-----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, Duv0QeTI9h2qakUIkSJkZiJ/GUMq1hZXOyUYZdY3CZIqc0Elf7RnR04FHfuMcYS/ tisfIIZyHcKhtZw4wePYmg== 0000950135-98-002069.txt : 19980401 0000950135-98-002069.hdr.sgml : 19980401 ACCESSION NUMBER: 0000950135-98-002069 CONFORMED SUBMISSION TYPE: 10-K405 PUBLIC DOCUMENT COUNT: 8 CONFORMED PERIOD OF REPORT: 19971231 FILED AS OF DATE: 19980331 SROS: NASD FILER: COMPANY DATA: COMPANY CONFORMED NAME: PROTEON INC/MA CENTRAL INDEX KEY: 0000874316 STANDARD INDUSTRIAL CLASSIFICATION: COMPUTER COMMUNICATIONS EQUIPMENT [3576] IRS NUMBER: 042531856 STATE OF INCORPORATION: MA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K405 SEC ACT: SEC FILE NUMBER: 000-19175 FILM NUMBER: 98581280 BUSINESS ADDRESS: STREET 1: NINE TECHNOLOGY DRIVE CITY: WESTBOROUGH STATE: MA ZIP: 01581 BUSINESS PHONE: 5088982800 MAIL ADDRESS: STREET 1: 9 TECHNOLOGY DR CITY: WESTBOROUGH STATE: MA ZIP: 01581 10-K405 1 PROTEON, INC. 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K (MARK ONE) [ x ] ANNUAL REPORT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1997 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period___________ to ____________. Commission File Number 0-19175 PROTEON, INC. (Exact name of registrant as specified in its charter) MASSACHUSETTS 04-2531856 ------------- ----------- (State or other jurisdiction of (I.R.S. Employer Identification Number) incorporation or organization) NINE TECHNOLOGY DRIVE, WESTBOROUGH, MA 01581 - -------------------------------------- ----- (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (508) 898-2800 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: COMMON STOCK, $.01 PAR VALUE ---------------------------- 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 report(s), and (2) has been subject to such filing requirements for the past 90 days. YES X NO Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X] Aggregate market value of Registrant's voting stock held by non-affiliates of the Registrant as of March 12, 1998; $16,252,911 (without admitting that any person whose shares are not included in determining such value is an affiliate). Indicate the number of shares outstanding of each of the Registrant's classes of common stock as of the latest practicable date. Shares of Common Stock outstanding as of March 12, 1998: 15,296,857. DOCUMENTS INCORPORATED BY REFERENCE Portions of the Registrant's Annual Report to Shareholders for the Company's fiscal year ended December 31, 1997 (the "1997 Annual Report") are incorporated by reference into Parts II and IV of this Report and portions of the Registrant's Proxy Statement for its 1998 Annual Meeting of Shareholders to be held on May 27, 1998 (the "1998 Proxy Statement") are incorporated by reference into Part III of this Report. With the exception of those portions of the 1997 Annual Report and 1998 Proxy Statement expressly incorporated in this Report by reference, such documents shall not be deemed filed as part of this Report. 2 PART I ITEM 1. GENERAL BUSINESS COMPANY OVERVIEW - ---------------- Proteon, Inc. (together with its subsidiaries, including "OpenROUTE Networks, Inc.," "Proteon," or "the Company") is known worldwide as a pioneer in the multi-billion dollar data communications industry. Proteon and its wholly owned subsidiary, OpenROUTE Networks Inc., have distinguished themselves as leaders in helping customers with network connectivity, and now, in particular, with connectivity from what is commonly referred to as the network edge. For more than 17 years, Proteon has shipped network connectivity products that have helped customers grow and prosper through deploying network-centric computing. Historically, Proteon local area networking (LAN) products have provided connectivity solutions in more than 70 percent of the Fortune 100 companies. Leveraging this expertise in mission-critical network solutions, Proteon has now started to aggressively deliver this same quality of product and service for Internet and Intranet connectivity. The Company is committed to providing complete network access solutions that make networks more accessible, secure, easier to use, manage, and operate. The Company's comprehensive line of network access solutions includes products for Internet and Intranet access, and supports small- to medium-sized enterprise businesses and large corporations that outsource to network service providers. The Company was incorporated in Massachusetts in January 1974 as Proteon Associates, Inc. The Company changed its name to Proteon, Inc. in July 1983. Its executive offices are located at Nine Technology Drive, Westborough, Massachusetts, 01581, and its telephone number at that location is (508) 898-2800. The Company's testing and final-assembly facilities are located at the same address. In January 1997, the Company announced the formation of a new wholly owned subsidiary named OpenROUTE Networks, Inc. ("OpenROUTE Networks"). This new subsidiary was incorporated in the state of Delaware. Going forward, the Company intends to focus its business on markets served by this new subsidiary. OpenROUTE Networks' markets encompass the fast growing Internet and Intranet segments of the overall networking industry. For Internet and Intranet connections, OpenROUTE Networks' products combine cost effectiveness with ease of operation, interoperability, network security, reliability and performance. The Company's customers include both the Global 1000 multinationals, as well as those small to medium-sized enterprises requiring connections to the Internet and to suppliers, customers, and business partners. Proteon, Inc.'s customers encompass local area networking sites that implement the Token Ring network topology. During the second half of 1997, the Company aggressively redefined its business strategy for its OpenROUTE Networks subsidiary. The new market opportunity for OpenROUTE Networks can best be described as the connection of businesses and institutions to public network services such as the Internet. The Company believes that this market -- which is expected to be the focus of the Company's energy throughout 1998 -- is just beginning to emerge. The Company believes there are two main segments of this market. The first addresses the connecting of a new generation of small- to medium-sized business users who do not have a network today, but will use a public network service to extend their competitive advantage and to transact business with each other. The Yankee Group, a leading market research group based in Boston, Massachusetts, has estimated that on a worldwide basis there are more than 10 million businesses with fewer than 500 employees. The second target is the outsourcing of networks from the traditional corporate MIS manager to an outside provider such as MCI, Sprint, Worldcom, PSINet, UUNet, or the Bell operating companies. Outsourcing allows the corporate enterprise to focus on its core business, and not the operation of the network. Corporations do not manage their own phone network, and the Company believes that they are beginning to realize that their data networks can be viewed in the same fashion. The Company believes that selling its customer premise equipment to these major outsourcing providers is another powerful way to grow the OpenROUTE Networks brand name. 3 NETWORKING INDUSTRY The data communications industry continues to undergo a fundamental shift away from hierarchical single-vendor systems to open, peer-to-peer communications networks and information management tools that provide users with greater computing power and access to information. This evolution has fostered the growth of two dynamic markets: workstations and networking. Workstations deliver increasingly powerful, personal productivity tools, and data communications networks provide the "highways" that distribute and share this processing power throughout an organization. This enables users to more fully leverage and manage information resources. The peer-to-peer evolution has created an increased demand for client/server based applications. The first impact of client/server based networks is the increasing demand for inexpensive, easy to use, remote access routers. Remote offices can now access corporate databases while running local application programs. In addition, users are now gaining access to previously unreachable resources including the Internet, corporate headquarters and other remote sites. Any LAN-attached workstation with Internet Protocol (IP) client software can send and receive electronic mail, access public databases worldwide, share files and programs through File Transfer Protocol (FTP), participate in thousands of business and consumer-related newsgroups, and easily browse the massive quantities of information available on the World Wide Web. The Company believes its OpenROUTE Networks products address the needs of this marketplace. FORMATION OF NEW SUBSIDIARY The formation of the new OpenROUTE Networks subsidiary is in keeping with the Company's strengthened focus on the rapidly growing market for Internet and Intranet connectivity. The Company defines Internet as a "public" network accessible by all audiences, and the Intranet as a "private," secure network with Internet-like characteristics that is most often used only by the employees of a specific company or organization. OpenROUTE Networks is focusing on the development, marketing and distribution of the Company's award-winning GT and GTX Internet access router products and the new Dragon series of Internet connectivity devices. The new subsidiary was formed to bring together the Company's resources on the GT family of high-performance, low-cost Internet Access routers and the ongoing licensing of its OpenROUTE internetworking software suite. The name OpenROUTE Networks is intended to reflect the Company's specific emphasis in the Internet Access marketplace. In conjunction with the establishment of this new subsidiary, the Company in 1997 also unveiled a new corporate logo. The new logo is being used in a corporate branding campaign to better position GT and GTX products in the market for Internet access connectivity, and Dragon products for eventual sale at the retail level. The new name also reflects the "open" nature of the public Internet. OpenROUTE Networks has a multi-faceted sales strategy to meet the growing need to connect hundreds of thousands of organizations to the Internet in a cost-effective and secure manner. A major OpenROUTE Networks sales thrust is to focus on key and emerging product features for Internet Service Providers (ISPs) and service providers which include ISPs, carriers and telcos among their customers. PSINet, Inc., of Herndon, Virginia, one of the largest independent ISPs in North America, has been a large customer of OpenROUTE Networks for more than 18 months. Other significant ISP partners announced in 1997 included Ultranet Communications and IDT Corporation. The Company continues to seek partnerships with other large ISPs. 4 OpenROUTE Networks also markets products through OEM relationships. Digital Equipment Corporation's Networking Division (now owned by Cabletron, Inc.) and Nippon Telegraph and Telephone's (NTT) Advanced Technology Division currently resell Proteon's GT Internet Access routers under their own brand names. A business goal of OpenROUTE Networks is to announce other OEM relationships during 1998. OpenROUTE Networks also sells Internet Access products through some of the world's largest distributors such as Tech Data Corp. and Ingram Micro. In addition, Value Added Resellers (VARs), including Racal Data Group, actively market GT and GTX products in most domestic and international markets. OpenROUTE Networks is targeting major sales in markets such as government, financial services, health care, education, publishing, manufacturing, insurance, professional services, libraries and entertainment through its service provider partners. SIGNIFICANT EXECUTIVE APPOINTMENTS AND CHANGES During the second half of 1997, the Company initiated a program to significantly strengthen its senior management staff. The Company believes this series of appointments will enhance its position in the marketplace, allow for better management of the Company's financial operations, and further strengthen its sales and marketing operations. The Company appointed Steven T. Shedd as Vice President, Finance, Chief Financial Officer, Treasurer and Clerk in July 1997. Prior to joining Proteon, Mr. Shedd served as the Vice President and Chief Financial Officer of Zoom Telephonics since 1996. In 1995 Mr. Shedd was the Vice President and Chief Financial Officer for Versyss, Inc. and from 1992 to 1995 Mr. Shedd served as Vice President and Chief Financial Officer of TSI Corporation. Mr. Eugene Y. Chang joined the Company as Vice President, Marketing in September 1997 from General DataComm Industries, Inc. where he had been serving as Assistant Vice President for Systems and Architectures. From 1995 to early 1997, Mr. Chang was Vice President for Strategic Business Development at Zoom Telephonics. From 1985-1995, Mr. Chang served as Vice President of ISDN/Digital Access Technologies at Microcom, Inc. Mr. Robert A. Koch is presently Vice President, Engineering, Product Planning and Management for the Company, a position he has held since October 1997. Mr. Koch joined the Company in August 1993 as Product Marketing Director and held that position until April 1997. From April 1997 until October 1997, Mr. Koch served as Vice President of Product Planning for the Company. In November 1997, Mr. Kenneth W. Hovaldt joined the Company as Vice President, Sales for the Americas and Canada. From September 1996 to October 1997, Mr. Hovaldt held the position of Vice President, Global Sales for Telco Systems. From 1988 to 1996 Mr. Hovaldt served as Senior Vice President of Marketing, Sales and Business Services for Fijitsu Network Switching of America, Inc. Mr. Jack A. Ritter joined the Company in December 1997 as Vice President, Asia Pacific Operations. Prior to joining Proteon, Mr. Ritter was the Director of Marketing and Sales for the Southeast Asia Trade Alliance since 1995. From 1993 to 1995 Mr. Ritter held the position of Director of Independent Company Sales for Fujitsu Networking Switching of America, Inc. 5 LAN PRODUCTS AGREEMENT In mid-1997, Proteon, Inc. and Microvitec PLC jointly announced the signing of an agreement that provides for Microvitec to resell certain of Proteon's products and obtain intellectual property rights for the Company's Ethernet LAN products, manufacturing licenses, and access to other Proteon resources to develop products and services for the LAN marketplace. Proteon LAN Products are now being sold under the name "Proteon LAN Products by Microvitec," as well as under the "Proteon" nameplate. Microvitec PLC is a publicly listed information technology group based in Bradford, UK, with 1997 annual revenues of approximately 55 million pounds ($91 million U.S.). The group has three divisions - Software, Networking and Displays - - and operations in the UK, Germany, Canada and USA. The Network Division includes companies that supply components to the major LAN equipment manufacturers, manufacturers of Token Ring, Ethernet and wireless LAN products and a large systems integrator. COMMITMENT TO OPEN STANDARDS Proteon and OpenROUTE Networks have always been committed to open, standards-based product offerings. The Company believes that developing products that offer multi-vendor interoperability achieved through leadership in, and adherence to, open networking standards will continue to expand market opportunities for many years to come. Proteon believes that the Company contributes significant technical expertise to the development, promulgation and adoption of key industry standards. From a historical perspective, The Company co-authored both the Simple Network Management Protocol (SNMP) network management standard and the Open Shortest Path First (OSPF) internetwork routing standard. The Company has also developed and shipped an extension to OSPF known as Multicast. Proteon continues to be an active member of the OSPF Interoperability Group, an industry consortium formed to ensure interoperability and further the acceptance of this important standard. The Company has also continued to execute another high-level standards activity as it has aggressively marketed its Data Link Switching (DLSw) technology. DLSw technology, an industry standard, allows the Company's routers to encapsulate Systems 6 Network Architecture (SNA) traffic in IP, thus eliminating the need to have separate backbone networks for SNA and LAN traffic. The implementation of DLSw technology in its routing products continues to give the Company opportunities in larger, headquarters site operations. STRENGTHENING THE INTERNET ACCESS PRODUCT LINE The Company continued to make progress during 1997 in introducing products for the segments of the Internet Access marketplace that it believes are key to its business strategy. During 1997, the Company introduced two new major product lines. At the Networld+Interop trade show in Atlanta, OpenROUTE Networks unveiled the GTX 1000, a new class of modular router that the Company believes leads the industry in price/performance, network security, ease-of-use and management, and investment protection. Designed and engineered to significantly reduce the cost of investment in the essential networking equipment for Internet, Intranet and Wide Area Networking (WAN) Connectivity, the GTX 1000 has a unique design that puts the processing unit, memory, operating system software, and a built-in Ethernet interface in the base unit. Depending on their individual needs, users then select from a wide range of interface modules to be plugged into the three configurable slots. This breakthrough design in a single box gives users the flexibility to mix and match modules and add or change capabilities as their needs change. The Company has applied for a U.S. Patent on the GTX 1000. The GTX 1000 is also the first router in its class to ship with true Virtual Private Network (VPN) functionality. VPNs, which are rapidly driving the global acceptance of Internet commerce, connect sites within an organization's Intranet over a public network such as the Internet. The VPN provides secure connections via data encryption and authentication to guarantee the privacy of the information as it passes over the public network. The GTX 1000 is priced according to the modules selected. The product began shipping in December 1997. When ordering, users can start with a single module and then add other capabilities as their networks grow internally and expand geographically. The GTX 1000 can support up to three "personality modules" including serial interfaces with integrated CSU/DSU technology. ISDN modules are offered in four variations (ISDN "U", ISDN "S/T", ISDN "U" with POTS, and ISDN "S/T" with POTS) and are homologated for worldwide deployment. The GTX 1000 can also support up to three modem modules, including support for 56K. Toward the end of 1997, the Company introduced the Dragon(TM) series of Internet Access devices. The two new Dragon products, which were formally introduced before some 50,000 Internet World attendees in New York City, allow small businesses to connect all their employees to the Internet through one small unit. The base model Dragon features the ultimate in ease-of-use features and the Company believes it is the best value on the market. The Dragon series gives users the cost benefit of connecting their workgroup of PCs to the Internet using a single shared Internet account via a shared modem and one telephone line. Dragon users also have room to grow with an upgrade path to the Dragon Pro. The Dragon Pro is ideal for the professional working at home or in a small office. It features support for inbound calls; support for inbound connections from the Internet; support for personal Web servers and other small office servers; upgradability to dedicated high speed Internet links; and an upgrade path to OpenROUTE Networks' GT Business Series product line. The base model Dragon comes standard with a wide range of software features including TCP/IP, asynchronous dial-up operation, PPP with PAP, CHAP, and compression. A secure Internet connection is provided through Network Address Translation (NAT). The Dragon Pro adds support for synchronous operation and other advanced software features. Both Dragon products feature a 5-year limited warranty. Dragon models, which began shipping in February 1998, are first available from OpenROUTE Networks' Web site (http://www.openroute.com) and specialty catalogs. The Company is also recruiting partners to sell Dragon products through the retail channel. 7 Also during the past year, the Company continued to expand its GT product line. New products included: the GT 65 and GT 75, which provide support for the OSPF protocol; the GTS 100 and GTS 205, more fully functional routers that now include firewall support; the GT 255, a versatile wide area network concentrator; and the GTSecure 250, a high performance LAN to LAN and LAN to WAN firewall router for more complex network connections. MAJOR EMPHASIS ON NETWORK SECURITY AND VIRTUAL PRIVATE NETWORKS The Company has launched a major product marketing effort for network security products. The program has been designed to address the networking marketplace's need for affordable and secure ways of remotely accessing the Internet and corporate Intranets. The Secure Internet/Intranet Program is offered to Internet Service Providers (ISPs), telcos, carriers and end users, and is based on a security hierarchy that recognizes the need for increasingly stronger security mechanisms depending upon the type of user and the type of application. During 1997, OpenROUTE Networks addressed each of those levels of user/application with strategic partnerships and products. Recent industry research indicates that in a drive to achieve greater business success in the face of increasing global competition, Internet and Intranet-based services hold the key for today's virtual organization. Acting as a global backbone, these networks can link branch offices, telecommuters, partners, suppliers or customers directly into the business process. The first product implementation of this program was the GTSecure-60 Firewall Router, a high-performance, cost-effective solution that uniquely integrates both full firewall and routing capabilities into a single product. The Company believes that it was one of the first in the industry to offer this type of integrated security product. Most other solutions call for users to manage security in a separate server environment running expensive security software. The Company believes that its low-cost approach provides adequate network security for most small office users. Key features in the GTSecure-60 include a dynamic firewall capability that restricts access from unauthorized users, a sophisticated filtering system that opens only required ports while adapting to changing network and user activity, and extensive authentication services via industry-standard based RADIUS technology. Later, the Company added the GTSecure-70 Firewall Router to its product line for ISDN connections. In addition, the Company added IP filtering technology and began active participation in testing with the National Computer Security Association. The GTSecure Firewall Routers were subsequently certified by the NCSA. During the spring of 1997, OpenROUTE Networks, Inc. expanded the functionality of its GT line of Internet Access products to include Sun Microsystems' Simple Key Management for IP (SKIP) technology standard. Sun and OpenROUTE Networks also announced plans for future joint sales and marketing activities. OpenROUTE Networks' GTX and GT Business Series VPN solutions are interoperable with other SKIP equipped network devices, including Sun's own SunScreen(TM) SPF and SunScreen(TM) EFS Product lines, as well as the SunScreen(TM) SKIP client software for Solaris and Windows '95 (also available from Sun). The Company believes that customers who wish to communicate with their partners, customers or employees using the scalability, ubiquity, and low costs of the Internet -- but demand industrial grade security -- now have a solution that scales from client software, to the network infrastructure, on into the large scale Intranet servers. The Company believes that the combination of Sun and OpenROUTE Networks technology provides users with seamless, end-to-end network security for privacy on the Internet today. In the fall of 1997, OpenROUTE Networks continued to expand the functionality of its product line by announcing expanded capabilities for its "ALLWays Secure(TM)" network security portfolio. The Company believes that the "ALLWays Secure" portfolio is the industry's broadest program for all-in-one, bulletproof network security. With this new VPN capability, the Company believes OpenROUTE Networks products now offer the most extensive levels of network security including; stateful IP packet inspection, user authentication for Remote Access users under the RADIUS protocol; and a dynamic Internal Firewall capability. 8 INTERNETWORKING SOFTWARE LICENSING WITH OPENROUTE OpenROUTE Networks' world class internetworking software suite -- known as OpenROUTE -- is the foundation of the Company's high performance internetworking solutions. All of OpenROUTE Networks' internetworking products ship with this software technology. The Company has been developing this software suite for approximately 12 years. In the later half of 1994, Proteon began licensing this software. At that time, the Company completed two major internetworking software licensing agreements. These agreements were reached with IBM and Digital Equipment Corporation, two of the world's largest information technology providers. The Company has also licensed its OpenROUTE software to Motorola's Information Systems Group (ISG) and TELDAT, S.A., a leading European networking products vendor headquartered in Madrid, Spain. In late 1997, the Company announced that it had licensed a subset of OpenROUTE software to Ascend Communications. The Company believes that open routing software will be pervasive throughout next generation networking technologies. OpenROUTE Network's charter is to expand and manage the OpenROUTE software licensing business. This unit is providing technology assessment, design feasibility and software porting analysis for OpenROUTE licensees. OPENROUTE DEVELOPMENT The Company continues to invest research and development spending in its OpenROUTE software. During the past year, the Company announced two new OpenROUTE software upgrades. Early in the year, the Company released OpenROUTE 2.3 which included several new WAN capabilities that significantly enhance the GT product line for ISDN links. Key new features included IP Address assignment, support for callback, improved IP filters and support for IPXWAN, a new Novell protocol that standardizes the transfer of IPX packets over various WAN media. Later in the year, the Company announced Version 3.0 of OpenROUTE software. This release featured support for OpenROUTE Addressing Services (OAS) which includes: an extensive array of IP address management and configuration capabilities; a number of Traffic Control Services (TCS) for better management of costly connections and increased traffic associated with Internet and Intranet-based networks; and enhanced ISDN with D-Channel Call-back, DOSBS and ISDN leased line support. BUSINESS PARTNERING WITH INTERNET SERVICE PROVIDERS The Company continues to seek out business partnerships with Internet Service Providers. The Company believes that Internet Service Providers offer a solid path of wide-scale distribution for GT and GTX products. As ISPs have evolved around the world, their equipment needs have paralleled this process. In many cases where ISPs are connecting small businesses to the Internet or Intranet, the installation of an Internet Access router is a necessity. By solidifying its presence with ISPs on a global basis, the Company believes it can expand its distribution and increase the potential to grow its business. The Company does not currently have any agreements with ISPs that provide for the exclusive installation of OpenROUTE Networks products. However, a major effort is being made to work on development with ISPs, the goal of which is to ensure that OpenROUTE Networks' products are the preferred choice. The Company's most significant relationship continued to be with PSINet, Inc. of Herndon, Virginia. Going forward, the Company's strategy is to increase the number of ISPs that carry OpenROUTE Networks routers. The Company will also work with ISPs as they support carriers and telcos who provide outsourced networking services for corporations. 9 COMPANY AWARDS AND HONORS The Company continued to participate in industry-wide product testing and evaluation and, as a result, has earned a number of recent honors. In the fall of 1997, the Company won a "Tester's Choice" Award from Data Communications magazine for the performance of its GlobeTrotter (GT) 72 and 75 ISDN routers. In the September 1997 issue of ZD Internet magazine, the GT 72 was number one in a data compression test that ranked 11 competitors. Earlier, Strategic Networks Consulting, a leading market research firm, named the GT 70 the fastest overall ISDN router in a major performance test among 10 leading vendors. The GT line has also won a "Users' Choice" award from Communications News magazine. During the first quarter of 1998, the Company's GTSecure 70 Firewall Router scored one of the top two performance marks in an industry-wide test sponsored by Network Computing magazine. The Company earned further recognition of its innovative products when the GTX 1000 was voted a finalist in the Paris Networld+Interop '97 Best of Show Awards for Best Internetworking Product. LOCAL AREA NETWORKING PRODUCTS The Company is continuing to market a number of Token Ring LAN products. However, as mentioned earlier in this report, the Company is putting less emphasis on LAN products than in previous years. The decision to partner with Microvitec enhances the Company's ability to support current LAN customers and future prospects. As the relationship with Microvitec ensues, Proteon will continue to sell and service its brand name LAN products. Microvitec will undertake its own sales and marketing efforts to market products under the Proteon LAN Products by Microvitec brand name. In the future, Microvitec and Proteon will share product development and engineering resources. LOCAL ACCESS (TOKEN RING ADAPTERS) Token Ring adapters provide the physical connectivity and Token Ring signaling between the PC or workstation and the LAN cabling. Proteon markets the ProNET family of Token Ring adapters. The family supports unshielded twisted pair (UTP) and shielded twisted pair (STP) cabling options, the major PC platforms, and the leading network operating systems. The ProNET-4/16 Plus Series features models for all popular personal computer bus types, including Industry Standard Architecture (ISA), Extended Industry Standard Architecture (EISA), MicroChannel Architecture (MCA), Personal Computer Memory Card International Association (PCMCIA), and Peripheral Component Interconnect (PCI). The Company's newer model adapters are fully compatible with the hundreds of thousands of earlier ProNET-4/16 models now operating in production systems around the world. The ProNET-4/16 family has demonstrated a Mean Time Between Failure (MTBF) of more than 900,000 hours, or 200 years of continuous operation. All the Plus Series adapters have a limited lifetime warranty, are designed with state-of-the-art technology such as Surface Mounted Technology components, have high levels of integration and are software configurable. 10 Plus Series adapters also come with an assurance of interoperability. Proteon offers a broad suite of certified compatible software drivers. Its RapiDrivers are included as a standard feature inside leading network operating system software such as Novell NetWare 4.0, Banyan VINES and Microsoft Windows NT. Proteon's adapters have achieved interoperability certification with popular third-party intelligent hub products in testing at the Token Ring Interoperability Lab (TRIL) in Santa Clara, California. Intelligent hubs are important elements for building structured and manageable local area networks (LANs), since they provide connectivity and management of the different cabling schemes and LAN topologies used throughout the network. Proteon's Token Ring intelligent hubs and wire centers, which compete in the workgroup network computing market, provide flexible and modular solutions to cabling, as well as centralized physical network management and configuration. The Company's Series 80 and Series 70 Intelligent Wire Center families provide integrated support for 4/16 Mbps UTP, STP and fiber optic cabling, and are appropriate for workgroups of up to 30 users. The Company also markets the Series 75 Stackable Hub family, a portfolio of standards-based, high-performance products that provides a cost effective solution for building networked workgroups and extended workgroups and meeting the demands for current and evolving client/server applications. The Series 75 Hub line is based on the p7500 base unit, a 16-port, self-managed active UTP hub. The p7500 has a rear panel option slot for the addition of stack and SNMP management modules, and modular ports for installation of trunk options such as fiber optic links. The Series 75 architecture will support a stack of nine units high, thus providing connectivity for up to 144 users. MARKETING, SALES AND CUSTOMERS End-users of the Company's products have typically been organizations with critical applications requiring connectivity integrating their headquarters and wide area computing environments. The Company's marketing and distribution strategy is to reach these end-users primarily through an indirect sales channel comprised of selected large systems integrators, Internet Service Providers, original equipment manufacturers (OEMs), value added resellers (VARs), telecommunications carriers, and distributors with experience in network integration and a reputation for excellent service. As the Company moves forward, it will be targeting a customer base that may not be familiar with standard networking terms. The Company believes that this new generation of users is mainly comprised of business executives who have used the Internet in the home environment, and are now demanding this type of connectivity in the workplace. MARKETING PROGRAMS The Company understands the critical nature of creating end-user awareness for its products and capabilities. The Company's marketing programs in 1997 and planned marketing programs for 1998 are focused on channel, telco, ISP, and end-user awareness through: direct mail campaigns; targeted advertising; significant educational and product announcement activities; public relations; seminar programs; electronic advertising mediums such as the Internet; and regional and large, national industry trade shows. These programs are intended to enhance brand name recognition for the Company and its products with end-users, generate sales leads for the Company's field sales force and the Company's resellers, and support the sales efforts of its resellers. In the future, the Company plans to devote more time and money to increasing recognition of OpenROUTE Networks brand name. In conjunction with the creation of OpenROUTE Networks, the Company adopted a new, colorful logo that will play a key role in the branding campaign. The Company plans to use some consumer-oriented branding techniques to better drive sales. In 1998, the Company also intends to launch new reseller programs and recruit more reseller partners. 11 Field Sales Force The Company's field sales force is primarily responsible for providing sales support and training to the Company's systems integrators, OEMs, ISPs, VARs, telecommunications carriers, and distributors. In 1997, the Company focused a portion of its sales force on direct presence at end-user sites with the goal of providing awareness to the end-user of Proteon and OpenROUTE Networks' products and the development of leads to support its reseller partners. The field sales force has a number of offices in the United States, and international offices in London, Singapore, Tokyo, Toronto, Paris, and Hong Kong. In late 1997, the Company incurred expenses to add additional sales personnel in various parts of the world. In a limited number of sales situations, the Company sells directly to end user customers. Systems Integrators and OEMs Proteon and OpenROUTE Networks sell a large number of units through systems integrators and OEMs. These organizations typically have technical expertise and an installed customer base in either telecommunications or computer communications, and are experienced in the sale and support of complex networking solutions. In late 1997, and continuing into 1998, the Company is attempting to increase its shipments through telecommunications providers who install customer premise equipment. This trend is often referred to as outsourcing. VARs The Company also sells its complete product line through Value Added Resellers (VARs), which include Premier Access Partners and smaller regional VARs in markets around the world. Many of these VARs are selected for their capability to sell to and service small to medium-sized organizations, as well as for their expertise in vertical industries or technologies. The Company's VARs also include a number of large national and regional resellers. In late 1997, and continuing into 1998, the Company has been de-emphasizing its reliance on VARs and concentrating more of its sales efforts through telecommunications carriers, ISPs and other service providers. Distributors Proteon sells a substantial portion of its Token Ring adapter and intelligent hub and wirecenter products in North America to a number of distributors, which usually resell to resellers and dealers, including several national chains. Typically, distributors market Proteon's Token Ring and intelligent hub products to dealers, whereas VARs sell the complete product line, including routers, to end-users. The Company's distributors include Ingram Micro and Tech Data. Distributors also carry OpenROUTE Networks' internetworking products and service the needs of VARs and other types of system integrators. INTERNATIONAL SALES The Company's products are currently marketed, sold and serviced internationally by over 60 distributors, VARs, and OEMs. These resellers generally have non-exclusive agreements applying to a countrywide territory. International sales accounted for approximately 35.4% percent of net sales in 1997. BACKLOG Because of the generally short cycle between order and shipment (typically less than 45 days) and occasional customer-initiated changes in delivery schedules, the Company does not believe its backlog as of any particular date is necessarily indicative of future sales levels. 12 CUSTOMER SUPPORT AND SERVICE The Company's customer service organization provides a comprehensive suite of service and support programs for resellers and end-users. The underlying philosophy of the Company is to provide end-users with alternatives for acquiring services for their networking requirements. Users can contract directly with the Company for service. Additionally, Proteon offers multiple maintenance contract options designed to match the servicing capabilities and needs of the customer. The service offerings consist of technical support (remote and on-site), maintenance contracts, hardware and software upgrades, product exchange, spares, depot repair, and professional services. RESEARCH AND PRODUCT DEVELOPMENT Management believes the Company's future success depends in large part upon timely enhancement of existing products and the development of new products that not only maintain technological excellence, but also improve the capabilities, efficiency, and cost-effectiveness of the end-users' data communications networks. The Company is developing new products to improve price/performance ratios, enhance its network management capabilities, simplify ease of use, enhance network security and ensure interoperability with other vendors' standards-based products. The Company is also helping to define and support emerging industry standards that underly the use of new technological capabilities. The Company is currently participating in a variety of Internet Engineering Task Force (IETF) working groups, and the IEEE 802.5 and 802.12 subcommittees. In 1997, 1996, and 1995, the Company's research and product development expenditures were $5,987,000, $9,353,000, and $8,802,000, respectively. All of the Company's expenditures for hardware and software research and development costs have been expensed as incurred. MANUFACTURING The Company's manufacturing operations primarily consist of systems level integration and testing. The Company has developed a strategic relationship with U.S. Assemblies, Taunton, Mass., a major subcontract manufacturer with access to cost-effective, high volume manufacturing, distribution, and repair capability worldwide. U.S. Assemblies manufactures the Company's board assemblies for its router, hub, and adapter card product lines and specific, turnkey manufacturing for a number of Proteon and OpenROUTE Networks products. The Company believes that in the event of an interruption in manufacturing at U.S. Assemblies, alternative subcontractors could be brought on line quickly. U.S. Assemblies also operates a number of other facilities across the United States. Proteon does some final assembly and testing of its intelligent hubs and routers at its Westborough, Massachusetts manufacturing facility. A repair depot and logistic operation is also located at Westborough, coordinating global service requirements for all products. The Token Ring chipsets used in the Company's 4/16 Mbps adapters are currently manufactured by Texas Instruments. The Company has an agreement with Texas Instruments under which it believes it will be able to obtain adequate supplies of these chipsets in a timely manner to meet customer demand. However, the reduction or interruption in supply or a significant price increase could adversely affect the Company's operating results. The RISC processor presently used in the Company's CNX 600 and CNX 500 bridging routers is available solely from AMD. The Company believes, however, that other available RISC processors could be substituted for the AMD chip, if necessary, with some product modifications. Certain logic semiconductors, signal processors, and subassembly components used in the Company's products are also available only from limited sources. The Company has not experienced any significant problems in obtaining required supplies of such limited source components and believes that alternative sources could be developed quickly. However, such shortages could result in production delays that might adversely affect the Company's business. The Company's line of GTX and GT Business Series products incorporates microprocessors supplied by Motorola. The Company is not aware of any shortages of chips from Motorola, and believes that supplies will be adequate for the coming year. 13 Proteon continues to have OEM arrangements with manufacturers for some of its Token Ring product offerings. The Company does not feel these arrangements jeopardize the quality of the products the Company is shipping. In most cases, if supply from one vendor was interrupted or made scarce, the Company could find a comparable source for the affected product with limited delays in shipment. COMPETITION The data communications, networking and computer industries are highly competitive and characterized by rapidly changing technology and evolving industry standards. These advances result in frequent new product introductions, increased capabilities and improvements in the relative price/performance of networking products. The Company competes with several companies having greater research and development, marketing and financial resources, manufacturing capability, customer support organizations, and name recognition than those of Proteon and OpenROUTE Networks. Internet Access Market Competition In its newer GTX and GT Business Series product lines, the Company manufactures routers that connect users on the network edge. The Company believes that major competitors in this market segment include Ascend Communications, Livingston Systems, Netopia Systems, Cisco Systems, 3COM, Bay Networks, Xyplex, ACC, and Ramp Networks, among others. Local Area Networking Competition IBM dominates the market for Token Ring network adapter card products. Other significant competitors in the market for Token Ring adapter cards include Madge Networks and Olicom. While Token Ring networking is an industry standard, Proteon believes that its ability to successfully address the market for Token Ring network products is dependent upon the compatibility and interoperability of the Company's products with products offered by IBM and upon maintaining compatibility with the Token Ring standard as it continues to evolve. In addition, IBM is both the dominant supplier of Token Ring network products as well as an established vendor of computer and networking systems and products at most of the Company's existing and potential end user sites. As a result, the Company believes that in order to address the market for Token Ring network interface card products successfully, the Company's products and systems must have more features, greater functionality, higher performance and/or lower price than those offered by IBM. In the past, the Company believes it has been successful in offering Token Ring network interface card products with better features, functionality, performance and/or price than Token Ring products offered by IBM. INTELLECTUAL PROPERTY RIGHTS The Company was granted a patent on February 18, 1992, for its Token Ring synchronization technology, commonly referred to as JitterBuster. On July 21, 1992 the Company was granted a patent for Token Ring Equalizer. Each of these patents has a life of 17 years from the date of grant. In September 1997 the Company applied for a U.S. patent for its GTX modular Internet Access router. Currently, Proteon relies principally upon a combination of contractual rights, trade secrets, and copyright laws to establish and protect its proprietary rights in its products. The Company believes that because of the rapid pace of technological change in the data communications and computer industries, the legal protection for its products is a less significant factor in the Company's success than the knowledge, ability and experience of the Company's employees, the frequency of product enhancements and the timeliness and quality of support services provided by the Company. 14 Certain technology used in the Company's products is licensed by the Company from third parties, generally on a non-exclusive basis. These license agreements generally require the Company to pay royalties (certain of these license agreements include minimum royalty requirements) and to fulfill confidentiality obligations in order to maintain the licenses. One of the Company's license agreements is an exclusive license for a portion of the software incorporated in the Company's bridging routers. In order to maintain the exclusivity of this license, the Company must make minimum annual royalty or other payments in addition to those required to maintain the license. The sum of these payments for each year is relatively insignificant to the Company. The maximum royalties payable under this license are limited in accordance with a formula. Generally, if the Company does not pay minimum royalties or make other minimum payments each year under this license, the license may be terminated. Absent a breach of this license agreement by the Company, the license may be continued indefinitely at the Company's option. The termination of this license would have a material adverse effect on the Company's operations because the technology licensed under this agreement is included in the software incorporated in the Company's bridging router products, which provide a significant portion of the Company's revenues. RISK FACTORS Technological Change, New Products and Industry Standards The data communications industry continues to undergo a fundamental shift away from hierarchical single vendor systems to open, peer-to-peer communications networks and information management tools that provide users with greater computing power and access to information. This evolution has fostered the growth of two dynamic markets: workstations and networking. Workstations deliver increasingly powerful, personal productivity tools, and data communications networks provide the "highways" that distribute and share leverage and manage information resource. As the deployment of networks matures, four recent trends continue to develop: networking of remote sites to the headquarters office via remote access routers; reduction of network congestion with the implementation of local area networks (LAN's); segmentation using various switching technologies; and the push by businesses of all sizes and individuals to connection their systems and networks to the Internet. Proteon is positioning itself as a company focused on the network access market. Proteon views the networks access market as having two segments - Internet access and local access. Its current strategy is based upon concentration on the Internet access market segment. The market for the Company's products in characterized by rapidly changing technology, new product introductions and multiplicity of current and evolving industry standards. Accordingly, the Company believes that its future success will depend on its continuing ability to enhance and expand its existing products and to develop or private label other manufacturer's technology and introduce in a timely fashion new products which incorporate new technologies, conform to standards and achieve market acceptance. There can be no assurance that the Company's strategy is the correct one under the circumstances; that the Company has correctly assessed trends in the marketplace; that the Company will be able to develop, market or support, or secure external supplies of, such products successfully; or that the Company will be able to respond effectively to technological changes, new product announcements by others or new industry standards. Manufacturing and Supply; Dependence on Suppliers The Company's manufacturing operations primarily consist of assembly, testing and quality control of materials, components, subassemblies, and systems. US Assemblies, a major subcontract manufacturer with access to cost effective, high volume manufacturing, distribution, and repair capability worldwide, and other manufacture and majority of Proteon's board assemblies for its router, hub, and adapter card product lines. The Token Ring chipsets used in the Company's 4/16 Mbps and 4 Mbps adapters are currently manufactured for external sale solely by Texas Instruments. The Company has a agreement with Texas Instruments under which it believes it will be able to obtain adequate suppliers of these chipsets in a timely manner to meet customer demand. Certain logic semiconductors, signal processors, and subassembly components used in the Company's products are also available only from limited sources. The Company has not experienced any significant problems in obtaining required supplies of such limited source components and believes that alternative sources could be developed quickly, in necessary. Proteon continues to have OEm arrangement with manufacturers for some of its Ethernet product offering. In most cases, if supplies from one vendor were interrupted or reduced, the Company could find a comparable source for the affected product with limited delays in shipment. The inability to obtain sufficient sole or limited source components as required, or to develop alternative sources if and as required in the future, could result in delays or reductions in product shipments which would adversely affect the Company's operation results. There can be no assurance that, in the event of interruptions in contract manufacturing, supplies of components from sole or limited sources or supplies of units from OEM vendors or similar occurrences, the Company could find and engage suitable alternatives in a timely manner. Such interruptions or the inability of Proteon to counteract them successfully could have an adverse effect on the Company's business, operations and finances. Intellectual Property Currently, Proteon relies principally upon a combination of contractual rights, trade secrets, and copyright laws to establish and protect proprietary aspects of its products. The Company believes that, because of the rapid pace of technological change in the data communications and computer industries, legal protection for its products is a less significant factor in the Company's success than the knowledge, ability, and experience of the Company's employee, the frequency of product enhancements and the timeliness and quality of support services provided by the Company. However, should a successful challenge be mounted against the rights of Proteon in and to its intellectual property, by allegations of infringement on the rights of other or for any other reason, the Company's business, operations and finances could be adversely affected. Certain technology used in the Company's products is licensed by the Company from third parties. The termination of certain of these license would have a material adverse effect on the Company's operations. PRODUCT COMPATIBILITY AND COMPETITION Network Interface Card Products The market for Token Ring network interface card products is dominated by IBM. While Token Ring networking is an industry standard, Proteon believes that its ability to address successfully the market for Token Ring network products is dependent upon the compatibility and interoperability of the Company's products with products offered by IBM and upon maintaining compatibility with the Token Ring standard as it continues to evolve. Internet Access (Routers) Proteon expects to participate significantly in the market segment of internet access routing specifically addressing the needs to users to connect to the Internet of build corporate intranets The Company has enhanced its internet access capabilities with the introduction of new products and expanded its presence in the Integrated Services Digital Network (INDN) marketplace. LAN Access The Company continues to sell Token Ring Switches; intelligent hubs that provide connectivity and management of different network cabling schemes and LAN topologies; Ethernet hubs, the ProNET/E series, for the workgroup market segment; Token Ring hubs, the Serial 75 Stackable Hub family for building networked and extended workgroups; Token Ring adapters for physical connectivity and Token Ring signaling between a PC or workstation and LAN cabling; a muliport cards intended to provide a full range of solution for the client/server marketplace. The Company also seeks opportunities to leverage technology through licensing arrangements. Internetworking Software OpenROUTE(TM), Proteon's internetworking software suite, is the foundation of the Company's high performance Internet access products. All of the Proteon's internetworking products ship this software technology installed. Also, Proteon licenses this software to other providers of internetworking products. As routing technology progresses, the Company may be required to modify its routing and bridging software to maintain compatibility of its products with various standards and interoperability with other manufacturers router products. Failure by the Company to maintain such compatibility, interoperability, and technical competencies could adversely affect the Company's business, operations and finances. 15 Competition The data communications, networking and computer industries are highly competitive and characterized by rapidly changing technology and evolving industry standards. These advances result in frequent new product introductions, increased capabilities and improvements in the relative price/performance of networking products. As a competitor in the networking industry, Proteon believes one of the keys to success will be making networks more accessible to a broader base of customers. Proteon is committed to open, standards based products, innovative solutions to customer requirements for reliable and high performance networks, a favorable price/performance ratio, ease of installation and ease of use. The Company competes with several companies having greater research and development, marketing and financial resources, manufacturing capability, customer support organizations, and name recognition than those of the Company. There can be no assurance that the Company will be able to compete successfully in the future or that competitive pressures will not adversely affect the Company's business. Research and Product Development Management believes the Company's future success depends in large part upon timely enhancement of existing products and the development of new products that not only maintain technological excellence, but also improve the capabilities, efficiency, and cost effectiveness of the end users' data communication networks. The Company is developing new products to improve price/performance ratios, enhance its network management capabilities, simplify ease of use, and ensure interoperability with other vendors' standards based products. Variability of Quarterly Operating Results The Company's quarterly operating results may vary significantly depending upon factors such as the timing of new product announcements and releases by the Company and its competitors, the timing of significant orders, the mix of products sold and the mix of distribution channels through which the products are sold. In addition, substantially all of the Company's sales in each quarter result from orders booked in that quarter. Consequently, if sales do not close in any quarter as anticipated, the Company's results of operations for that quarter would be adversely affected. Further, the Company's expense levels are based, in part on its expectations of future sales. If sales levels are below expectations, operating results may be adversely affected. Also, quarterly results can be materially affected by the existence and/or the timing of software licensing revenues. Method of Distribution The Company sells its products to end users worldwide primarily through an indirect sales channel comprised of Internet Service Providers ("ISPs"), Original Equipment Manufacturers ("OEMs"), Value Added Resellers ("VARs") and distributor. These resellers also represent other lines of products which are, in some cases, identical or complementary to, or which compete with, those of the Company. While the Company attempts to encourage these resellers to focus on its products through marketing and support programs, there is a risk that these resellers may give higher priority to products of other suppliers, thereby reducing their efforts devoted to selling the Company's products. One reseller accounted for approximately 11%, 11% and 12%, of the Company's sales in 1997, 1996 and 1995, respectively, and a second reseller accounted for approximately 8%, 14% and 10% of the Company's sales in 1997, 1996, and 1995, respectively. There can be no assurance that the Company has selected appropriate channels of distribution for its products or that existing resellers will dedicate adequate resources to sales of the Company's products. Failure to do so could result in an adverse impact on the Company's business, operations and finances. Marketing, Sales and Customers End users of Proteon's products have typically been organizations with critical applications requiring connectivity integrating their headquarters and wide area computing environments. Proteon's marketing and distribution strategy is to reach these end users primarily through an indirect sales channel comprised of ISPs, OEMs, VARs and distributors with experience in network integration and reputation for excellent service. In addition, the Company's strategy includes increased presence of Proteon's sales force in end user sites. There can be no assurance that the Company has correctly formulated its end user profile or selected appropriate methods of marketing and selling its products. Failure to do so could result in an adverse impact on the Company's business, operations and finances. Liquidity Failure of the Company to create and maintain adequate working capital and liquidity, by sales of equity, obtaining lines of credit or otherwise, could adversely impact the Company's business, operations and finances. International Sales, Regulatory Standards and Currency Exchange International sales accounted for 35.4%, 38.3% and 35.7% in 1997, 1996 and 1995 respectively, of the Company's net sales and the Company expects that international sales will continue to be a significant portion of the Company's business. Foreign regulatory bodies continue to establish standards different from those in the United States, and the Company's products are designed generally to meet those standards. The inability of the Company to design products in compliance with such foreign standards could have an adverse effect on the Company's operating results. The Company's international business may be affected by changes in demand resulting from fluctuation in currency exchange rates and tariffs and difficulties in obtaining export licenses. Possible Volatility of Stock Price The Company believes factors such as announcements of new products by the Company or its competitors and quarterly variations in financial results could cause the market price of the Common Stock to fluctuate substantially. In addition, the stock market has experienced volatility which has particularly affected the market prices for many high technology companies' stock and which often has been unrelated to the operating performance of such companies. These market fluctuations may adversely affect the price of the Company's Common Stock. Certain Charter and By Law Provisions The Company's Amended and Restated Articles of Organization and By Laws contain certain provisions that could have the effect of making it more difficult for the third party to acquire, or of discouraging a third party from attempting to acquire, control of the Company. Such provisions could limit the price that certain investors might be willing to pay in the future for shares of the Company's Common Stock. Certain of such provisions allow the Company to issue preferred stock with rights senior to those of the Common Stock and impose various procedural and other requirements which could make it more difficult for stockholders to effect certain corporate actions. YEAR 2000 The Company has given careful consideration to all systems and equipment, which may be affected by the Year 2000 issue. Management is in the process of developing an action plan that provides for the repair of replacement of all systems with exposure to Year 2000 problems by the end of 1998, the cost of which is not expected to have a material financial impact on the Company. The plan calls for a combination of internal and external resources. The commitment of internal resources is not expected to have a significant impact on the Company's future sales and operating results. EMPLOYEES As of December 31, 1997, The Company employed a total of 127 persons, including 69 in sales, marketing and customer support, 27 in engineering and product development, 13 in manufacturing, and 18 in finance and administration. None of the Company's employees is represented by a labor union. The Company has experienced no work stoppages and believes its employee relations are good. REGISTERED TRADEMARKS Proteon, OpenROUTE, TokenVIEW and ProNET are registered trademarks and JitterBuster CNX 600, CNX 500, CNX 400, DNX 350, RapiDriver, OneVIEW, and OverVIEW are trademarks of Proteon. Ethernet is a registered trademark and XNS is a trademark of Xerox Corporation. IBM and NetView are registered trademarks and SNA is a trademark of IBM. Motorola is a trademark of Motorola, Inc.; AMD is a trademark of Advanced Micro Devices, Inc. AT&T is a trademark of AT&T. 16 ITEM 2. PROPERTIES The Company's principal administrative, marketing, manufacturing and product development facilities are located in one building in Westborough, Massachusetts and occupied a total of approximately 44,000 square feet as of December 31, 1997. The Company occupies these facilities under a lease agreement that expires in April 2002. The Company has the option to extend the term of the lease of its primary office and manufacturing facility for two five-year periods commencing on May 1, 2002 and May 1, 2007. In addition, the Company leases nine sales and support offices elsewhere in the United States and abroad. The Company believes that its existing facilities are adequate for its current needs. ITEM 3. LEGAL PROCEEDINGS Neither the Company nor any of its subsidiaries is a party to any material legal proceedings nor is any property of the Company the subject of material legal proceedings. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of stockholders during the fourth quarter of the fiscal year ended December 31, 1997. 17 PART II ITEM 5. MARKET FOR PROTEON COMMON STOCK AND RELATED STOCKHOLDER MATTERS The section entitled "Stock Price History" in the 1997 Annual Report is incorporated herein by reference. ITEM 6. SELECTED FINANCIAL DATA The table entitled "Selected Consolidated Financial Data" contained in the 1997 Annual Report is incorporated herein by reference. The table should be read in conjunction with the consolidated financial statements and related notes and other financial information appearing elsewhere in the 1997 Annual Report, including Management's Discussion and Analysis of Financial Condition and Results of Operations. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations" contained in the 1997 Annual Report is incorporated herein by reference. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Not applicable. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The sections entitled "Consolidated Balance Sheets," "Consolidated Statements of Operations," "Consolidated Statements of Stockholders' Equity," "Consolidated Statements of Cash Flows," "Notes to Consolidated Financial Statements," "Quarterly Financial Data" and "Report of Independent Accountants" contained in the 1997 Annual Report are incorporated herein by reference. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. 18 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF PROTEON The sections entitled "Information About The Executive Officers," "Proposal 1: Election of Directors" and "Section 16(a) Beneficial Ownership Reporting Compliance" contained in the Company's 1998 Proxy Statement which the Company intends to file with the Securities and Exchange Commission on or about April 8, 1998 are incorporated herein by reference. ITEM 11. EXECUTIVE COMPENSATION The sections entitled "Compensation of Directors and Executive Officers" contained in the 1998 Proxy Statement is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The section entitled "Principal Shareholders" contained in the 1998 Proxy Statement is incorporated herein by reference. 19 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULE, AND REPORTS ON FORM 8-K (a) Financial Statements, Schedule, and Exhibits The financial statements, schedule, and exhibits listed below are filed as part of this Report: 1. Financial statements: Consolidated Balance Sheets as of December 31, 1997 and 1996 Consolidated Statements of Operations for the years ended December 31, 1997, 1996 and 1995 Consolidated Statements of Stockholders' Equity for the years ended December 31, 1997, 1996 and 1995 Consolidated Statements of Cash Flows for the years ended December 31, 1997, 1996 and 1995 Notes to Consolidated Financial Statements Report of Independent Accountants 2. Schedule: II Valuation and Qualifying Accounts Schedules not listed above are omitted because of the absence of conditions under which they are required or because the required information is included in the consolidated financial statements or notes submitted. 20 3. Exhibits: Exhibit Number Description (3.1) Restated Articles of Organization as Amended (3.3) By-Laws, as amended and restated (4.1) Article 4 of the Restated Articles of Organization, (See Exhibit 3.1) (4.2) Form of Common Stock Certificate (10.1) Manufacturing Services Agreement, dated August 1, 1989 between the Registrant and Texas Instruments, Inc. (10.2) Purchase Agreement, dated August 1, 1989 between the Registrant and Texas Instruments, Inc. (10.3) Software License Agreement, dated January 1, 1990 between the Registrant and Noel Chiappa (10.4)* 1991 Restated Stock Option Plan (10.5)* 1988 Nonqualified Stock Option Plan (10.6)* Restated Employee Stock Award Plan (10.7)* Consulting Agreement, dated August 31, 1989 between the Registrant and David Clark (10.8)* Form of Indemnification Agreement. An Indemnification Agreement was entered into by and between the Registrant and each of: Steven J. Bielagus, Daniel Capone, Jr., David Clark, Howard C. Salwen, and certain other former Directors and Executives. Although the agreements were executed on various dates, each is the same as the Form of Indemnification Agreements in all material respects and details, and therefore the individual agreements are not filed herewith. (10.9)* Executive Compensation Arrangements Not Set Forth in Formal Documents (10.10)* Consulting Agreement, dated August 25, 1993, between the Registrant and Howard Salwen (10.11)* Employment Agreement dated March 18, 1994, between the Registrant and Steven J. Bielagus. (10.12)* Employment Agreement dated June 27, 1994 between the Registrant and Daniel J. Capone, Jr. (10.13) Lease Agreement dated December 19, 1994 between the Registrant and WCB Twenty Limited Partnership. (10.14)* Severance Compensation Agreement dated March 11, 1996 between the Registrant and William T. Greer (10.15)* Employment Agreement dated October 16, 1996 between the Registrant and Robert J. Connaughton, Jr. (10.16)* Severance Compensation Agreement dated October 21, 1996 between the Registrant and Robert J. connaugton, Jr. (10.17)* Form of Severance Compensation Agreement. A Severance Compensation Agreement was entered into by and between the Registrant and each of: Robert Koch, Steven T. Shedd, Richard J. Arena, Eugene Y. Chang, Daniel Capone, Jr., Steven J. Bielagus, Kenneth Holvaldt and Jack A. Ritter. Although the agreements were executed on various dates, each is the same as the Form of Severance Compensation Agreements in all material respects and details, and therefore the individual agreements are not filed herewith. (10.18) Amendment to Lease Agreement dated December 19, 1994 between the Registrant and WCB Twenty Limited Partnership, dated May 23, 1997 21 3. Exhibits (continued) Exhibit Number Description (11) Statement RE: Computation of Per Share Earnings (13) The Annual Report to Stockholders of the Company for the fiscal year ended December 31, 1997 (except for the pages and information thereof expressly incorporated by reference in this Form 10-K, the Annual Report to Shareholders is provided solely for the information of the Securities and Exchange Commission and is not deemed "filed" as part of this Form 10-K) (21) Subsidiaries of the Registrant (23) Consent of Coopers & Lybrand L.L.P. (27) Financial Data Schedule * Exhibit is a management contract or compensatory plan, contract or arrangement required to be filed as an Exhibit to this Form 10-K. (b) Reports on Form 8-K The Company filed no reports on Form 8-K with the Securities and Exchange Commission during the last quarter of the fiscal year ended December 31, 1997. 22 SIGNATURES Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, Proteon, Inc. has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized. PROTEON, INC. (Registrant) March 25, 1998 By:/s/ Daniel J. Capone, Jr. ------------------------------------ Daniel J. Capone, Jr. President & Chief Executive Officer (principal 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. March 25, 1998 By:/s/ Daniel J. Capone, Jr. ---------------------------- Daniel J. Capone, Jr. President & Chief Executive Officer and Director March 25, 1998 By:/s/ Steven T. Shedd ---------------------- Steven T. Shedd Vice President, Finance and Chief Financial Officer Treasurer and Clerk (principal financial officer) March 25, 1998 By:/s/ James M. Roller ---------------------- James M. Roller Corporate Controller (principal accounting officer) March 25, 1998 By:/s/ David Clark ---------------------- David Clark, Director March 25, 1998 By:/s/ Robert M. Glorioso ------------------------- Robert M. Glorioso, Director March 25, 1998 By:/s/ Howard C. Salwen ----------------------- Howard C. Salwen, Director 23 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders of Proteon, Inc.: Our report on the consolidated financial statements of Proteon, Inc. has been incorporated by reference in the Form 10-K from the 1997 Annual Report to Shareholders of Proteon, Inc. In connection with our audits of such financial statements, we have also audited the related financial statement schedule listed in item 14a(2) in this Form 10-K. In our opinion, the financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information required to be included therein. /s/ COOPERS & LYBRAND L.L.P. ----------------------------- Boston, Massachusetts Date: February 11, 1998 24 SCHEDULE II PROTEON, INC. VALUATION AND QUALIFYING ACCOUNTS
Balance at Uncollectible Balance at Allowance for Beginning Provision Accounts End of Doubtful Accounts of Period for Bad Debt Written Off Period - --------------------------------------------------------------------------------------- Year ended December 31, 1997 $671,755 $438,773 ($183,920) $926,608 Year ended December 31, 1996 889,276 - (217,521) 671,755 Year ended December 31, 1995 887,524 - 1,752 889,276
25 EXHIBIT INDEX Exhibit Number Description (3.1) Restated Articles of Organization as Amended*(c) (filed as Exhibit 3.1) (3.3) By-Laws, as amended and restated, of the Registrant * (a) (filed as Exhibit 3.3) (4.1) Article 4 of the Restated Articles of Organization, (See Exhibit 3.1) (4.2) Form of Common Stock Certificate * (b) (filed as Exhibit 4.2) (10.1) Manufacturing Services Agreement, dated August 1, 1989 between the Registrant and Texas Instruments, Inc. * (a) (filed as Exhibit 10.3) (10.2) Purchase Agreement, dated December 1, 1990 between the Registrant and Texas Instruments, Inc. * (a) (filed as Exhibit 10.4) (10.3) Software License Agreement, dated January 1, 1990 between the Registrant and Noel Chiappa * (a) (filed as Exhibit 10.5)(+) (10.4) 1991 Restated Stock Option Plan * (d) (filed as Exhibit 19.1) (10.5) 1988 Nonqualified Stock Option Plan * (a) (filed as Exhibit 10.7) (10.6) Restated Employee Stock Award Plan * (a) (filed as Exhibit 10.8) (10.7) Consulting Agreement, dated August 31, 1989 between the Registrant and David Clark * (a) (filed as Exhibit 10.11) (10.8) Form of Indemnification Agreement. An Indemnification Agreement was entered into by and between the Registrant and each of: David Allen, Steven J. Bielagus, Daniel Capone, Jr., David Clark, Howard C. Salwen, and certain other former Directors and Executives. Although the agreements were executed on various dates, each is the same as the Form of Indemnification Agreements in all material respects and details, and therefore the individual agreements are not filed herewith. * (a) (filed as Exhibit 10.17) (10.9) Executive Compensation Arrangement Not Set Forth in Formal Document* (e) (filed as Exhibit 10.26) (10.10) Consulting Agreement, dated August 25, 1993, between the Registrant and Howard Salwen * (f) (filed as Exhibit 10.1) (10.11) Employment Agreement, dated March 18, 1994, between the Registrant and Steven J. Bielagus * (g) (filed as Exhibit 10.3) (10.12) Employment Agreement, dated June 27, 1994 between the Registrant and Daniel J. Capone, Jr. * (h) (filed as Exhibit 10.4) (10.13) Lease Agreement dated December 19, 1994 between the Registrant and WCB Twenty Limited Partnership * (i) (filed as Exhibit 10.31) (10.14) Severance Compensation Agreement dated March 11, 1996 between the Registrant and William T. Greer * (j) (filed as Exhibit 10.28) (10.15) Employment Agreement, dated October 16, 1996 between the Registrant and Robert J. Connaughton, Jr. * (j) (filed as Exhibit 10.29) (10.16) Severance Compensation Agreement dated October 21, 1996 between the Registrant and Robert J. Connaughton, Jr. * (j) (filed as Exhibit 10.30) (10.17) Form of Severance Compensation Agreement. A Severance Compensation Agreement was entered into by and between the Registrant and each of: Robert Koch, Steven T. Shedd, Richard J. Arena, Eugene Y. Chang, Daniel J. Capone, Jr., Steven J. Bielagus, Kenneth Holvaldt and Jack A. Ritter. Although the agreements were executed on various dates, each is the same as the Form of Severance Compensation Agreements in all material respects and details, and therefore the individual agreements are not filed herewith. (10.18) Amendment to Lease Agreement dated December 19, 1994 between Registrant and WCB Twenty Limited Partnership, dated May 23, 1997 26 EXHIBIT INDEX (continued) Exhibit Number Description (11) Statement RE: Computation of Per Share Earnings (13) The Annual Report to Stockholders of the Company for the fiscal year ended December 31, 1997 (except for the pages and information thereof expressly incorporated by reference in this Form 10-K, the Annual Report to Shareholders is provided solely for the information of the Securities and Exchange Commission and is not deemed "filed" as part of this Form 10-K) (21) Subsidiaries of the Registrant (23) Consent of Coopers & Lybrand L.L.P. (27) Financial Data Schedule All exhibit descriptions followed by an asterisk and a letter in parentheses were previously filed with the Securities and Exchange Commission as Exhibits to, and are hereby incorporated by reference from, the following documents: (a) Registrant's Registration Statement on Form S-1 Registration No. 33-40073. (b) Amendment No. 1 on Form 8 to the Registrant's Registration Statement on Form 8-A, File No. 0-19175. (c) Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1991. (d) Registrant's Quarterly Report on Form 10-Q for the quarter ended June 27, 1992. (e) Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992. (f) Registrant's Quarterly Report on Form 10-Q for the quarter ended October 2, 1993. (g) Registrant's Quarterly Report on Form 10-Q for the quarter ended April 2, 1994. (h) Registrant's Quarterly Report on Form 10-Q for the quarter ended July 2, 1994. (i) Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1994. (j) Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1996 All exhibit descriptions followed by a (+) indicate documents with respect to which confidential treatment has been granted. EX-10.17 2 FORM OF SEVERANCE COMPENSATION AGREEMENT 1 FORM OF SEVERANCE COMPENSATION AGREEMENT ---------------------------------------- EXHIBIT 10.17 ------------- SEVERANCE COMPENSATION AGREEMENT SEVERANCE COMPENSATION AGREEMENT dated as of ______________ by and between PROTEON, INC. and/or OpenROUTE Networks, Inc. (the "Company"), a Massachusetts corporation with its principal offices at Nine Technology Drive, Westboro, Massachusetts 01581, and ___________ (the "Executive"), residing at _________ ________________________________. WHEREAS, the Company's Board of Directors has recognized that the possibility of a change in control of the Company may cause uncertainty among the Company's senior management and may result in the departure or distraction of its senior management to the detriment of the Company and its stockholders; WHEREAS, the Company's Board of Directors has determined that it is appropriate to reinforce and encourage the continued attention and dedication of members of the Company's senior management, including the Executive, to their duties without distraction arising from the possibility of a change in control of the Company; WHEREAS, the Executive desires assurance as to his compensation and benefits in the event of any change in control of the company; NOW, THEREFORE, in consideration of the covenants and agreements herein contained and for other good and valuable consideration, the receipt and adequacy of which are hereby acknowledged, the Company and the Executive agree as follows: 1. TERM. This Agreement shall terminate, except to the extent that any obligation of the Company hereunder remains unpaid as of such time, upon the earliest to occur of: (a) two (2) years from the date hereof; (b) the termination of the Executive's employment with the Company based on (i) the death of the Executive, (ii) the Disability of the Executive, (iii) termination by the Company for Cause, or (iv) termination by the Executive other than for Good Reason; and (c) one year after the date of a Change in Control. As used in this Agreement the term "Term" shall mean the period beginning on the date hereof and ending upon the earliest to occur of events specified above. 2 2. CHANGE IN CONTROL. No compensation shall be payable under this Agreement unless and until there shall have been a Change in Control. As used in this Agreement, the term "Change in Control" means that any of the following events has occurred: (i) any person (as defined in Section 3(a)(9) of the Securities Exchange Act of 1934, as amended (the "1934 Act)) (or any successor provision), becomes the beneficial owner (determined in accordance with Rule 13d-3 under the 1934 Act, or any successor provision), directly or indirectly, of more than fifty percent (50%) of the outstanding Common Stock of the Company, or otherwise becomes entitled to vote more than fifty percent (50%) of the voting power entitled to be cast at elections for directors ("Voting Power") of the Company; (ii) there shall have been consummated any consolidation or merger of the Company (A) in which the Company is not the continuing or surviving corporation unless such merger is with a corporation at least eighty percent (80%) of the Voting Power of which is held by the Company, or (B) pursuant to which the holders of the Company's shares of Common Stock immediately prior to such merger or consolidation are not the holders immediately after such merger or consolidation of at least a majority of the Voting Power of the entity resulting from such consolidation or merger; (iii) there shall have been consummated any sale, lease, exchange or other transfer (in one transaction or a series of related transactions) of all or substantially all of the assets of the Company; or (iv) during any period of two consecutive years, individuals who at the beginning of such period were members of the Board of Directors of the Company ceased for any reason to constitute a majority thereof, unless the election, or the nomination for election by the Company's stockholders, of each new director was approved by a vote of at least two-thirds of the directors still in office at the time of such election or nomination who were directors at the beginning of such Period. As used in this definition of Change in Control, "Common Stock" means the Common Stock, or if changed, the capital stock of the Company as it shall be constituted from time to time entitling the holders thereof to share generally in the distribution of all assets available for distribution to the Company's stockholders 3 after the distribution to any holders of capital stock with preferential rights. 3. TERMINATION FOLLOWING CHANGE IN CONTROL. The Executive shall be entitled to the compensation provided in Section 4 hereof upon the termination of the Executive's employment with the Company during the Term of this Agreement and after a Change in Control unless such termination is as a result of (i) the Executive's death, (ii) the Executive's Disability, (iii) termination by the Company for Cause, or (iv) termination by the Executive other than for Good Reason. As used in this Agreement, the following terms shall have the following meanings: (a) the term "Disability" shall mean that as a result of the Executive's incapacity due to physical or mental illness or physical injury (excluding illness or injury which was caused by repeated substance abuse by the Executive), the Executive shall have been absent from his duties with the Company on a full-time basis (i) for a period of sixty (60) consecutive days or (ii) for an aggregate of ninety (90) days during any period of twelve (12) consecutive months; (b) the term "Cause" shall mean any of (i) the willful and continued failure by the Executive to perform his duties with the Company, other than any such willful or continued failure resulting from his incapacity due to physical or mental illness or physical injury (provided that if such willful and continued failure resulted from illness or injury which was caused by repeated substance abuse by the Executive, then the foregoing exception for physical or mental illness or physical injury shall not be applicable), (ii) the willful or knowingly reckless engaging by the Executive in misconduct which is materially injurious to the Company, financially or otherwise, including, without limitation, willful breach by the Executive of any employment or other agreement between the Executive and the Company, or (iii) the conviction of the Executive of a felony by a court of competent jurisdiction. For purposes of the foregoing, (x) the failure of the Company to achieve desired or projected results shall not constitute Cause, but Cause shall only mean and include acts and/or omissions by the Executive which are specified in clauses (i), (ii) and (iii) of the immediately preceding sentence, and (y) no act or failure to act on the part of the Executive shall be considered "willful" unless done or admitted to be done by him not in good faith and without reasonable belief that his action or omission was in the best interests 4 of the Company. Notwithstanding the first sentence of this subparagraph (b), the Executive's employment shall not be deemed to have been terminated for Cause unless (A) reasonable notice shall have been given to him setting forth in detail the reasons for the Company's intention to terminate for Cause and, if such termination is pursuant to clause (i) or (ii) above, only if the Executive has been provided a period of five (5) business days from receipt of such notice to cease the actions or inactions, and if he has not done so (B) an opportunity shall have been provided for the Executive, together with his counsel, to be heard before the Board of Directors of the Company, and (C) if such termination is pursuant to clause (i) or (ii) above, delivery shall have been made to the Executive of a Notice of Termination from the Board of Directors stating that in the good faith opinion of a majority of the Board of Directors (excluding the Executive) he was guilty of conduct set forth in clause (i) or (ii) above and specifying the particulars thereof in detail; (c) the term "Good Reason" shall mean any of the following (without the Executive's express written consent): (i) after a Change in Control, the assignment to the Executive by the Company of duties inconsistent with the Executive's position, duties, responsibilities and status with the Company immediately prior to such Change in Control, or a change in the Executive's titles or offices as in effect immediately prior to such Change in Control, or any removal of the Executive from or any failure to reelect the Executive to any of such positions, except in connection with the termination of his employment for Disability, for Cause, as a result of the Executive's death or by the Executive other than for Good Reason: (ii) after a Change in Control, a reduction by the Company in the Executive's base salary as in effect on the date hereof or as the same may be increased from time to time during the Term of this Agreement, or the Company's failure after a Change in Control to increase (within 12 months of the Executive's last increase in base salary) the Executive's base salary by an amount which, on a percentage basis, is not more than two percentage points below the average percentage increase in base salary effected in the preceding 12 months 5 for all officers of the Company having severance compensation agreements similar to this Agreement; (iii)after a Change in Control, any failure by the Company to continue in effect any benefit plan or arrangement (including, without limitation, the Company's group life insurance plan, and medical, dental, accident and disability plans) in which the Executive is participating at the time of a Change in Control (or any other substitute plans providing the Executive with substantially similar benefits) (hereinafter referred to as "Benefit Plans"), or the taking of any action by the Company which would adversely affect the Executive's participation in or materially reduce the Executive's benefits under any such Benefit Plan or deprive the Executive of any material fringe benefit enjoyed by the Executive at the time of a Change in Control; (iv) after a Change in Control, any failure by the Company to continue in effect any incentive plan or arrangement (including, without limitation, the Company's Management Incentive Plan, and the right to receive performance awards and similar incentive compensation benefits) in which the Executive is participating at the time of a Change in Control (or any other substitute plans or arrangements providing him with substantially similar benefits) (hereinafter referred to as "Incentive Plans") or the taking of any action by the Company which would adversely affect the Executive's participation in any such Incentive Plan or reduce the Executive's benefits under any such Incentive Plan, expressed as a percentage of his base salary, by more than 10 percentage points in any fiscal year as compared to the immediately preceding fiscal year; (v) after a Change in Control, any failure by the Company to continue in effect any plan or arrangement to receive securities of the Company (including, without limitation, the Company's 1991 Restated Stock Option Plan and any other plan or arrangement to receive and exercise stock options, stock appreciation rights, restricted stock or grants thereof) in which the Executive is participating at the time of a Change in Control of the Company (or substitute plans or arrangements providing him with substantially 6 similar benefits) (hereinafter referred to as "Securities Plans") or the taking of any action by the Company which would adversely affect the Executive's participation in or materially reduce the Executive's benefits under any such Securities Plans; (vi) after a Change in Control, requirement by the Company of the Executive's relocation to any place other than the location at which the Executive performed the Executive's duties prior to a Change in Control, except for required travel by the Executive on the Company's business to an extent substantially consistent with the Executive's business travel obligations at the time of a Change in Control; (vii) after a Change in Control, any failure by the Company to provide the Executive with the number of paid vacation days to which the Executive is entitled at the time of a Change in Control; (viii) any material breach by the Company of any provision of this Agreement; (xi) any failure by the Company to obtain the assumption of this Agreement by any successor or assign of the Company in accordance with Section 7 hereof: or (x) any purported termination of the Executive's employment which is not effected pursuant to a Notice of Termination, and for purposes of this Agreement, no such purported termination shall be effective. (d) The term "Notice of Termination" shall mean a written notice which shall indicate those specific termination provisions in this Agreement relied upon and which sets forth in reasonable detail the facts and circumstances claimed to provide a basis for termination of the Executive's employment under the provision so indicated. For purposes of this Agreement, no such purported termination by the Company shall be effective without such Notice of Termination. e) the term "Date of Termination" shall mean (i) if the Executive's employment is terminated by the Company for Disability, 30 days after Notice of Termination is 7 given to the Executive (provided that the Executive shall not have returned to the performance of the Executive's duties on a full-time basis during such 30-day period) or (b) if the Executive's employment is terminated by the Company for any other reason, the date on which a Notice Of Termination is given; PROVIDED that if within 30 days after any Notice of Termination is given to the Executive by the Company the Executive notifies the Company that a dispute exists concerning the Termination, the Date of Termination shall be the date the dispute is finally determined, whether by mutual agreement by the parties or upon final judgment, order or decree of a court of Competent jurisdiction (the time for appeal therefrom having expired and no appeal having been perfected). 4, SEVERANCE COMPENSATION (a) Subject to the provisions of section 4(b) below, and subject to the Executive's continuing compliance with the provisions of Section 6 hereof and the Agreement Regarding Confidential Information and Intellectual Property attached hereto as EXHIBIT A, the compensation and benefits payable to the Executive pursuant to this Agreement shall be the following (collectively the "Severance Benefits"): (i} The Company shall pay to the Executive in cash an amount equal to the Executive's aggregate compensation from the Company for the twelve (12) months ending upon the Change in Control. Such amount shall be payable by, the Company in twelve (12) equal monthly installments payable on the first day of each month commencing with the month following the Executive's Date of Termination. For purposes of this Section 4(a)(1), the. Executive's "compensation" preceding a Change in Control shall include the Executive's base salary and any amounts paid or accrued pursuant to any Incentive Plans, but shall not include any amounts or benefits paid or accrued pursuant to any Benefit Plans or any Securities Plan nor shall it include the value of any other fringe benefits, (ii} Within thirty (30) days following the Date of Termination, the Company shall pay to the Executive, in a lump sum in cash, any accrued but unpaid salary, vacation and awards under any Incentive Plans earned but not paid as of the Date of Termination; 8 (iii)Effective not later than the Date of Termination, the Company shall (notwithstanding any contrary provision in any Securities Plan or any employment agreement) accelerate and make immediately exercisable in full all unvested options and other rights which the Executive holds under any Securities Plans as of the Date of Termination, and all such options and rights shall be exercisable for an exercise period of 60 days following the Date of Termination; and (iv) The Company at its own expense shall maintain in full force and effect for the Executive's continued benefit until the earlier of (i) one (1) year after the Date of Termination or (ii) the Executive's commencement of full-time employment with a new employer, medical and dental (but not life insurance or disability) plans, programs or arrangements in which the Executive was entitled to participate immediately prior to the Date of Termination, provided that his continued participation is possible under the general terms and provisions of such plans and programs. In the event that his participation in any such plan or program is barred, the Company shall arrange to provide the Executive with benefits substantially similar to those to which he was entitled to receive under such plans and programs. (b) Notwithstanding the foregoing, any Severance Benefits otherwise payable to the Executive hereunder shall be limited as follows: (I) No Severance Benefits shall be payable to the Executive under this Agreement to the extent that the total of such Severance Benefits and any payments otherwise payable to the Executive by the Company on or after a Change in Control, which would be deemed under Section 280 (of the Internal Revenue Code of 1986 as amended (the "Code"), to constitute "parachute payments" without regard to Section 280G(b)(2)(A)(ii), would equal or exceed in their present value (as determined under Section 280G(d)(4) of the Code and any regulations thereunder) 300% of the Executive's base amount (as defined in Section 280G(b)(3) of the Code and regulations thereunder). In the event that the present value of such payments equals or exceeds such amount, the provisions set forth below will apply, and Severance Benefits payable to the Executive under this Agreement will be made only in accordance with this Section 4(b) notwithstanding any other provision to the contrary in this Agreement. 9 (ii) Not later than thirty (30) days after the Date of Termination, the Company will provide the Executive with a schedule specifying the present value of such Severance Benefits payable to the Executive under this Agreement (specifying the Section hereof under which each such payment is to be made) and any other payments otherwise payable to the Executive by the Company on or after the Change in Control which, in the Company's opinion, could constitute parachute payments under Section 280G. No payments under this Agreement shall be made until after thirty (30) days from the receipt of such schedule by the Executive. At any time prior to the expiration of said 30-day period, the Executive shall have the right to select from all or part of any category of payment to be made under this Agreement those payments to be made to the Executive in an amount the present value of which (when combined with the present value of any other payments otherwise payable to the Executive by the Company that may be deemed to be parachute payments) the Company determines is less than 300% of the Executive's base amount. If the Executive fails to exercise his right to make a selection, the selection shall be made by the Company. (iii) At any time prior to exercising the right to make a selection under paragraph (ii) of this Section 4(b), the Executive shall have the right to request that the Company obtain a ruling from the Internal Revenue Service ("Service") as to whether any or all payments listed on the schedule provided hereunder are, in the view of the Service, parachute payments under section 280G. Such ruling shall be sought made at the Company's expense unless, in the written opinion of independent counsel for the Company, there is no reasonable likelihood of obtaining a favorable ruling, in which event such expense shall be borne by the Executive. If a ruling is sought pursuant to such request, no Severance Benefit under this Agreement shall be paid to the Executive until after thirty (30) days from the date the Company provides the Executive with a copy of such ruling, and the period during which the Executive may exercise his right to make a selection under paragraph (ii) hereof shall be extended to a date thirty (30) days from such date. For purposes of this Section 4(b), the Executive and the Company hereby agree to be bound by the Service's ruling as to whether payments constitute parachute payments under Section 280G. If the Service declines, for any reason, to provide the ruling requested, the Company's 10 determination with respect to what payments constitute parachute payments shall control, and the period during which the Executive may exercise his right to make a selection under paragraph (ii) hereof shall be extended to a date thirty (30) days from the date of the Service's notice indicating that no ruling will be forthcoming. (iv) The references to Section 280G herein are specific references to Section 280G as amended to date. If Section 280G is amended prior to the expiration or termination of this Agreement, or replaced by a successor statute, the limitations imposed by this Section 4(b) upon payments to be made to the Executive under this Agreement shall be deemed modified without further action of the parties so as to provide only for such limitations that are consistent with such amendment(s) or successor statute(s), as the case may be. In the event that Section 280G, or any successor statute, is repealed, this Section 4(b) shall cease to be effective on the date of such repeal. The parties to this Agreement recognize that final Treasury Regulations under Section 280G may affect the amounts that may be paid hereunder and agree that, upon issuance of such final Regulations, this Agreement may be modified as in good faith deemed necessary in light of the provisions of such Regulations to achieve the purposes hereof, and that consent to such modification(s) shall not be unreasonably withheld 5. NO OBLIGATION TO MITIGATE DAMAGES; NO EFFECT ON OTHER CONTRACTUAL RIGHTS. (a) The Executive shall not be required to mitigate damages or the amount of any payment provided for under this Agreement by seeking other employment or otherwise, nor shall the amount of any payment provided for under this Agreement be reduced by any compensation earned by the Executive as the result of employment by another employer after the Date of Termination, or otherwise. (b) The provisions of this Agreement, and any payment provided for hereunder, shall not reduce any amounts otherwise payable, or in any way diminish the Executive's existing rights, or rights which would accrue solely as a result of the passage of time, under any Benefit Plan, Incentive Plan or Securities Plan, employment agreement or other contract, plan or arrangement. 11 6. NON-COMPETITION; CONFIDENTIALITY. (a) The Executive covenants and agrees that if the Executive shall become entitled to compensation hereunder as provided in Section 3 hereof, then for a period of twelve (12) months following the Date of Termination, the Executive shall not, without the Company's prior written consent, engage, directly or indirectly, in any work or other activity which is in competition with the business of the Company in the local area network or internetworking field in any geographical area in which the Company conducts or is then actively planning to conduct business at the Date of Termination. By way of example only of the types of activities prohibited hereby, the Executive shall not: solicit or accept (or assist any person or entity in soliciting or accepting) any business in the local area network or internetworking field from any person or entity who or which was an active account of the Company at the Date of Termination (b) Contemporaneously with the execution and delivery of this Agreement, the Executive and the Company shall enter into an Agreement Regarding Confidential Information and Intellectual Property in the Company's standard form, a copy of which is attached hereto as EXHIBIT A. 7. SUCCESSORS. (a) The Company will require any successor or assign (whether direct or indirect, by purchase, merger, consolidation or otherwise) to all or substantially all of the business and/or assets of the Company, by agreement in form and substance satisfactory to the Executive, expressly, absolutely and unconditionally to assume and agree to perform this Agreement in the same manner and to the same extent that the Company would be required to perform it if no such succession or assignment had taken place. Any failure of the Company to obtain such agreement prior to the effectiveness of any such succession or assignment shall be a material breach of this Agreement and shall entitle the Executive to terminate the Executive's employment for Good Reason. As used in this Agreement, "Company" shall mean the Company as herein before defined and any successor or assign to its business and/or assets as aforesaid which executes and delivers the agreement provided for in this Section 7 or which otherwise becomes bound by all the terms and provisions of this Agreement by operation of law. If at any time during the Term of this Agreement the Executive is employed by any corporation a majority of the Voting Power of which is then owned by the Company, directly or indirectly, "Company" as used in Sections 3,4 and 12 hereof shall in addition include such employer. In such event, the Company agrees that it shall pay or shall cause 12 such employer to pay any amounts owed to the Executive pursuant to Section 4 hereof (b) This Agreement shall inure to the benefit of and be enforceable by the Executive's personal and legal representatives, executors, administrators, successors, heirs, distributees, devisees and legatees. If the Executive should die while any amounts are still payable to him hereunder, all such amounts, unless otherwise provided herein, shall be paid in accordance with the terms of this Agreement to the Executive's devisee, legatee, or other designee or, if there be no such designee, to the Executive's estate. 8. NOTICE. For purposes of this Agreement, notices and all other communications provided for in the Agreement shall be in writing and shall be deemed to have been duly given when delivered in person (including by any commercial courier service) or three (3) days after mailing by United States certified or registered mail, return receipt requested, postage prepaid, to a party at his or its address set forth at the beginning of this Agreement or such other address as either party may have furnished to the other in writing in accordance herewith, except that notices of change of address shall be effective only upon receipt. 9. MISCELLANEOUS. No provisions of this Agreement may be modified, waived or discharged unless such waiver, modification or discharge is agreed to in writing signed by the Executive and the Company. No waiver by either party hereto at any time of any breach by the other party hereto of, or compliance with, any condition or provision of this Agreement to be performed by such other party shall be deemed a waiver of similar or dissimilar provisions or conditions at the same or at any prior or subsequent time. No agreements or representations, oral or otherwise, express or implied, with respect to the subject matter hereof have been made by either party which are not set forth expressly in this Agreement. This Agreement shall be governed by and construed in accordance with the laws of the Commonwealth of Massachusetts (without regard to conflicts of laws rules). 10. VALIDITY. The invalidity or unenforceability of any provisions of this Agreement shall not affect the validity or enforceability of any other provision of this Agreement, which shall remain in full force and effect 11. COUNTERPARTS. This Agreement may be executed in one or more counterparts, each of which shall be deemed to be an original but all of which together will constitute one and the same instrument. 13 12. LEGAL FEES AND EXPENSES. The Company shall pay all legal fees and expenses which the Executive may incur as a result of the Company's contesting the validity, enforceability or the Executive's interpretation of, or determinations under, this Agreement. 13. FURTHER ASSURANCES. The Company shall do, make, execute and deliver all such additional and further acts, things, assurances and instruments as the Executive may reasonably request in order to assure to the Executive his rights hereunder and to carry into effect the provisions and intent of this Agreement. Without limiting the generality of the foregoing, the Company shall, upon request of the Executive, convert any options under any Securities Plan which are "incentive stock options" into "non-qualified options" and amend outstanding option agreements in a manner not inconsistent with such Securities Plans IN WITNESS WHEREOF, the parties have executed this Severance Compensation Agreement as of the date first above written. PROTEON, INC. BY: /s/ Daniel J. Capone, Jr. ------------------------------------------ Title: President & Chief Executive Officer BY: /s/ ------------------------------------------ Executive EX-10.18 3 AMENDMENT TO LEASE 1 EXHIBIT 10.18 AMENDMENT TO LEASE ------------------ This Amendment to Lease (the "Amendment") dated as of May 23, 1997 by and between WCB TWENTY LIMITED PARTNERSHIP, a Delaware limited partnership ("Landlord") and PROTEON, INCORPORATED ("Tenant"). WITNESSETH: WHEREAS, Landlord is the landlord and Tenant is the tenant under that certain Lease dated December 19, 1994 (the "Lease"), pursuant to which the Tenant leases 96,166 square feet of rentable space in the building known as and numbered Nine Technology Drive, Westborough, Massachusetts; and WHEREAS, Landlord and Tenant desire to amend the Lease by deleting 52,204 square feet of rentable space from the Premises demised under the Lease, and by making certain other amendments to the terms and provisions of the Lease, all as more fully set forth herein; NOW, THEREFORE, in consideration of the foregoing and for other good and valuable consideration, the receipt and sufficiency of which are hereby mutually acknowledged, Landlord and Tenant hereby confirm and mutually agree as follows: 1. DEFINITIONS. Unless otherwise defined herein, all capitalized terms used in this Amendment to Lease shall have the definitions ascribed to them in the Lease. 2. EFFECTIVE DATE. This Amendment to Lease shall take effect as of 12:01 am on May 23, 1997 (the "Effective Date"). 3. TERM EXPIRATION DATE. The definition of "INITIAL TERM EXPIRATION DATE" set forth in Section 1.1 of the Lease shall remain unchanged, such Initial Term Expiration Date being 12:00 midnight on April 30, 2002. 4. EXTENSION TERMS. The provisions of Section 2.4.1 of the Lease shall remain unchanged. 5. PREMISES. Effective as of the Effective Date, the definition of "PREMISES" set forth in Section 1.1 of the Lease shall be deleted in its entirety and the following inserted in its place: "PREMISES: The Premises, comprising 43,962 square feet of Rentable Floor Area on the first floor of the Building, are outlined on Exhibit A attached hereto and incorporated by reference herein." 6. RENTABLE FLOOR AREA. Effective as the Effective Date, the definition of "RETABLE FLOOR AREA OF PREMISES" shall be deleted in it entirety and the following inserted in its place: "RENTABLE FLOOR AREA OF PREMISES: 43,962 square feet." 7. TENANT'S PROPORTIONATE SHARE. Effective as of the Effective Date, the definition of "TENANT'S PROPORTIONATE SHARE" set forth in Section 1.1 of the Lease shall be deleted in its entirety and the following inserted in its place: "TENANT's PROPORTIONATE SHARE: Seventeen and 53/100 percent (17.53%), being the ratio of the Rentable Floor Area of the Premises to the Rentable Floor Area of the Building." 8. PLAN OF PREMISES. Effective as of the Effective Date, Exhibit A of the Lease shall be deleted in its entirety and the new Exhibit A attached hereto shall be inserted in its place. 9. PARKING. Effective as of the Effective Date, Tenant acknowledges and agrees that Landlord shall have the right to assign and designate 10 parking spaces adjacent to the exit door of Stairwell #5 of the Building for the exclusive use of The TJX Companies, Inc. ("TJX"). 10. VACATION OF SPACE. On or before the Effective Date, Tenant shall vacate the deliver to Landlord those portions of the 96,166 square feet of Rentable Floor Area that Tenant currently occupies which are not part of the Premises as defined in Section 5 above and described on Exhibit A attached hereto (being 52,204 square feet of Rentable Floor Area, herein referred to as the "Vacated Space"), time being of the essence. Tenant shall deliver the Vacated Space in its "AS IS" condition, free of all of its personal property and trade fixtures (except with respect to the cafeteria and exercise room on the first floor, both of which are the subject of a separate agreement between Tenant and TJX) HVAC, plumbing and electrical and mechanical systems included in the Vacated Space in good working order and repair. 11. CONDITIONS PRECEDENT. This Amendment to Lease is subject to conditioned in all respects upon the execution and delivery of a Lease between Landlord and TJX pursuant to which TJX shall lease the Vacated Space (the "TJX Lease"). In the event that Landlord and TJX do not execute and deliver a Lease for the Vacated Space on or before the Effective Date, this Amendment to Lease shall be null and void and of no further force and effect. 2 12. PAYMENTS BY TENANT. Tenant acknowledges and agrees that is shall be responsible for, and shall pay (i) to Landlord, a lump sum payment on or before the Effective Date in an amount equal to the Fixed rent and Additional Rent for the Vacated Space for the period commencing May 23, 1997 through and including July 14, 1997, and (ii) all of the Landlord's costs, fees and expenses with respect to the preparation of this Amendment to Lease and the TJX Lease, including, without limitation, the fees and expenses of Landlord's counsel in connection with same. 13. BROKERAGE. Landlord and Tenant each represent and warrant to the other that it has not engaged any broker or similar agent in connection with this Amendment to Lease or the TJX Lease except Whittier Partners, the Columbia Group and Lynch, Murphy & Partners. Tenant acknowledges and agrees that it shall be responsible for and shall pay directly the brokerage commissions and fees in connection with this Amendment to Lease and the TJX Lease, including any commissions and fees due and owing Whittier Partners, the Columbia Group or Lynch, Murphy & Partners, and Tenant agrees to indemnify and hold Landlord harmless from and against any claim against Landlord for brokerage commission or fees in connection with this Amendment to Lease or the TJX Lease (i) by Whittier Partners, the Columbia Group or Lynch, Murphy & Partners, or (ii) by any other broker or similar agent with which Tenant has dealt in connection with this Amendment to Lease or the TJX Lease or the transactions contemplated hereby or thereby. 14. EFFECT OF AMENDMENT. Except as set forth herein, the lease shall remain unchanged and in full force and effect. All references to the "Lease" shall be deemed to be references to the Lease as amended by this Amendment to the Lease. 3 IN WITNESS WHEREOF, Landlord and Tenant have caused this Amendment to Lease to be executed by their duly authorized officers as an instrument under seal as of the day and year first above written. LANDLORD WCB TWENTY LIMITED PARTNERSHIP a Delaware limited partnership By: WCB TWENTY, INC. a Delaware corporation By: /s/ JOHN M. MARKEY ------------------------------------ John M. Markey Senior Vice President - East TENANT: PROTEON INCORPORATED By: /s/ DANIEL J. CAPONE, JR. ------------------------------------ Daniel J. Capone, Jr. President & CEO EX-11 4 COMPUTATION OF PER SHARE EARNINGS 1 EXHIBIT 11 PROTEON, INC. STATEMENT RE: COMPUTATION OF PER SHARE EARNING (in thousands, except per share amounts)
Twelve months ended December 31, December 31, December 31, 1997 1996 1995 -------- -------- -------- Net (Loss) Income ($ 7,847) ($12,014) $ 8,220 ======== ======== ======== Basic: Weighted average number of common shares outstanding used to calculate per share data 15,301 15,630 15,416 ======== ======== ======== Diluted: Weighted average number of common shares outstanding 15,301 15,630 15,416 Weighted average common equivalent shares - - 276 -------- -------- -------- Weighted average number of common and common equivalent shares outstanding used to calculate per share data 15,301 15,630 15,692 ======== ======== ======== Net (loss) income per share Basic ($ 0.51) ($ 0.77) $ 0.53 ======== ======== ======== Diluted ($ 0.51) ($ 0.77) $ 0.52 ======== ======== ========
EX-13 5 ANNUAL REPORT 1 Proteon, Inc. EXHIBIT 13 - ---------------------------------------- SELECTED CONSOLIDATED FINANCIAL DATA - ---------------------------------------- CONSOLIDATED STATEMENT OF OPERATIONS DATA: - -------------------------------------------------------------------------------
Years ended December 31, (in thousands, except per share data) 1997 1996 1995 1994 1993 - ------------------------------------------------------------------------------------------------------------------- Net sales $26,944 $ 45,296 $75,323 $93,912 $103,405 Cost of sales 15,340 25,670 36,664 48,148 61,723 - ------------------------------------------------------------------------------------------------------------------- Gross profit 11,604 19,626 38,659 45,764 41,682 Operating expenses: Research and development 5,987 9,353 8,802 11,162 15,481 Selling and marketing 10,703 15,486 17,903 23,955 31,778 General and administrative 3,870 4,590 4,683 7,065 10,222 Restructure costs (241) 3,312 - 6,330 7,711 - ------------------------------------------------------------------------------------------------------------------- Total operating expenses 20,319 32,741 31,388 48,512 65,192 - ------------------------------------------------------------------------------------------------------------------- (Loss) income from operations (8,715) (13,115) 7,271 (2,748) (23,510) Interest income (expense), net 1,052 1,261 1,437 455 330 Other income - - - 1,205 - - ------------------------------------------------------------------------------------------------------------------- (Loss) income before income taxes (7,663) (11,854) 8,708 (1,088) (23,180) Provision (benefit) for income taxes 184 160 488 251 (3,385) - ------------------------------------------------------------------------------------------------------------------- (Loss) income before cumulative effect of accounting change (7,847) (12,014) 8,220 (1,339) (19,795) Cumulative effect of accounting change for income taxes - - - - 452 - ------------------------------------------------------------------------------------------------------------------- Net (loss) income $(7,847) $(12,014) $ 8,220 $(1,339) $(19,343) - ------------------------------------------------------------------------------------------------------------------- Basic (loss) income per share: (Loss) income per share before cumulative effect of accounting change $ (0.51) $ (0.77) $ 0.53 $( 0.09) $ (1.36) Cumulative effect of accounting change for income taxes - - - - 0.03 - ------------------------------------------------------------------------------------------------------------------- Basic (loss) income per common and common equivalent share $ (0.51) $ (0.77) $ 0.53 $ (0.09) $ (1.33) - ------------------------------------------------------------------------------------------------------------------- Diluted (loss) income per share: (Loss) income per share before cumulative effect of accounting change $ (0.51) $ (0.77) $ 0.52 $( 0.09) $ (1.36) Cumulative effect of accounting change for income taxes - - - - 0.03 - ------------------------------------------------------------------------------------------------------------------- Diluted (loss) income per common and common equivalent share $ (0.51) $ (0.77) $ 0.52 $ (0.09) $ (1.33) - ------------------------------------------------------------------------------------------------------------------- Weighted average number of common shares outstanding 15.301 15,630 15,416 14,808 14,527 Weighted average number of common and common equivalent shares outstanding 15,301 15,630 15,692 14,808 14,527 - ------------------------------------------------------------------------------------------------------------------- CONSOLIDATED BALANCE SHEET DATA: Working capital $23,620 $ 30,597 $39,006 $27,550 $ 20,698 Total assets 33,403 45,571 59,029 56,911 56,767 Stockholders' equity 26,892 35,191 47,323 37,679 36,739
2 - ------------------------------------------------------------------------------- Management's Discussion and Analysis of Financial Condition and Results of Operations - ------------------------------------------------------------------------------- The following discussion and analysis should be read in conjunction with the consolidated financial statements and notes thereto. Results of Operations During 1997 the Company continued to make progress in its transition from the LAN business environment to the Internet Access marketplace. Although overall product revenue decreased by 30.9% in 1997, the Company's GlobeTrotter Internet Access product revenue increased by 76.5% on a unit sales increase of 92.7%. Sales of GlobeTrotter products increased to 26.4% of total product revenue from 10.3% in 1996. The Company continued to experience losses in 1997 as the growth of the GlobeTrotter product line was not sufficient to offset the 44.1% decline in product revenue from LAN products and the winding up of the IBM and Digital Equipment software licensing agreements. The 1997 operating loss reflects approximately $880,000 or $0.06 per share of certain adjustments and accruals relating to business operations in the ASIA-Pacific region as well as certain employee incentive programs, both of which transpired in the fourth quarter of 1997. Net Sales Product sales decreased by 30.9% to $22,248,000 in 1997 from $32,175,000 in 1996. This anticipated decline reflects Proteon's continuing product transition from LAN products to Internet Access products. Although overall product revenue declined in 1997, GlobeTrotter product revenue increased 76.5% from 1996 as a result of increased unit sales. Corporate Enterprise and LAN product revenue declined in 1997 by 43.3% from 1996 levels. Software licensing revenue in 1997 decreased by 88.1% to $895,000 from $7,530,000 in 1996 reflecting the declining revenue produced from the IBM and Digital Equipment software licensing agreements. The Company expects that it will continue to have software licensing revenue in the future, however at varying and uncertain levels since software licensing revenue is an ancillary component of the Company's core revenue stream but strategic in its promotion of OpenROUTE routing technology in the marketplace. Service and other sales in 1997 decreased by 32.0% to $3,801,000 from $5,591,000 in 1996. This decrease was primarily due to the reduction in service contracts and upgrade revenue worldwide resulting from the Company's transition to Internet Access products which require less support services. Product sales decreased by 37.9% to $32,175,000 in 1996 from $51,810,000 in 1995. This decline was due to the Company's redirection of its business and products. The Company experienced declining revenues in both its LAN products and Corporate Enterprise product categories. The decrease in LAN products net sales in 1996 was due primarily to lower average selling prices and declining unit volumes of Adapter Cards, Switches and Hubs. The Corporate Enterprise reduction was due to a planned reduction in CNX backbone router as the Company shifted to Internet Access routers. Although in 1996 total units in the Internet Access category increased 63.3% from 1995 due primarily to GlobeTrotter sales which are typically lower average per unit sales prices, this increase was not enough to offset the decline in product revenues in the LAN and Corporate Enterprise categories. Software licensing sales in 1996 decreased by 47.3% to $7,530,000 from $14,284,000 in 1995. This anticipated reduction in software licensing revenue was a result of the continued decline in remaining revenue from the near completion of two major multi-year agreements with IBM and Digital Equipment Corporation. The Company expected software licensing revenue from these agreements to decrease quarterly as the contracts neared completion. Service and other sales in 1996 decreased by 39.4% to $5,591,000 from $9,229,000 in 1995. This decrease was primarily due to the reduction in service spares and upgrades revenue worldwide as corporate enterprise sales decreased. International sales accounted for approximately 35.4%, 38.3%, and 35.7% of net sales in 1997, 1996, and 1995, respectively. GROSS PROFIT Total gross profit margin decreased slightly in 1997 to 43.1% from 43.3% in 1996. Gross margin on product revenue improved significantly to 42.8% in 1997 from 35.3% in 1996 principally due to the expansion of the GlobeTrotter product line into a number of higher margin models as well as to reductions in manufacturing overhead expenses. Gross margin on service and other revenues also increased to 31.1% in 1997 from 23.0% in 1996 primarily due to improved efficiencies in the customer service area. However, these improvements were not sufficient to offset the substantial decline in software licensing revenue which is highly profitable. Total gross profit margin decreased in 1996 to 43.3% from 51.3% in 1995. Gross profit margin from the 3 Company's software licensing and service and other sales increased in 1996 to 63.1% from 60.5% in 1995 due primarily to the decreased engineering efforts related to existing agreements. Gross profit margin on product sales decreased in 1996 to 35.3% from 47.2% in 1995 due mainly to both declining margins and volume decreases in token ring adapter card segment of the LAN product category. During the fourth quarter of 1996, the Company recorded an additional inventory provision of $2,400,000 to reflect further inventory exposures as the Company transitioned from LAN to Internet Access products. RESEARCH AND DEVELOPMENT The Company considers product development expenditures to be critical to future revenues. These activities are closely related to product enhancement and new product development. The Company's strategy also includes joint development partnerships to bring new technologies and products to market. All of the Company's research and development costs to date have been expensed as incurred. Research and development expenses were $5,987,000 or 22.2%, $9,353,000 or 20.6%, and $8,802,000 or 11.7% of net sales in 1997, 1996 and 1995, respectively. The decrease in expenses of $3,366,000 in 1997 from 1996 was primarily due to lower personnel and personnel-related costs as well as a more defined focus on the Internet Access products only. When comparing 1996 to 1995, the increase of $551,000 in research and development expenses was due to the reallocation of engineering efforts from software licensing contracts to internally funded development. Major efforts in 1997 included the continuing development of the GlobeTrotter series of products with the introduction of several new models during the year. During 1996, the Company initiated the GlobeTrotter series, as well as the continued development of the RBX router, the CSX 900ER routing and switching product, the CSX 900E Ethernet switch/repeater and the CSX 901T Token Ring Switch. SELLING AND MARKETING Selling and marketing expenses were $10,703,000 or 39.7%, $15,486,000 or 34.2%, and $17,903,000 or 23.8% of net sales in 1997, 1996 and 1995, respectively. The decrease in expenses in 1997 from 1996 of $4,783,000 was primarily the result of lower personnel and personnel-related costs including sales commissions due to the decline in revenues in 1997 from 1996. However, 1997 selling and marketing expenses as a percentage of net sales increased when compared to 1996 in part due to the effort to promote the new Internet Access products. In 1996 sales and marketing expenses decreased by $2,417,000 when compared to 1995. This decrease was due mainly to lower personnel and personnel-related costs as well as a reduction in advertising expenses for 1996. GENERAL AND ADMINISTRATIVE General and administrative expenses were $3,870,000, $4,590,000, and $4,683,000 in 1997, 1996 and 1995, respectively. When comparing 1997 to 1996, the decrease in expenses of $720,000 was largely due to lower personnel and personnel-related costs. During 1996, general and administrative expenses decreased by $93,000 when compared to 1995. This slight decrease was also due to a lower level of personnel and personnel-related costs for 1996. RESTRUCTURING OF OPERATIONS The Company's management continually reviews methods to reduce its expense base in response to decreased revenue streams. As a result, the Company has implemented a series of restructurings, the most recent of which transpired in 1996. This restructuring of operations was necessary to reestablish the strategic direction of the Company and better align its operating expenses with anticipated revenues. In the fourth quarter of 1996, the Company recorded a $3,312,000 restructuring charge in connection with its strategic redirection of the Company's business to the Internet Access marketplace. This charge included approximately $410,000 of severance costs, approximately $785,000 to reduce the Company's occupancy requirements, approximately $1,922,000 associated with the disposal of fixed assets, and $195,000 of other costs. During 1996 the cash impact for restructuring was insignificant and as of December 31, 1996 there was an accrual of $1,661,000 relating to future spending. During 1997, the Company incurred cash expenditures in connection with the 1996 restructuring of approximately $495,000 for severance and payroll related costs, approximately $672,000 as a result of reducing its occupancy costs and $253,000 in other restructuring related costs. Management has determined that all of the Company's obligations from 4 the 1996 and prior restructurings have been settled. Accordingly, the Company reversed its remaining restructuring provision of $241,000 in the third quarter of 1997. PROVISION FOR INCOME TAXES In 1997, the Company recorded an income tax provision of $184,000 primarily due to foreign taxes on income earned outside the United States. The difference between the effective tax rate and the statutory tax rate for 1997 is mainly due to net operating loss carryforwards whose future realization is uncertain. In 1996, the Company recorded an income tax provision of $160,000, primarily due to foreign taxes on income earned outside the United States. The difference between the effective tax rate and the statutory tax rate for 1996 is also due primarily to net operating loss carryforwards whose future realization is uncertain. In 1995, the Company recorded an income tax provision $488,000 principally associated with alternative minimum tax, and state and foreign taxes. The difference between the effective tax rate and the statutory tax rate in 1995 is due primarily to the utilization of net operating loss carryforwards in 1995. YEAR 2000 The Company is reviewing all systems and equipment which may be affected by the Year 2000 issue. Management is also in the process of developing an action plan that provides for the repair or replacement of all systems with exposure to Year 2000 problems by the end of 1998, the cost of which is not expected to have a material financial impact on the Company. The plan calls for a combination of internal and external resources. The commitment of internal resources is not expected to have a significant impact on the Company's future sales and operating results. NEWLY ISSUED ACCOUNTING STANDARDS The FASB recently issued Statement No. 130 ("SFAS 130") "Reporting Comprehensive Income." This Statement requires changes in comprehensive income to be shown in a financial statement that is displayed with the same prominence as other financial statements. While not mandating a specific financial statement format, the Statement requires that an amount representing total comprehensive income be reported. The Statement will become effective for periods beginning after December 15, 1997. Reclassification of financial statements for earlier periods is required for comparative purposes. The Company does not believe that the adoption of SFAS 130 will have a material impact on its result of operations. The FASB also issued Statement No. 131 ("SFAS 131"), "Disclosures about Segments of an Enterprise and Related Information". This Statement, which supersedes Statement No. 14 "Financial Reporting for Segments of a Business Enterprise," changes the way public companies report information about segments. The Statement, which is based on the management approach to segment reporting, includes requirements to report segment information quarterly and entity-wide disclosures about products and services, major customers, and the material countries in which the entity holds assets and reports revenues. The Statement is effective for periods beginning after December 15, 1997. Restatement for earlier years is required for comparative purposes unless impracticable. In addition, SFAS 131 need not be applied to interim periods in the initial year; however, in subsequent years, interim period information must be presented on a comparative basis. The Company is currently evaluating this Statement and its effect on financial statement disclosures. LIQUIDITY AND CAPITAL RESOURCES During 1997, the Company's working capital decreased to $23,620,000 from $30,597,000 in 1996. Cash, cash equivalents and marketable securities constituted $17,760,000 of the $23,620,000 in working capital at December 31, 1997. 5 Cash consumed by operating activities decreased by $2,789,000 in 1997 from 1996. This change was due mainly to a smaller net operating loss in 1997 of $8,715,000 when compared to the 1996 net operating loss of $13,115,000, reducing cash consumption by $4,400,000. Also contributing to the change was a reduction in inventory levels at year end 1997 of $3,027,000 when compared to year end 1996 inventory levels. However, these two significant reductions were partially offset by a reduction in accounts payable and accrued expenses of $3,869,000. Cash consumed by investing activities increased by $4,533,000 in 1997 from 1996. This cash use was due primarily to marketable securities purchases exceeding sales by $5,525,000 in 1997. The Company's management believes that its cash, cash equivalents and marketable securities will satisfy its expected working capital and capital expenditure requirements through the next twelve months. SAFE HARBOR FOR FORWARD-LOOKING STATEMENTS The 1997 Annual Report, including the President's Letter and the Management's Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements within the meaning of the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on management's current expectations and involve a number of risks and uncertainties. The Company's future results remain difficult to predict and may be affected by a number of factors including: business conditions within the networking industry; timing of orders from, and shipments to major customers; timing of new products introductions; acceptance of products in the marketplace; increased competition; changes in manufacturing costs; changes in the mix of product sales; and changes in world economic conditions. Other risk factors are listed from time to time in the required documents including the Company's annual report on Form 10-K, filed with the SEC. 6 PROTEON, INC. Consolidated Balance Sheets
As of December 31, - ------------------------------------------------------------------------------------------------------------ (in thousands, except share data) 1997 1996 - ------------------------------------------------------------------------------------------------------------ ASSETS Current assets: Cash and cash equivalents $ 5,317 16,612 Marketable securities 12,443 6,918 Accounts receivable less reserve for doubtful accounts of $927 and $672 at December 31, 1997 and 1996, respectively 6,224 7,625 Inventories 5,710 8,737 Deposits and other assets 437 1,085 - ------------------------------------------------------------------------------------------------------------ Total current assets 30,131 40,977 Property and equipment, net 3,272 4,594 - ------------------------------------------------------------------------------------------------------------ Total assets $ 33,403 $ 45,571 - ------------------------------------------------------------------------------------------------------------ LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $ 2,292 $ 3,010 Accrued compensation 765 1,075 Accrued expenses 2,779 3,560 Accrued restructuring costs - 1,661 Accrued warranty 675 1,074 - ------------------------------------------------------------------------------------------------------------ Total current liabilities 6,511 10,380 Commitments and Contingencies (Note F) - - Stockholders' equity: Preferred stock, par value $.01, authorized 7,500,000 shares - - Common stock, par value $.01 per share, authorized 30,000,000 shares, issued 15,669,524 and 15,637,670 shares at December 31, 1997 and 1996, respectively 157 156 Capital in excess of par value 49,347 49,292 Accumulated deficit (21,666) (13,819) Cumulative translation adjustments 110 177 Less treasury stock, at cost, 397,435 shares and 210,685 shares (1,056) (615) at December 31, 1997 and 1996, respectively - ------------------------------------------------------------------------------------------------------------ Total stockholders' equity 26,892 35,191 - ------------------------------------------------------------------------------------------------------------ Total liabilities and stockholders' equity $ 33,403 $ 45,571 - ------------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial statements. 7 PROTEON, INC. Consolidated Statements of Operations
For the years ended December 31, - ---------------------------------------------------------------------------- (in thousands, except per share data) 1997 1996 1995 - ---------------------------------------------------------------------------- Sales: Product $22,248 $ 32,175 $51,810 Software licensing 895 7,530 14,284 Service and other 3,801 5,591 9,229 - ---------------------------------------------------------------------------- Net sales 26,944 45,296 75,323 Cost of sales: Product 12,722 20,825 27,373 Software licensing - 538 2,656 Service and other 2,618 4,307 6,635 - ---------------------------------------------------------------------------- Cost of sales 15,340 25,670 36,664 - ---------------------------------------------------------------------------- Gross profit 11,604 19,626 38,659 Operating expenses: Research and development 5,987 9,353 8,802 Selling and marketing 10,703 15,486 17,903 General and administrative 3,870 4,590 4,683 Restructure costs (241) 3,312 - - ---------------------------------------------------------------------------- Total operating expenses 20,319 32,741 31,388 - ---------------------------------------------------------------------------- (Loss)/income from operations (8,715) (13,115) 7,271 Interest income 1,052 1,271 1,490 Interest expense - (10) (53) - ---------------------------------------------------------------------------- (Loss)/income before income taxes (7,663) (11,854) 8,708 Provision for income taxes 184 160 488 - ---------------------------------------------------------------------------- Net (loss)/income ($7,847) ($12,014) $8,220 - ---------------------------------------------------------------------------- (Loss)/earnings per share -- Basic ($0.51) ($0.77) $0.53 ----------------------------------- Weighted average number of common shares outstanding -- Basic 15,301 15,630 15,416 - ---------------------------------------------------------------------------- (Loss)/earnings per share -- Diluted ($0.51) ($0.77) $0.52 ----------------------------------- Weighted average number of common and common equivalent shares outstanding -- Diluted 15,301 15,630 15,692 - ----------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial statements. 8 PROTEON, INC. CONSOLIDATED STATEMENT OF STOCKHOLDER'S EQUITY
Common stock ----------------------------------- Capital in Cumulative Treasury stock Total excess of Accumulated translation ----------------- stockholders' (in thousands) Shares Amount par value deficit adjustment Shares Amount equity - -------------------------------------------------------------------------------------------------------------------------------- BALANCE, DECEMBER 31, 1994 15,315 $153 $47,884 ($10,025) ($46) 81 ($287) $37,679 Issuance of common stock 274 3 1,257 1,260 Currency translation 164 164 Net income 8,220 8,220 - --------------------------------------------------------------------------------------------------------------------------------- BALANCE, DECEMBER 31, 1995 15,589 156 49,141 (1,805) 118 81 (287) 47,323 Issuance of common stock 48 151 151 Repurchase of stock as treasury stock 130 (328) (328) Currency translation 59 59 Net loss (12,014) (12,014) - -------------------------------------------------------------------------------------------------------------------------------- BALANCE, DECEMBER 31, 1996 15,637 156 49,292 (13,819) 177 211 (615) 35,191 Issuance of common stock 33 1 55 56 Repurchase of stock as treasury stock 186 (441) (441) Currency translation (67) (67) Net loss (7,847) (7,847) - --------------------------------------------------------------------------------------------------------------------------------- BALANCE, DECEMBER 31, 1997 15,670 $157 $49,347 ($21,666) $110 397 ($1,056) $26,892 - ---------------------------------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial statements. 9 PROTEON, INC. Consolidated Statements of Cash Flows
For the years ended December 31, - ----------------------------------------------------------------------------------------------- (in thousands) 1997 1996 1995 - ----------------------------------------------------------------------------------------------- Cash flows provided by operating activities: Net income (loss) $ (7,847) $(12,014) $ 8,220 Adjustments to reconcile net income (loss) to cash flows (consumed) provided by operating activities: Bad debt provision 439 - - Inventory provision - 2,374 - Depreciation and amortization 1,550 3,401 4,185 Restructuring cost - 1,922 - Loss (gain) on disposition of fixed assets 198 (117) (44) Changes in assets and liabilities: Decrease (increase) in accounts receivable 962 4,513 (152) Decrease (increase) in inventories 3,027 (6,686) 598 Decrease in deposits and other assets 768 372 1,260 Decrease in accounts payable and accrued expenses (3,869) (1,326) (7,526) ------------------------------------ Net cash (consumed) provided by operating activities (4,772) (7,561) 6,541 ------------------------------------ Cash flows consumed by investing activities: Proceeds from the sale of fixed assets 182 117 82 Capital expenditures (728) (1,600) (2,411) Marketable securities sales and maturities 19,428 15,456 7,120 Marketable securities purchases (24,953) (15,511) (11,883) ------------------------------------ Net cash consumed by investing activities (6,071) (1,538) (7,092) ------------------------------------ Cash flows (consumed) provided by financing activities Proceeds from the issuance of common stock 56 151 1,260 Purchase of treasury stock (441) (328) - ------------------------------------ Net cash (consumed) provided by financing activities (385) (177) 1,260 Effect of exchange rate changes on cash (67) 59 164 ------------------------------------ Net (decrease) increase in cash and cash equivalents (11,295) (9,217) 873 Cash and cash equivalents at beginning of year 16,612 25,829 24,956 ------------------------------------ Cash and cash equivalents at end of year $ 5,317 $ 16,612 $ 25,829 ------------------------------------ Supplemental disclosure of cash flow information: Non cash investing in finance activities: Note receivable on sale of fixed assets $ 120 - - Interest paid during the year - $ 10 $ 53 ------------------------------------ Income taxes paid during the year $ 230 $ 321 $ 344 ------------------------------------
The accompanying notes are an integral part of the consolidated financial statements. 10 - ------------------------------------------------------------------------------- Notes To Consolidated Financial Statements - ------------------------------------------------------------------------------- A. NATURE OF OPERATIONS Proteon, Inc. and its subsidiaries including its wholly owned subsidiary OpenROUTE Networks, Inc., develops, markets and supports a wide range of networking products that encompass the Internet Access, Local Area Networking and Remote Access components of the networking industry. The Company's principal markets include North America, Europe and the Far East. B. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Use of Estimates To prepare the financial statements in conformity with generally accepted accounting principles, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. In particular, the Company records reserves for estimated product returns, as well as the estimated collectibility of accounts receivable, estimated inventory obsolesence and estimated warranty obligations. All estimates are based upon experience and actual results could differ from the estimates and assumptions used by management. Principles of Consolidation The consolidated financial statements include the accounts of the Company and its subsidiaries including its wholly owned subsidiary OpenROUTE Networks, Inc. All intercompany transactions have been eliminated in consolidation. Revenue Recognition The Company recognizes revenue from product sales upon shipment of the product. Revenue from service agreements is recognized ratably over the term of the agreement. Revenue from software licensing is recognized upon performance of milestones when collectibility is reasonably assured. Revenue from development contracts is recognized under the percentage-of-completion method of accounting as costs are incurred. Provisions for estimated losses on contracts are recorded in the period when such losses are determined. Significant Customers and Export Sales In 1997, 1996 and 1995, net sales to one customer accounted for approximately 11%, 14% and 12%, respectively. A second customer accounted for approximately 8%, 14% and 10% of net sales in 1997, 1996, and 1995, respectively. The Company had international sales of approximately $9,541,000, $17,355,000 and $26,884,000 in 1997, 1996, and 1995, respectively. Export sales consisted of approximately $7,043,000, $11,698,000 and $18,548,000 for those same periods. Of these export sales, sales into Europe were approximately $5,337,000, $8,185,000, and $13,089,000 in 1997, 1996 and 1995, respectively. Export sales do not include direct sales from the Company's foreign subsidiaries. Translation of Foreign Currencies The Company has designated the local currency as the functional currency for all foreign locations. Accordingly, assets and liabilities of all foreign subsidiaries are translated at year-end rates of exchange, and income statement accounts are translated at average rates of exchange. The resulting translation adjustments are excluded from net earnings, and accumulated as a separate component of stockholder's equity. Foreign currency transaction gains and losses are included in results of operations in the periods in which they occur, and are immaterial for all periods presented. Cash, Cash Equivalents, and Marketable Securities The Company considers all highly liquid instruments purchased with a maturity of three months or less to be cash equivalents. Marketable securities consist of highly liquid investments with maturities of more than three months when purchased. Investments are stated at cost, plus accrued interest, which approximates fair market value. In addition, the Company classified all investments as available-for-sale securities. Realized gains and losses are determined on the specific identification method and are included in interest income or expense. The portfolio at December 31, 1997 matures at various dates through December 31, 1998. 11 Inventories Inventories are stated at the lower of cost or market, with cost determined under the first-in, first-out method. Property and Equipment Property and equipment are stated at cost. Depreciation and amortization of property and equipment are computed principally using the straight-line method over the estimated useful lives of the assets as follows: Machinery and equipment 1-5 years Furniture and fixtures 7 years Leasehold improvements shorter of lease term or estimated useful life. Maintenance and repairs are charged to expense as incurred. Upon retirement or sale, the cost of the disposed assets and the related accumulated depreciation are removed from the accounts and any resulting gain or loss is credited or charged to income. Income Taxes Deferred tax assets and liabilities reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. A valuation allowance is provided for the net deferred tax assets if, based on the weighted available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. Accrued Warranty The Company provides an accrual for future warranty costs based upon the relationship of prior years' sales to actual warranty costs which approximates expected future warranty costs. Research and Development Cost incurred in the research and development of software products are expensed as incurred until the technological feasibility of the product has been established. After technological feasibility is established, any additional costs would be capitalized. As the Company believes the current process for developing software is essentially completed concurrently with the establishment of technological feasibility, no costs have been capitalized to date. Concentration of Credit Risk Financial instruments, which potentially subject the Company to concentration of credit risk, are principally cash and cash equivalents, marketable securities, and accounts receivable. The Company places its investments in highly rated financial institutions and, by policy, limits the amount of credit exposure to any one financial institution. Concentration of credit risk with respect to accounts receivable is limited to certain customers with whom the Company makes substantial sales. Two customers accounted for approximately 28% and 30% of the Company's outstanding accounts receivable at December 31, 1997 and 1996, respectively. To reduce credit risk, the Company performs ongoing credit evaluation, account monitoring procedures and maintains reserves for potential losses. These losses have been within management's expectations. Net Income (Loss) Per Common Share and Common Equivalent Share The Company adopted the requirements of SFAS No. 128 "Earnings per Share" in the fourth quarter, 1997. This statement replaced the calculation of primary and fully diluted earnings per share with basic and diluted earnings per share (EPS). Basic EPS excludes the effect of any dilutive options, warrants or convertible securities and is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity. Diluted EPS is computed by dividing income available to common stockholders by the sum of the weighted average number of common shares and common share equivalents computed using the average market price for the period under the treasury stock method. All earnings per share amounts have been restated to conform with the SFAS 128 requirements. The following table reconciles the numerator and the denominators of the basic and diluted EPS computations shown on the Consolidated Statements of Operations:
For the years ended December 31, - -------------------------------------------------------------------------------- (in thousands, except per share data) 1997 1996 1995 - -------------------------------------------------------------------------------- Basic EPS computation: Numerator: Net (loss) income ($7,847) ($12,014) $ 8,220 Denominator: Weighted average common shares outstanding 15,301 15,630 15,416 Basic EPS ($0.51) ($0.77) $0.53 Diluted EPS computation: Numerator: Net (loss) income ($7,847) ($12,014) $ 8,220 Denominator: Weighted average common shares outstanding 15,301 15,630 15,416 Stock options - - 276 --------------------------------- Total shares 15,301 15,630 15,692 Diluted EPS ($0.51) ($0.77) $0.52
Outstanding options of 1,758,605 and 1,272,009 as of December 31, 1997 and 1996, respectively, were not included in the diluted EPS computation because their effect would be antidilutive. Options to purchase shares of the Company's common stock of 69,837 for the year ended December 31,1995 were outstanding during the period but were not included in the computation of diluted EPS because the price of the options, which range from $7.73 to $14.00 for 1995, was greater than the average market price of the common stock for the reported period. The outstanding options not included in the calculation for 1995 will expire between September 25, 2001 and October 25, 2005. 12 Newly Issued Accounting Standards The FASB has issued Statement No. 130 ("SFAS 130") "Reporting Comprehensive Income." This Statement requires changes in comprehensive income to be shown in a financial statement that is displayed with the same prominence as other financial statements. While not mandating a specific financial statement format, the Statement requires that an amount representing total comprehensive income be reported. The Statement will become effective for fiscal years beginning after December 15, 1997. Reclassification of financial statements for earlier periods is required for comparative purposes. The Company does not believe that the adoption of SFAS 130 will have a material impact on result of operations. The FASB also issued Statement No. 131 ("SFAS 131"), "Disclosures about Segments of an Enterprise and Related Information". This Statement, which supersedes Statement No. 14 "Financial Reporting for Segments of a Business Enterprise," changes the way public companies report information about segments. The Statement, which is based on the management approach to segment reporting, includes requirements to report segment information quarterly and entity-wide disclosures about products and services, major customers, and the material countries in which the entity holds assets and reports revenues. The Statement is effective for periods beginning after December 15, 1997. Restatement for earlier years is required for comparative purposes unless impracticable. In addition, SFAS 131 need not be applied to interim periods in the initial year; however, in subsequent years, interim period information must be presented on a comparative basis. The Company is currently evaluating this Statement and its effect on financial statement disclosures. Change In Presentation of Consolidated Statements of Cash Flows During 1997 the Company changed from the direct to the indirect method of presenting its consolidated statements of cash flows. Prior year amounts have been reclassified to conform to the current year presentation. C INVESTMENTS Investment classified as current assets were as follows:
1997 1996 - -------------------------------------------------- (in thousands) - -------------------------------------------------- Cash equivalents: Repurchase agreements $ 1,260 $ 1,950 Mutual funds 1,674 6,750 Commercial paper 808 2,448 - -------------------------------------------------- Total cash equivalents $ 3,742 $11,148 - -------------------------------------------------- Marketable securities: Fixed income securities $ 7,074 $ - Repurchase agreements 263 - Certificates of deposit 1,291 - Commercial paper 2,557 2,918 U.S. Government securities 1,258 4,000 - -------------------------------------------------- Total marketable securities $12,443 $ 6,918 - --------------------------------------------------
13 D. INVENTORIES Inventories consist of:
December 31, - ------------------------------------------------ (in thousands) 1997 1996 - ------------------------------------------------ Raw materials $1,043 $1,373 Work in process 373 718 Finished goods 4,294 6,646 - ------------------------------------------------ Total inventories $5,710 $8,737 - ------------------------------------------------
During 1996, the Company recorded an additional inventory provision of $2,400,000 to reflect inventory exposures as the Company transitioned from LAN to remote access products. E. PROPERTY AND EQUIPMENT Property and equipment consist of:
December 31, - ---------------------------------------------------------------------- (in thousands) 1997 1996 - ---------------------------------------------------------------------- Machinery and equipment $11,492 $12,083 Furniture and fixtures 554 572 Leasehold improvements 1,188 970 - ---------------------------------------------------------------------- 13,234 13,625 Less accumulated depreciation and amortization 9,962 9,031 - ---------------------------------------------------------------------- Property and equipment, net $ 3,272 $ 4,594 - ----------------------------------------------------------------------
F. COMMITMENTS AND CONTINGENCIES Letter of Credit The Company has an outstanding letter of credit of approximately $288,000 at December 31, 1997 and 1996. This letter of credit which matures on April 30, 2002, automatically renews annually on December 31. This letter of credit collateralized the Company's obligation to a third party for a certain lease transaction. The fair value of this letter of credit is estimated to be the same as the contract amount. Operating Leases The Company leases its office and manufacturing facilities under operating leases expiring at various dates through 2002. Under certain leases the Company is obligated to pay taxes, repairs, and other operating costs. The Company has the option to extend the term of the lease of its primary office and manufacturing facility for two five-year periods commencing on May 1, 2002 and May 1, 2007. Rental expense amounted to approximately $1,128,000, $1,556,000 and $1,666,000 in 1997, 1996 and 1995, respectively. At December 31, 1997 future rental commitments are as follows:
- --------------------------- (in thousands) - --------------------------- 1998 $ 653 1999 543 2000 496 2001 476 2002 162 Thereafter - - --------------------------- Total $2,330
14 G. CAPITAL STOCK Common Stock The Company has an Employee Stock Purchase Plan ("Purchase Plan") available to most full time employees. Under this plan, 300,000 shares of common stock were reserved for issuance. Eligible employees may designate not more than 5% of their cash compensation to be deducted each pay period for the purchase of common stock under the Purchase Plan. The purchase price of the shares under the plan is equal to the lower of 85% of the fair market value per share of the stock on the grant date (first day of the exercise period) or 85% of the fair market value on the exercise date (the last day of the exercise period, the fair market value as of a given date is determined by averaging the last sales price of the stock for the ten trading days immediately proceeding the given date. The Company sold 32,677 shares and 41,628 shares to employees in 1997 and 1996, respectively, under the Purchase Plan. At December 31, 1997, 257,097 shares remained unissued under the Purchase Plan. The weighted average fair value of the purchase right to a share of Company stock under the Purchase Plan was estimated to be $1.33 and $1.65 for 1997 and 1996, respectively. No compensation cost has been recognized for shares purchased. Preferred Stock In 1991, the Shareholders approved the authorization of 7,500,000 shares of preferred stock. The Board of Directors is authorized, subject to any limitations prescribed by law, to issue from time to time such shares of preferred stock in one or more series. Each such series of preferred stock will have such number of shares, designations, preferences, voting power, qualifications, and special or private rights or privileges as shall be determined by the Board of Directors, which may include, among others, dividend rights, voting rights, preemptive and sinking fund provisions, liquidation preferences, conversion rights and preemptive rights. No such shares have been issued to date. Stock Options The Company's stock option plans generally provide for the granting to employees of incentive stock options to purchase shares of common stock at the fair market value as defined by the plan on the date of grant and of non-qualified stock options at no less than 50% of the fair market value as defined by the plan on the date of the grant. To date the Company has never issued non-qualified stock options at an exercise price less than the fair market value on the date of the grant. Generally, options become exercisable at the rate of 25% at the end of each of the first four anniversaries of the grant. Options generally expire ten years from the date of grant, or ninety days from the date of termination of employment. As of December 31, 1997, 4,384,000 shares of common stock were reserved under the plans and 349,400 shares were available for grant. In September 1996, the Compensation Committee of the Board of Directors, pursuant to the authority granted under the Company's 1991 Restated Stock Option Plan, voted to allow employees of the Company holding options with exercise prices greater than $3.625 per share to exchange those options for substitute options having an option exercise price of $3.625 per share. In October 1996, 707,154 options were surrendered by employees and exchanged for new options at the new option exercise price and vesting schedule. A summary of the status of the Company's stock plans as of December 31, 1997, 1996 and 1995, and changes during the years ended on those dates is presented below: 15
1997 1996 1995 ---------------------- ----------------------- ---------------------- Weighted Weighted Weighted Average Average Average Number of Exercise Number of Exercise Number of Exercise Options Price Options Price Options Price ---------------------- ----------------------- ---------------------- Outstanding at the beginning of the year 1,272,009 $3.34 1,237,649 $5.52 1,446,597 $5.37 Granted 1,007,805 $2.02 1,245,726 $4.11 404,700 $6.76 Exercised - - (6,712) $4.01 (218,875) $4.72 Canceled (521,209) $3.18 (1,204,654) $6.23 (394,773) $6.67 ------------ ------------- ------------ Outstanding 1,758,605 $2.70 1,272,009 $3.34 1,237,649 $5.52 ---------------------- ----------------------- ---------------------- Options exercisable at year end 685,270 $3.41 522,604 $3.41 440,778 $5.44 Weighted average fair value of options granted during the year $1.34 $2.78 $4.70
The following table summarizes information concerning outstanding options at December 31, 1997:
Weighted Average Weighted Range of Number of Remaining Average Exercise Prices Outstanding Contractual Life Exercise Price --------------- ---------- ----------------- -------------- $0.73 - $1.10 12,300 9.58 $0.95 $1.45 - $1.56 248,100 9.95 $1.45 $1.70 - $2.10 346,905 9.62 $1.85 $2.53 - $3.63 1,130,350 8.14 $3.18 $6.00 - $7.50 20,950 3.36 $7.43 -------------------------------------------------------- 1,758,605 8.64 $2.71 =========================================================
Pro Forma Impact of SFAS 123 SFAS 123 "Accounting for Stock-Based Compensation" requires that companies either recognize compensation expense for grants of stock, stock options, and other equity instruments based on fair value, or provide pro forma disclosure of net income and earnings per share in the notes to the financial statements. The Company adopted the disclosure provisions of SFAS 123 in 1996 and has applied APB Opinion 25 and related interpretations in accounting for its plans. Had compensation cost for the Company's stock-based compensation plans been determined based on fair value at grant dates as calculated in accordance with SFAS 123, the Company's net (loss) income and (loss) income per share for the years ended December 31, 1997, 1996 and 1995 would have been reduced to the pro forma amounts indicated below:
1997 1996 1995 ------------------------- ------------------------- ------------------------------------------------ Basic/Diluted Basic/Diluted Basic Diluted Net loss loss per share Net loss loss per share Net Income Income per share Income per share ------------------------- ------------------------- ------------------------------------------------- As reported ($7,847) ($0.51) ($12,014) ($0.77) $8,220 $0.53 $0.52 Pro forma ($8,140) ($0.53) ($12,627) ($0.81) $8,011 $0.51 $0.51
The fair value of each stock option is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions: an expected life of six years, expected volatility of 75% in 1997, and 65% in 1996 and 1995, and no dividends assumed. The weighted average assumptions for the risk-free interest rates for 1997, 1996 and 1995 were 6.11%, 6.32% and 6.58%, respectively. The effects of applying SFAS 123 in this pro forma disclosure are not indicative of future amounts since SFAS 123 does not apply to awards prior to 1995, and additional awards in future years are anticipated. 16 H. RESTRUCTURING OF OPERATIONS During the fourth quarter of 1996, the Company's management announced a restructuring plan for the strategic redirection of the Company. The restructuring principally addressed the move toward the continued development of the OpenROUTE Networks subsidiary. The strategies for this subsidiary are designed to allow the Company to aggressively focus its efforts on the rapidly growing Internet/Intranet connectivity marketplace. The Company is attempting to leverage its strengths in the OpenROUTE internetworking software and its successful line of GlobeTrotter Remote Access routers. The Company is concentrating its efforts on gaining more market share and increasing revenue. As a result, the Company recorded a $3,312,000 charge for restructuring of operations in the fourth quarter of 1996. This included a reduction in the Company's work force of forty-two employees, or approximately 22%, accounting for approximately $410,000 of severance costs. The Company incurred a charge of approximately $785,000 in connection with the substantial reduction in its occupancy requirements. In addition, the charge included approximately $1,922,000 for disposal of fixed assets and approximately $195,000 of other costs. During 1997, the Company incurred cash expenditures relating to the 1996 restructuring of approximately $495,000 for severance and payroll related costs, approximately $672,000 as a result of reducing its occupancy costs and $253,000 in other restructuring related costs. Management has determined that all of the Company's obligations from the 1996 and prior restructurings have been settled. Accordingly, the Company reversed its remaining restructuring provision of $241,000 against operating expenses in the third quarter of 1997.
I. INCOME TAXES The provision for income taxes consists of the following: December 31, - ------------------------------------------------------------------------------- (in thousands) 1997 1996 1995 - ------------------------------------------------------------------------------- Federal - current $ - ($65) $319 State - current 28 10 57 Foreign - current 156 215 112 - ------------------------------------------------------------------------------- Total $184 $160 $488 - -------------------------------------------------------------------------------
Reconciliation between the Company's effective tax rate and the U.S. statutory is as follows:
- ---------------------------------------------------------------------- December 31, 1997 1996 1995 - ---------------------------------------------------------------------- U.S. statutory rate (34.0%) (34.0%) 34.0% Foreign tax rate differential 2.4 0.1 (2.8) Change in federal valuation allowance 34.0 35.2 (26.1) State income taxes, net of U.S. Federal income tax effect - - 0.5 - ---------------------------------------------------------------------- Effective tax rate 2.4% 1.3% 5.6% - ----------------------------------------------------------------------
A valuation allowance of $13,210,000 and $9,982,000 for 1997 and 1996 respectively has been recorded to offset the related net deferred tax assets due to the uncertainty of realizing the benefit of these assets. The following is a summary of the significant components of the Company's deferred tax assets and liabilities as of December 31, 1997 and 1996:
- --------------------------------------------------------- (in thousands) 1997 1996 - --------------------------------------------------------- Deferred tax assets: Bad debt reserve $360 $ - Restructuring charge - 644 Inventory reserves 533 884 Product warranty 262 417 Federal tax benefit of net operating loss carryforwards 7,889 3,878 State tax benefit of net operating loss carryforwards 1,827 1,286 Tax credit carryforwards 912 912 Alternative minimum tax credit 699 542 Depreciation 144 - Other items 584 919 - --------------------------------------------------------- Total deferred tax assets 13,210 9,482 Valuation allowance for deferred tax assets (13,210) (9,112) - --------------------------------------------------------- Net deferred assets - 370 Deferred tax liability: Depreciation 370 - --------------------------------------------------------- Net deferred tax asset $0 $0 - ---------------------------------------------------------
As of December 31, 1997 the Company had net operating loss forwards of approximately $23,000,000 and $38,000,000 for federal and state income tax purposes, respectively. The federal net operating losses begin to expire in 2010 and state net operating losses begin to expire in 1998. Similarly, research and development credit carryforwards of approximately $912,000 were available on December 31, 1997, expiring at various dates through 2005. 17 J. RETIREMENT SAVINGS PLAN The Company has a retirement savings plan for its employees, which has been qualified under Section 401(k) of the Code. Eligible employees are permitted to contribute to the 401 (k) Plan through payroll deductions within statutory limitations and subject to any limitations included in the 401 (k) Plan. The Plan provides for the matching contribution by the Company in an annual amount approximating 2% of a participant's compensation. The Company contributed approximately $128,000, $185,000, and $165,000 to the plan in 1997, 1996, and 1995, respectively. K. QUARTERLY FINANCIAL DATA (unaudited) Selected quarterly financial data for the years ended December 31, 1997 and 1996 is as follows:
- -------------------------------------------------------------------------------------------- Basic/diluted Net income Net Gross Net income (loss) (in thousands, except per share amounts) sales profit (loss) per share - -------------------------------------------------------------------------------------------- 1997 First Quarter $9,125 $4,256 ($313) ($0.02) Second Quarter 7,748 3,748 (1,133) (0.07) Third Quarter 5,006 1,754 (2,894) (0.19) Fourth Quarter 5,065 1,846 (3,507) (0.23) - -------------------------------------------------------------------------------------------- Total $26,944 $11,604 ($7,847) ($0.51) ============================================================================================ 1996 First Quarter $14,018 $7,231 $141 $0.01 Second Quarter 10,646 4,932 (2,345) (0.15) Third Quarter 10,589 5,119 (1,763) (0.11) Fourth Quarter 10,043 2,344 (8,047) (0.52) - -------------------------------------------------------------------------------------------- - -------------------------------------------------------------------------------------------- Total $45,296 $19,626 ($12,014) ($0.77) - --------------------------------------------------------------------------------------------
The 1997 fourth quarter operating loss reflects approximately $880,000 or $0.06 per share of certain adjustments and accruals relating to business operations in the Asia-Pacific region, as well as certain employee incentive programs. 18 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders of Proteon, Inc.: We have audited the accompanying consolidated balance sheets of Proteon, Inc. as of December 31, 1997 and 1996, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1997. 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, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Proteon, Inc. as of December 31, 1997 and 1996 and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1997 in conformity with generally accepted accounting principles. /s/ COOPERS & LYBRAND L.L.P. ---------------------------- Coopers & Lybrand, L.L.P. Boston, Massachusetts February 11, 1998 19 - ------------------------- STOCK PRICE HISTORY - ------------------------- The following table sets forth the high and low sales prices of the Company's Common Stock as reported on the NASDAQ Stock Market from January 1, 1996 to December 31, 1997. As of December 31, 1997, the Company had approximately 507 stockholders of record. The Company has paid no dividends on its Common Stock and anticipates it will reinvest any earnings to finance future growth.
For year ended December 31, 1997 High Low - ----------------------------------------------------------------------- First Quarter 3 11/16 1 5/16 Second Quarter 2 15/16 1 7/16 Third Quarter 2 1/2 1 9/16 Fourth Quarter 3 1/2 1 1/32 For year ended December 31, 1996 High Low - ----------------------------------------------------------------------- First Quarter 7 1/2 4 3/4 Second Quarter 6 1/2 3 5/8 Third Quarter 4 1/4 2 3/8 Fourth Quarter 4 1/4 2 1/16
EX-21 6 SUBSIDIARIES OF THE REGISTRANT 1 EXHIBIT 21 ---------- Proteon, Inc. Subsidiaries of the registrant: I. Proteon International Ltd. Lockington Hall Derby DE74 2RH England Organized under the laws of England II. Proteon International SARL 2000 route des Lucioles Les Algorithmes Bat Aristote A-BP 29 Sophia Antipolis 06901 France Organized under the laws of France III. Proteon International GMBH Falkensteiner Strasse 11 Kelkheim D 65779 Germany Incorporated under the laws of Germany IV. Proteon Networks PTE Ltd. 30 Bideford Road #02-02 Thongsia Building Singapore 229922 Organized under the laws of Singapore V. OpenROUTE Networks, Inc. Nine Technology Drive Westborough, Massachusetts 01581-1799 USA Incorporated in the state of Delaware VI. Proteon Securities Corporation Nine Technology Drive Westborough, Massachusetts 01581-1799 USA Incorporated in the Commonwealth of Massachusetts VII. Proteon Federal Systems, Inc. (Inactive) Nine Techology Drive Westborough, Massachusetts 01581-1799 USA Incorporated in the Commonwealth of Massachusetts VIII. Proteon FSC, Inc. 55-11 Curaco Gade Charlotte Amalie Virgin Islands 00803 Incorporated in the U.S. Virgin Islands IX. Proteon Australia PTY 80 Mount Street Level 8 North Sydney NSW 2060 Australia Organized under the laws of Australia EX-23 7 CONSENT OF COOPERS & LYBRAND L.L.P. 1 EXHIBIT 23 CONSENT OF INDEPENDENT ACCOUNTANTS We consent to the incorporation by reference in the registration statement of Proteon, Inc. on Forms S-8 (File No. 33-85524 and File No. 333-31055) of our reports dated February 11, 1998, on our audits of the consolidated financial statements and financial statement schedule of Proteon, Inc. as of December 31, 1997 and 1996, and for the three years ended December 31, 1997 which reports are included or incorporated by reference in this Annual Report on Form 10-K. /s/ COOPERS & LYBRAND L.L.P. Boston, Massachusetts March 30, 1998 EX-27 8 FINANCIAL DATA SCHEDULE
5 1,000 U.S DOLLARS YEAR YEAR YEAR DEC-31-1995 DEC-31-1996 DEC-31-1997 JAN-01-1995 JAN-01-1996 JAN-01-1997 DEC-31-1995 DEC-31-1996 DEC-31-1997 1 1 1 25,829 16,612 5,317 6,863 6,918 12,443 12,138 7,625 6,224 0 0 0 4,425 8,737 5,710 50,712 40,977 30,131 31,875 13,625 13,234 23,558 9,031 9,962 59,029 45,571 33,403 11,706 10,380 6,511 0 0 0 49,141 49,292 49,347 0 0 0 0 0 0 (1,818) (14,101) (22,455) 59,029 45,571 33,403 51,810 32,175 22,248 75,323 45,296 26,944 27,373 20,825 12,722 36,664 25,670 15,340 31,388 32,741 20,319 0 0 0 (1,437) (1,261) (1,052) 8,708 (11,854) (7,663) 488 160 184 8,220 (12,014) (7,847) 0 0 0 0 0 0 0 0 0 8,220 (12,014) (7,847) 0.53 (0.77) (0.51) 0.52 (0.77) (0.51)
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