activities, our business could suffer and our stock price could decline. UNPLANNED SYSTEM INTERRUPTIONS AND CAPACITY CONSTRAINTS COULD REDUCE OUR ABILITY TO PROVIDE MESSAGING AND COLLABORATION SERVICES AND COULD HARM OUR BUSINESS AND REPUTATION. Our customers have in the past experienced some interruptions in our messaging service. We believe that these interruptions will continue to occur from time to time. These interruptions are due to hardware failures, unsolicited bulk email, or "spam," attacks and operating system failures. For example, in January 2000, our customers experienced a service interruption due to an operating system failure. Our revenues depend on the number of end-users who use our messaging services. Our business will suffer if we experience frequent or long 32 36 CRITICAL PATH, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) system interruptions that result in the unavailability or reduced performance of systems or networks or reduce our ability to provide email services. We expect to experience occasional temporary capacity constraints due to sharply increased traffic, which may cause unanticipated system disruptions, slower response times, impaired quality and degradation in levels of customer service. If this were to continue to happen, our business and reputation could suffer dramatically. We have entered into service agreements with some customers that require minimum performance standards, including standards regarding the availability and response time of messaging services. If we fail to meet these standards, our customers could terminate their relationships with us and we could be subject to contractual monetary penalties. Any unplanned interruption of services may adversely affect our ability to attract and retain customers. IF WE DO NOT SUCCESSFULLY ADDRESS THE RISKS INHERENT IN THE EXPANSION OF OUR INTERNATIONAL OPERATIONS, OUR BUSINESS COULD SUFFER. We intend to continue to expand into international markets and to spend significant financial and managerial resources to do so. If revenues from international operations do not exceed the expense of establishing and maintaining these operations, our business, financial condition and operating results will suffer. At present, we have international operations in Canada, Argentina, Brazil, Denmark, France, Germany, Ireland, Italy, Japan, Switzerland and the United Kingdom and for the nine months ended September 30, 2000 we derived approximately 39% of our revenues from international sales. We have limited experience in international operations and may not be able to compete effectively in international markets. We face certain risks inherent in conducting business internationally, such as: - Unexpected changes in regulatory requirements including U.S. export restrictions on encryption technologies; - Difficulties and costs of staffing and managing international operations; - Differing technology standards; - Difficulties in collecting accounts receivable and longer collection periods; - Political and economic instability; - Fluctuations in currency exchange rates; - Imposition of currency exchange controls; - Potentially adverse tax consequences; and - Reduced protection for intellectual property rights in some countries. Any of these factors could adversely affect international operations and, consequently, business and operating results. Specifically, failure to successfully manage international growth could result in higher operating costs than anticipated, or could delay or preclude altogether our ability to generate revenues in key international markets. WE DEPEND ON STRATEGIC RELATIONSHIPS AND OTHER SALES CHANNELS AND THE LOSS OF ANY STRATEGIC RELATIONSHIPS COULD HARM OUR BUSINESS AND HAVE AN ADVERSE IMPACT ON REVENUES. We depend on strategic relationships to expand distribution channels and to undertake joint product development and marketing efforts. Our ability to increase revenues depends upon marketing services through new and existing strategic relationships. We have entered into written agreements with ICQ (a subsidiary of America Online), E*TRADE, Network Solutions, Sprint, MCI Worldcom, US West, Yahoo!, Aether Systems, and Brightmail, among others. We depend on a broad acceptance of outsourced messaging services on the part of potential partners and acceptance of our company as the supplier for these outsourced 33 37 CRITICAL PATH, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) messaging services. We also depend on joint marketing and product development through strategic relationships to achieve market acceptance and brand recognition. For example, through our relationship with E*TRADE, we can conduct shared advertising campaigns and include messaging services in E*TRADE's international strategic relationships. Our agreements with strategic partners typically do not restrict them from introducing competing services. These agreements typically are for terms of one to three years, and automatically renew for additional one-year periods unless either party gives prior notice of its intention to terminate the agreement. In addition, these agreements are terminable by our partners without cause, and some agreements are terminable by us, upon 30 - 120 days' notice. Most of the agreements also provide for the partial refund of fees paid or other monetary penalties in the event that our services fail to meet defined minimum performance standards. Distribution partners may choose not to renew existing arrangements on commercially acceptable terms, or at all. If we lose any strategic relationships, fail to renew these agreements or relationships or fail to develop new strategic relationships, business will suffer. The loss of any key strategic relationships would have an adverse impact on current and future revenue. In addition to strategic relationships, we also depend on the ability of our customers to sell and market our services to their end-users. WE MAY NOT BE ABLE TO RESPOND TO THE RAPID TECHNOLOGICAL CHANGE OF THE INTERNET MESSAGING AND COLLABORATION INDUSTRY. The Internet messaging industry is characterized by rapid technological change, changes in user and customer requirements and preferences, and the emergence of new industry standards and practices that could render our existing services, proprietary technology and systems obsolete. We must continually improve the performance, features and reliability of our services, particularly in response to competitive offerings. Our success depends, in part, on our ability to enhance our existing email and messaging services and to develop new services, functionality and technology that address the increasingly sophisticated and varied needs of prospective customers. If we don't properly identify the feature preferences of prospective customers, or if we fail to deliver email features that meet the standards of these customers, our ability to market our service successfully and to increase revenues could be impaired. The development of proprietary technology and necessary service enhancements entail significant technical and business risks and require substantial expenditures and lead-time. We may not be able to keep pace with the latest technological developments. We may also be unable to use new technologies effectively or adapt services to customer requirements or emerging industry standards. IF OUR SYSTEM SECURITY IS BREACHED, OUR BUSINESS AND REPUTATION COULD SUFFER. A fundamental requirement for online communications is the secure transmission of confidential information over public networks. Third parties may attempt to breach our security or that of our customers. If these attempts are successful, customers' confidential information, including customers' profiles, passwords, financial account information, credit card numbers or other personal information could be breached. We may be liable to our customers for any breach in security and a breach could harm our reputation. We rely on encryption technology licensed from third parties. Although we have implemented network security measures, our servers are vulnerable to computer viruses, physical or electronic break-ins and similar disruptions, which could lead to interruptions, delays or loss of data. We may be required to expend significant capital and other resources to license encryption technology and additional technologies to protect against security breaches or to alleviate problems caused by any breach. Failure to prevent security breaches may have a material adverse effect on business and operating results. WE WILL CONTINUE TO DEPEND ON BROAD MARKET ACCEPTANCE FOR OUTSOURCED INTERNET-BASED EMAIL SERVICE. The market for outsourced Internet-based email service is new and rapidly evolving. Concerns over the security of online services and the privacy of users may inhibit the growth of the Internet and commercial 34 38 CRITICAL PATH, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) online services. We cannot estimate the size or growth rate of the potential market for our service offerings, and we do not know whether our service will achieve broad market acceptance. To date a substantial portion of our revenues have been derived from sales of email service offerings and we currently expect that email service offerings will account for a substantial portion of our revenues for the foreseeable future. We depend on the widespread acceptance and use of outsourcing as an effective solution for email. If the market for outsourced email fails to grow or grows more slowly than we currently anticipate, our business would suffer dramatically. WE EXPECT THE MESSAGING SERVICES MARKET WILL BE VERY COMPETITIVE AND WE WILL NEED TO COMPETE SUCCESSFULLY IN THIS MARKET. We expect that the market for Internet-based email service will be intensely competitive. In addition to competing with companies that develop and maintain in-house solutions, we compete with email service providers, such as USA.NET, Inc. and mail.com, and with product-based companies, such as Lotus Development Corporation and Microsoft. We believe that competition will increase and that companies such as Software.com, which currently offers email products primarily to Internet service providers that provide access to the Internet; web hosting companies; web sites intended to be major starting sites for users when they connect to the Internet, commonly referred to as web portals; and corporations may leverage their existing relationships and capabilities to offer email services. We believe competition will increase as current competitors increase the sophistication of their offerings and as new participants enter the market. Many current and potential competitors have longer operating histories, larger customer bases, greater brand recognition and significantly greater financial, marketing and other resources than we do and may enter into strategic or commercial relationships with larger, more established and better-financed companies. Further, any delays in the general market acceptance of the email hosting concept would likely harm our competitive position. Any delay would also allow competitors additional time to improve their service or product offerings, and provide time for new competitors to develop email service solutions and solicit prospective customers within our target markets. Increased competition could result in pricing pressures, reduced operating margins and loss of market share, any of which could cause our business to suffer. IF WE DO NOT SUCCESSFULLY ADDRESS SERVICE DESIGN RISKS, OUR REPUTATION COULD BE DAMAGED AND OUR BUSINESS AND OPERATING RESULTS COULD SUFFER. We must accurately forecast the features and functionality required by target customers. In addition, we must design and implement service enhancements that meet customer requirements in a timely and efficient manner. We may not successfully determine customer requirements and may be unable to satisfy customer demands. Furthermore, we may not be able to design and implement a service incorporating desired features in a timely and efficient manner. In addition, if customers and end-users do not favorably receive any new service we launch, our reputation could be damaged. If we fail to accurately determine customer feature requirements or service enhancements or to market services containing such features or enhancements in a timely and efficient manner, our business and operating results could suffer materially. WE NEED TO UPGRADE OUR SYSTEMS AND INFRASTRUCTURE TO ACCOMMODATE INCREASES IN MESSAGING TRAFFIC. We must continue to expand and adapt our network infrastructure as the number of users and the amount of information we wish to transmit increases, and as their requirements change. The expansion and adaptation of our network infrastructure will require substantial financial, operational and management resources. Due to the limited deployment of services to date, the ability of our network to connect and manage a substantially larger number of customers at high transmission speeds is unknown, and we face risks related to the network's ability to operate with higher customer levels while maintaining expected performance. 35 39 CRITICAL PATH, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) As the frequency and complexity of messaging increases, we will need to make additional investments in our infrastructure, which may be expensive. In addition, we may not be able to accurately project the rate or timing of messaging traffic increases or upgrade our systems and infrastructure to accommodate future traffic levels, which may cause service degradation or outages. We may also not be able to achieve or maintain a sufficiently high capacity of data transmission as customer usage increases. Customer demand for our services could be greatly reduced if we fail to maintain high capacity data transmission. In addition, as we upgrade our network infrastructure to increase capacity available to customers, we are likely to encounter equipment or software incompatibility that may cause delays in implementations. We may not be able to expand or adapt our network infrastructure to meet additional demand or customers' changing requirements in a timely manner or at all. BECAUSE WE PROVIDE MESSAGING AND COLLABORATION SERVICES OVER THE INTERNET, OUR BUSINESS COULD SUFFER IF EFFICIENT TRANSMISSION OF DATA OVER THE INTERNET IS INTERRUPTED. The recent growth in the use of the Internet has caused frequent interruptions and delays in accessing the Internet and transmitting data. To date we have not experienced a significant adverse effect from these interruptions. However, because we provide messaging and collaboration services over the Internet, interruptions or delays in Internet transmissions will adversely affect customers' ability to send or receive their messages. We rely on the speed and reliability of the networks operated by third parties. Therefore, our market depends on improvements being made to the entire Internet infrastructure to alleviate overloading and congestion. We depend on telecommunications network suppliers such as Level 3, Qwest, Exodus and TeleHouse to transmit messages across their networks. In addition, to deliver our services, we rely on a number of public and private peering interconnections, which are arrangements among access providers to carry one another's traffic. If these providers were to discontinue these arrangements, and alternative providers did not emerge or were to increase the cost of providing access, our ability to transmit messaging traffic would be reduced. If we were to increase our current prices to accommodate any increase in the cost of providing access, it could negatively impact sales. If we did not increase prices in response to rising access costs, margins would be negatively affected. Furthermore, if additional capacity is not added as traffic increases, our ability to distribute content rapidly and reliably through these networks will be adversely affected. IF WE ENCOUNTER SYSTEM FAILURES, WE MAY NOT BE ABLE TO PROVIDE ADEQUATE SERVICE AND OUR BUSINESS AND REPUTATION COULD BE DAMAGED. Our ability to successfully receive and send messages and provide acceptable levels of customer service largely depends on the efficient and uninterrupted operation of computer and communications hardware and network systems. Our systems and operations are vulnerable to damage or interruption from fire, flood, earthquake, power loss, telecommunications failure and similar events. The occurrence of any of the foregoing risks could subject us to contractual monetary penalties if we fail to meet minimum performance standards, and could have a material adverse effect on business and operating results and damage our reputation. WE MUST RECRUIT AND RETAIN OUR KEY EMPLOYEES TO EXPAND OUR BUSINESS. Our success depends on the skills, experience and performance of senior management and other key personnel, many of whom have worked together for only a short period of time. For example, our Chief Financial Officer has joined us within the past eight months. The loss of the services of any senior management or other key personnel, including the President, David Thatcher, and Chief Executive Officer, Douglas Hickey, could materially and adversely affect business results. We do not have long-term employment agreements with any executive officers and other key personnel. Our success also depends on our ability 36 40 CRITICAL PATH, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) to recruit, retain and motivate other highly skilled sales and marketing, technical and managerial personnel. Competition for these people is intense, and we may not be able to successfully recruit, train or retain qualified personnel. In particular, we may not be able to hire a sufficient number of qualified software developers. UNKNOWN SOFTWARE DEFECTS COULD DISRUPT SERVICES, WHICH COULD HARM OUR BUSINESS AND REPUTATION. Our service offerings depend on complex software, both internally developed and licensed from third parties. Complex software often contains defects, particularly when first introduced or when new versions are released. We may not discover software defects that affect new or current services or enhancements until after they are deployed. Although we have not experienced any material software defects to date, it is possible that, despite testing, defects may occur in the software. These defects could cause service interruptions, which could damage our reputation or increase service costs, cause us to lose revenue, delay market acceptance or divert development resources, any of which could cause business to suffer. WE MAY NEED ADDITIONAL CAPITAL AND RAISING ADDITIONAL CAPITAL MAY DILUTE EXISTING SHAREHOLDERS. We believe that existing capital resources will enable us to maintain current and planned operations for at least the next twelve months. However, we may be required to raise additional funds due to unforeseen circumstances. If capital requirements vary materially from those current planned, we may require additional financing sooner than anticipated. Such financing may not be available in sufficient amounts or on terms acceptable to us and may be dilutive to existing shareholders. WE MAY NOT BE ABLE TO PROTECT INTELLECTUAL PROPERTY AND PROPRIETARY RIGHTS. We regard our copyrights, service marks, trademarks, trade secrets and similar intellectual property as critical to our success, and we rely on trademark and copyright law, trade secret protection and confidentiality and/or license agreements with employees, customers and partners to protect proprietary rights. Despite these precautions, unauthorized third parties may infringe or copy portions of our services or reverse engineer or obtain and use information that we regard as proprietary. End-user license provisions protecting against unauthorized use, copying, transfer and disclosure of the licensed program may be unenforceable under the laws of certain jurisdictions and foreign countries. The status of United States patent protection in the software industry is not well defined and will evolve as the U.S. Patent and Trademark Office grants additional patents. We have several patents pending in the United States and may seek additional patents in the future. We do not know if the patent application or any future patent application will be issued with the scope of the claims sought, if at all, or whether any patents received will be challenged or invalidated. In addition, the laws of some foreign countries do not protect proprietary rights to the same extent as do the laws of the United States. Our means of protecting proprietary rights in the United States or abroad may not be adequate and competitors may independently develop similar technology. Third parties may infringe or misappropriate copyrights, trademarks and similar proprietary rights belonging to us. In addition, other parties have asserted and may assert infringement claims against us. For example, a company that we acquired is a party to a lawsuit involving alleged infringement of a third party's patent. The recently acquired company has denied the allegations of infringement and has made counterclaims. Although we have not received notice of any other alleged patent infringement, we cannot be certain that our products do not infringe issued patents that may relate to our products. In addition, because patent applications in the United States are not publicly disclosed until the patent is issued, applications may have been filed which relate to our software products. We may be subject to legal proceedings and claims from time to time in the ordinary course of business, including claims of alleged infringement of trademarks and other intellectual property rights of third parties. Intellectual property litigation is expensive and time-consuming and could divert management's attention away from operating our business. 37 41 CRITICAL PATH, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) WE MAY NEED TO LICENSE THIRD-PARTY TECHNOLOGIES AND WE FACE RISKS IN DOING SO. We intend to continue to license certain technology from third parties, including web server and encryption technology. The market is evolving and we may need to license additional technologies to remain competitive. We may not be able to license these technologies on commercially reasonable terms or at all. In addition, we may fail to successfully integrate any licensed technology into our services. These third-party in-licenses may expose us to increased risks, including risks related to the integration of new technology, the diversion of resources from the development of proprietary technology, and an inability to generate revenues from new technology sufficient to offset associated acquisition and maintenance costs. An inability to obtain any of these licenses could delay product and service development until equivalent technology can be identified, licensed and integrated. Any such delays in services could cause our business and operating results to suffer. THE TRADING PRICES AND VOLUMES OF OUR STOCK HAVE BEEN VOLATILE AND WE EXPECT THAT THIS VOLATILITY WILL CONTINUE. Our stock price and trading volumes have been highly volatile since our initial public offering on March 29, 1999. We expect that this volatility will continue in the future due to factors such as: - Actual or anticipated fluctuations in results of operations; - Changes in or failure to meet securities analysts' expectations; - Announcements of technological innovations and acquisitions; - Introduction of new services by us or our competitors; - Developments with respect to intellectual property rights; - Conditions and trends in the Internet and other technology industries; and - General market conditions. In addition, the stock market has from time to time experienced significant price and volume fluctuations that have affected the market prices for the common stocks of technology companies, particularly Internet companies. These broad market fluctuations may result in a material decline in the market price of our common stock. In the past, following periods of volatility in the market price of a particular company's securities, securities class action litigation has often been brought against that company. We may become involved in this type of litigation in the future. Litigation is often expensive and diverts management's attention and resources, which could have a material adverse effect on our business and operating results. GOVERNMENTAL REGULATION AND LEGAL UNCERTAINTIES COULD IMPAIR THE GROWTH OF THE INTERNET AND DECREASE DEMAND FOR OUR SERVICES OR INCREASE OUR COST OF DOING BUSINESS. Although there are currently few laws and regulations directly applicable to the Internet and messaging services, a number of laws have been proposed involving the Internet, including laws addressing user privacy, pricing, content, copyrights, distribution, antitrust and characteristics and quality of products and services. Further, the growth and development of the market for messaging services may prompt calls for more stringent consumer protection laws that may impose additional burdens on those companies conducting business online. The adoption of any additional laws or regulations may impair the growth of the Internet or commercial online services which could decrease the demand for our services and increase our cost of doing business, or otherwise harm business and operating results. Moreover, the applicability to the Internet of existing laws in various jurisdictions governing issues such as property ownership, sales and other taxes, libel and personal privacy is uncertain and may take years to resolve. 38 42 CRITICAL PATH, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) WE MAY HAVE LIABILITY FOR INTERNET CONTENT AND WE MAY NOT HAVE ADEQUATE LIABILITY INSURANCE. As a provider of messaging services, we face potential liability for defamation, negligence, copyright, patent or trademark infringement and other claims based on the nature and content of the materials transmitted via our services. We do not and cannot screen all of the content generated by our users, and we could be exposed to liability with respect to this content. Furthermore, some foreign governments, such as Germany, have enforced laws and regulations related to content distributed over the Internet that are more strict than those currently in place in the United States. Although we carry general liability and umbrella liability insurance, our insurance may not cover claims of these types or may not be adequate to indemnify us for all liability that may be imposed. There is a risk that a single claim or multiple claims, if successfully asserted against us, could exceed the total of our coverage limits. There is also a risk that single claim or multiple claims asserted against us may not qualify for coverage under our insurance policies as a result of coverage exclusions that are contained within these policies. Should either of these risks occur, capital contributed by our stockholders may need to be used to settle claims. Any imposition of liability, particularly liability that is not covered by insurance or is in excess of insurance coverage could have a material adverse effect on our reputation and business and operating results, or could result in the imposition of criminal penalties. FUTURE SALES OF OUR COMMON STOCK MAY DEPRESS THE PRICE OF OUR COMMON STOCK. As of October 31, 2000, we had approximately 73.7 million shares of Common Stock outstanding. Sales of a substantial number of shares of Common Stock in the public market could cause the market price of our Common Stock to decline. Up to 2.9 million shares may be issued upon the conversion of our Convertible Subordinated Notes and will become eligible for sale under an S-3 registration statement which we filed in July of 2000 to meet our registration rights obligations in connection with our sale of Convertible Subordinated Notes. Certain of our shareholders and warrant holders have registration rights with respect to the Common Stock and Common Stock issuable under the warrants. OUR DIRECTORS, EXECUTIVE OFFICERS AND PRINCIPAL SHAREHOLDERS WILL BE ABLE TO EXERT SIGNIFICANT INFLUENCE OVER US. As a result of our offerings, our directors, executive officers and principal shareholders will beneficially own a substantial portion of our outstanding Common Stock. These shareholders, if they vote together, will be able to exercise significant influence over all matters requiring shareholder approval, including the election of directors and approval of significant corporate transactions. This concentration of ownership may also delay or prevent a change in control of our company. OUR ARTICLES OF INCORPORATION AND BYLAWS CONTAIN PROVISIONS THAT COULD DELAY OR PREVENT A CHANGE IN CONTROL. Our Articles of Incorporation and Bylaws contain provisions that could delay or prevent a change in control of our company. These provisions could limit the price that investors might be willing to pay in the future for shares of our Common Stock. Some of these provisions: - Authorize the issuance of preferred stock that can be created and issued by the board of directors without prior stockholder approval, commonly referred to as "blank check" preferred stock, with rights senior to those of Common Stock; - Prohibit shareholder action by written consent; and - Establish advance notice requirements for submitting nominations for election to the board of directors and for proposing matters that can be acted upon by shareholders at a meeting. 39 43 CRITICAL PATH, INC. SUPPLEMENTAL PRO FORMA FINANCIAL DATA (UNAUDITED) The following supplemental pro forma financial information presents the Company's condensed consolidated results of operations for the three- and nine-month periods ended September 30, 1999 and 2000, excluding the impact of certain special charges consisting of (i) amortization of intangible assets associated with purchase business combinations, (ii) accruals for employee retention bonuses associated with purchase business combinations, (iii) stock-based compensation associated with outstanding options and warrants, (iv) in-process research and development associated with purchase business combinations, and (v) employee severance expenses associated with workforce reductions. This supplemental presentation is for informational purposes, only, and is not intended to replace the condensed consolidated operating results prepared and presented in accordance with generally accepted accounting principles.
THREE MONTHS ENDED NINE MONTHS ENDED ------------------------------ ------------------------------ SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, 1999 2000 1999 2000 ------------- ------------- ------------- ------------- Net revenues Licenses............................. $ -- $ 12,365 $ -- $ 37,332 Services............................. 4,913 22,977 8,074 56,058 ------- -------- -------- -------- Total net revenues........... 4,913 35,342 8,074 93,390 ------- -------- -------- -------- Cost of net revenues Licenses............................. -- 634 -- 2,378 Services............................. 4,681 19,076 9,829 50,154 ------- -------- -------- -------- Total cost of net revenues... 4,681 19,710 9,829 52,532 ------- -------- -------- -------- Gross profit (loss).................... 232 15,632 (1,755) 40,858 ------- -------- -------- -------- Operating expenses Sales and marketing.................. 3,557 16,128 8,760 47,075 Research and development............. 1,895 7,853 4,705 23,389 General and administrative........... 3,678 6,568 7,919 20,666 ------- -------- -------- -------- Total operating expenses..... 9,130 30,549 21,384 91,130 ------- -------- -------- -------- Loss from operations................... (8,898) (14,917) (23,139) (50,272) Interest and other income (expense), net.................................. 2,841 4,905 5,074 10,859 Interest expense....................... (151) (5,198) (363) (10,699) Equity in net loss of joint venture.... -- (640) -- (640) Minority interest in net income of consolidated subsidiary.............. -- (201) -- (526) ------- -------- -------- -------- Loss before income taxes............... (6,208) (16,051) (18,428) (51,278) Provision for income taxes............. -- (2,534) -- (4,333) ------- -------- -------- -------- Net Loss............................... $(6,208) $(18,585) $(18,428) $(55,611) ======= ======== ======== ======== Net loss per share -- basic and diluted.............................. $ (0.17) $ (0.30) $ (0.71) $ (0.98) ======= ======== ======== ======== Weighted average shares -- basic and diluted.............................. 37,158 61,614 25,715 56,925 ======= ======== ======== ========
40 44 CRITICAL PATH, INC. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK As of September 30, 2000, the Company did not have any derivative financial instruments. However, the Company is exposed to interest rate risk. The Company employs established policies and procedures to manage its exposure to changes in the market risk of its marketable securities, which are classified as available-for-sale as of September 30, 2000. The Company's capital lease obligations and $300 million five-year, 5.75% Convertible Subordinated Notes due April 2005, have fixed interest rates and fixed redemption amounts. The fair value of these instruments is affected by changes in market interest rates. The Company believes that the market risk arising from holdings of its financial instruments is not material. A substantial portion of the Company's worldwide operations has a functional currency other than the United States Dollar. In particular, the Company maintains substantial development operations in Ireland, where the functional currency is the Irish Pound; Germany, where the functional currency is the German Mark; and Italy, where the functional currency is the Italian Lira. In addition, a significant portion of the Company's revenue is also denominated in currencies other than the United States Dollar. Fluctuations in exchange rates may have a material adverse effect on the Company's results of operations and could also result in exchange losses. The impact of future exchange rate fluctuations cannot be predicted adequately. To date, the Company has not sought to hedge the risks associated with fluctuations in exchange rates, but may undertake such transactions in the future. There can be no assurance that any hedging techniques implemented by the Company would be successful or that the Company's results of operations will not be materially adversely affected by exchange rate fluctuations. 41 45 PART 2 -- OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS See Footnote 8, "Commitments and Contingencies", in the Notes to Consolidated Financial Statements. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS See Footnote 2, "Acquisitions and Joint Venture", in the Notes to Consolidated Financial Statements. ITEM 3. DEFAULTS UPON SENIOR SECURITIES None. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. ITEM 5. OTHER INFORMATION None. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits (b) Reports on Form 8-K On August 8, 2000, the Company filed a report on Form 8-K announcing the expected acquisition of PeerLogic, Inc. On October 2, 2000, the Company filed a report on Form 8-K announcing that Paul Gigg, Executive Vice President and Chief Operating Officer, would be leaving Critical Path. On October 6, 2000, the Company filed a report on Form 8-K announcing the completion of its acquisition of PeerLogic, Inc. 42 46 SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this amended report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: April 4, 2001 CRITICAL PATH, INC. By: /s/ LAWRENCE REINHOLD ------------------------------------------- Lawrence P. Reinhold Executive Vice President, Chief Financial Officer (Duly Authorized Officer and Principal Financial and Accounting Officer) 43