-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, H5VVWMB6JlJHC8P/EMNHkQSsE4g6IhSpgSnNODtlZctC5bYjYp6j/3NKAOEx9LCN yIdgiwt3eo9aTH81t+SoBw== 0000706015-97-000004.txt : 19970407 0000706015-97-000004.hdr.sgml : 19970407 ACCESSION NUMBER: 0000706015-97-000004 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 11 CONFORMED PERIOD OF REPORT: 19961231 FILED AS OF DATE: 19970404 SROS: NASD FILER: COMPANY DATA: COMPANY CONFORMED NAME: FILENET CORP CENTRAL INDEX KEY: 0000706015 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-COMPUTER INTEGRATED SYSTEMS DESIGN [7373] IRS NUMBER: 953757924 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 000-15997 FILM NUMBER: 97574776 BUSINESS ADDRESS: STREET 1: 3565 HARBOR BLVD CITY: COSTA MESA STATE: CA ZIP: 926261420 BUSINESS PHONE: 7149663400 MAIL ADDRESS: STREET 1: 3565 HARBOR BLVD CITY: COSTA MESA STATE: CA ZIP: 926261420 10-K 1 FORM 10-K FOR THE FISCAL YEAR ENDED 12/31/96 ================================================================================ FORM 10-K SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1996 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission File Number 0-15997 FILENET CORPORATION (Exact name of Registrant as specified in its charter) Delaware 95-3757924 (State or other jurisdiction (I.R.S. Employer Identification No.) of incorporation or organization) 3565 Harbor Boulevard, Costa Mesa, California 92626 (Address of principal executive office) (Zip code) Registrant's telephone number, including area code: (714) 966-3400 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Title of each class Name of each exchange which registered Common stock, $0.01 par value Nasdaq Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days: Yes [X] No [ ] Indicate by check mark whether the disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X] Based on the closing sale price of March 21, 1997, the aggregate market value of the 14,835,635 shares of voting stock of the Registrant held by nonaffiliates of the Registrant on such date was $237,370,160. For purposes of such calculation, only executive officers, board members and beneficial owners of more than 10% of the Company's outstanding common stock are deemed to be affiliates. The number of shares outstanding of the Registrant's common stock was 15,085,811 at March 21, 1997. DOCUMENTS INCORPORATED BY REFERENCE Portions of Registrant's definitive proxy statement for its 1997 Annual Meeting are incorporated by reference into Part III as set forth herein. Portions of Registrant's Annual Report to Stockholders for the fiscal year ended December 31, 1996 are incorporated by reference into Parts II, III and IV as set forth herein. ================================================================================ FILENET CORPORATION FORM 10-K For the Fiscal Year Ended December 31, 1996 INDEX Page PART I Item 1. Business.............................................................................. 3 Item 2. Properties............................................................................ 10 Item 3. Legal Proceedings..................................................................... 10 Item 4. Submission of Matters to a Vote of Security Holders................................... 10 PART II Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters.............. 10 Item 6. Selected Financial Data............................................................... 11 Item 7. Management's Discussion and Analysis of Results of Operations and Financial Condition. 12 Item 8. Financial Statements and Supplementary Data........................................... 12 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.. 12 PART III Item 10. Directors and Executive Officers of the Registrant................................... 12 Item 11. Executive Compensation............................................................... 12 Item 12. Security Ownership of Certain Beneficial Owners and Management....................... 12 Item 13. Certain Relationships and Related Transactions....................................... 12 PART IV Item 14. Exhibits, Financial Statement Schedule, and Reports on Form 8-K...................... 13 Signatures.................................................................................... 18
2 PART I Item 1. Business GENERAL FileNet Corporation ("FileNet" or the "Company") develops, markets and services an open, integrated family of workflow, document-imaging, electronic document-management and computer output to laser disk ("COLD") client/server product solutions which control and manage the movement of document images, data, text and other information throughout an enterprise. In August 1995, the Company acquired Watermark Software Inc. ("Watermark"), a leader in document-imaging software for the Microsoft Windows NT platform. In the first quarter of 1996, the Company acquired Saros Corporation ("Saros"), one of the leading suppliers of enterprise electronic document-management software, and International Financial Systems, Ltd. ("IFSL"), whose Greenbar(TM) product is an innovative COLD software application for archiving computer-generated reports. The current product line enables FileNet to offer a broad range of software and support capabilities to customers who are seeking a single vendor to manage their unstructured business information. MARKETS AND APPLICATIONS With its recent acquisitions, the Company now offers a family of complementary products which will enable users to manage the storage, processing and workflow for all documents and other unstructured information, including scanned images, faxes, text, spreadsheets, graphics, drawings, photographs, computer output reports, voice, and video on an enterprise-wide basis. Because the Company's products provide an integrated document-management architecture that can be implemented on a modular basis, organizations can choose one, some, or all of the Company's products to build the system that most effectively meets their needs. The Company's products include workflow and document-imaging software for those organizations which have large, active paper document files, process large numbers of documents in their day-to-day operations, or have complex, mission-critical business processes for a variety of applications such as mortgage loan servicing, credit card customer service, insurance claims processing, retirement account management, technical document management and change control, and the management of personnel, accounts payable, traffic, property and criminal records. Additionally, the Company's products address ad hoc business processes at the departmental and workgroup levels to improve overall enterprise productivity. The Company markets its products through a direct sales force in Australia, Canada, France, Germany, the United Kingdom and the United States. In addition, the Company markets in the United States and in 60 other countries through its Valuenet(R) partner program consisting of systems integrators, resellers and distributors. A number of firms, including Andersen Consulting and American Management Systems, operate as third-party resellers under the Company's ValueNet program and combine FileNet products with vertical market-specific value-added services to provide turnkey solutions and complex systems integration for customers. Other firms such as Tech Data, Law Cypress, IAI Canada, Image Choice and Paperlink are distributors of the Company's products selling to hundreds of resellers throughout the world. The Company also has OEM agreements with other firms involving the Company's software and hardware products. The Company offers software maintenance service for its products in the United States and in countries where it has direct international operations. Its international resellers offer maintenance in the countries they serve. The Company subcontracts hardware maintenance to Hewlett-Packard Corporation ("HP") and other third parties. In June 1995, the Company entered into a joint venture development partnership and distribution agreement with Novell, Inc. ("Novell") to provide workflow software components for Novell's Groupwise software product family. A version of this software is also being marketed by FileNet directly as of November 1996. In September 1995, the Company entered into an alliance with SAP AG to deliver data archiving and document solutions for their client/server-based R/3 enterprise application systems environment. Deliveries of this product commenced in December 1995. The Company also has porting and licensing agreements with HP and Sun Microsystems, Inc. ("Sun") to co-market versions of FileNet's document-imaging and workflow software products to users of those companies' products. Sales of the HP based product commenced in December 1993 and the Sun based product in March 1995. In 1996, the Company became a Global Partner with HP's General Systems Division. 3 The Company is a Certified Microsoft Solutions Developer and will continue to develop products for the Microsoft BackOffice computing environment. PRODUCTS SOFTWARE The following software products are currently being offered by the Company: Document Imaging The Company's Image Management Services ("IMS") software is used for organizing, storing and accessing multiple types of information including document images, data, text, graphics, voice and photographs from different sources. IMS software currently supports the Microsoft Windows NT Server operating system and the AIX/6000, HP-UX, and Solaris operating environments which are IBM Corporation's ("IBM"), HP's, and Sun's implementation of the UNIX operating system, respectively. IMS software operates on high performance servers attached to Token-Ring, Ethernet and FDDI local area networks utilizing TCP/IP and SPX/IPX communication protocols. The Company's WorkForce Desktop(R) Software is a suite of document-imaging and workflow management products which run on IBM and IBM compatible personal computers running Microsoft Corporation's ("Microsoft") Windows operating environments or IBM's OS/2 operating system. The suite provides search and access features, image viewing, and manipulation capabilities for stored images. Additionally, the user can develop custom applications for the WorkForce Desktop products using one of the following software development tools and application programming interfaces: WorkFlo(R)--a proprietary application development software product that enables users to develop business process automation programs by defining individual processing tasks and process flows using a series of high level language commands. WorkFlo programs can be easily modified by the user to respond to new business requirements. In addition, the software enables users to create standard electronic forms for entering information in prescribed formats. WorkFlo Controls--a software development tool that integrates with Microsoft's Visual Basic programming system to increase productivity when developing custom document-imaging and workflow applications. WorkFlo Power Libraries--a software development tool that integrates with Sybase/Powersoft's PowerBuilder programming system and C language programs to increase productivity when developing custom document-imaging and workflow applications. WorkFlo Application Libraries--a standard application programming interface layer to FileNet's IMS software for various workstations, network and application environments including Microsoft Windows, OS/2, Sun Solaris, HP-UX, and IBM AIX/6000. The Company's FileNet:WorkGroup(TM) software is a midrange document-imaging and work management product based on a subset of the above products combined with certain prepackaged software applications. The Company's Document Warehouse(TM) for SAP software product is a document and data archiving application, certified by SAP, for use with the popular R/3 Enterprise Resource Planning (ERP) application suite. FileNet Image View II(TM) is a client software product introduced in 1996 that integrates with and accesses documents stored in FileNet's IMS server and the Watermark Image Server products to enable the use of scanned documents and faxes with any OLE-compatible Windows application, such as spreadsheets, workflows, forms, databases, e-mail, etc. The Company's Watermark(R) software products enable users worldwide to exchange, process and share scanned images, faxes and other electronic documents within departments and workgroups of large enterprises and throughout midsize and small business environments. Watermark documents and folders are easily integrated into existing line-of-business applications and take advantage of the latest Microsoft operating systems, database technologies and Internet capabilities. The Watermark family consists of the following products: 4 Watermark Client software replaces document handling procedures with integrated electronic processing of scanned images, faxes and other electronic documents. The software provides easy-to-use tools for document capturing, filing, viewing, annotation and OCR that image enable any OLE- or ODMA- compatible Windows application, such as e-mail, databases and workflows. Watermark Image Server software is used for organizing, storing and optimizing shared network access to scanned documents, faxes and electronic files. The software intelligently captures the business rules governing document security, version control, migration and storage through easy client-based administration and reporting tools designed for Microsoft Backoffice. Watermark Hierarchical Storage Manager software extends the document storage and retrieval capacity of the Watermark Image Server by providing Windows NT services to migrate documents to and from high-density optical disks. Watermark Fax Router software is a fax management solution that streamlines inbound fax communications with customers, suppliers and other business partners. The software delivers documents electronically to the intended recipient and immediately routes for processing. Faxes are securely managed side-by-side with all other business documents. Watermark Developer's Toolkit software allows a developer to build client/server and intranet applications by taking advantage of the full power and range of Watermark functionality via OLE Objects and ActiveX Controls specifically designed to simplify application building. Workflow The Company's Visual WorkFlo(R) software provides an open, flexible, component software framework for workflow application development. This product enables users and ValueNet partners to automate business processes using object-oriented programming technology, and supports standard tools such as C++, Visual Basic, PowerBuilder, Microsoft Windows-compatible tools, and FileNet's other WorkFlo products. All work management functions, including routing, queuing, exception handling, and management control, are managed by Visual WorkFlo using standard Windows interfaces and graphical tools. FileNet Ensemble(TM) is a general purpose workflow tool introduced in 1996 that automates a wide range of everyday business processes and is integrated with Microsoft Exchange and Novell Groupwise to enhance these messaging (e-mail) system products. FileNet markets this product through all of its direct and indirect sales channels worldwide. A version of this software will be marketed by Novell starting in 1997 under the product name "Groupwise Workflow." Electronic Document Management The Company's Saros(R) software products simplify the management and maintenance of electronic documents and other unstructured information, ensuring the right information is always available. Needed information is readily accessible, providing total manageability and security. The Saros family consists of the following products: Saros Mezzanine(R) is a server software product that enables electronic document management applications across large enterprise LANs and WANs. It acts as a network librarian, simplifying the management and maintenance of all files on the user's network. Saros Document Manager is a client-based ready-to-use document management system based on Saros Mezzanine. Saros Document Manager provides the user with tools to create, communicate and control electronic documents. Saros @mezzanine(TM) is a software product used to organize, protect and maintain documents published on the World Wide Web. @mezzanine provides improved organization and access methods to the Web browser and special document management features such as version control, security and archiving needed by the Web server. Saros Document Server for BackOffice is a special version of the Mezzanine software and is designed expressly for the Microsoft BackOffice server platform. Saros Document Server for BackOffice takes advantage of the full power of Microsoft Windows NT Server to create an enterprise-wide electronic information library. 5 COLD The Company's Greenbar software product stores and retrieves computer-generated reports to replace the use of printed reports and computer output to microfiche. It also enables the user to search for specific information located in one or more reports and extract the information to use with popular desktop software applications. It is a client/server software product running on servers using the Microsoft Windows NT Server operating system and PC workstations running Microsoft Windows. It also integrates with FileNet's IMS software product to provide large capacity archival storage capabilities. HARDWARE The Company markets an optional integration service, offering customers the option to purchase complete solutions, including industry standard hardware, directly from FileNet. The Company also manufactures and markets an optical storage and retrieval library (OSAR(R)) based on 12-inch optical disk storage technology. All named products mentioned in this Form 10-K, other than the Company's named products, are trademarks or registered trademarks of the respective holder. RESEARCH AND DEVELOPMENT The Company's research and development activities are focused on software product development. Research and development expenditures were $36.5 million, $24.7 million and $18.3 million for the fiscal years ended December 31, 1996, December 31, 1995, and January 1, 1995, respectively. The Company believes that its future success depends upon its ability to continue to enhance its existing software products and to develop new software products that satisfactorily meet market needs. Accordingly, the Company intends to continue to make substantial investments in its research and development activities. BACKLOG The Company typically ships its products within a short period of time after acceptance of orders, which is common in the computer software industry. The Company does not consider the level of backlog to be a significant or important indicator of future revenue or earnings. SERVICES, SUPPORT AND MANUFACTURING The Company maintains service and support organizations which provide both pre-sales and post-sales services in the United States and the foreign countries where the Company has direct operations. The Company's integration facilities in Costa Mesa, California and Dublin, Ireland, conduct software manufacturing, integration, test and quality control. In those cases in which the customer requests that FileNet provide a turnkey solution, the Company uses standard products and components which are available from multiple vendors. Certain parts and components are purchased from sole sources, including optical disk drives for its OSAR product. The Company is dependent upon the ability of vendors to deliver these items in accordance with the Company's specifications and delivery schedules. Scanners, printers, magnetic disks, memory circuits, frames, panels and harnesses are available from a number of domestic sources. The failure of certain suppliers to deliver on schedule could delay or interrupt the Company's delivery of products and thereby adversely affect the Company's operating results. To date, the Company has not experienced any delays in deliveries from its suppliers which have had a material impact on its business. EMPLOYEES As of December 31, 1996, the Company had 1,443 full-time employees of which 364 were employed in research and development; 853 in sales, marketing, professional services and customer support; 96 in operations; and 130 in finance and administration. Employees in the Company's German subsidiary are represented by a labor union. No other employees are represented by labor unions, and the Company has never experienced a work stoppage. The Company believes that it enjoys good employee relations. 6 COMPETITION The market for the Company's products is highly competitive. The Company's principal competitors for its various product lines include the following companies: 1) Workflow and document imaging-- Banctec, Inc., IBM, Keyfile, Optika, Unisys Corporation, Mosaix, Wang Laboratories, Inc., 2) Electronic Document Management--Documentum, IBM, Interleaf, Novasoft, Novell, Open Text, PC DOCS, and 3) COLD--Computron, IBM and Microbank. Numerous smaller software vendors also compete in each product area. The Company also experiences competition from systems integrators who configure hardware and software into customized systems. In addition, RDBMS vendors, such as Oracle, Sybase and Informix, may compete with the Company in the future. Oracle has announced products that compete with the Company's document management products. It is also possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share. The Company also expects that competition will increase as a result of software industry consolidations. To the extent one or more of the Company's competitors introduce products that more fully address customer requirements, the Company's business and operating results could be adversely affected. PATENTS AND LICENSES The Company holds three patents for its OSAR product which expire August 26, 2003, June 23, 2004 and August 4, 2004, respectively. The Company has also entered into non-exclusive license arrangements with a number of organizations, including IBM and Oracle, which permit the Company and its resellers to grant sublicenses to end users of the Company's systems to use software developed by these third-party vendors. CERTAIN CONSIDERATIONS This report and the Company's Annual Report to Stockholders for the year ended December 31, 1996 contains forward-looking statements that involve risks and uncertainties, including those discussed below and in the Management's Discussion and Analysis of Financial Condition and Results of Operations section and Notes to Consolidated Financial Statements in the Company's Annual Report to Stockholders incorporated herein by reference as set forth in Items 7 and 8 of this report. The actual results that the Company achieves may differ materially from any forward-looking statements due to such risks and uncertainties. All such factors should be considered by investors in the Company. Rapid Technological Change; Product Development. The market for the Company's products is characterized by rapid technological developments, evolving industry standards, changes in customer requirements and frequent new product introductions and enhancements. The Company's continued success will be dependent upon its ability to continue to enhance its existing products, develop and introduce, in a timely manner, new products incorporating technological advances and respond to customer requirements. To the extent one or more of the Company's competitors introduce products that more fully address customer requirements, the Company's business could be adversely affected. There can be no assurance that the Company will be successful in developing and marketing enhancements to its existing products or new products on a timely basis or that any new or enhanced products will adequately address the changing needs of the marketplace. If the Company is unable to develop and introduce new products or enhancements to existing products in a timely manner in response to changing market conditions or customer requirements, the Company's business and operating results could be adversely affected. From time to time, the Company or its competitors may announce new products, capabilities or technologies that have the potential to replace or shorten the life cycles of the Company's existing products. There can be no assurance that announcements of currently planned or other new products will not cause customers to delay their purchasing decisions in anticipation of such products, which could have a material adverse effect on the Company's business and operating results. Uncertainty of Future Operating Results; Fluctuations in Quarterly Operating Results. Prior growth rates in the Company's revenue and operating results should not necessarily be considered indicative of future growth or operating results. Future operating results will depend upon many factors, including the demand for the Company's products, the effectiveness of the Company's efforts to continue to integrate various products it has developed or acquired through acquisition of others and to achieve the desired levels of sales from such product integration, the level of product and price competition, the length of the Company's sales cycle, seasonality of individual customer buying patterns, the size and timing of individual transactions, the delay or deferral of customer implementations, the budget cycles of the Company's customers, the timing of new product introductions and product enhancements by the Company and its competitors, the mix of sales by products, services and distribution channels, levels of international sales, acquisitions by competitors, changes in foreign currency exchange rates, the ability of the Company to develop and market new products and control costs, and general domestic and international economic and political conditions. As a result of these factors, revenues and operating results for any quarter are subject to variation and are not predictable with any significant degree of accuracy. Therefore, the Company believes that period-to-period comparisons of its results of operations are not necessarily meaningful and should not be relied upon as indications of future performance. Moreover, such factors could cause the Company's operating results in a given quarter to be below the expectations of public market analysts and investors. In either case, the price of the Company's common stock could be materially adversely affected. 7 Competition. The document imaging, workflow, COLD and document management software markets are highly competitive, and there are certain competitors of the Company with substantially greater sales, marketing, development and financial resources. The Company believes that the competitive factors affecting the market for its products and services include vendor and product reputation; product quality, performance and price; the availability of products on multiple platforms; product scalability; product integration with other enterprise applications; product functionality and features; product ease-of use; and the quality of customer support services and training. The relative importance of each of these factors depends upon the specific customer involved. While the Company believes it competes favorably in each of these areas, there can be no assurance that it will continue to do so. Moreover, the Company's present or future competitors may be able to develop products comparable or superior to those offered by the Company, offer lower price products or adapt more quickly than the Company to new technologies or evolving customer requirements. Competition is expected to intensify. In order to be successful in the future, the Company must respond to technological change, customer requirements and competitors' current products and innovations. There can be no assurance that it will be able to continue to compete effectively in its market or that future competition will not have a material adverse effect on its business, operating results and financial condition. Intellectual Property and Other Proprietary Rights. The Company's success depends in part on its ability to protect its proprietary rights to the technologies used in its principal products. The Company relies on a combination of copyrights, trademarks, trade secrets, confidentiality procedures and contractual provisions to protect its proprietary rights. There can be no assurance that the Company's existing or future copyrights, trademarks, trade secrets or other intellectual property rights will be of sufficient scope or strength to provide meaningful protection or commercial advantage to the Company. FileNet has no software patents. Also, in selling certain of its products, the Company relies on "shrink wrap" licenses that are not signed by licensees and, therefore, may be unenforceable under the laws of certain jurisdictions. In addition, the laws of some foreign countries do not protect the Company's proprietary rights to the same extent as do the laws of the United States. There can be no assurance that such factors would not have a material adverse effect on the Company's business or operating results. The Company may from time to time be notified that it is infringing certain patent or intellectual property rights of others. Combinations of technology acquired through past or future acquisitions and the Company's technology will create new products and technology which may give rise to claims of infringement. While no actions other than the ones discussed below are currently pending against the Company for infringement of patent or other proprietary rights of third parties, there can be no assurance that third parties will not initiate infringement actions against the Company in the future. Infringement actions can result in substantial cost to and diversion of resources of the Company. If the Company were found to infringe upon the rights of others, no assurance can be given that licenses would be obtainable on acceptable terms or at all, that significant damages for past infringement would not be assessed or that further litigation relative to any such licenses or usage would not occur. The failure to successfully defend any claims or obtain necessary licenses or other rights, the ultimate disposition of any claims or the advent of litigation arising out of any claims of infringement, could have a material adverse effect on the Company's business, financial condition or results of operations. In October 1994, Wang Laboratories, Inc. ("Wang") filed a complaint in the United States District Court for the District of Massachusetts alleging that the Company is infringing five patents held by Wang. On June 23, 1995, Wang amended its complaint to include an additional related patent. On July 2, 1996, Wang filed a complaint in the same court alleging that Watermark, formerly a wholly-owned subsidiary that was merged into the Company, is infringing three of the same patents asserted in the initial complaint. On October 9, 1996, Wang withdrew its claim that one of the patents it initially asserted is infringed by the Company's products which were commercialized before the initial complaint was filed. Wang reserved the right to assert that patent against the Company's products commercialized after that date in a separate lawsuit. Based on the Company's analysis of these Wang patents and their respective file histories, the Company believes that it has meritorious defenses to Wang's claims; however, the ultimate outcome or any resulting potential loss cannot be determined at this time. In January 1997, Wang and Eastman Kodak Company ("Kodak") announced that they have entered into an agreement under which Kodak will acquire the Wang business unit that has responsibility for this litigation. The acquisition is scheduled to close in March-April 1997 and the Company can not predict what, if any, impact this will have on the litigation. If it should be determined that the patents at issue in the litigation are valid and are infringed by any of the Company's products, including Watermark products, the Company will, depending on the product, redesign the infringing products or seek to obtain a license to market the products. There can be no assurance that the Company will be able to obtain such a license on acceptable terms. Dependence on Certain Relationships The Company has entered into a number of co-marketing relationships with other companies such as Microsoft Corporation, Compaq Computer Corporation, SAP AG, Hewlett-Packard Company ("HP") and Sun Microsystems, Inc. There can be no assurance that these companies will not reduce or discontinue their relationships with or support of the Company and its products. Disruption of these relationships could have a material adverse effect on the Company's business and operating results. 8 Dependence on Key Management and Technical Personnel. The Company's success depends to a significant degree upon the continued contributions of its key management, marketing, technical and operational personnel, including members of senior management and technical personnel of acquired companies. The Company has no agreements providing for the employment of any of its key employees or any fixed term contracts and the Company's key employees may voluntarily terminate their employment with the Company at any time. The loss of the services of one or more key employees, including key employees of acquired companies, could have a material adverse effect on the Company's operating results. The Company also believes its future success will depend in large part upon its ability to attract and retain additional highly skilled management, technical, marketing, product development and operational personnel. Competition for such personnel is intense, and there can be no assurance that the Company will be successful in attracting and retaining such personnel. International Sales. Historically, the Company has derived approximately one-third of its total revenues from international sales. International business is subject to certain risks including varying technical standards, tariffs and trade barriers, political and economic instability, reduced protection for intellectual property rights in certain countries, difficulties in staffing and maintaining foreign operations, difficulties in managing foreign distributors, potentially adverse tax consequences, currency exchange fluctuations, the burden of complying with a wide variety of complex operations, foreign laws, regulations and treaties and the possibility of difficulties in collecting accounts receivable. There can be no assurance that any of these factors will not have a material adverse effect on the Company's business or operating results. Acquisition-Related Risks. The Company recently completed the acquisitions of Watermark, Saros and IFSL. These recent acquisitions by the Company have presented and will continue to present it with numerous challenges, including difficulties in the assimilation of the operations, technologies and products of the acquired companies and managing separate geographic operations. The challenges have absorbed and may continue to absorb significant management attention that would otherwise be available for the ongoing development of the Company's business. If the Company's management does not respond to these challenges effectively, the Company's results of operations could be adversely affected. Moreover, there can be no assurance that the anticipated benefits of the acquisitions will be realized. The Company and the acquired companies could experience difficulties or delays in integrating their respective technologies or developing and introducing new products. In particular, one of the reasons for FileNet's acquisition of Saros was the perceived market potential for Saros' new products, including the recently announced @mezzanine and Saros Document Server for BackOffice, which have yet to be proven in the marketplace, as well as other products currently under development. Delays in or non-completion of the development of these new products, or lack of market acceptance of such products, could have an adverse impact on the Company's future results of operations and result in a failure to realize anticipated benefits of the acquisitions. Product Liability. The Company's license agreements with customers typically contain provisions designed to limit their exposure to potential product liability claims. However, it is possible that such limitation of liability provisions may not be effective under the laws of certain jurisdictions. Although the Company has not experienced any product liability claims to date, the sale and support of products by them may entail the risk of such claims, and there can be no assurance that the Company will not be subject to such claims in the future. A successful product liability claim brought against the Company could have a material adverse effect upon the Company's business, operating results and financial condition. Stock Price Volatility. The Company believes that a variety of factors could cause the price of its common stock to fluctuate, perhaps substantially, including quarter-to-quarter variations in operating results; announcements of developments related to its business; fluctuations in its order levels; general conditions in the technology sector or the worldwide economy; announcements of technological innovations, new products or product enhancements by the Company or its competitors; key management changes; changes in joint marketing and development programs; developments relating to patents or other intellectual property rights or disputes; and developments in the Company's relationships with its customers, distributors and suppliers. In addition, in recent years the stock market in general, and the market for shares of high technology stocks in particular, has experienced extreme price fluctuations which have often been unrelated to the operating performance of affected companies. Such fluctuations could adversely affect the market price of the Company's common stock. 9 Item 2. Properties The Company currently leases 250,000 square feet of office, development and manufacturing space in Costa Mesa, California; 42,000 square feet of office and development space in Bellevue, Washington; 12,500 square feet of office and development space in Burlington, Massachusetts. The Company also leases sales and support offices in 41 locations in the United States, 13 in Europe, 2 in Australia, 3 in Canada, and 3 in Asia. The Company believes that the Costa Mesa, Bellevue and Burlington facilities will be adequate for the Company's anticipated needs through 1997. Item 3. Legal Proceedings In October 1994, Wang filed a complaint in the United States District Court for the District of Massachusetts alleging that the Company is infringing five patents held by Wang. On June 23, 1995, Wang amended its complaint to include an additional related patent. On July 2, 1996, Wang filed a complaint in the same court alleging that Watermark, formerly a wholly-owned subsidiary that was merged into the Company, is infringing three of the same patents asserted in the initial complaint. On October 9, 1996, Wang withdrew its claim that one of the patents it initially asserted is infringed by the Company's products which were commercialized before the initial complaint was filed. Wang reserved the right to assert that patent against the Company's products commercialized after that date in a separate lawsuit. Based on the Company's analysis of these Wang patents and their respective file histories, the Company believes that it has meritorious defenses to Wang's claims; however, the ultimate outcome or any resulting potential loss cannot be determined at this time. In January 1997, Wang and Kodak announced that they have entered into an agreement under which Kodak will acquire the Wang business unit that has responsibility for this litigation. The acquisition is scheduled to close in March-April 1997 and the Company cannot predict what, if any, impact this will have on the litigation. If it should be determined that the patents at issue in the litigation are valid and are infringed by any of the Company's products, including Watermark products, the Company will, depending on the product, redesign the infringing products or seek to obtain a license to market the products. There can be no assurance that the Company will be able to obtain such a license on acceptable terms. On December 20, 1996, plaintiff Michael I. Goldman filed a class action complaint against the Company and certain of its officers and directors in the Superior Court of California, County of Orange. The action was purportedly filed on behalf of a class of purchasers of the Company's common stock during the period October 19, 1995 through July 2, 1996. Plaintiff alleges that the Company and other defendants violated Cal. Corp. Code Sections 25400 and 25500, Cal. Civ. Code Sections 1709-1710 and Cal. Bus. & Prof. Code Sections 17200 et seq. in connection with various public statements made by the Company and certain of its officers and directors during the putative class period. The complaint seeks unspecified compensatory and punitive damages, interest, payment of attorney's fees and costs, and equitable or injunctive relief; however, at this time it is not possible to determine the potential liability, if any. The Company has not yet responded to the complaint. The Company believes the complaint is without merit and intends to defend the action vigorously. The Company, in the normal course of business, is subject to various other legal matters. While the results of litigation and claims cannot be predicted with certainty, the Company believes that the final outcome of these other matters will not have a materially adverse effect on the Company's consolidated results of operations or financial condition. Item 4. Submission of Matters to a Vote of Security Holders None. PART II Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters There is hereby incorporated herein by reference the information appearing under the caption "Stock Market and Dividend Information," which appears on page 42 of the Registrant's Annual Report to Stockholders for the year ended December 31, 1996 and is filed herewith as Exhibit 13.1. 10 Item 6. Selected Financial Data 1 The following table summarizes certain selected financial data:
For Fiscal Years Ended -------------------------------------------------------------------------------------- Dec. 31, 1996 Dec. 31, 1995 Jan. 1, 1995 Jan. 2, 1994 Jan. 3, 1993 ---------------- ---------------- --------------- ---------------- --------------- (1996) (1995) (1994) (1993) (1992) ------ ------ ------ ------ ------ (In thousands, except per share amounts) Consolidated statements of operations data: Revenue: Software revenue $140,659 $116,052 $ 81,102 $ 54,067 $ 34,089 Service revenue 82,118 67,174 60,753 60,933 45,803 Hardware revenue 46,136 46,152 50,480 51,410 62,608 ---------------------------------- ---------------- ----------------- ---------------- Total revenue 268,913 229,378 192,335 166,410 142,500 Costs and expenses: Cost of software revenue 16,464 15,146 12,472 7,831 6,324 Cost of service revenue 53,568 44,277 41,645 42,812 36,650 Cost of hardware revenue 29,633 28,800 30,999 34,116 28,330 Research and development 36,502 24,711 18,274 15,247 15,142 Selling, general and administrative 117,761 96,499 71,267 61,711 59,277 Merger, restructuring and write-off of purchased in-process research and development costs 16,011 6,393 -- -- 10,044 -------------------------------------------------------------------------------------- Total costs and expenses 269,939 215,826 174,657 161,717 155,767 -------------------------------------------------------------------------------------- Operating income (loss) (1,026) 13,552 17,678 4,693 (13,267) Other income 2,838 2,780 1,821 333 348 -------------------------------------------------------------------------------------- Income (loss) before income taxes 1,812 16,332 19,499 5,026 (12,919) Provision (benefit) for income taxes 4,456 8,116 5,356 4,760 (1,827) -------------------------------------------------------------------------------------- Net income (loss) $ (2,644) $ 8,216 $ 14,143 $ 266 $(11,092) ================= ================= ================ ================= =============== Net income (loss) per share $ (0.18) $ 0.52 $ 0.95 $ 0.02 $ (0.95) Weighted average common and common equivalent shares outstanding 15,007* 15,856 14,834 13,178 11,705* *Excludes common share equivalents Consolidated balance sheet data: Working capital $ 89,339 $ 86,354 $ 63,149 $ 47,819 $ 46,292 Total assets 195,679 189,682 152,642 124,986 104,350 Long-term debt, excluding current portion -- -- -- 163 68 Stockholders' equity 132,806 131,158 101,006 78,383 71,346
1 All historical data has been restated to reflect the acquisition of Saros Corporation on March 1, 1996 which was accounted for as a pooling of interests. Certain reclassifications have been made to the prior years' selected financial data to conform with the current year's presentation. 11 Item 7. Management's Discussion and Analysis of Results of Operations and Financial Condition There is hereby incorporated herein by reference the information appearing under the caption "Management's Discussion and Analysis of Results of Operations and Financial Condition," which appears on pages 18 through 24 of the Registrant's Annual Report to Stockholders for the year ended December 31, 1996 and is filed herewith as Exhibit 13.2. Item 8. Financial Statements and Supplementary Data There is hereby incorporated herein by reference the information appearing on pages 25 through 39 of the Registrant's Annual Report to Stockholders for the year ended December 31, 1996 and is filed herewith as Exhibit 13.3. The accompanying Independent Auditors' Report is also incorporated herein by reference and filed herewith as Exhibit 13.3. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. PART III Item 10. Directors and Executive Officers of the Registrant There is hereby incorporated herein by reference the information appearing under the caption "Election of Directors," under the caption "Executive Officers of the Company," and under the caption "Compliance with Securities Laws" of the Registrant's definitive Proxy Statement for its 1997 Annual Meeting to be filed with the Securities and Exchange Commission. Item 11. Executive Compensation There is hereby incorporated herein by reference the information appearing under the caption "Executive Compensation" and under the caption "Election of Directors" of the Registrant's definitive Proxy Statement for its 1997 Annual Meeting to be filed with the Securities and Exchange Commission. Item 12. Security Ownership of Certain Beneficial Owners and Management There is hereby incorporated herein by reference the information appearing under the caption "Voting Securities and Principal Holders Thereof" of the Registrant's definitive Proxy Statement for its 1997 Annual Meeting to be filed with the Securities and Exchange Commission. Item 13. Certain Relationships and Related Transactions There is hereby incorporated herein by reference the information appearing under the caption "Note 11: Related Party Transaction," which appears on page 38 of the Registrant's Annual Report to Stockholders for the year ended December 31, 1996 and is filed herewith as part of Exhibit 13.4. 12 PART IV Item 14. Exhibits, Financial Statement Schedule, and Reports on Form 8-K (a) Financial statements 1. The list of financial statements contained in the accompanying Index to Consolidated Financial Statements covered by the Independent Auditors' Report is herein incorporated by reference. 2. Financial statement schedule The listed financial statement schedule contained in the accompanying Index to Consolidated Financial Statements covered by the Independent Auditors' Report is herein incorporated by reference. 3. Exhibits The list of exhibits contained in the accompanying Index to Exhibits is herein incorporated by reference. (b) Reports on Form 8-K No reports on Form 8-K were filed during the fourth quarter of fiscal 1996. Index to Consolidated Financial Statements Covered by Independent Auditors' Report Item 14(a) (1) and (2)
Page Reference --------------------------- 1996 Annual Report to Form 10-K Stockholders The information under the following captions, which is included in the 1996 Annual Report to Stockholders, is incorporated herein by reference: Independent Auditors' Report 39 Consolidated balance sheets at December 31, 1996 and December 31, 1995 25 Consolidated statements of operations for each of the years ended December 31, 1996, December 31, 1995 and January 1, 1995 26 Consolidated statements of stockholders' equity for each of the years ended December 31, 1996, December 31, 1995 and January 1, 1995 27 Consolidated statements of cash flows for each of the years ended December 31, 1996, December 31, 1995 and January 1, 1995 28 Notes to consolidated financial statements 29 Independent Auditors' Report on Schedule 14 Schedule for each of the three years ended December 31, 1996, December 31, 1995 and January 1, 1995 II. Valuation and qualifying accounts and reserves 15
13 INDEPENDENT AUDITORS' REPORT ON SCHEDULE To the Stockholders and the Board of Directors of FileNet Corporation: We have audited the consolidated financial statements of FileNet Corporation and its subsidiaries as of December 31, 1996 and 1995 and for each of the three years in the period ended December 31, 1996, and have issued our report thereon dated February 10, 1997. Such consolidated financial statements and report are included in your 1996 Annual Report to Stockholders and are incorporated herein by reference. Our audits also included the consolidated financial statement schedule of FileNet Corporation and its subsidiaries, listed in Item 14. The consolidated financial statement schedule is the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such consolidated financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. /s/ Deloitte & Touche LLP February 10, 1997 Costa Mesa, California 14 SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS ($ in thousands)
Balance at Additions- Beginning of Charged to Costs Balance at End Description Period and Expenses Deductions of Period - ----------------------------------- ---------------------------------------------------------------------- Year ended January 1, 1995: Inventory reserves $ 771 $ 532 $ 652 (1) $ 651 Allowance for doubtful accounts 562 222 53 (2) 731 Reserve for returned systems 3,418 489 1,160 (3) 2,747 Year ended December 31, 1995: Inventory reserves 651 482 560 (1) 573 Allowance for doubtful accounts 731 857 48 (2) 1,540 Reserve for returned systems 2,747 869 463 3,153 Year ended December 31, 1996: Inventory reserves 573 635 548 (1) 660 Allowance for doubtful accounts 1,540 1,205 605 (2) 2,140 Reserve for returned systems 3,153 32 - 3,185
(1) Consists primarily of the write-off of excess/obsolete inventories. (2) Consists primarily of uncollectible invoice amounts. (3) Includes an amount attributable to the resolution of a specific customer dispute. Such amount was recognized in revenue in 1994. 15 Index to Exhibits Exhibit No. Description - ------- ---------------------------------------------------------------------- 3.1* Restated Certificate of Incorporation, as amended (filed as Exhibit 3.1 to Form S-4 filed on January 26, 1996; Registration No. 333-00676). 3.1.1* Certificate of Amendment of Restated Certificate of Incorporation (filed as Exhibit 3.1.1 to Form S-4 filed on January 26, 1996, Registration No. 333-00676). 3.2* Bylaws (filed as Exhibit 3.2 of the Registrant's registration statement on Form S-1, Registration No. 33-15004 (the "Form S-1")). 4.1* Form of certificate evidencing Common Stock (filed as Exhibit 4.1 to the Form S-1, Registration No. 33-15004). 4.2* Rights Agreement, dated as of November 4, 1988 between FileNet Corporation and the First National Bank of Boston, which includes the form of Rights Certificate as Exhibit A and the Summary of Rights to Purchase Common Shares as Exhibit B (filed as Exhibit 4.2 to Form S-4 filed on January 26, 1996; Registration No. 333-00676). 10.1* Amended and Restated Credit Agreement (Multicurrency) by and among the Registrant and Bank of America National Trust and Savings Association dated August 8, 1995, effective May 1, 1995 (filed as Exhibit 10.1 to Form 10-Q for the quarter ended July 2, 1995). 10.2 Waiver and Second Amendment dated December 18, 1996, to the Amended and Restated Credit Agreement (Multicurrency) by and among the Registrant and Bank of America National Trust and Savings Association dated August 8, 1995. 10.3* Business Alliance Program Agreement between the Registrant and Oracle Corporation dated July 1, 1996, as amended by Amendment One thereto (filed as Exhibit 10.4 to Form 10-QA for the quarter ended June 30, 1996). 10.4* Runtime Sublicense Addendum between the Registrant and Oracle Corporation dated July 1, 1996, as amended by Amendment One thereto (filed as Exhibit 10.4 to Form 10-QA for the quarter ended June 30, 1996). 10.5* Full Use and Deployment Sublicense Addendum between the Registrant and Oracle Corporation dated July 1, 1996, as amended by Amendment One thereto (filed as Exhibit 10.4 to Form 10-QA for the quarter ended June 30, 1996). 10.6* Lease between the Registrant and C. J. Segerstrom & Sons for the headquarters of the Company, dated April 30, 1987 (filed as Exhibit 10.19 to the Form S-1). 10.7 Third Amendment to the Lease between the Registrant and C. J. Segerstrom & Sons dated April 30, 1987, for additional facilities at the headquarters of the Company, dated October 1, 1992. 10.8* 1989 Stock Option Plan for Non-Employee Directors of FileNet Corporation, as amended by the First Amendment, Second Amendment, Third Amendment thereto (filed as Exhibit 10.9 to Form S-4 filed on January 26, 1996; Registration No. 333-00676). 10.9* Amended and Restated 1995 Stock Option Plan of FileNet Corporation as approved by stockholders at the Registrant's Annual Meeting on May 8, 1996 (filed as Exhibit 99.1 to Form S-8 filed on July 29, 1996). 10.10* Second Amended and Restated Stock Option Plan of FileNet Corporation, together with the forms of Incentive Stock Option Agreement and Non-Qualified Stock Option Agreements (filed as Exhibits 4(a), 4(b) and 4(c), respectively, to the Registrant's Registration Statement on Form S-8, Registration No. 33-48499), and an Amendment thereto (filed as Exhibit 4(d) to the Registrant's Registration Statement on Form S-8, Registration No. 33-69920), and the Second Amendment thereto (filed as Appendix A to the Registrant's Proxy Statement for the Registrant's 1994 Annual Meeting of Stockholders, filed on April 29, 1994). - -------------------------------------------- * Incorporated herein by reference 16 Exhibit No. Description - ----------------------- -------------------------------------------------------- 10.11* Agreement for the Purchase of IBM products dated December 20, 1991 (filed on May 5, 1992 with the Form 8 amending the Company's Form 10-K for the fiscal year ended December 31, 1991). 10.12 Amendment #A1011-941003-01 dated September 30, 1994, to the Agreement for the Purchase of IBM products dated December 20, 1991. 10.13* Development and Initial Supply Agreement between the Registrant and Quintar Company dated August 20, 1992 (filed as Exhibit 10.21 to Form 10-K for the year ended January 3, 1993). 10.14* Amendment dated December 22, 1992 to the Development and Initial Supply Agreement between the Registrant and Quintar Company dated August 20, 1992 (filed as Exhibit 10.22 to Form 10-K for the year ended January 3, 1993). 10.15* Product License Agreement between the Registrant and Novell, Inc. dated May 16, 1995 (filed as Exhibit 10.26 to Form 10-Q for the quarter ended July 2, 1995). 10.16* Agreement and Plan of Merger between the Registrant and Watermark Software Inc. dated July 18, 1995 (filed as Exhibit 10.27 to Form 10-Q for the quarter ended July 2, 1995). 10.17* Agreement and Plan of Merger between the Registrant and Saros Corporation, as amended, dated January 17, 1996 (filed as Exhibits 2.1, 2.2, 2.3, and 2.4 to Form 8-K on March 13, 1996). 10.18* Stock Purchase Agreement by and Among FileNet Corporation, IFS Acquisition Corporation, Jawaid Khan and Juergen Goersch dated January 17, 1996 and Amendment 1 to Stock Purchase Agreement dated January 30, 1996 (filed as Exhibit 10.2 to form 10-K for the year ended December 31, 1995). 13.1 Market for the Registrant's Common Stock and Related Stockholder Matters incorporated by reference to page 42 of the 1996 Annual Report. 13.2 Management's Discussion and Analysis of Results of Operations and Financial Condition incorporated by reference to pages 18 through 24 of the 1996 Annual Report. 13.3 Financial Statements incorporated by reference to pages 25 through 39 of the 1996 Annual Report. 13.4 Certain Relationships and Related Transactions incorporated by reference to page 38 of the 1996 Annual Report. 21.1 List of subsidiaries of Registrant (filed as FileNet Corporation Subsidiary Information). 23.1 Consent of Deloitte & Touche LLP (filed as Independent Auditors' Consent). 27 Financial Data Schedule - --------------------------------------------- * Incorporated herein by reference 17 Signatures Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. FILENET CORPORATION Date: April 2, 1997 By: /s/ T. J. Smith -------------------------------------------- T. J. Smith President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Date: April 2, 1997 By: /s/ T. J. Smith -------------------------------------------- T. J. Smith President (Principal Executive Officer) Director Date: April 2, 1997 By: /s/ Mark S. St. Clare -------------------------------------------- Mark S. St. Clare Chief Financial Officer and Sr. Vice President, Finance (Principal Financial Officer) Date: April 2, 1997 By: /s/ William R. Hughes -------------------------------------------- William R. Hughes Chief Accounting Officer and Controller Date: April 2, 1997 By: /s/ Frederick K. Fluegel -------------------------------------------- Frederick K. Fluegel Director Date: April 2, 1997 By: /s/ J. Burgess Jamieson -------------------------------------------- J. Burgess Jamieson Director Date: April 2, 1997 By: /s/ John C. Savage -------------------------------------------- John C. Savage Director Date: April 2, 1997 By: /s/ William P. Lyons -------------------------------------------- William P. Lyons Director 18 EX-10.2 2 AMENDMENT TO CREDIT AGREEMENT WAIVER AND SECOND AMENDMENT TO CREDIT AGREEMENT THIS WAIVER AND SECOND AMENDMENT TO AMENDED AND RESTATED CREDIT AGREEMENT ("Waiver and Amendment"), dated as of December 18 , 1996, is entered into by and between FILENET CORPORATION (the "Borrower") and BANK OF AMERICA NATIONAL TRUST AND SAVINGS ASSOCIATION (the "Bank"). RECITALS A. The Bank and the Borrower are parties to an Amended and Restated Credit Agreement (Multicurrency) dated as of August 8,1995, effective as of May 1, 1995, as amended by that Waiver and Amendment to Credit Agreement dated as of July 11, 1996 (as so amended, the "Credit Agreement"), pursuant to which the Bank has extended certain credit facilities to the Borrower. B. The Borrower has reported to the Bank the existence of an Event of Default under the Credit Agreement. The Borrower has requested that the Bank waive such Event of Default and agree to an amendment to the Credit Agreement. C. The Bank is willing to waive such Event of Default under the Credit Agreement, and to amend the Credit Agreement, subject to the terms and conditions of this Waiver and Amendment. NOW, THEREFORE, for valuable consideration, the receipt and adequacy of which are hereby acknowledged, the parties hereto hereby agree as follows: 1. Defined Terms. Unless otherwise defined herein, capitalized terms used herein shall have the meanings, if any, assigned to them in the Credit Agreement. 2. Default and Waiver. (a) For purposes of this Waiver and Amendment, the "Existing Default" shall mean the Event of Default existing on this date under Section 8.01(c) of the Credit Agreement as a consequence of a breach of the negative covenant set forth at Section 7.13 of the Credit Agreement solely for the quarter ended September 30, 1996. (b) Subject to and upon the terms and conditions hereof, the Bank hereby waives the Existing Default. (c) Nothing contained herein shall be deemed a waiver of (or otherwise affect the Bank's ability to enforce) any other default or Event of Default, including without limitation (i) any default or Event of Default as may now or hereafter exist and arise from or otherwise be related to 1 the Existing Default (including without limitation any cross-default arising under the Credit Agreement by virtue of any matters resulting from the Existing Default), and (ii) any default or Event of Default arising at any time after the Effective Date and which is the same as the Existing Default. 3. Amendments to Credit Agreement. (a) Section 7.13 of the Credit Agreement shall be amended and restated in its entirety so as to read as follows: "7.13 Tangible Net Worth. The Borrower shall not permit at any time on a consolidated basis its Tangible Net Worth to be less than $115,000,000 plus the sum of (i) 75% of net income after income taxes (without subtracting losses) earned in each quarterly accounting period commencing after September 30, 1996, (ii) the net proceeds from any equity securities issued after September 30, 1996, and (iii) any increase in stockholders' equity resulting from the conversion of debt securities to equity securities after September 30, 1996." (b) Schedule 2 to the Compliance Certificate shall be amended and restated in its entirety so as to read as in the schedule attached hereto as Schedule 2. 4. Representations and Warranties. The Borrower hereby represents and warrants to the Bank as follows: (a) Other than the Existing Default, no Default or Event of Default has occurred and is continuing. (b) The execution, delivery and performance by the Borrower of this Waiver and Amendment have been duly authorized by all necessary corporate and other action and do not and will not require any registration with, consent or approval of, notice to or action by, any person (including any governmental authority) in order to be effective and enforceable. The Credit Agreement as amended by this Waiver and Amendment constitutes the legal, valid and binding obligations of the Borrower, enforceable against it in accordance with its respective terms. without defense, counterclaim or offset. (c) Subject to the Existing Default, all representations and warranties of the Borrower contained in the Credit Agreement are true and correct. (d) The Borrower is entering into this Waiver and Amendment on the basis of its own investigation and for its own reasons, without reliance upon the Bank or any other person. 2 5. Effective Date. This Waiver and Amendment will become effective as of the date first above written (the "Effective Date"), provided that each of the following conditions precedent are satisfied. (a) The Bank has received from the Borrower a duly executed original (or, if elected by the Bank, an executed facsimile copy) of this Waiver and Amendment; and (b) All representations and warranties contained herein are true and correct as of the Effective Date. 6. Reservation of Rights. The Borrower acknowledges and agrees that neither the Bank's forbearance in exercising its rights and remedies in connection with the Existing Default, nor the execution and delivery by the Bank of this Waiver and Amendment, shall be deemed (i) to create a course of dealing or otherwise obligate the Bank to forbear or execute similar waivers under the same or similar circumstances in the future, or (ii) to waive, relinquish or impair any right of the Bank to receive any indemnity or similar payment from any person or entity as a result of any matter arising from or relating to the Existing Default. 7. Miscellaneous. (a) Except as herein expressly amended, all terms, covenants and provisions of the Credit Agreement are and shall remain in full force and effect and all references therein to such Credit Agreement shall henceforth refer to the Credit Agreement as amended by this Waiver and Amendment. This Waiver and Amendment shall be deemed incorporated into, and a part of, the Credit Agreement. (b) This Waiver and Amendment shall be binding upon and inure to the benefit of the parties hereto and thereto and their respective successors and assigns. No third party beneficiaries are intended in connection with this Waiver and Amendment. (c) This Waiver and Amendment shall be governed by and construed in accordance with the law of the State of California. (d) This Waiver and Amendment may be executed in any number of counterparts, each of which shall be deemed an original, but all such counterparts together shall constitute but one and the same instrument. Each of the parties hereto understands and agrees that this document 3 (and any other document required herein) may be delivered by any party thereto either in the form of an executed original or an executed original sent by facsimile transmission to be followed promptly by mailing of a hard copy original, and that receipt by the Bank of a facsimile transmitted document purportedly bearing the signature of the Borrower shall bind the Borrower, with the same force and effect as the delivery of a hard copy original. Any failure by the Bank to receive the hard copy executed original of such document shall not diminish the binding effect of receipt of the facsimile transmitted executed original of such document which hard copy page was not received by the Bank. (e) This Waiver and Amendment, together with the Credit Agreement, contains the entire and exclusive agreement of the parties hereto with reference to the matters discussed herein and therein. This Waiver and Amendment supersedes all prior drafts and communications with respect thereto. This Waiver and Amendment may not be amended except in accordance with the provisions of Section 9.05 of the Credit Agreement. (f) If any term or provision of this Waiver and Amendment shall be deemed prohibited by or invalid under any applicable law, such provision shall be invalidated without affecting the remaining provisions of this Waiver and Amendment or the Credit Agreement, respectively. (g) The Borrower covenants to pay to or reimburse the Bank at cost, upon demand, for all reasonable costs and expenses (including allocated costs of in-house counsel) incurred in connection with the development, preparation, negotiation, execution and delivery of this Waiver and Amendment and the administration of the Existing Default. 4 IN WITNESS WHEREOF, the parties hereto have executed and delivered this Waiver and Amendment as of the date first above written. FILENET CORDORATION By: /s/ Mark S. St. Clare Typed Name: Mark S. St. Clare Title: Chief Financial Officer By: /s/ William R. Hughes Typed Name: William R. Hughes Title: Controller/Chief Accounting Officer BANK OF AMERICA NATIONAL TRUST AND SAVINGS ASSOCIATION By: /s/ John Cinderey Typed Name: John Cinderey Title: Managing Director 5 Date: , 199 For the fiscal quarter/year ended , 199 SCHEDULE 2 to Compliance Certificate Actual Required/Permitted ------ ------------------ 1. Section 7.01(d) Other Bank Borrowings by Subsidiaries Indebtedness of Subsidiaries for borrowed money from other bank Not to exceed $5,000,000 2. Section 7.01(e) Purchase Money Obligations and Section 7.02 purchase Money Liens Purchase money obligations and related liens Not to exceed $10,000,000 3. Section 7.03 Capital Assets Obligations for the acquisition of fixed or capital assets during current fiscal year Not to exceed $25,000,000 4. Section 7.07(d) Sale and Leaseback Financing under sale and leaseback agreements of fixed or capital assets Not to exceed $5,000,000 A11 amounts determined on a consolidated basis. 1 Actual Required/Permitted ------ ------------------ 5. Section 7.11 Quick Ratio A. (i) cash (ii) net accounts receivable (iii) short-term cash investments (iv) investment grade marketable securities not classified as long- term investments (v) long-term investments in compliance with the Investment Guidelines (not to exceed $25,000.000) (i) + (ii) + (iii) + (iv) + (v) = B. Current liabilities (including all funded and unfunded obligations under the credit Agreement and other Credit Documents, including undrawn amounts (or the Equivalent Amount thereof) of all letters of credit and Bank Guaranties and drawn and unreimbursed obligations with respect thereto A = B = Not less than 1.75 to 1.00 2 Actual Required/Permitted ------ ------------------ 6. Section 7.l2 Total Liabilities to Total Net Worth the ratio of A. total liabilities (including all funded and unfunded obligations under the Credit Agreement and other Credit Documents. including undrawn amounts (or the Equivalent Amount thereof) of all letters of credit and Bank Guaranties and drawn and unreimbursed obligations with respect thereto B. Tangible Net Worth the difference of: (i) gross book value of assets less (ii) goodwill, patents, trademarks, trade names, organization expense, capitalized software, treasury stock, unamortized debt discount and expense, deferred charges, and other like intangibles, monies due from affiliates, officers, directors. or shareholders of the Borrower or any of its Subsidiaries. and value placed on any leasehold (other than leasehold improvements) less (iii)applicable reserves less (iv) all liabilities (including accrued and deferred income taxes) (i) - (ii) - (iii) - (iv) = A = B Not greater than 0.75 to 1.00 3 Actual Required/Permitted ------ ------------------ 7. Section 7.13 Tangible Net Worth Tangible Net Worth (from 6 above) Not less than the sum of: A.$115,000,000 $115,000,000 plus B.75% of net income after taxes (with-out subtracting losses)for each fiscal quarter commencing after 9/30/96 plus C.100% of net proceeds from the issuance of any equity securities issued after 9/30/96 plus D.100% of any increase in shareholders' equity from conversion of debt to equity after 9/30/96 = A + B + C + D = 8. Section 7.24 Consecutive Quarterly Losses: Losses in One Quarter A. (i) Net (after tax) income (loss) for fiscal quarter reported on Not in excess of ($5,000,000) (ii) Operating income (loss) for fiscal quarter reported on Not in excess of ($5,000.000) B. (i) Net (after tax) income (loss) immediately preceding fiscal quarter (ii) Net (after tax) income (loss) for fiscal quarter If (i) is a loss, (ii) shall reported on not be a loss. C. (i) Operating income (loss) for the immediately preceding fiscal quarter (ii) Operating income (loss) for If (i) is a loss, (ii) shall not be fiscal quarter reported on a loss. 4 EX-10.7 3 AMENDMENT TO LEASE THIRD AMENDMENT TO LEASE THIS THIRD AMENDMENT TO LEASE (the "Amendment") is made and entered into as this 1st day of October, 1992, by and between C. J. SEGERSTROM & SONS, a general partnership, hereinafter called "Landlord," and FILENET CORPORATION, a California corporation, hereinafter called "Tenant," with respect to the following: RECITALS A. Landlord is the landlord and Tenant is the tenant pursuant to that certain High Technology/Research and Development Lease dated July 23, 1986, as amended by a certain letter agreement dated July 2, 1987 (collectively; the "Original Lease"). The Original Lease covers certain premises consisting of a total of approximately 120,000 square feet of Rentable Area located in two buildings, of approximately 60,000 square feet each ("Buildings 1 and 2") located at the Northwest corner of Harbor Boulevard and Scenic Avenue in that certain business park known as Harbor Gateway Business Center (the "Center"), in the City of Costa Mesa, State of California and more particularly described in the Original Lease. B. Landlord and Tenant have also entered into that certain Option: Agreement dated and executed July 23, 1986, as amended by certain letter agreements dated, respectively, June 23, 1987, March 15, 1988, and May 23, 1988 (collectively; the "Option Agreement"). By means of the Option Agreement, Landlord and Tenant amended the Original Lease to add to the Premises certain additional premises consisting of approximately 50,000 square feet located in a single building denominated as High-Tech 3 ("Building 3") and located in the Center. Buildings 1, 2 and 3 are herein referred to, collectively, as the "Premises," and the Original Lease and the Option Agreement are sometimes referred to herein, collectively, as the "Lease." C. Tenant desires to amend the Original Lease to add to the Premises another additional building located within the Center, commonly known as 1535 Scenic Avenue and consisting of approximately 60,000 square feet of Rentable Area ("Building 14"), as more particularly shown on Exhibit "A" attached hereto. Landlord is willing to so amend the Original Lease, but only upon the terms and conditions set forth in this Amendment. AGREEMENT IN CONSIDERATION OF the foregoing recitals and the promises and covenants contained in this Amendment, Landlord and Tenant agree as follows: 1. Leasing of Building 14. Landlord hereby leases to Tenant, and Tenant hereby hires from Landlord, Building 14 upon all of the terms of the Original Lease, as modified by this Amendment. 2. Terms of Leasing. Tenant shall hold and occupy Building 14 as part of the Premises upon all of the terms and conditions of the Original Lease, except that: (a) The term of the Lease with respect to Building 14 shall commence on July 1, 1993 (the "Building 14 Commencement Date"), and thereafter shall be coterminous with the term of the Lease with respect to Building 3. Tenant shall also have the option to extend the term of the Lease with respect to Building 14. Such option shall be upon the terms set forth in paragraph 4(b)(xi) of the Option Agreement and Section 48.1 of the Original Lease, and the additional term for Building 14 shall be coterminous with the additional term for Building 3. From and after the Building 14 Commencement Date, Tenant and Landlord shall each observe and perform all of their respective obligations pursuant to the Lease, as hereby amended, with respect to Building 14, including, without limitation, the payment of Basic Annual Rent and Additional Rent. Landlord and Tenant contemplate that Landlord will deliver possession of Building 14 to Tenant and Tenant will commence occupancy of Building 14 on July 1, 1993, the Building 14 Commencement Date. In no event shall Tenant be required to pay Basic Annual Rent or Additional Rent with respect to Building 14 for any period prior to July 1, 1993, notwithstanding any delivery of possession of Building 14 to Tenant prior to the Building 14 Commencement Date. Notwithstanding the foregoing Tenant shall have a license (the "License") to enter Building 14 prior to the Building 14 Commencement Date. Such License shall be upon the following terms: (i) The License shall extend for the period from April 1, 1993 through June 30 1993. (ii) Entry pursuant to the License may be made at any time during normal business hours (8 a.m.. to 5:30 p.m., Monday through Friday, legal holidays excepted). For this purpose, Tenant shall not retain a key to Building 14. Rather, access shall be afforded by Landlord's management or security personnel upon request to Landlord's management office at the Center. Such request may be made in person or by telephone. (iii) Entry pursuant to the License shall be for any purpose reasonably related to Tenant's occupancy of Building 14 following the Building 14 Commencement Date, including but not limited to measurement of areas to be occupied, inspection of Building 14 and the equipment located therein or thereon, installation of furniture, furnishings, equipment and operating systems (such as telephone, security and fire), replacement of existing signage with respect to Building 14 and installation of tenant improvements. (iv) Entry pursuant to the License is limited to Tenant, its employees and to third parties retained by Tenant for the purposes specified in clause (iii) above and designated in writing by Tenant to Landlord. As between Landlord and Tenant, all persons entering Building 14 at the request of Tenant shall be deemed agents of Tenant, and Tenant shall be solely responsible for the safety of and actions of such persons. In no event shall Landlord have any responsibility for such persons or any liability to them, and Tenant shall indemnify. defend and hold Landlord harmless from and against all claims by any such persons for damages (including punitive damages, costs and attorneys fees) resulting from injury, death or property damage arising out of such entry. (v) Any work in or on Building 14 performed by or for Tenant pursuant to the License shall be the sole responsibility of Tenant as to performance and payment of costs and shall comply with Articles 9 and 12 of the Original Lease, all applicable provisions of Exhibit "D" thereto and all applicable requirements of all governmental authorities having jurisdiction of Building 14. Such requirements shall include the prior written approval of Landlord when required by the Original Lease. (vi) The insurance required by Sections 15.1, 15.2 and 15,3 of the Original Lease shall extend to any entry pursuant to the License and all activities by or on behalf of Tenant in or about Building 14. In addition, the indemnification and exculpation provisions contained in Sections 15.4, 15.5 and 15,6 of the Original Lease shall extend to any such entry and any such activities. 2 (vii) As used in this License, all references to Building 14 shall include the Permanent Building 14 Parking Area, as defined in subparagraph (g) below. (viii) In the event that Tenant fails to perform any of its obligations pursuant to clauses (v) and (vi) above with respect to the License, and such failure continues for ten (10) days after delivery of written notice from Landlord to Tenant, Landlord may immediately terminate the License upon written notice to Tenant, with such termination to be effective upon receipt by Tenant of Landlord's notice of termination. In addition, if Tenant fails to perform any of its obligations pursuant to the License, Landlord shall have the right to perform such obligations for Tenant's account pursuant to Article 33 of the Original Lease, but without requirement of further notice and a grace period pursuant to Article 19 of the Original Lease. (b) Notwithstanding anything to the contrary in this Amendment and except as provided in this subparagraph (b), Tenant accepts Building 14 "AS IS". Tenant acknowledges that, except as provided to the contrary in clause (ii) below, Landlord shall have no responsibility, either as to performance or payment of costs, to remodel or renovate Building 14 or the Permanent Building 14 Parking Area for Tenant use. Any remodel, renovation or improvement to Building 14 or the Permanent Building 14 Parking Area undertaken by Tenant shall be completed in accordance with the terms and conditions of paragraphs 5, 6 and 8 of Exhibit "D" to the Original Lease and notwithstanding anything to the contrary therein, all such work shall be completed at Tenant's sole cost and expense. Without limiting the generality of the foregoing: (i) Landlord represents and warrants to Tenant that, to the knowledge of Landlord, no hazardous, toxic carcinogenic, reproductive toxic, corrosive, reactive or ignitable substances, wastes or materials, as defined in any applicable federal, state or local law or regulation promulgated thereunder, including, without limitation, petroleum (including crude oil or any fraction thereof), asbestos or asbestos-containing materials and polychlorinated byphenyls (PCB's), collectively, "Substances," are incorporated into Building 14 or-any other improvements or facilities located on the Permanent Building 14 Parking Area. Tenant acknowledges and accepts that Landlord has not conducted any investigation or testing for the purposes of making the foregoing representation and warranty. Rather, Landlord makes such representation and warranty solely on the basis of Landlord's construction of Building 14 and the Permanent Building 14 Parking Area and its continuous ownership thereof since such construction. The foregoing representation and warranty shall not extend to any Substances incorporated into, brought into or maintained in or upon Building 14 or the Permanent Building 14 Parking Area by Emulex Corporation ("Emulex"), the existing tenant of Building 14 and the Permanent Building 14 Parking Area. (ii) Prior to execution and delivery of this Amendment, Landlord, Tenant and Emulex have mutually inspected Building 14 and on the basis of such inspection, Landlord and Emulex have compiled a list of maintenance and repair work with respect to Building 14 to be performed by Emulex prior to delivery of possession of Building 14 to Landlord. A copy of such list u attached to this Amendment as Exhibit "B." Landlord shall use its best efforts to cause Emulex to perform all work specified on such list (the "Repair List"). Except for (A) the performance of the work specified on the Repair List, (B) normal wear and tear and (C) removal by Emulex of all signage and all personal property and fixtures not permanently attached to Building 14 other than the FF&E, as defined in paragraph 4 below, upon delivery of possession of Building 14 to Tenant, Building 14 shall be in the same condition as on the date of the inspection described herein. 3 (iii) As described in paragraph 4 below, Tenant shall purchase directly from Emulex certain FF&E located in Building 14. Tenant may, during the period from surrender of possession of Building 14 by Emulex to Landlord and the Building 14 Commencement Date, desire to leave the FF&E in place in Building 14. Landlord consents to such storage arrangement by Tenant. Such storage shall be without requirement of payment of rent or any other amount to Landlord However, Tenant shall be solely responsible for all such FF&E, including security of the same and maintenance of insurance upon the FF&E. Except for intentional acts and negligence of Landlord, Landlord shall have no responsibility with respect to the FF&E. Without limiting the generality of the foregoing Landlord shall have no responsibility to provide special security for, maintenance of or insurance with respect to the FF&E. By its signature hereto, Tenant releases and forever discharges Landlord from any and all such responsibilities and/or liability and irrevocably waives any and all claims against Landlord its partners, agents and employees arising out of or resulting from any loss, theft, damage or destruction to or of the FF&E, or any of it while stored in Building 14 pursuant to this clause (iii), except for intentional acts and negligence of Landlord. (c) The provisions of the Option Agreement, other than paragraph 4(b)(xi) thereof shall have no application with respect to Building 14. (d) The provisions of Sections 2.2, 2.4. 3.5, 48.1(c) and Articles 38 and 41 of the Original Lease shall have no application with respect to Building 14. The provisions of Exhibit "D" to the Original Lease, other than paragraphs 5, 6 and 8 thereof, shall have no application to Building 14. (e) All references to the term "Building" or "Buildings" in the Original Lease, when referring to Buildings 1 and/or 2 generically shall be construed to refer to Building 3 and Building 14 to the extent, in each such case, that such a reference is capable of reasonable application to Building 3 and Building 14. (f) Any provisions of the Lease superseded by or inconsistent with the provisions of this Amendment shall have no application with respect to Building 14. (g) Tenant's Allocated Parking Spaces with respect to Building 14 shall be 240 spaces. Tenant shall be entitled to use such Allocated Parking Spaces, in common with others, in the Parking Area for the Center, as defined in Article 44 of the Original Lease. Tenant's use of its Allocated Parking Spaces shall be subject to the terms and provisions of Article 44 of the Original Lease. Without limiting the generality of the foregoing, Landlord and Tenant agree and acknowledge that: (i) The primary parking area currently designated for Building 14 (the "Current Building 14 Parking Area") is the area depicted on Exhibit "C" attached hereto with single hatching. As described in clause (iv) below and paragraph 5(e) below, Landlord will cause Emulex to exchange with Tenant that portion of the Building B parking area located to the east of Building 14 ("Exchange Area No. 1") for that portion of the Current Building 14 Parking Area located to the west of Building B ("Exchange Area No. 2"). Exchange Area No. 1 and Exchange Area No. 2 are depicted and designated on Exhibit "C' attached hereto. The Building 14 parking area resulting from such exchange is herein referred to as the "Permanent Building 14 Parking Area" Tenant's primary or principal parking area for Building 14 shall be the Permanent Building 14 Parking Area. Tenant's Allocated Spaces shall not, however, be limited to the Permanent Building 14 Parking Area, and Tenant may, subject to the provisions of Article 44 of the Original Lease and clause (ii) below, utilize for purposes of its Allocated Parking Spaces the Parking Area for the Center. 4 (ii) Those spaces identified with cross-hatching on Exhibit "C," other than Exchange Area No. 1, and Exchange Area No. 2 are or shall be exclusive to the tenants of Buildings A, B and High-Tech 15. Tenant and its employees shall not be entitled to park in such areas. (iii) The Permanent Building 14 Parking Area is subject to the provisions of that certain Reciprocal Parking Agreement, Amendment No. 8 to Lease with Emulex Corporation and Notice of Deletion of Territory as to Declaration as to Easements, Restrictions add Common Facilities for Harbor Gateway Center, dated May 25, 1984, by and among Citibank N.A., Ticor Title Insurance Company of California, Landlord and Emulex (the "Parking Agreement"). As provided in paragraph 5(e) below, Tenant shall cooperate with Landlord (and Emulex) to amend and restate the Parking Agreement to, among other things, modify the Parking Agreement to reflect the exchange of Exchange Area No. 1 and Exchange Area No. 2 as provided in clause (i) above. (iv) There is currently located, approximately at the location depicted with an "x" on Exhibit "B," a vehicle entry barrier maintained by Emulex and which prevents entry to a portion of the Current Building 14 Parking Area except through a guarded gate located at the southerly end of Building A. Emulex shall not relocate such entry barrier and Tenant shall not use the portion of the Current Building 14 Parking Area now protected by such vehicle entry barrier. Rather, Landlord shall cause Emulex to effect the exchange of parking areas provided for in clause (i) above. In addition, Landlord, Tenant and Emulex shall as a part of the refinancing provided for in Paragraph 6 below, use reasonable efforts to cause the Parking Agreement to be amended to create the Permanent Building 14 Parking Area by recognition of the exchange to be effected pursuant to clause (i) above. (h) Tenant shall not be required to make any additional security deposit with respect to Building 14, but the existing security deposit under the Original Lease shall apply to the leasing of Building 14 in addition to the leasing of Buildings 1, 2 and 3. (i) Upon the Effective Date of this Amendment, as defined in paragraph 6 below, Tenant shall deposit with Landlord the sum of $49,200 as the first month's Basic Annual Rent due hereunder with respect to Building 14, which sum shall be applied by Landlord, without interest, to the first monthly installment of Basic Annual Rent due hereunder with respect to Building 14. (j) Tenant shall use and occupy Building 14 only for the purposes of a corporate headquarters, corporate offices, general offices uses and research and development activities. (k) From and after the Building 14 Commencement Date, Tenant's monthly Proportionate Share of Common Facilities Expenses, as defined and determined in accordance with Exhibit "B" to the Original Lease, shall be determined by including the Allocated Parking Spaces for Building 14. In other words, from and after the Building 14 Commencement Date, Tenant's Proportionate Share of Common Facilities Expenses shall be determined using the Allocated Parking Spaces for all of Buildings 1, 2, 3 and 14. Expressed as a percentage, Tenant's Proportionate Share of Common Facilities Expenses for the Center shall be 42.2%, determined by dividing Tenant's aggregate of 824 allocated Parking Spaces by 1,952 total Allocated Parking Spaces in the Center of tenants who contribute to Common Facilities Expenses. As of the Building 14 Commencement Date, Tenant's Allocated Parking Spaces, by Building, shall be as follows: 5 Building Allocated Spaces -------- ---------------- 1 212 2 172 3 200 14 240 It is understood and acknowledged that the 1,952 Allocated Spaces in the Center of tenants who contribute to Common Facilities Expenses are less than all Allocated Spaces in the Center. Landlord represents and warrants to Tenant that all tenants with allocated Spaces in the Center who do not contribute to Common Facilities Expenses either (i) maintain and operate their own Allocated Spaces, including direct payment of real property taxes and other expenses of maintaining and operating such allocated Spaces or (ii) pay rent to Landlord on a so-called "gross" basis which includes an allocated portion of the expenses of operating and maintaining the allocated Spaces of such tenants, which such allocated portion is applied by Landlord to expenses of operating and maintaining Allocated Spaces in the Canter. During the term of the Lease, all leases of space in the Center shall provide either that (A) the tenants pursuant to such leases shall pay a Proportionate Share of Common Facilities Expenses for the Center determined in the same manner as provided in Exhibit "B" to the Original Lease or (B) such tenants shall pay, directly or indirectly, the expenses of maintaining and operating their allocated Spaces in one of the manners provided in clauses (i) and (ii) of this subparagraph. 3. Rent. (a) From and after the Building 14 Commencement Date, Tenant shall pay, as Basic Annual Rent with respect to Building 14, the sum of $9.84 per square foot of Rentable Area ($590,400) triple net, per year, payable in equal monthly installments of $49,200 ($0.82 per square foot of Rentable Area)concurrently with Tenant's monthly installments of Basic Annual Rent for the balance of the Premises, without deduction or offset. Basic Annual Rent shall be paid at the times and in the manner provided in Section 3.1 of the Original Lease (b) The Basic Annual Rent payable with respect to Building 14 shall be adjusted in the manner provided in Section 3.4 of the Original Lease, except that, (i) the term "Adjustment Date" as applied to the Basic Annual Rent payable with respect to Building 14 shall mean July 1, 1995, and again on April 30, 1997, (ii) as to Building 14, in no event shall the Basic Annual Rent as to Building 14 be increased on any such Adjustment Date to more than eight percent (8%) per year of the Basic Annual Rent with respect to Building 14 in effect immediately prior to such adjustment and (iii) for the purpose of the adjustments to the Basic Annual Rent with respect to Building 14, the phrase "twenty-five (25) multiplied by "appearing in the third sentence of Section 3.4 of the Original Lease shall not be applicable. For the purposes of clause (ii) of this subparagraph, if the number of months in the period from the Building 14 Commencement Date to the first Adjustment Date or the period from the first Adjustment Date to the second Adjustment Date, as the case may be, is not evenly divisible by twelve (12), then the percentage increase at the end of such period shall be equal to eight percent (8%) for each full year in such period plus for the partial year in such period, a percentage equal to eight (8) times a fraction whose numerator is the number of months in the partial year and whose denominator is twelve (12). 4. Furniture. Fixtures and Equipment. Landlord and Tenant acknowledge and agree that Building 14 has been previously built-out by Landlord, and that all permanently attached improvements in Building 14 are the property of Landlord. Concurrently with Tenant's execution of this Amendment, Tenant shall enter into an 6 agreement with Emulex to acquire directly from Emulex certain fixtures, furniture and equipment (the "FF&E') of Emulex currently located in Building 14. A list of the FF&E to be so acquired is attached hereto as Exhibit "D". Such list has been compiled by Tenant and Emulex, and Landlord has no responsibility for the compilation of such list and makes no representation or warranty as to the accuracy or completeness of such list. Such agreement shall be the sole responsibility of Tenant, and Landlord shall have no responsibility, either as to performance or payment, with respect to the FF&E, payment therefor or delivery thereof. Landlord shall have no claim to the FF&E or any proceeds thereof, and title to the FF&E shall be conveyed to Tenant by Emulex in such manner and using such instruments as shall be agreed upon by Tenant and Emulex 5. Representations and Covenants. (a) Zoning. Landlord represents and warrants to Tenant that Building 14 is zoned, as of the date hereof, in a manner which permits the use of Building 14 as specifically permitted by paragraph 2(j) above and that no variance or special use permit is required for the use of Building 14 as specifically permitted by paragraph 2(j) above or, if any special use permit has been granted, such special use permit is still in effect and will apply to Tenant's use of Building 14 as specifically permitted by paragraph 2(j) above. (b) Use. Landlord represents and warrants to Tenant that the use of Building 14 as specifically permitted by paragraph 2 (j) above complies with the Declaration as to Easements, Restrictions and Common Facility Provisions for Harbor Gateway Center dated July 31, 1981, executed by Landlord and recorded in the Office of the Orange County Recorder. (c) Brokers. Landlord and tenant each represents w~ and covenants to the other that such warranting party shall defend, indemnify and hold harmless the other party from and against any and all claims, costs, losses, expenses, damages, actions and Muses of action incurred in any claim or action instituted by any broker, agent or finder, including, but not limited to, CB Commercial Real Estate Group, Inc., claiming under the warranting party with respect to Building 14. Landlord and Tenant agree that payment shall not be a condition precedent to recovery upon the foregoing indemnification provisions. (d) Schematics and As-Built Drawings. Prior to the Building 14 Commencement Date, Landlord shall provide to Tenant one copy of all existing schematic drawings and as-built drawings in Landlord's possession with respect to Building 14. However, Landlord makes no representations or warranties as to the accuracy or completeness of any items supplied to Tenant pursuant to the provisions of this subparagraph. (e) Cooperation, Tenant recognizes that Landlord is in the process of refinancing certain property within the Center with Teachers Insurance and Annuity Association of America ('Teachers"), including Building 14, and that the Permanent Parking Area for Building 14 is subject to existing restrictions as contained within the Parking Agreement. Tenant will take all action as may reasonably be necessary for Landlord to obtain refinancing approval from Teachers with respect to Building 14, and to amend and restate the Parking Agreement to, among other things, (i) substitute Tenant for Emulex as to the Permanent Building 14 Parking Area, (ii) terminate all rights of Emulex as to the Permanent Building 14 Parking Area, (iii) amend and restate the Parking Agreement to eliminate therefrom those portions superseded by the passage of time or various construction or development of the property described in the Parking Agreement and (iv) eliminate the Current Building 14 7 Parking Area and create the Permanent Building 14 Parking Area by giving effect to and recognizing the exchange of Exchange Area No. 1 for Exchange Area No. 2 provided for in paragraph 2(g) above. Such amendment to and restatement of the Parking Agreement shall be consistent with the parking rights granted to Tenant with respect to Building 14 pursuant to this Amendment. Such amendment to and restatement of the Parking Agreement shall be at no cost or liability to Tenant other than Tenant's own attorneys' fees and costs, and no such amendment and restatement shall effect any changes to the business terms embodied in this Amendment with respect to Tenant's use of Building 14 and the Permanent Building 14 Parking Area. In addition, in connection with such refinancing, Landlord shall use reasonable efforts to obtain from Teachers s subordination agreement, in recordable form and in the form attached hereto as Exhibit "E," with appropriate references to the refinancing documents executed by Landlord and Teachers. Nothing contained herein shall, however, be deemed to constitute a representation, warranty or covenant by Landlord to the effect that (i) Landlord shall. be able to obtain such subordination agreement from Teachers or (ii) Landlord shall be able to obtain such subordination agreement by any particular date or within any particular time. 6. Contingencies. The effectiveness of this Amendment is expressly contingent upon each of the following: (a) Landlord's review and approval of Tenant's current audited financial statements (including consolidated balance sheets, consolidated statements of operations and consolidated statements of cash flows) for Tenant's fiscal year ended December 31, 1991, and for the interim period ended June 30 1992. Accordingly, Tenant shall deliver to Landlord the foregoing financial statements on or before October 16, 1992, and Landlord shall approve or disapprove such financial statements by written notice to Tenant given within ten (10) days after Landlord's receipt of such statements. Landlord's failure to approve or disapprove such statements in such manner and within such time shall be deemed approval thereof; (b) Approval by Teachers, on or before November 15, 1992 (the 'Target Date"), of the terms of this Amendment and the agreement described in subparagraph (d) below. (c) Delivery by Teachers to Landlord on or before the Target Date of an executed letter providing, in substance, that Teachers' commitment to refinance the existing Teachers financing upon Building 14 and other portions of the Center on the terms and conditions set forth in Teachers' commitment letter dated August 20, 1992 remains in effect without modification notwithstanding this Amendment and the agreement provided for in subparagraph (d) below; (d) The execution and delivery by Emulex and Landlord, on or before the Target Date, of an agreement, on terms and conditions mutually satisfactory to Landlord and Emulex, providing, among other things, for the termination of Emulex' existing lease (as to Building 14 and the Building 14 Parking Area only) on or before March 31, 1993 and delivery by Emulex to Landlord of possession of Building 14 and the Building 14 Parking Area on or before March 31, 1993; (e) Delivery, on or before the Target Date, of a letter executed by an appropriate official of the City of Costa Mesa providing in substance, that (i) the existing zoning for Building 14 permits Tenant's use thereof as specified in paragraph 2(j) above and (ii) no additional permits are required to permit the use of Building 14 as specified in paragraph 2 (j) above; 8 (f) Execution and delivery by Tenant and Emulex, on or before the Target Date, of an agreement covering the transfer of the FF&E as provided in paragraph 4 above and in form and substance satisfactory to Tenant and Emulex. (g) Review and approval by Tenant of the Parking Agreement. Such approval shall be deemed given unless, on or before October 14 1992 Tenant notifies Landlord in writing of the portion(s) of the Parking Agreement which Tenant disapproves. In the event that (i) the contingencies set forth in subparagraphs (b) through (d) above shall fail to occur within the time periods specified therein or (ii) Landlord disapproves of Tenant's financial statements within the time and in the manner set forth in subparagraph (a) above, then Landlord shall have the option to terminate this Amendment by written notice to Tenant given (A) as to subparagraph (a) above, by delivery to Tenant of Landlord's notice of disapproval (B) as to subparagraphs (b), (c) and (d) above, on or before November 15, 1992. Similarly, if (x) either or both of the conditions set forth in subparagraphs (e) and (f) above shall fail to occur on or before the Target Date or (y) Tenant disapproves the Parking Agreement, then Tenant shall have the right to terminate this Amendment by written notice to Landlord given (C) as to subparagraphs (e) and (f) above, on or before the Target Date and (D) as to subparagraph (g) above by delivery to Landlord of Tenant's written notice of disapproval. If either party has the right to terminate this Amendment and does so within the times and in the manner set forth herein: (1) this Amendment shall terminate on the date of the addressee's receipt of the notice of termination given by the other party; (2) each party shall bear its own costs and fees incurred in the negotiation and preparation of this Amendment and in performing its respective obligations hereunder through the date of such termination; and (3) all amounts deposited by Tenant with Landlord pursuant to this Amendment shall be returned to Tenant and neither party shall have any further obligation to the other with respect to Building 14 or the Permanent Building 14 Parking Area. Any termination hereunder shall not have any effect on Landlord's and Tenant's obligations to one another pursuant to the Lease. Pending any termination of this Amendment as provided herein, Landlord and Tenant each agree to diligently pursue their respective obligations hereunder. As soon as any of the conditions contained herein are met, the party entitled to terminate on the basis of failure of such condition shall promptly notify the other party of the satisfaction of such condition. The date on which such notice is received as to the last condition to be satisfied shall be the effective date (the "Effective Date") of this Amendment. 7. Other Matters. Landlord and Tenant further agree that: (a) Notwithstanding anything to the contrary contained in the Original Lease, upon the expiration or any earlier termination of the Lease with respect to Building 14, reasonable wear and tear shall be excepted from the condition in which Tenant is required to deliver possession of Building 14 to Landlord. (b) By their signatures hereto, Landlord and Tenant confirm the following information with respect to Buildings 1, 2, 3 and 14: 9 (i) Building 1 - Commencement Date is November 1, 1987 and expiration date is April 30 1998; one five (5) year option (May 1, 1998 through April 30 2003) exercisable upon not more than 15 and not less than 12 months prior written notice to Landlord. (ii) Building 2 - Commencement Date is August 1, 1987 and expiration date is January 31, 1998; one five (5) year option (February 1, 1998 through January 31, 2003) exercisable upon not more than 15 and not less than 12 months prior written notice to Landlord. (iii) Building 3 - Commencement Date is June 1, 1990 and expiration date is May 31, 2000; one five (5) year option (June 1, 2000 to May 31, 2005) exercisable upon not more than 15 and not less than 12 months prior written notice to Landlord. (iv) Building 14 - Commencement Date is July 1, 1993 and expiration date is May 31, 2000; one five (5) year option (June 1, 2000 to May 31, 2005) exercisable upon not more than 15 and not less than 12 months prior written notice to Landlord. (c) There currently exists a free standing concrete sign monument located at the entrance to the Permanent Building 14 Parking Area from Scenic Drive (the "monument"). Such Monument is currently occupied by a sign erected by Emulex. Tenant agrees that, from and after the Target Date, Tenant shall acquire from Emulex all rights in and to the use of the Monument and that the sign thereon shall be redesigned to reflect thereon the name of Tenant only. The removal of the existing Emulex sign, the design and fabrication of Tenant's sign, and all costs and expenses with respect to such removal, design, construction and installation, shall be the sole responsibility of Tenant and Emulex, and Tenant indemnifies and holds Landlord harmless with respect to any claims or liability with respect thereto. Tenant shall obtain or cause to be obtained all necessary permits and approvals for the modified signage from the governmental agency having jurisdiction. Landlord shall have the right to approve such replacement signage in accordance with its rights under the Lease. (d) Landlord and Tenant acknowledge that Tenant may, at some date in the future, desire to consolidate some or all operations currently conducted in Buildings 1, 2, 3 and 14 into a single, larger building and may approach Landlord with a proposal to construct for and lease to Tenant a building in the Center, or in or on any other property owned or controlled by Landlord or an affiliate of Landlord, with a Rentable Area of 150,000 to 200,000 or more square feet. Landlord agrees, upon any such proposal by Tenant, to consider such proposal. For the purposes of this subparagraph, Landlord and Tenant acknowledge and agree that: (i) Nothing contained in this subparagraph shall be deemed or construed to require Tenant to present any such proposal to Landlord, or to require Tenant to remain in the Center beyond the several expiration dates in the Lease (and any option terms as to which Tenant timely and properly exercises its options). (ii) Nothing contained in this subparagraph shall be deemed or construed to require Landlord to accept any proposal made by Tenant, to make any, counterproposal to Tenant or to permit Tenant to remain in the Canter beyond the several expiration dates in the Lease (and any option terms as to which Tenant timely and properly exercises its options). (iii) In determining whether to make or accept any such proposal or counter-proposal, each party shall be free to take into account any fact or 10 factor which such party deems relevant to its decision, including but not limited to the availability of land in the Center or elsewhere, alternative space available to Tenant, the cost of construction of any such building. the rent payable with respect to any such building and with respect to alternative available space, any other leasing goals or plans of Landlord with respect to the Center or other property of Landlord or its affiliates, the ability of Landlord (or its affiliates) to obtain construction and/or permanent financing with respect to any new building to be constructed for Tenant and the impact of any total or partial lease termination pursuant to clause (iv) below upon any financing then existing and encumbering Buildings 1, 2, 3 and/or 14. (iv) In connection with any proposal or counter-proposal of the type described in this subparagraph, one element thereof shall be the termination of the Lease, if then existing, as to each building covered thereby surrendered by Tenant to Landlord in connection with Tenant's relocation to the new building constructed by Landlord or its affiliate for Tenant. (v) Nothing contained in this subparagraph shall be deemed or construed to create or grant to either party any option, put, call, right of first refusal or right of first offer. There shall be no right to recover damages on account of any alleged "breach" of the provisions of this subparagraph and no right to specific performance or injunctive relief on account of any such alleged "breach" or threatened "breach." 8. Defined Terms. All terms used in this Amendment with initial capital letters and not defined herein shall have the meanings given to such terms in the Original Lease. 9. Lease in Effect. Landlord and Tenant acknowledge and agree that the Lease, as hereby amended and modified, remains in full force and effect in accordance with its terms. IN WITNESS WHEREOF, Landlord and Tenant have executed this Third Amendment to Lease as of the day and year first above written. FILENET CORPORATION, C. J. SEGERSTROM & SONS, a California corporation a general partnership By _____________________, By_________________ Managing Partner Title Sr. VP Operations By_________________ By ____________________ Managing Partner Title __________________ "Landlord" 'Tenant" 11 EX-10.12 4 AMENDMENT TO IBM AGREEMENT Amendment #A1011-941003-01 IBM Agreement #A1011 This is amendment #A1011-941003-01 to IBM/FileNet agreement #A1101dated 12/20/91 between IBM Corporation and FileNet Corporation effective 02/21/92. The parties agree to amend the agreement by adding a new Section 4.6 below. 4.6 Buyer will have the option to extend this agreement for two additional one-year scheduling periods, (sixth and seventh scheduling periods), by notifying IBM in writing at least six months prior to expiration of the fifth scheduling period, subject to approval by IBM and subject to agreement by the parties as to duration, Products, prices, discounts and other terms and conditions. FileNet /s/William Kreidler /s/Luciano J. Bifano - ------------------- -------------------- Sam Rossiter Lucian J. Bifano Director, Purchasing/Planning Division Director, OEM and FileNet Corporation Technology Licensing, IBM Risc System/6000 Division October 3 1994 September 30, 1994 Date: Date: EX-13.1 5 MARKET FOR THE REGISTRANT'S COMMON STOCK Stock Market and Dividend Information The Company's common stock is traded in the National Market System ("Nasdaq") under the symbol FILE. The following are the high and low closing prices from January 1, 1994 through December 31, 1996 as reported by Nasdaq: High Low 1994 1st Quarter $28.75 $20.75 2nd Quarter 28.00 15.69 3rd Quarter 24.50 17.75 4th Quarter 27.00 22.25 1995 1st Quarter $35.50 $26.00 2nd Quarter 40.38 31.00 3rd Quarter 50.25 40.25 4th Quarter 48.75 38.50 1996 1st Quarter $65.25 $40.75 2nd Quarter 57.88 33.25 3rd Quarter 35.00 20.63 4th Quarter 36.13 26.00 The closing price of the Company's common stock on December 31, 1996 was $32.00. The approximate number of stockholders of record on March 7, 1997 was 817; the closing price of the Company's common stock on this date was $20.00. The Company has not paid any dividends on its common stock. The Company currently intends to retain earnings for use in its business and does not anticipate paying cash dividends in the foreseeable future. The Company's ability to pay dividends is limited by the terms of its line of credit agreement. EX-13.2 6 MANAGEMENT'S DISCUSSION AND ANALYSIS Management's Discussion and Analysis of Results of Operations and Financial Condition Results of Operations The following discussion should be read in conjunction with the Consolidated Financial Statements and Notes thereto for FileNet Corporation ("FileNet" or the "Company") contained elsewhere herein. On March 1, 1996, the Company acquired all the outstanding shares of Saros Corporation ("Saros"). The merger was accounted for as a pooling-of-interests for financial reporting purposes. The historical financial statements for the periods prior to the merger are restated as though the companies had been combined. The Saros stockholders received an aggregate of approximately 2.2 million shares and options to purchase the Company's common stock in exchange for all of their Saros common stock and options (see Note 2 to Notes to Consolidated Financial Statements for information related to the acquisition). Factors That May Affect Future Operating Results and Financial Condition The market for the Company's products is characterized by rapid technological developments, evolving industry standards, changes in customer requirements and frequent new product introductions and enhancements. The Company's continued success will be dependent upon its ability to continue to enhance its existing products, develop and introduce, in a timely manner, new products incorporating technological advances and respond to customer requirements. To the extent one or more of the Company's competitors introduce products that more fully address customer requirements, the Company's business could be adversely affected. There can be no assurance that the Company will be successful in developing and marketing enhancements to its existing products or new products on a timely basis or that any new or enhanced products will adequately address the changing needs of the marketplace. If the Company is unable to develop and introduce new products or enhancements to existing products in a timely manner in response to changing market conditions or customer requirements, the Company's business and operating results could be adversely affected. From time to time, the Company or its competitors may announce new products, capabilities or technologies that have the potential to replace or shorten the life cycles of the Company's existing products. There can be no assurance that announcements of currently planned or other new products will not cause customers to delay their purchasing decisions in anticipation of such products, which could have a material adverse effect on the Company's business and operating results. Prior growth rates in the Company's revenue and operating results should not necessarily be considered indicative of future growth or operating results. Future operating results will depend upon many factors, including the demand for the Company's products, the effectiveness of the Company's efforts to continue to integrate various products it has developed or acquired through acquisition of others and to achieve the desired levels of sales from such product integration, the level of product and price competition, the length of the Company's sales cycle, seasonality of individual customer buying patterns, the size and timing of individual transactions, the delay or deferral of customer implementations, the budget cycles of the Company's customers, the timing of new product introductions and product enhancements by the Company and its competitors, the mix of sales by products, services and distribution channels, levels of international sales, acquisitions by competitors, changes in foreign currency exchange rates, the ability of the Company to develop and market new products and control costs, and general domestic and international economic and political conditions. As a result of these factors, revenues and operating results for any quarter are subject to variation and are not predictable with any significant degree of accuracy. Therefore, the Company believes that period-to-period comparisons of its results of operations are not necessarily meaningful and should not be relied upon as indications of future performance. Moreover, such factors could cause the Company's operating results in a given quarter to be below the expectations of public market analysts and investors. In either case, the price of the Company's common stock could be materially adversely affected. The document imaging, workflow, computer output to laser disk ("COLD") and document management software markets are highly competitive, and there are certain competitors of the Company with substantially greater sales, marketing, development and financial resources. The Company believes that the competitive factors affecting the market for its products and services include vendor and product reputation; product quality, performance and price; the availability of products on multiple platforms; product scalability; product integration with other enterprise applications; product functionality and features; product ease-of use; and the quality of customer support services and training. The relative importance of each of these factors depends upon the specific customer involved. While the Company believes it competes favorably in each of these areas, there can be no assurance that it will continue to do so. Moreover, the Company's present or future competitors may be able to develop products comparable or superior to those offered by the Company, offer lower price products or adapt more quickly than the Company to new technologies or evolving customer requirements. Competition is expected to intensify. In order to be successful in the future, the Company must respond to technological change, customer requirements and competitors' current products and innovations. There can be no assurance that it will be able to continue to compete effectively in its market or that future competition will not have a material adverse effect on its business, operating results and financial condition. The Company's success depends in part on its ability to protect its proprietary rights to the technologies used in its principal products. The Company relies on a combination of copyrights, trademarks, trade secrets, confidentiality procedures and contractual provisions to protect its proprietary rights. There can be no assurance that the Company's existing or future copyrights, trademarks, trade secrets or other intellectual property rights will be of sufficient scope or strength to provide meaningful protection or commercial advantage to the Company. FileNet has no software patents. Also, in selling certain of its products, the Company relies on "shrink wrap" licenses that are not signed by licensees and, therefore, may be unenforceable under the laws of certain jurisdictions. In addition, the laws of some foreign countries do not protect the Company's proprietary rights to the same extent as do the laws of the United States. There can be no assurance that such factors would not have a material adverse effect on the Company's business or operating results. The Company may from time to time be notified that it is infringing certain patent or intellectual property rights of others. Combinations of technology acquired through past or future acquisitions and the Company's technology will create new products and technology which may give rise to claims of infringement. While no actions other than the ones discussed below are currently pending against the Company for infringement of patent or other proprietary rights of third parties, there can be no assurance that third parties will not initiate infringement actions against the Company in the future. Infringement actions can result in substantial cost to and diversion of resources of the Company. If the Company were found to infringe upon the rights of others, no assurance can be given that licenses would be obtainable on acceptable terms or at all, that significant damages for past infringement would not be assessed or that further litigation relative to any such licenses or usage would not occur. The failure to successfully defend any claims or obtain necessary licenses or other rights, the ultimate disposition of any claims or the advent of litigation arising out of any claims of infringement, could have a material adverse effect on the Company's business, financial condition or results of operations. In October 1994, Wang Laboratories, Inc. ("Wang") filed a complaint in the United States District Court for the District of Massachusetts alleging that the Company is infringing five patents held by Wang. On June 23, 1995, Wang amended its complaint to include an additional related patent. On July 2, 1996, Wang filed a complaint in the same court alleging that Watermark Software Inc. ("Watermark"), formerly a wholly-owned subsidiary that was merged into the Company, is infringing three of the same patents asserted in the initial complaint. On October 9, 1996, Wang withdrew its claim that one of the patents it initially asserted is infringed by the Company's products which were commercialized before the initial complaint was filed. Wang reserved the right to assert that patent against the Company's products commercialized after that date in a separate lawsuit. Based on the Company's analysis of these Wang patents and their respective file histories, the Company believes that it has meritorious defenses to Wang's claims; however, the ultimate outcome or any resulting potential loss cannot be determined at this time. In January 1997, Wang and Eastman Kodak Company ("Kodak") announced that they have entered into an agreement under which Kodak will acquire the Wang business unit that has responsibility for this litigation. The acquisition is scheduled to close in March-April 1997 and the Company can not predict what, if any, impact this will have on the litigation. If it should be determined that the patents at issue in the litigation are valid and are infringed by any of the Company's products, including Watermark products, the Company will, depending on the product, redesign the infringing products or seek to obtain a license to market the products. There can be no assurance that the Company will be able to obtain such a license on acceptable terms. The Company has entered into a number of co-marketing relationships with other companies such as Microsoft Corporation, Compaq Computer Corporation, SAP AG, Hewlett-Packard Company ("HP") and Sun Microsystems, Inc. There can be no assurance that these companies will not reduce or discontinue their relationships with or support of the Company and its products. Disruption of these relationships could have a material adverse effect on the Company's business and operating results. The Company's success depends to a significant degree upon the continued contributions of its key management, marketing, technical and operational personnel, including members of senior management and technical personnel of acquired companies. The Company has no agreements providing for the employment of any of its key employees or any fixed term contracts and the Company's key employees may voluntarily terminate their employment with the Company at any time. The loss of the services of one or more key employees, including key employees of acquired companies, could have a material adverse effect on the Company's operating results. The Company also believes its future success will depend in large part upon its ability to attract and retain additional highly skilled management, technical, marketing, product development and operational personnel. Competition for such personnel is intense, and there can be no assurance that the Company will be successful in attracting and retaining such personnel. Historically, the Company has derived approximately one-third of its total revenues from international sales. International business is subject to certain risks including varying technical standards, tariffs and trade barriers, political and economic instability, reduced protection for intellectual property rights in certain countries, difficulties in staffing and maintaining foreign operations, difficulties in managing foreign distributors, potentially adverse tax consequences, currency exchange fluctuations, the burden of complying with a wide variety of complex operations, foreign laws, regulations and treaties and the possibility of difficulties in collecting accounts receivable. There can be no assurance that any of these factors will not have a material adverse effect on the Company's business or operating results. The Company recently completed the acquisitions of Watermark, Saros and International Financial Systems Ltd. ("IFSL"). These recent acquisitions by the Company have presented and will continue to present it with numerous challenges, including difficulties in the assimilation of the operations, technologies and products of the acquired companies and managing separate geographic operations. The challenges have absorbed and may continue to absorb significant management attention that would otherwise be available for the ongoing development of the Company's business. If the Company's management does not respond to these challenges effectively, the Company's results of operations could be adversely affected. Moreover, there can be no assurance that the anticipated benefits of the acquisitions will be realized. The Company and the acquired companies could experience difficulties or delays in integrating their respective technologies or developing and introducing new products. In particular, one of the reasons for FileNet's acquisition of Saros was the perceived market potential for Saros' new products, including the recently announced @mezzanine and Saros Document Server for BackOffice, which have yet to be proven in the marketplace, as well as other products currently under development. Delays in or non-completion of the development of these new products, or lack of market acceptance of such products, could have an adverse impact on the Company's future results of operations and result in a failure to realize anticipated benefits of the acquisitions. The Company's license agreements with customers typically contain provisions designed to limit their exposure to potential product liability claims. However, it is possible that such limitation of liability provisions may not be effective under the laws of certain jurisdictions. Although the Company has not experienced any product liability claims to date, the sale and support of products by them may entail the risk of such claims, and there can be no assurance that the Company will not be subject to such claims in the future. A successful product liability claim brought against the Company could have a material adverse effect upon the Company's business, operating results and financial condition. The Company believes that a variety of factors could cause the price of its common stock to fluctuate, perhaps substantially, including quarter-to-quarter variations in operating results; announcements of developments related to its business; fluctuations in its order levels; general conditions in the technology sector or the worldwide economy; announcements of technological innovations, new products or product enhancements by the Company or its competitors; key management changes; changes in joint marketing and development programs; developments relating to patents or other intellectual property rights or disputes; and developments in the Company's relationships with its customers, distributors and suppliers. In addition, in recent years the stock market in general, and the market for shares of high technology stocks in particular, has experienced extreme price fluctuations which have often been unrelated to the operating performance of affected companies. Such fluctuations could adversely affect the market price of the Company's common stock. Revenue As shown below, the Company derived 52% of its 1996 revenue from the licensing of the Company's software products compared to 51% in 1995 and 42% in 1994. Service revenue consisting of revenue from software and hardware maintenance services provided to the Company's customer installed base and other revenue that includes professional services, training, and supplies increased to 31% of total revenue, compared to 29% in 1995 and 32% in 1994. Hardware revenue consisting primarily of 12-inch optical storage and retrieval libraries ("OSAR") and third-party server hardware represented 17% of total revenue compared to 20% in 1995 and 26% in 1994.
Percent Percent (Dollars in millions) 1996 change 1995 change 1994 Software revenue $140.7 21% $116.1 43% $ 81.1 As a percentage of total revenue 52% 51% 42% Service revenue $ 82.1 22% $ 67.2 11% $ 60.7 As a percentage of total revenue 31% 29% 32% Hardware revenue $ 46.1 - $ 46.1 (9%) $ 50.5 As a percentage of total revenue 17% 20% 26% ------------------------------------------ Total revenue $268.9 17% $229.4 19% $192.3 ==========================================
Total revenue increased 17% in 1996 and 19% in 1995. Software revenue increased in 1996 and 1995 from an increase in the volume of product shipments from the addition of new products and reselling partners and additional revenue generated through the Company's co-marketing arrangement with HP. The Company believes the software revenue growth rate for 1996 was negatively impacted by difficulties experienced with integrating the Saros and Watermark selling efforts and personnel into FileNet's sales organization. Service revenue increased 22% in 1996 compared to 11% in 1995. The increase in service revenue in 1996 was due to the growth of the Company's customer installed base, an increase in training due primarily to the training of new resellers, and the recognition of $7.6 million of revenue from the sale and repair of spare parts in connection with the continued transition of hardware maintenance activities to HP. There were no such sales in 1995 and 1994, and future sales to HP are not expected to be significant in 1997. Growth in service revenue in 1995 was lower due to the impact of the Company's decision in 1994 to begin outsourcing its hardware maintenance to HP and others. By the end of 1995, all worldwide hardware maintenance was being performed by third parties. In spite of this, service revenue increased in 1995 due to the growth of the Company's installed base and an increase in the volume of international consulting contracts. Hardware revenue remained flat in 1996 compared to a 9% decline in 1995. Despite stronger than expected OSAR sales in 1996 which contributed to the consistency of hardware revenue between 1996 and 1995, the Company expects hardware revenue to continue to decline in both absolute dollars and as a percentage of total revenue as the Company focuses on increasing its higher margin software revenue. The Company sells its products through its direct sales force in Australia, Canada, France, Germany, the United Kingdom and the United States; and indirectly in the United States and in 60 countries internationally through ValueNet partners, resellers, and OEMs. Domestic and international revenue by source are shown in the following table (revenue is attributed to the customer's location):
Percent Percent (Dollars in millions) 1996 change 1995 change 1994 Domestic Software revenue $ 87.6 12% $ 77.9 46% $ 53.5 Service revenue 61.4 29% 47.5 7% 44.6 Hardware revenue 28.3 3% 27.4 (19%) 34.0 ------------------------------------------ Domestic revenue $177.3 16% $152.8 16% $132.1 As a percentage of total revenue 66% 67% 69% International Software revenue $ 53.1 39% $ 38.2 38% $ 27.6 Service revenue 20.7 5% 19.7 22% 16.1 Hardware revenue 17.8 (5%) 18.7 13% 16.5 ------------------------------------------ International revenue $ 91.6 20% $76.6 27% $ 60.2 As a percentage of total revenue 34% 33% 31% ------------------------------------------ Total revenue $268.9 17% $229.4 19% $192.3 ==========================================
Total domestic revenue increased 16% in 1996 and 1995. Domestic software revenue increased 12% in 1996 compared to 46% in 1995 due to the reasons cited above. Domestic service revenue increased 29% in 1996 compared to 7% in 1995. The increase in service revenue for 1996 was positively impacted by the repair and sale of spare parts to HP discussed above. Domestic hardware revenue increased 3% in 1996 compared to a 19% decline in 1995 due to stronger than expected sales of the Company's OSAR products. As a percentage of total revenue, domestic revenue decreased to 66% in 1996 from 67% in 1995 and 69% in 1994. This trend is expected to continue as the Company continues to expand its operations internationally. Total international revenue increased 20% in 1996 and 27% in 1995. International software revenue increased 39% in 1996, remaining fairly constant with the 38% increase in 1995. Service revenue increased 5% in 1996 and 22% in 1995. The growth in international service revenue slowed due to the impact of hardware maintenance outsourcing partially offset by an increase in the international customer installed base. International hardware revenue decreased 5% in 1996 as expected. International revenue as a percentage of total revenue increased to 34% in 1996 from 33% in 1995 and 31% in 1994. Cost of Revenue Cost of revenue as a percentage of revenue is shown in the table below for each of the last three years:
Percent Percent (Dollars in millions) 1996 change 1995 change 1994 Cost of software revenue $16.5 9% $15.1 21% $12.5 As a percentage of software revenue 12% 13% 15% Cost of service revenue $53.6 21% $44.3 6% $41.6 As a percentage of service revenue 65% 66% 69% Cost of hardware revenue $29.6 3% $28.8 (7%) $31.0 As a percentage of hardware revenue 64% 62% 61% ----------------------------------------- Cost of total revenue $99.7 13% $88.2 4% $85.1 =========================================
The cost of software revenue includes royalties paid to third parties, amortization of capitalized software and the cost of manufacturing and distributing software. In 1996 and 1995, the cost of software revenue increased 9% and 21%, respectively, over the previous year due to the increased volume of software revenue. The cost of software revenue as a percentage of software revenue decreased to 12% in 1996 from 13% in 1995 and 15% in 1994 due to a decrease in the amount of capitalized software amortized and savings related to the consolidation of software manufacturing and distributing activities. The cost of service revenue includes software support and professional services personnel, supplies, and the cost of third party hardware maintenance. The cost of service revenue increased 21% in 1996 and 6% in 1995 due to an increase in software support and professional services personnel to support the increase in the Company's installed base. The cost of service revenue as a percentage of service revenue decreased to 65% in 1996 from 66% in 1995 and 69% in 1994. The decrease in 1996 was the result of the sale and repair of spare parts at favorable margins in connection with the continued transition of hardware maintenance activities to HP, offset by lower margins associated with international maintenance. The decrease in 1995 was the result of improved efficiencies in the Company's international professional services and customer support operations. The cost of hardware revenue includes the Company's cost of OSAR manufacturing, third-party purchased hardware and the cost of hardware integration personnel. The cost of hardware revenue as a percentage of hardware revenue has remained relatively consistent at 64% in 1996, 62% in 1995 and 61% in 1994. The slight increase in 1996 was due to a less favorable mix from the Company's OSAR product line and lower margins from third party purchased equipment. Operating Expenses
Percent Percent (Dollars in millions) 1996 change 1995 change 1994 Research and development $ 36.5 48% $24.7 35% $18.3 As a percentage of total revenue 14% 11% 10% Selling, general and administrative $117.8 22% $96.5 35% $71.3 As a percentage of total revenue 44% 42% 37%
The Company's research and development expenses increased 48% in 1996 and 35% in 1995 due to the addition of development personnel and the related facilities and depreciation expenses to fund new development activities. Research and development expenses reported in the above table are after capitalized software development costs of $1.6 million in 1995 and $3.2 million in 1994. As a percentage of total revenue, research and development expenses increased to 14% in 1996 from 11% in 1995 and 10% in 1994. The increase in 1996 was due to the increase in research and development personnel to support new development activities without the corresponding expected revenue growth, and a decrease in the amount of capitalized software development costs. The increase in 1995 was due to a decrease in the amount of capitalized software development costs. Selling, general and administrative expenses increased 22% in 1996 and 35% in 1995. The increase in 1996 was due primarily to an increase in the number of marketing and sales support personnel employed internationally as the Company expanded its international reseller and sales operations and to an increase in commissions associated with higher revenues. The increase in 1995 was a result of international expansion, increased commissions, an adverse effect of foreign currency fluctuations on international expenses, the costs associated with implementing a new corporate business information system and higher costs for Watermark in relation to revenue due to its early stage of operations. In 1996, selling, general and administrative expenses as a percentage of total revenue increased to 44% from 42% in 1995 and 37% in 1994 primarily due to the reasons cited above. Geographic Information The operating loss from the United States operations was $18.6 million in 1996 compared to operating income of $0.4 million in 1995 and $14.4 million in 1994. The decrease in 1996 and 1995 was due to merger, restructuring and write-off of purchased in-process research and development costs and the increase in corporate research and development and general administrative expenses. Operating income from European operations, including the income from all international software sales, increased to $17.7 million in 1996 from $12.6 million in 1995 and $3.1 million in 1994. Operating income for other international operations increased to $1.7 million in 1996 from $0.6 million in 1995 and $0.2 million in 1994 (see Note 9 to Notes to Consolidated Financial Statements for information related to the operating results of the Company's various geographic locations). Merger, Restructuring and Write-off of Purchased In-process Research and Development Costs The $16.0 million merger, restructuring and write-off of purchased in-process research and development costs in 1996 consisted of $10.0 million for the write-off of purchased in-process research and development costs related to the IFSL acquisition, $4.2 million in merger costs related to the Saros acquisition, and $1.8 million in restructuring costs related to the Saros and Watermark acquisitions. The restructuring charge represents the costs of consolidating the various companies' sales and administrative functions and includes $1.4 million for severance payments for 30 employees and $0.4 million for the write-off of certain contractual obligations and professional fees. At December 31, 1996, accrued restructuring costs of $1.3 million is included in other accrued liabilities. The Company anticipates that the remaining restructuring costs will be expended during 1997 (see Note 2 to Notes to Consolidated Financial Statements for information related to the acquisitions of Watermark, Saros and IFSL). The $6.4 million merger, restructuring and write-off of purchased in-process research and development costs in 1995 consisted of a charge for the buyout of certain Watermark European marketing and manufacturing rights, a write-off of capitalized research and development expenses for FileNet projects made redundant by the Watermark acquisition and other direct acquisition related fees and expenses. Other Income Other income, net of other expenses, was $2.8 million in both 1996 and 1995 and $1.8 million in 1994. The increase in 1995 was primarily due to increased interest income on a higher balance of cash and marketable securities. Provision for Income Taxes The provision for income taxes was a charge of $4.5 million in 1996, down from $8.1 million and $5.4 million recorded in 1995 and 1994, respectively. The Company's effective tax rate was 50% in 1995 and 27% in 1994. The 1996 effective tax rate is not meaningful. The 1996 provision is impacted from expensing the purchased in-process research and development as part of the acquisition of IFSL with no corresponding tax benefit, nondeductible one-time costs associated with the Saros merger and a result of earnings generated in certain international jurisdictions, partially offset by the benefit of tax losses incurred in the United States. The Company currently anticipates that the effective tax rate for 1997 will be approximately 28%. However, the actual tax rate may differ due to a variety of factors including the geographical mix of revenues and the ability to use certain deferred tax assets. Net Income (Loss) In 1996, the Company reported a net loss of $2.6 million, or $0.18 per share, on 15.0 million shares outstanding compared to net income of $8.2 million, or $0.52 per share, on 15.9 million weighted average common and common equivalent shares outstanding in 1995 and $14.1 million, or $0.95 per share, on 14.8 million weighted average common and common equivalent shares outstanding in 1994. Income before one-time after-tax charges for merger, restructuring and write-off of purchased in-process research and development costs of $16.0 million and $5.0 million for 1996 and 1995, respectively, was $13.4 million, or $0.83 per share, on 16.1 million weighted average common and common equivalent shares outstanding in 1996, compared to $13.2 million, or $0.83 per share, on 15.9 million weighted average common and common equivalent shares outstanding in 1995. The 1994 net income per share figure includes $0.12 per share due to a deferred revenue transaction related to the settlement of a customer dispute. Foreign Currency Fluctuations and Inflation The Company's performance can be affected by changes in foreign currency values relative to the U.S. dollar as discussed above in relation to the Company's revenue and operating expenses. The net impact to net income from foreign exchange transactions and hedging activities are immaterial for all periods reported. The foreign currency translation adjustment included in stockholders' equity increased $1.7 million during 1996 over 1995 due primarily to the strength of the Irish currency against the U.S. dollar applied to the Company's net assets in Ireland. Management believes that inflation has not had a significant impact on the prices of the Company's products, the cost of its materials, or its operating results during 1994 through 1996. Liquidity and Capital Resources As of December 31, 1996, combined cash, cash equivalents, and marketable securities (short- and long-term) were $67.3 million, a decrease of $23.3 million from the $90.6 million at the end of 1995. Cash used by operating activities in 1996 was $1.8 million. The balance is primarily due to a net loss and the effect of higher accounts receivable balances associated with higher revenue and higher average sales days outstanding offset in part by the noncash additions to net loss for the write-off of capitalized and purchased in-process research and development costs, depreciation, and amortization of capitalized software. Cash used by investing activities totaled $16.7 million, consisting of capital expenditures and the purchase of IFSL (see Note 2 to Notes to Consolidated Financial Statements for information related to the Company's purchase of IFSL), offset by proceeds from the sale of equipment and the net sale and maturity of marketable securities. Net cash provided by financing activities was $2.6 million and was the result of proceeds from the issuance of common stock and stock option income tax benefits offset by the repurchase of common stock. Cash provided by operating activities in 1995 was $24.7 million. The balance is primarily due to net income and the noncash additions to net income for the write-off of capitalized and purchased in-process research and development costs, depreciation, and amortization of capitalized software. Cash used by investing activities totaled $20.3 million, consisting of capital expenditures, capitalized software and a net purchase of marketable securities. Net cash provided by financing activities in 1995 was $14.1 million consisting of proceeds from the issuance of common stock and stock option income tax benefits. The Company's capital expenditures were $17.9 million in 1996, $14.7 million in 1995, and $11.0 million in 1994. The Company's primary capital equipment expenditures are for research and development costs, demonstration and training equipment and enhancements to its internal business systems. The Company anticipates that it will acquire approximately $20 million of capital equipment in 1997. The Company also anticipates that its present cash balances, together with internally generated funds and credit lines, will be sufficient to meet its working capital and capital expenditure needs throughout 1997 (see Note 5 to Notes to Consolidated Financial Statements for information related to the Company's credit facilities). OTHER MATTERS On March 7, 1994, the Company's Board of Directors resolved to dissolve FileNet S.A., its French subsidiary. The Company is now marketing and supporting its products and customers in France through a branch of the U.S. corporation. The dissolution of FileNet S.A. resulted in a U.S. tax benefit in 1994 of approximately $2.1 million due to the utilization of losses previously sustained by its French subsidiary. The Company is not aware of any issues related to environmental concerns that have or are expected to materially affect its business. - -------------------------------------------------------------------------------- This annual report contains forward-looking statements that involve risks and uncertainties, including, but not limited to, those discussed in "Management's Discussion and Analysis of Results of Operations and Financial Condition - Factors That May Affect Future Operating Results and Financial Condition" in this annual report and those discussed in "Business - Certain Considerations" in the Company's annual report on Form 10-K for the year ended December 31, 1996. The actual results that the Company achieves may differ materially from any forward-looking statements due to such risks and uncertainties. - -------------------------------------------------------------------------------- EX-13.3 7 FINANCIAL STATEMENTS Consolidated Balance Sheets (In thousands, except share amounts)
At December 31, 1996 and December 31, 1995 1996 1995 Assets -------- -------- Current assets: Cash and cash equivalents $ 28,530 $ 43,378 Short-term marketable securities 22,037 28,782 -------- -------- Total cash and short-term marketable securities 50,567 72,160 Accounts receivable (net of allowance for doubtful accounts of $2,140 and $1,540 at December 31, 1996 and December 31, 1995, respectively) 75,469 53,501 Inventories 8,794 6,620 Prepaid expenses and other 8,336 6,573 Deferred income taxes 5,641 3,735 -------- -------- Total current assets 148,807 142,589 -------- -------- Property, net 28,329 25,796 Capitalized software, net - 1,226 Long-term marketable securities 16,705 18,395 Other 1,838 1,676 -------- -------- Total assets $195,679 $189,682 ======== ======== Liabilities and Stockholders' Equity Current liabilities: Accounts payable $ 16,752 $ 16,073 Accrued liabilities: Compensation 10,728 10,997 Income taxes payable 2,152 2,228 Unearned maintenance revenue 5,554 5,761 Royalties 4,531 3,572 Other 19,751 17,604 -------- -------- Total current liabilities 59,468 56,235 -------- -------- Deferred income taxes 3,405 2,289 Stockholders' equity: Convertible preferred stock - $.001 par value; authorized, 39,000,000 shares; 35,232,029 issued and outstanding shares and 1,531,485 common equivalent shares at the liquidation preference at December 31, 1995 - 19,879 Common stock - $.01 par value; authorized, 100,000,000 shares; issued and outstanding, 15,230,566 and 13,254,222 shares at December 31, 1996 and December 31, 1995, respectively 127,813 100,719 Retained earnings 7,874 10,518 Other 1,687 42 -------- -------- 137,374 131,158 Less 200,000 Treasury shares at cost 4,568 - -------- -------- Total stockholders' equity 132,806 131,158 -------- -------- Total liabilities and stockholders' equity $195,679 $189,682 ======== ========
See notes to consolidated financial statements. Consolidated Statements of Operations (In thousands, except per share amounts)
Years ended December 31, 1996, December 31, 1995 and January 1, 1995 1996 1995 1994 -------- -------- -------- Revenue Software revenue $140,659 $116,052 $ 81,102 Service revenue 82,118 67,174 60,753 Hardware revenue 46,136 46,152 50,480 -------- -------- -------- Total revenue 268,913 229,378 192,335 -------- -------- -------- Costs and expenses Cost of software revenue 16,464 15,146 12,472 Cost of service revenue 53,568 44,277 41,645 Cost of hardware revenue 29,633 28,800 30,999 Research and development 36,502 24,711 18,274 Selling, general and administrative 117,761 96,499 71,267 Merger, restructuring and write-off of purchased in-process research and development costs 16,011 6,393 - -------- -------- -------- Total costs and expenses 269,939 215,826 174,657 -------- -------- -------- Operating income (loss) (1,026) 13,552 17,678 Other income 2,838 2,780 1,821 -------- -------- -------- Income before income taxes 1,812 16,332 19,499 Provision for income taxes 4,456 8,116 5,356 -------- -------- -------- Net income (loss) $ (2,644) $ 8,216 $ 14,143 ======== ======== ======== Net income (loss) per share $ (0.18) $ 0.52 $ 0.95 ======== ======== ======== Weighted average common and common equivalent shares outstanding 15,007 15,856 14,834 ======== ======== ========
See notes to consolidated financial statements. Consolidated Statements of Stockholders' Equity (In thousands, except share amounts)
Convertible Common stock preferred stock Retained Treasury stock Shares Amount Shares Amount earnings Shares Amount Other Total ---------- -------- --------- -------- --------- --------- -------- ------- --------- Balances, January 2, 1994 11,710,614 $ 73,518 1,357,656 $ 16,895 $(11,841) - $ - $ (189) $ 78,383 Stock options exercised 325,882 3,512 3,512 Income tax benefit from the exercise or disposition of stock options 1,142 1,142 Common stock issued under the Employee Qualified Stock Purchase Plan 43,222 658 658 Preferred stock issued by Saros 173,829 2,984 2,984 Watermark common stock converted to redeemable preferred stock (659,606) Accretion to liquidation value of Watermark redeemable preferred stock (52) (52) Foreign currency translation adjustment 234 234 Net income 14,143 14,143 Other 2 2 ---------- -------- --------- -------- --------- --------- -------- ------- --------- Balances, January 1, 1995 11,420,112 78,778 1,531,485 19,879 2,302 - - 47 101,006 Stock options exercised 542,142 7,471 7,471 Income tax benefit from the exercise or disposition of stock options 3,722 3,722 Common stock issued under the Employee Qualified Stock Purchase Plan 35,235 814 814 Proceeds from exercise of Saros warrants 194,421 2,235 2,235 Conversion of Watermark redeemable convertible preferred stock to FileNet common stock 1,062,312 7,699 8 7,707 Foreign currency translation adjustment (53) (53) Net income 8,216 8,216 Other 40 40 ---------- -------- --------- -------- --------- --------- -------- ------- --------- Balances, December 31, 1995 13,254,222 100,719 1,531,485 19,879 10,518 - - 42 131,158 Stock options exercised 398,041 3,330 3,330 Income tax benefit from the exercise or disposition of stock options 2,606 2,606 Common stock issued under the Employee Qualified Stock Purchase Plan 37,693 1,028 1,028 Proceeds from exercise of Saros warrants 9,125 251 251 Conversion of Saros convertible preferred stock to FileNet common stock 1,531,485 19,879 (1,531,485) (19,879) - Repurchase of treasury shares at cost (200,000) (4,568) (4,568) Foreign currency translation adjustment 1,671 1,671 Net loss (2,644) (2,644) Other (26) (26) ---------- -------- --------- -------- --------- --------- -------- ------- --------- Balances, December 31, 1996 15,230,566 $127,813 - $ - $ 7,874 (200,000) $(4,568) $1,687 $132,806 ========== ======== ========= ======== ========= ========= ======== ======= =========
See notes to consolidated financial statements. Consolidated Statements of Cash Flows (In thousands)
Years ended December 31, 1996, December 31, 1995 and January 1, 1995 1996 1995 1994 --------- --------- --------- Cash flows from operating activities Net income (loss) $ (2,644) $ 8,216 $ 14,143 Adjustments to reconcile net income (loss) to net cash provided by operating activities Write-off of capitalized and purchased in-process research and development costs 10,011 1,393 - Depreciation and amortization 11,823 10,275 8,531 Software amortization 1,226 1,800 3,600 Provision for losses on accounts receivable 591 809 134 Deferred taxes (780) 196 440 Changes in operating assets and liabilities, net of effect of business acquisition Accounts receivable (21,307) (10,674) (5,044) Inventories (2,161) (1,464) 2,115 Prepaid expenses and other (1,764) (2,497) 101 Accounts payable 639 4,683 1,434 Accrued liabilities Compensation (270) 2,689 2,380 Income taxes payable (174) 537 (1,907) Unearned maintenance revenue (207) 1,864 16 Royalties 959 1,125 687 Other 2,263 5,734 796 Net cash provided (used) by operating activities (1,795) 24,686 27,426 Cash flows from investing activities Capital expenditures (17,866) (14,692) (11,033) Proceeds from sale of property 3,304 393 946 Capitalized software - (1,600) (3,200) Payment for purchase of IFSL, net of assets acquired (10,011) - - Purchase of marketable securities (32,092) (49,815) (45,346) Proceeds from sale and maturity of marketable securities 39,990 45,402 24,036 Net cash used by investing activities (16,675) (20,312) (34,597) Cash flows from financing activities Debt repayments, net - (163) (650) Short-term bank borrowings, net - - (2,855) Proceeds from notes receivable from stockholders - - 1,250 Proceeds from issuance of convertible preferred and common stock 4,609 10,520 11,084 Common stock repurchased (4,568) - - Stock option income tax benefits 2,606 3,722 1,142 Net cash provided by financing activities 2,647 14,079 9,971 Effect of exchange rate changes on cash and cash equivalents 975 (25) (6) Net increase (decrease) in cash and cash equivalents (14,848) 18,428 2,794 Cash and cash equivalents, beginning of year 43,378 24,950 22,156 Cash and cash equivalents, end of year $ 28,530 $ 43,378 $ 24,950 Supplemental cash flow information Interest paid $ 443 $ 229 $ 194 Income taxes paid $ 3,236 $ 3,527 $ 5,286
See notes to consolidated financial statements. Notes to Consolidated Financial Statements Note 1: Summary of Significant Accounting Practices Nature of Operations FileNet Corporation ("FileNet" or the "Company") develops, markets and services an open, integrated family of workflow, document-imaging, electronic document-management and computer output to laser disk ("COLD") client/server software solutions. The Company's software products manage and control the movement of document images, data, text and other information throughout an enterprise. Software from FileNet enables organizations in industries, such as banking and financial services, insurance, manufacturing, services, telecommunications and healthcare and in all levels of government worldwide, to maximize enterprise productivity. Additionally, the Company manufactures a line of 12-inch optical storage and retrieval libraries (OSARs). The Company markets its products through a direct sales force in Australia, Canada, France, Germany, the United Kingdom ("UK"), and the United States. In addition, the Company markets through ValueNet partners, resellers and OEMs in both the United States and international markets. Consolidation The consolidated financial statements include the accounts of FileNet and its wholly-owned subsidiaries. All intercompany balances and transactions have been eliminated. Watermark Software Inc. ("Watermark") and Saros Corporation ("Saros"), formerly wholly-owned subsidiaries of FileNet, were merged into FileNet on July 25, 1996 and August 26, 1996, respectively (see Note 2). Year End The Company changed its fiscal year end to December 31 beginning in fiscal 1996. The Company's year end had been the Sunday closest to December 31. Fiscal 1995 ended on December 31, 1995, and fiscal 1994 ended on January 1, 1995. Investments The Company accounts for investments in accordance with Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments and Equity Securities." The Company's investments consist primarily of high-grade corporate and government securities with maturities of less than three years and considers investments purchased with an original maturity of three months or less to be cash equivalents. The Company classifies all of its investments as available-for-sale. Available-for-sale securities are carried at fair value, with the unrealized gains and losses, net of tax, reported in a separate component of stockholders' equity. Realized and unrealized gains and losses on available-for-sale securities were immaterial. Other Financial Instruments Effective January 2, 1995, the Company adopted the provisions of SFAS No. 119, "Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments." The Company enters into forward foreign exchange contracts as a hedge against effects of fluctuating currency exchange rates on monetary assets and liabilities denominated in currencies other than the functional currency of the relevant entity. The Company is exposed to market risk on the forward exchange contracts as a result of changes in foreign exchange rates; however, the market risk should be offset by changes in the valuation of the underlying exposures. Gains and losses on these contracts, which equal the difference between the forward contract rate and the prevailing market spot rate at the time of valuation, are recognized in the consolidated statement of operations. The counterparties to these instruments are major financial institutions. The Company uses commercial rating agencies to evaluate the credit quality of the counterparties, and the Company does not anticipate a loss resulting from any credit risk of these institutions. At December 31, 1996 and December 31, 1995, the Company had forward currency sales contracts open in 10 currencies with a notional amount of $59.6 million and 7 currencies with a notional amount of $27.1 million, respectively; all having maturities within three months. The unrealized gains and losses from these contracts were immaterial at both December 31, 1996 and December 31, 1995. Fair Value of Financial Instruments The recorded amounts of assets and liabilities at December 31, 1996 and December 31, 1995 approximate fair value in accordance with SFAS No. 107, "Disclosures About Fair Value of Financial Instruments" due to the relatively short period of time between origination of the instruments and their expected realization. Inventories Inventories are stated at the lower of first-in, first-out cost or market (see Note 3). The Company regularly monitors inventory for excess or obsolete items and makes any necessary adjustments at each balance sheet date. Foreign Currency Translation In accordance with SFAS No. 52, "Foreign Currency Translation," the Company measures the financial statements for the Company's foreign subsidiaries using the local currency as the functional currency. Assets and liabilities of these subsidiaries are translated at the exchange rate on the balance sheet date. Translation adjustments resulting from this process are included in equity. Revenues, costs and expenses are translated at the rates of exchange prevailing during the year. Gains and losses from foreign currency transactions are included in "other income." Property Property is stated at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the related assets, generally three to five years. Leasehold improvements are amortized over the shorter of the estimated useful lives of the improvements or the term of the related lease (see Note 4). Research and Development The Company expenses research and development costs as incurred. SFAS No. 86, "Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed," does not materially affect the Company. The Company did capitalize certain software development costs up to and including the second quarter of 1995. Capitalization was $1.6 million for the year ended December 31, 1995 and $3.2 million for the year ended January 1, 1995. The Company amortized the remaining capitalized software, net of accumulated amortization during 1996. Capitalized software net of accumulated amortization was amortized over the expected life of the related products, estimated to be one year commencing upon the delivery of the related product. Amortization expense was $1.2 million, $1.8 million, and $3.6 million for the years ended December 31, 1996, December 31, 1995, and January 1, 1995, respectively. Included in 1996 merger, restructuring and write-off of purchased in-process research and development costs is the write-off of $10.0 million of in-process research and development costs related to the purchase of International Financial Systems, Ltd. ("IFSL"). Included in 1995 merger, restructuring and write-off of purchased in-process research and development costs is the write-off of $1.4 million of capitalized research and development expenses for FileNet projects made redundant by the Watermark acquisition (see Note 2). Revenue Recognition Revenue from software and hardware sales related to the Company's electronic document-management, document-imaging and workflow software products is generally recognized when the product is delivered to the customer in accordance with the American Institute of Certified Public Accountants Statement of Position 91-1, "Software Revenue Recognition." The Company recognizes other revenue at the time of product delivery and accrues any remaining costs, including insignificant vendor obligations. Revenue from service and post-contract customer support is recognized ratably over the term of the contract. Product Warranty The Company provides a warranty for its products against defects in materials and workmanship. A provision for estimated warranty costs is recorded at the time of sale and periodically adjusted to reflect actual experience. Income Taxes The Company accounts for income taxes under the provisions of SFAS No. 109, "Accounting for Income Taxes" (see Note 7). Net Income (Loss) Per Share Net loss per share for the year ended December 31, 1996 was computed using the weighted average number of actual common shares outstanding. Net income per share for the years ended December 31, 1995 and January 1, 1995 were computed based on the weighted average number of common shares and dilutive common equivalent shares outstanding after the effect of the conversion of the then outstanding shares of Watermark's redeemable convertible preferred stock and Saros' convertible preferred stock into common stock, which conversion occurred upon completion of the acquisitions (see Notes 2 and 6). Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles necessarily requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates. Supplier Concentrations Certain components for the Company's proprietary 12-inch OSARs are available from a limited number of sources. Any inability to obtain components in the amounts needed on a timely basis could result in short-term delays in product shipments which could have a material adverse effect on the Company's operating results and financial condition. The Company has qualified and is selling 51/4-inch optical storage and retrieval devices from an alternative company which could be utilized by the Company's customers in the event of any interruptions in the delivery of components for the Company's own OSAR product. Stock-based Compensation The Company accounts for stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board Opinion ("APB") No. 25, "Accounting for Stock Issued to Employees." Long-Lived Assets The Company accounts for the impairment and disposition of long-lived assets in accordance with SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of." In accordance with SFAS No. 121, long-lived assets to be held are reviewed for events or changes in circumstances which indicate that their carrying value may not be recoverable. Reclassifications Certain reclassifications have been made to the prior years' balances to conform with the current year's presentation. Note 2: Acquisitions Acquisition of Saros Corporation On March 1, 1996, FileNet acquired all the outstanding shares of Saros, a Washington corporation (the "Saros Acquisition"). The Saros Acquisition was consummated pursuant to an Agreement and Plan of Merger (the "Saros Merger Agreement") dated January 17, 1996 by and among Saros, the Company, and FileNet Acquisition Corporation ("Acquisition Corp."), a Washington corporation and wholly-owned subsidiary of the Company. Pursuant to the Saros Merger Agreement, Acquisition Corp. was merged with and into Saros, with Saros surviving as a wholly-owned subsidiary of the Company. The Saros stockholders received an aggregate of approximately 1.9 million shares of the Company's common stock and approximately 337,000 options to purchase the Company's common stock in exchange for all of their Saros stock and options. Approximately 188,000 of the total number of the Company's shares issued to the Saros stockholders (the "Saros Escrow Shares") were placed in an escrow account upon consummation of the Saros Acquisition. Pursuant to the escrow agreement entered into by the Company, the stockholders' agent and the escrow agent, the Company may recover from the escrow up to the entire amount of Saros Escrow Shares in the event the Company incurs any loss, expense, liability or other damages (collectively, "Damages") due to a breach by Saros of any of its representations, warranties and covenants in the Saros Merger Agreement in the event Damages exceed $1.0 million in the aggregate. The Company believes it has certain claims for damages and intends to make a claim against all or a portion of the Saros Escrow Shares. The Saros Acquisition was accounted for as a pooling-of-interests for financial reporting purposes. The pooling-of-interests method of accounting is intended to present as a single interest two or more common stockholders' interests which were previously independent; accordingly, the historical financial statements for the periods prior to the acquisition have been restated as though the companies had been combined. Saros Acquisition fees and expenses aggregating $4.2 million were expensed in the first quarter of 1996. Included in the charges are professional fees, write-off of certain contractual obligations and settlement costs, write-off of certain fixed assets (including redundant hardware and software systems) and other integration costs. Net revenue, net income (loss) and net income (loss) per share of the companies for the years ended December 31, 1995 and January 1, 1995 are as follows:
(In thousands, except per share amounts) 1995 1994 Net revenue FileNet $215,477 $176,924 Saros 13,901 15,411 -------- -------- Combined $229,378 $192,335 ======== ======== Net income (loss) FileNet $ 14,830 $ 13,263 Saros (6,614) 880 -------- -------- Combined $ 8,216 $ 14,143 ======== ======== Net income (loss) per share FileNet $ 0.94 $ 0.89 Saros (0.42) 0.06 -------- -------- Combined $ 0.52 $ 0.95 ======== ========
Acquisition of International Financial Systems, Ltd. On January 30, 1996, the Company purchased for cash all of the outstanding shares of IFSL, the developer of a COLD software product for archiving documents. The acquisition was accounted for as a purchase, and the purchase price was allocated to net assets of $1.7 million and in-process research and development costs of $10.0 million. Acquisition of Watermark Software Inc. In August 1995, the Company acquired Watermark by issuing approximately 1.3 million shares of FileNet common stock in exchange for all of the outstanding shares of Watermark. The transaction was accounted for as a pooling-of-interests for financial reporting purposes. Fees and expenses of $6.4 million before tax, related to the merger and consolidation of the two companies, were expensed in the third quarter of 1995. Restructuring Costs The Company incurred a $1.8 million restructuring charge in the first quarter of 1996. At December 31, 1996, accrued restructuring costs of $1.3 million is included in other accrued liabilities. The Company anticipates that the remaining restructuring costs will be paid during 1997. Note 3: Inventories Inventories consist of the following at December 31, 1996 and December 31, 1995:
(In thousands) 1996 1995 Raw materials $2,606 $3,418 Work-in-process 2,648 1,147 Finished goods 3,540 2,055 ------ ------ Total $8,794 $6,620 ====== ======
Note 4: Property and Leases Property consists of the following at December 31, 1996 and December 31, 1995:
(In thousands) 1996 1995 Machinery, equipment and software $ 66,404 $ 67,115 Furniture and fixtures 9,242 7,541 Leasehold improvements 5,120 3,502 -------- -------- Total 80,766 78,158 Less accumulated depreciation and amortization (52,437) (52,362) -------- -------- Property, net $ 28,329 $ 25,796 ======== ========
The Company leases its corporate office, sales offices, manufacturing facilities, and other equipment under noncancelable operating leases, some of which have renewal options and generally provide for escalation of the annual rental amount. Expenses related to operating leases were $9.6 million, $9.3 million, and $8.1 million during the years ended December 31, 1996, December 31, 1995, and January 1, 1995, respectively. The following table summarizes future minimum lease payments required under operating leases:
Fiscal year (In thousands) 1997 $10,171 1998 7,290 1999 4,843 2000 2,884 2001 1,532 Thereafter 1,713 ------- Total $28,433 =======
Note 5: Borrowing Arrangements The Company has a $20 million commercial line of credit which expires in April 1997. Borrowings under the arrangement are unsecured and bear interest at the bank's prime rate. The Company is restricted from paying dividends during the term of the arrangement and, under the arrangement, must comply with certain covenants, including quarterly and annual profitability covenants. The Company was in compliance with such covenants as of December 31, 1996 after consideration of a waiver received related to the purchase of treasury shares. The Company expects to renew or replace the line of credit under a similar arrangement in 1997. The Company has four additional borrowing arrangements with foreign banks, which expire at various times during 1997, under which the Company may borrow up to approximately $2 million. Borrowings under these arrangements bear interest at the various banks' prime rates plus 0.75% to 1.5%. Of the $2 million approximately $1 million may be borrowed on an unsecured basis, while the remaining $1 million is collateralized by cash deposits with the bank. There were no borrowings outstanding under any of the arrangements at December 31, 1996 and December 31, 1995. Interest expense was $443,000, $288,000 and $193,000 for the years ended December 31, 1996, December 31, 1995, and January 1, 1995, respectively. Note 6: Stockholders' Equity In October 1988, FileNet declared a dividend of one common stock purchase right for each outstanding share of common stock. Under certain circumstances, a right may be exercised to purchase one share of common stock at an exercise price of $55, subject to certain antidilution adjustments. The rights become exercisable if and when a person (or group of affiliated or associated persons) acquires 25% or more of FileNet's outstanding common stock, or announces an offer that would result in such person acquiring 30% or more of FileNet's common stock. After the rights become exercisable, each right will entitle its holder to buy a number of shares of FileNet's common stock having a market value of twice the exercise price of the rights. After the rights become exercisable, if FileNet is a party to certain merger or business combination transactions or transfers 50% or more of its assets or earnings power (as defined), each right will entitle its holder to buy a number of shares of common stock of the acquiring or surviving entity having a market value of twice the exercise price of the right. The rights expire November 17, 1998 and may be redeemed by FileNet at one cent per right at any time before a person has acquired 25% or more of FileNet's common stock. Treasury Stock During 1996, the Company purchased 200,000 shares of its common stock at an aggregate cost of $4.6 million. Employee Qualified Stock Purchase Plan In March 1988, FileNet adopted the 1988 Employee Qualified Stock Purchase Plan and reserved 450,000 shares of its common stock for purchases under the plan. Under the terms of the plan, options to purchase common stock may be granted in successive six-month offering periods to eligible employees of the Company at 85% of the lower of the market price of the common stock at the date of grant or at the date of exercise. The plan covers substantially all domestic employees of the Company. Each participant is limited in any plan year to the acquisition of that number of shares which have an aggregate fair market value of not more than $25,000. There are no charges or credits to income in connection with the plan. At December 31, 1996, $341,000 had been withheld from employees pursuant to the plan to exercise options to purchase common stock at the lower of $21.25 per share or 85% of the fair market value of common stock at March 31, 1997. Stock Option Plans In November 1983, the Company adopted the 1983 Incentive Stock Option Plan under which options to purchase an aggregate of 400,000 shares of the Company's common stock were granted to officers and employees. There were no options exercisable as of December 31, 1996. Options to purchase 1,850 common shares were exercisable as of December 31, 1995. This plan was terminated in March 1988 with respect to future option grants. Options granted became exercisable in 20% installments beginning one year from the date of grant and expired ten years from the date of grant. The exercise price of all options granted was the fair market value of the common stock at the date of grant. In April 1986, the Company adopted the 1986 Stock Option Plan. Under the amended terms of the 1986 plan, options to purchase 3,250,000 shares of the Company's common stock were available for issuance to employees, officers, and directors. Options to purchase 821,548 and 666,791 common shares were exercisable at December 31, 1996 and December 31, 1995, respectively. In May 1995, the 1986 plan was terminated and the remaining reserve of 70,049 shares was rolled into the 1995 Stock Option Plan and no common shares are available for future grants under the 1986 plan. Options granted are either incentive stock options or non-qualified stock options. Options granted become exercisable in 20% installments beginning one year after the date of grant, as determined by the Board of Directors, and expire no later than ten years plus one day from the date of grant. The exercise price of the incentive stock options and non-qualified options may not be less than 100% and 85%, respectively, of the fair market value of the Company's common stock at the date of grant. In May 1995, the Company adopted the 1995 Stock Option Plan and reserved 350,000 shares of common stock for issuance under the terms of the Plan. This reserve was added to the 70,049 shares of common stock then available under the 1986 Stock Option Plan (the "Predecessor Plan"). Outstanding options under the Predecessor Plan will continue to be governed by the provisions of the agreements evidencing those grants. To the extent any of those outstanding options terminate or expire prior to exercise, the shares subject to those unexercised options will be available for subsequent option grant pursuant to the provisions of the 1995 Plan. As of December 31, 1996, 309,130 options of the Predecessor Plan had been terminated and were rolled into the 1995 Plan. Options granted under the Plan's Discretionary Option Grant Program for employees and the Automatic Option Grant Program for directors have an exercise price per share of 100% of the fair market value per share on the grant date and become exercisable in 25% installments beginning one year from the date of grant. As of December 31, 1996, 1,867,915 options had been granted (including 530,571 under the cancellation/regrant program discussed below) and 52,173 options were exercisable under the Plan. Prior to the merger, Watermark had adopted the 1993 Stock Incentive Plan. The Watermark Plan was assumed by FileNet and outstanding options under the Watermark Plan were converted into options to purchase an aggregate of 151,075 shares of FileNet's common stock at a price equivalent (after conversion) to the original grant price (which was not less than the estimated fair value of Watermark common stock at the grant date). Outstanding options under the Watermark Plan will continue to be governed by the provisions of the agreements evidencing those grants. To the extent any of those outstanding options terminate or expire prior to exercise, the shares subject to those unexercised options will not be available for subsequent option grant. Options granted become exercisable in 20% installments one year from date of grant and in additional 5% installments for each full three-month period thereafter. At December 31, 1996, a total of 30,813 options were outstanding and 15,808 were exercisable. Prior to the merger, Saros had adopted the 1988 Restated Stock Option Plan. The Saros Plan was assumed by FileNet and outstanding options under the Saros Plan were converted into options to purchase an aggregate of 336,913 shares of FileNet's common stock at a price equivalent (after conversion) to the original grant price (which was not less than the estimated fair value of Saros common stock at the grant date). Outstanding options under the Saros Plan will continue to be governed by the provisions of the agreements evidencing those grants. To the extent any of those outstanding options terminate or expire prior to exercise, the shares subject to those unexercised options will not be available for subsequent option grant. Options granted may be either incentive stock options or non-qualified stock options and are exercisable over a period of four years. The initial option granted to the optionee becomes exercisable on the ninth month of the anniversary date of hire at a rate of 18.75% and each month thereafter at the rate of 2.0833%. Options granted following the initial option grant become exercisable at the rate of 2.0833% for each month from grant date. At December 31, 1996, a total of 183,922 shares were outstanding and 135,344 were exercisable. In December 1989, the Company adopted the 1989 Stock Option Plan for Non-Employee Directors. Under the terms of the plan, as amended, each FileNet director who was not an employee was automatically granted an initial option to purchase 10,000 shares of FileNet's common stock at its fair market value on the date of grant and was granted an additional option to purchase 3,500 shares every year following the initial grant, provided such person continued to be a director at such time. Options granted under the plan vested at the rate of 20% per year from the grant date. Options to purchase an aggregate of 70,000 shares at prices ranging from $11.50 to $32.69 per share were granted from December 18, 1989 to May 24, 1995. At December 31, 1996, options to purchase 26,000 shares of common stock were exercisable and 20,000 have been exercised to date. This plan was terminated in May 1995 with respect to future option grants. Future grants to non-employee directors are granted under the provisions of the 1995 Stock Option Plan. On August 8, 1996 the Company approved a stock option cancellation/regrant program (the "Program") which allowed employees, excluding all directors and reporting officers defined in Section 16 of the Securities Exchange Act of 1934 as amended, to exchange options with an exercise price greater than $26.00 for new options. Outstanding options of 530,571 shares were canceled and regranted at $26.00 per share, the current market value on August 8, 1996. Under the Program, the regranted options are considered granted on August 8, 1996 and are exercisable prospectively in accordance with the provisions of the agreements evidencing those grants. Information regarding the stock option plans, after giving retroactive effect to the conversions of the Watermark and Saros stock options on their original grant dates, is as follows:
Number of Weighted average options exercise price Balances, January 2, 1994 2,355,386 $13.03 Granted 729,433 $20.84 Exercised (325,882) $10.80 Canceled (154,763) $16.07 ---------- ------ Balances, January 1, 1995 2,604,174 $15.27 Granted (weighted average fair value of $14.68) 771,674 $30.41 Exercised (542,142) $13.78 Canceled (130,597) $19.51 ---------- ------ Balances, December 31, 1995 2,703,109 $19.68 Granted (weighted average fair value of $14.96) 1,362,418 $36.65 Exercised (398,041) $ 8.37 Canceled (866,603) $43.34 ---------- ------ Balances, December 31, 1996 2,800,883 $22.22 ========== ======
The following table summarizes information concerning currently outstanding and exercisable options:
Options outstanding Options exercisable ----------------------------------------------- ----------------------------- Weighted average Range of exercise Number remaining Weighted average Number Weighted average prices outstanding contractual life exercise price exercisable exercise price $ 0.06 - $20.00 1,054,328 5.69 $11.75 717,600 $11.11 $20.00 - $30.00 1,256,083 8.49 $24.96 255,465 $23.23 $30.00 - $40.00 295,922 8.95 $34.34 37,348 $32.29 $40.00 - $50.00 164,550 8.95 $40.83 41,700 $40.87 $50.00 - $64.42 30,000 9.34 $54.08 - - --------- --------- $ 0.06 - $64.42 2,800,883 1,052,113 ========= =========
As discussed in Note 1, the Company continues to apply APB No. 25, "Accounting for Stock Issued to Employees," and related interpretations in accounting for its plans. Accordingly, no compensation expense has been recognized for its stock-based compensation plans. Had compensation cost for the Company's stock-based compensation plans been determined based on the fair market value at the grant dates for awards under those plans consistent with the method of SFAS No. 123, "Accounting for Stock-Based Compensation," the Company's net income (loss) and net income (loss) per share would have changed to the pro forma amounts indicated below:
(In thousands, except per share amounts) 1996 1995 Net income (loss) - as reported $(2,644) $8,216 Net income (loss) - pro forma (7,320) 7,273 Net income (loss) per share - as reported (0.18) 0.52 Net income (loss) per share - pro forma (0.49) 0.46
The fair value of each option grant was estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions used for grants in 1996 and 1995: expected volatility of 60%, risk-free interest rates of 5.9% to 6.9%, and an expected life of 1 year from vest date. Pro forma compensation cost of options granted under the Employee Qualified Stock Purchase Plan is measured based on the discount from market value. Watermark Common and Redeemable Convertible Preferred Stock On August 18, 1995, Watermark's capitalization consisted of common stock and Series A through C of Redeemable Convertible Preferred Stock ("Watermark Preferred Stock"). In May 1994, Watermark converted certain then outstanding common stock into Watermark Preferred Stock in connection with a financing. Upon conversion of the outstanding shares of Watermark Preferred Stock, the preferred stockholders were entitled to receive from Watermark the then current liquidation amount per share of Watermark Preferred Stock as stated in the Watermark Articles of Incorporation. Saros Common and Convertible Preferred Stock On March 1, 1996, Saros' capitalization consisted of common stock and Series A through E Convertible Preferred Stock ("Saros Preferred Stock"). The Saros Preferred Stock gave certain rights to the holders, was noncumulative, and was convertible, at the option of the holder, into an equal number of shares of common stock. Each share of Saros Preferred Stock had voting rights equivalent to those of the common shareholders and a conversion right that allowed them to convert outstanding shares of Saros Preferred Stock into common stock. Upon conversion of the outstanding shares of Saros Preferred Stock, the preferred stockholders were entitled to receive from Saros the liquidation amount ranging from $.33 to $1.875 per share. Note 7: Income Taxes The provision for income taxes consists of the following:
(In thousands) Years ended December 31, 1996, December 31, 1995 and January 1, 1995 1996 1995 1994 Current: Federal $2,930 $4,017 $3,200 State 75 867 514 Foreign 2,241 2,458 1,202 Deferred: Federal (772) 834 441 State (18) (60) (1) ------ ------ ------ Total provision $4,456 $8,116 $5,356 ====== ====== ======
A reconciliation of the Company's effective tax rate compared to the statutory federal tax rate is as follows:
Years ended December 31, 1996, December 31, 1995 and January 1, 1995 1996 1995 1994 Income taxes at statutory federal rate 35% 35% 35% State taxes, net of federal benefit 4 5 2 Unbenefited/utilized domestic losses 42 21 2 Foreign tax rate differential/unbenefited losses (130) (14) (13) Non-deductible acquisition costs 291 5 - Other 4 (2) 1 ---- --- --- Total 246% 50% 27% ==== === ===
The Company provides deferred income taxes for temporary differences between assets and liabilities recognized for financial reporting and income tax purposes. The income tax effects of these temporary differences representing significant portions of the deferred taxes at December 31, 1996 and December 31, 1995 are as follows:
(In thousands) Years ended December 31, 1996 and December 31, 1995 1996 1995 Deferred taxes: Foreign loss carryforwards $ 1,445 $ 975 Domestic loss carryforwards 9,198 9,479 Tax credit carryforwards 1,954 1,579 Accrued expenses 1,745 1,851 Inventory reserves 241 232 Sales returns and allowance reserves 1,359 1,169 Capitalized software (206) (783) Depreciable assets 802 (131) Residual U.S. tax on foreign earnings (3,710) (2,027) Other 2,420 2,105 ------ ------ Total 15,248 14,449 ------ ------ Valuation allowance (13,012) (13,003) ------ ------ Net deferred tax asset $ 2,236 $ 1,446 ======== =========
The Company has an approximate $27 million loss carryforward related to Watermark and Saros which can be used to reduce future taxable income. Sections 382 and 383 of the Internal Revenue Code of 1986 place certain limitations on the use of these acquired losses. A maximum of $18 million of the net operating loss carryforward can be utilized in 1997, and if not utilized, will carryforward to 1998 and subsequent years. The remaining $9 million of the net operating loss carryforward will be available in 1998 and, if not utilized, will carryforward to subsequent years. Any net operating loss carryforward not utilized will begin expiring in 2004. The Company has an approximate $2 million tax credit carryforward which will expire beginning in 2004. Utilization of the loss and credit carryforwards will result in a reduction of income tax expense. A valuation allowance has been established for 100% of the net deferred tax assets related to Watermark and Saros. The Company has not provided any residual U.S. tax on approximately $15 million of a portion of the Company's foreign subsidiaries' undistributed earnings as the Company intends to indefinitely reinvest such earnings. At December 31, 1996, the Company had Dutch, UK and French subsidiary tax loss carryforwards relating to its foreign subsidiary operations of $1.8 million, $1.8 million and $0.7 million, respectively, as well as other immaterial foreign tax loss carryforwards. The Dutch and UK tax loss carryforwards have no expiration. The French losses will begin to expire in 1997. Valuation allowances have been established for 100% of the foreign tax loss carryforwards. Note 8: Development Contracts The Company has entered into development contracts in 1996 and prior years with third parties under which the Company receives funding for certain development activities. Cumulatively through December 31, 1996, $5.6 million of expenses related to the development activities had been funded under this arrangement. The Company has also incurred aggregate royalty expenses of $3.8 million through December 31, 1996 to one of the third parties based on shipments of the related products. Note 9: Geographical Information
(In thousands) Years ended December 31, 1996, December 31, 1995 and January 1, 1995 1996 1995 1994 Revenue United States* Customers $174,618 $155,728 $137,420 Intercompany 23,355 14,597 14,180 -------- -------- -------- Total 197,973 170,325 151,600 Europe* Customers 83,786 67,916 49,725 Intercompany 15,815 11,448 6,825 -------- -------- -------- Total 99,601 79,364 56,550 Other Customers 10,509 5,734 5,190 Intercompany 1,794 2,086 496 -------- -------- -------- Total 12,303 7,820 5,686 Eliminations (40,964) (28,131) (21,501) -------- -------- -------- Total revenue $268,913 $229,378 $192,335 ======== ======== ======== Operating income (loss) United States** $(18,588) $ 369 $ 14,408 Europe** 17,680 12,589 3,051 Other 1,691 629 234 Eliminations (1,809) (35) (15) -------- -------- -------- Total operating income (loss) $ (1,026) $ 13,552 $ 17,678 ======== ======== ======== Assets United States $132,781 $151,929 $123,716 Europe 56,971 38,993 31,278 Other 6,043 2,672 3,124 Eliminations (116) (3,912) (5,476) -------- -------- -------- Total assets $195,679 $189,682 $152,642 ======== ======== ========
*U.S. revenue includes hardware sales to third-party international resellers. European revenue includes software sales to all third-party international resellers. **U.S. operating income includes $16.0 million in 1996 and $3.9 million in 1995 for merger, restructuring and write-off of purchased in-process research and development costs and European operating income includes $2.5 million for merger and other costs in 1995. For all years presented, U.S. operating income (loss) includes certain corporate expenses such as research and development, marketing communications and corporate administration and European and other operating income includes international headquarters expenses. Note 10: Contingencies In October 1994, Wang Laboratories, Inc. ("Wang") filed a complaint in the United States District Court for the District of Massachusetts alleging that the Company is infringing five patents held by Wang. On June 23, 1995, Wang amended its complaint to include an additional related patent. On July 2, 1996, Wang filed a complaint in the same court alleging that Watermark, formerly a wholly-owned subsidiary that was merged into the Company, is infringing three of the same patents asserted in the initial complaint. On October 9, 1996, Wang withdrew its claim that one of the patents it initially asserted is infringed by the Company's products which were commercialized before the initial complaint was filed. Wang reserved the right to assert that patent against the Company's products commercialized after that date in a separate lawsuit. Based on the Company's analysis of these Wang patents and their respective file histories, the Company believes that it has meritorious defenses to Wang's claims; however, the ultimate outcome or any resulting potential loss cannot be determined at this time. In January 1997, Wang and Eastman Kodak Company ("Kodak") announced that they have entered into an agreement under which Kodak will acquire the Wang business unit that has responsibility for this litigation. The acquisition is scheduled to close in March-April 1997 and the Company cannot predict what, if any, impact this will have on the litigation. If it should be determined that the patents at issue in the litigation are valid and are infringed by any of the Company's products, including Watermark products, the Company will, depending on the product, redesign the infringing products or seek to obtain a license to market the products. There can be no assurance that the Company will be able to obtain such a license on acceptable terms. On December 20, 1996, plaintiff Michael I. Goldman filed a class action complaint against the Company and certain of its officers and directors in the Superior Court of California, County of Orange. The action was purportedly filed on behalf of a class of purchasers of the Company's common stock during the period October 19, 1995 through July 2, 1996. Plaintiff alleges that the Company and other defendants violated Cal. Corp. Code Sections 25400 and 25500, Cal. Civ. Code Sections 1709-1710 and Cal. Bus. & Prof. Code Sections 17200 et seq. in connection with various public statements made by the Company and certain of its officers and directors during the putative class period. The complaint seeks unspecified compensatory and punitive damages, interest, payment of attorney's fees and costs, and equitable or injunctive relief; however, at this time it is not possible to determine the potential liability, if any. The Company has not yet responded to the complaint. The Company believes the complaint is without merit and intends to defend the action vigorously. The Company, in the normal course of business, is subject to various other legal matters. While the results of litigation and claims cannot be predicted with certainty, the Company believes that the final outcome of these other matters will not have a materially adverse effect on the Company's consolidated results of operations or financial condition. Note 11: Related Party Transaction Watermark originally entered into a republishing and distribution agreement with a UK company (the "Distributor") which provided the Distributor with exclusive distribution rights of Watermark's products in defined territories. The Chief Executive Officer of the Distributor is the brother of Watermark's then President and Chief Executive Officer. During 1995, Watermark elected to purchase the portion of the Distributor's business related to selling Watermark's products at a negotiated price of $2.5 million which is included in merger and other costs in 1995. Note 12: Quarterly Financial Information (Unaudited)
(In thousands, except per share amounts) Year ended December 31, 1996 First Second Third Fourth Fiscal quarter* quarter quarter* quarter year Revenue $66,744 $64,997 $64,622 $72,550 $268,913 Income (loss) before income taxes (10,417) 3,351 4,575 4,303 1,812 Net income (loss) (11,820) 2,513 3,431 3,232 (2,644) Net income (loss) per share $ (0.79) $ 0.15 $ 0.22 $ 0.20 $ (0.18) Year ended December 31, 1995 Revenue $48,421 $56,121 $57,098 $67,738 $229,378 Income (loss) before income taxes 4,842 3,354 (644) 8,780 16,332 Net income (loss) 3,149 1,331 (1,466) 5,202 8,216 Net income (loss) per share $ 0.20 $ 0.09 $ (0.10) $ 0.32 $ 0.52
*Includes a one-time after-tax charge of $16.0 million in the first quarter of 1996 and $5.0 million in the third quarter of 1995 for merger, restructuring and write-off of purchased in-process research and development costs. Independent Auditors' Report To the Stockholders and Board of Directors of FileNet Corporation: We have audited the accompanying consolidated balance sheets of FileNet Corporation and its subsidiaries as of December 31, 1996 and December 31, 1995, and the related consolidated statements of operations, stockholders' equity, and cash flows for the years ended December 31, 1996, December 31, 1995, and January 1, 1995. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of FileNet Corporation and its subsidiaries as of December 31, 1996 and December 31, 1995 and the results of their operations and their cash flows for the years ended December 31, 1996, December 31, 1995, and January 1, 1995 in conformity with generally accepted accounting principles. /S/ Deloitte & Touche LLP February 10, 1997 Costa Mesa, California EX-13.4 8 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Note 11: Related Party Transaction Watermark originally entered into a republishing and distribution agreement with a UK company (the "Distributor") which provided the Distributor with exclusive distribution rights of Watermark's products in defined territories. The Chief Executive Officer of the Distributor is the brother of Watermark's then President and Chief Executive Officer. During 1995, Watermark elected to purchase the portion of the Distributor's business related to selling Watermark's products at a negotiated price of $2.5 million which is included in merger and other costs in 1995. EX-21.1 9 LIST OF SUBSIDIARIES OF REGISTRANT FILENET CORPORATION SUBSIDIARY INFORMATION FileNet International Corporation (Virgin Islands) FileNet Corporation International (Delaware) FileNet Limited (United Kingdom) FileNet Canada, Inc. FileNet Company Limited (Ireland) FileNet GmbH (Germany) FileNet Corporation Europe, EURL (France) FileNet Corporation, Pty. Ltd. (Australia) FileNet KK (Japan) FileNet Asia Pacific, Pte. Ltd. (Singapore) International Financial Systems Limited (New York) EX-23.1 10 AUDITORS' CONSENT Exhibit 23.1 INDEPENDENT AUDITORS' CONSENT We consent to the incorporation by reference in Registration Statement Numbers 33-90454, 33-96076, 33-80899, 333-02194 and 333-09075 on Form S-8 of our report dated February 10, 1997 appearing in and incorporated by reference in the Annual Report on Form 10-K of FileNet Corporation for the fiscal year ended December 31, 1996. /s/ Deloitte & Touche LLP Costa Mesa, California March 25, 1997 EX-27 11 FINANCIAL DATA SCHEDULE
5 1,000 Year Dec-31-1996 Dec-31-1996 28,530 22,037 75,469 0 8,794 148,807 80,766 52,437 195,679 59,468 0 0 0 123,245 9,561 195,679 186,795 268,913 46,097 99,665 170,274 0 0 1,812 4,456 (2,644) 0 0 0 (2,644) (0.18) (0.18)
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