-----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, V7IVIcLQvw555KytGkjN4ZdHVQK/2hz6wunk/W6G9N8t+jDlcMjdQ2hQ8Z0srwPF xYOjnBTbai0uM2JmD+kSNA== 0001018893-97-000007.txt : 19970401 0001018893-97-000007.hdr.sgml : 19970401 ACCESSION NUMBER: 0001018893-97-000007 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 9 CONFORMED PERIOD OF REPORT: 19961231 FILED AS OF DATE: 19970331 SROS: NASD FILER: COMPANY DATA: COMPANY CONFORMED NAME: APPLIED DIGITAL ACCESS INC CENTRAL INDEX KEY: 0000919048 STANDARD INDUSTRIAL CLASSIFICATION: INSTRUMENTS FOR MEAS & TESTING OF ELECTRICITY & ELEC SIGNALS [3825] IRS NUMBER: 680132939 STATE OF INCORPORATION: CA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 000-23698 FILM NUMBER: 97571521 BUSINESS ADDRESS: STREET 1: 9855 SCRANTON RD CITY: SAN DIEGO STATE: CA ZIP: 92121 BUSINESS PHONE: 6196232200 10-K 1 FORM 10-K APPLIED DIGITAL ACCESS, INC. UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1996 [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 COMMISSION FILE NUMBER 000-23698 APPLIED DIGITAL ACCESS, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) CALIFORNIA 68-0132939 (STATE OR OTHER JURISDICTION OF (IRS EMPLOYER IDENTIFICATION NO.) INCORPORATION OR ORGANIZATION) 9855 SCRANTON ROAD, SAN DIEGO, CALIFORNIA 92121 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES, ZIP CODE) (619) 623-2200 (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE) SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: COMMON STOCK, NO PAR VALUE (TITLE OF CLASS) --------------------------------------------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No__ Indicate by check mark 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 ---- The aggregate market value of the voting stock held by non-affiliates of the registrant, based upon the closing sale price of the Common Stock on February 28, 1997 as reported on the Nasdaq National Market, was approximately $ 60,265,807. For the purposes of this calculation, shares owned by officers, directors and 5% shareholders known to the registrant have been deemed to be owned by affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes. There were 12,331,239 shares of the Registrant's Common Stock, no par value, outstanding as of February 28, 1997. DOCUMENTS INCORPORATED BY REFERENCE (1) Portions of the Registrant's 1996 Annual Report to Shareholders, a copy of which is attached hereto as Exhibit 13.1, referred to herein as the "Annual Report", are incorporated as provided in Part II. (2) Portions of the Registrant's Proxy Statement for the Annual Meeting of Shareholders to be held May 20, 1997, referred to herein as the "Proxy Statement", are incorporated as provided in Part III. PART I ITEM 1. BUSINESS THE DISCUSSION OF THE COMPANY'S BUSINESS CONTAINED IN THIS ANNUAL REPORT ON FORM 10-K MAY CONTAIN CERTAIN FORWARD-LOOKING STATEMENTS. FOR DISCUSSION OF FACTORS WHICH MAY AFFECT THE OUTCOME PROJECTED IN SUCH STATEMENTS, PLEASE SEE "RISKS AND UNCERTAINTIES" AT PAGES 13 THROUGH 16 OF THIS ANNUAL REPORT ON FORM 10-K. THE COMPANY UNDERTAKES NO OBLIGATION TO RELEASE PUBLICLY THE RESULTS OF ANY REVISIONS TO THESE FORWARD-LOOKING STATEMENTS TO RELFECT EVENTS OR CIRCUMSTANCES ARISING AFTER THE DATE HEREOF. Applied Digital Access Inc. ("ADA" or the "Company") was incorporated in California in August 1987. The Company's headquarters are located at 9855 Scranton Road, San Diego, California 92121, and its telephone number is (619) 623-2200. ADA is a leading provider of network performance management products that include systems, software, and services used to manage the quality, performance, availability and reliability of telecommunications service providers' ("TSPs") networks. ADA's products are designed to enable service providers to improve their quality of service, to increase productivity, to lower operating expenses and to effectively deploy new services. ADA has positioned its business to assist service providers in addressing the rapidly increasing demand for new services, higher bandwidth and access to the Internet. ADA's systems and software provide network management functions such as provisioning, configuration managment, performance management, testing and traffic management. ADA has approached the industry demand for network management products with a three-faceted approach: (1) Network Systems and Sensors that provide testing and performance monitoring functions as well as selected transport functions; (2) Network Management software that enables service providers to manage their network operations; and (3) Services that are customized to meet the evolving needs of our service provider market. In 1996, the Company formed two strategic business units: the Network Systems and Sensors business unit and the Network Management business unit. The business units are synergistic with the evolution of the Company from a single product line to multiple product lines. The Network Systems and Sensors business unit is built around the Company's T3AS products and services including its T3AS Test and Performance Monitoring System (T3AS"), Centralized Test System ("CTS") and Protocol Analysis Access System ("PAAS"), and the Remote Module, a DS1 network interface unit ("NIU"). The Network Management business unit focuses on Operations Systems ("OS") software products including Traffic Data Collection and Engineering System ("TDC&E"), Fault Management System ("FMS") and OS design services all acquired through acquisitions, as well as Graphical Test Assistant ("GTA") and Sectionalizer. The application of ADA's T3AS products enables TSPs telephone companies to quickly access high-speed data and voice circuits from remote network management centers. The Company believes its T3AS system is the only permanently-installed system that can remotely access circuits at both the DS3 and DS1 rates to provide an integrated suite of test and performance monitoring capabilities. Using the T3AS system's test capabilities, customer-reported problems can be quickly identified and localized without dispatching repair personnel. The T3AS system's performance monitoring capabilities help TSPs detect degradation of service and initiate action before service to the customer is interrupted. The Company has primarily focused its sales efforts on the seven regional bell operating companies ("RBOCs") which are under increasing competitive pressure to provide high-quality high-speed data and voice transmission at lower costs. To date, six of the seven RBOCs, Ameritech, BellSouth, NYNEX, Southwestern Bell, Pacific Bell, and U S WEST, and a major interexchange carrier have approved and are currently deploying the Company's T3AS products. The Company has sold equipment to an independent telephone company, Sprint Central Telephone-Nevada, and several competitive access providers, and has increased its sales and marketing efforts aimed at independent telephone companies, competitive access providers and interexchange carriers. In February 1996, the Company acquired certain assets of Applied Computing Devices, Inc. ("ACD"), a company that developed and marketed traffic management and fault management OS to TSPs. These products are complementary to the Company's Network Systems product line. In July, 1996, ADA purchased certain assets of MPR Teltech Ltd. ("MPR Teltech"), a subsidiary of BC TELECOM, Inc. BC TELECOM, Inc. is Canada's second largest telecommunications company. The assets acquired were part of MPR Teltech's operating unit known as the Special Services Network division ("SSN"). SSN was an OS software development group with expertise in development of network management systems for TSPs. SSN developed OS software primarily for Northern Telecom, Ltd. ("Nortel"). SSN has become part of ADA's Canadian subsidiary, ADA-Canada, and develops network performance management OS products for the Company and its customers, including Nortel. ADA has also licensed certain technology from Nortel for Network Performance Management applications in connection with the acquisition. 2 BACKGROUND The volume of digital information transmitted through the telecommunication system has grown rapidly in recent years. This growth has been driven primarily by the proliferation of personal computers and workstations, the prevalence of networking and use of the Internet, the adoption of client/server computing, the increase in cellular telephone and facsimile use, and the deployment of new digital information applications including multimedia, video conferencing, and image-processing. As a result, TSPs have been required to rapidly deploy high-speed data and voice circuits operating at a 1.54 megabit-per-second rate, called DS1, or T1, and at a 45 megabit-per-second rate, called DS3. The DS3 transmission rate is the highest electrical telecommunication circuit transmission rate in North America. The present structure of the telecommunications industry in the United States is largely a result of the court-mandated divestiture of AT&T in 1984. The AT&T divestiture resulted in the creation of the seven RBOCs, the competitive long distance telephone company market, and the emergence of competitive access providers ("CAPs") and competitive local exchange companies ("CLECs") which offer local telephone service in competition with the RBOCs or independent telephone companies ("ITOCs"). Regulation through competition is the philosophy that resulted in the breakup of AT&T, and it continues to be the philosophy of the Federal Communications Commission. The passage of the Telecommunication Bill of 1996 allows each of these telephone companies to enter the territories and businesses of the others. While the Company believes that the new law will bring new opportunities for network equipment suppliers, it is too early to assess the long-term impact of this new law on the telecommunications industry and ADA's business. Local telephone companies have faced increased competition from both CLECs and from the local service competitive initiatives of the long distance telephone companies and will potentially face competition from non-traditional providers of telephone service such as cable television companies. The Company believes that many of the new competitive entrants will continue to focus their efforts on corporate and government communications networks which are among the most profitable market segments. Customers in these segments require highly reliable data and voice communications circuits to enable them to conduct their day-to-day business without interruption. These new competitors are often able to offer higher-quality and lower-cost service than local telephone companies, and as a result, have gained significant market share in these segments. This increased competition has brought pressure on local telephone companies to protect their existing revenue bases by improving the quality of their service and to reduce their costs. At the same time, these local telephone companies continue to re-engineer and downsize their organizations. The large reductions in staff have often resulted in the loss of highly experienced and technical people, leaving less experienced staff to operate and maintain the networks. Prior to the divestiture, AT&T was responsible for end-to-end telecommunication service. When problems occurred with a telephone connection, customers called AT&T to diagnose and fix the problem. Today, however, a long distance data or voice circuit often involves three or more TSPs: the local telephone companies on each end and the long distance telephone company providing the connection between the two local companies. Responsibility for service in long distance high-speed data and voice networks is transferred from one carrier to another at their network boundaries. The Company believes that the segmentation of the telecommunications network has made it more difficult for telephone companies to identify and respond to problems in their networks. For example, many stock brokerage firms communicate real-time stock quotes and buy and sell orders to and from their brokers over high-speed data communications lines. Such firms monitor their own circuits and can detect when data communications service begins to degrade. When a degradation in service is noted, the telecommunications manager of the firm contacts the telephone company that manages the network - typically the long distance carrier. Initially, the long distance telephone company does not know where the problem is located and must initiate three trouble reports, one in each local telephone company and one in its own company. Each telephone company then dispatches multiple repair crews with portable test equipment to attempt to locate the problem. Typically, repair crews are dispatched to a number of locations, including the network boundary between the long distance and the local telephone company, the 3 telephone building nearest the user, and to outside facilities such as the cables and equipment beneath streets and on poles between the central offices and the end-user customer. This system of maintenance results in a number of inefficiencies. For example, the Company believes telephone company repair crews often incur needless expense only to report "no trouble found." Despite their best efforts, repair crews often inadvertently interrupt or damage circuits that are working and may make unnecessary repairs. Long distance telephone companies measure quality of service provided by the local telephone companies in two principal ways: failure rate (customer-reported troubles per 100 circuits per month), and mean-time-to-restore (the time needed to respond to and resolve a customer's complaint). These measures frequently influence long distance telephone company and end-user customer decisions about which local telephone company to use. To date, local telephone companies' level of services measured by these standards has often placed them at a competitive disadvantage. In order to reduce failure rates and improve restoration times, the Company believes telephone companies are motivated to change the traditional methods of handling service problems as described above. They are looking for solutions that do not require dispatching repair crews with portable test equipment when problems occur and, instead, allow them to monitor circuits remotely from a central management site. They are also seeking effective methods of remotely testing and monitoring DS3 and DS1 circuits at the network boundary. Finally, telephone companies are looking to improve their quality of service by moving from reactive maintenance to preventive maintenance through performance monitoring. These network quality and performance requirements have created a need for a cost-effective solution. THE APPLIED DIGITAL ACCESS SOLUTION ADA focuses on providing Network Performance Management solutions to TSPs. These solutions are comprised of products that address traffic, fault, performance, and test management. The Company has focused its research and development activities on creating products that provide answers, instead of data, to telecommunications service providers, and on making network management easier. ADA developed the T3AS, the first permanently installed network element to remotely access the network at both the DS3 and the DS1 rates providing an integrated suite of test and performance monitoring capabilities. ADA has enhanced T3AS and has developed additional network elements, such as CTS, PAAS, and Remote Module. The Company believes its T3AS products enable TSPs to greatly improve their reliability of service, reduce circuit repair time, reduce network management expense, and proactively maintain network quality. By providing remote access to DS3 and DS1 circuits located at network boundaries from the telephone company network management centers, the T3AS products allow telephone companies to remotely test individual circuits reported as problematic within seconds instead of hours. The continuous monitoring capability of T3AS allows TSPs to detect circuit degradation before receiving customer complaints, and to initiate maintenance actions to restore the circuit to full functionality without affecting the end-user. Finally, the Company believes proactive maintenance enabled by performance monitoring can reduce the number of trouble reports initiated by end-users. ADA's Remote Module, a DS1 NIU, enables TSPs to identify where reported troubles are located. When DS1 services are monitored with T3AS and the Remote Module, telephone companies can nonintrusively isolate troubles on these circuits. Additionally, these products monitor the performance of the DS1 service on a full-time basis. The Company refers to this application of its products as Network Administrative Boundary Sectionalization. This application addresses the multiple boundaries and multiple hand-offs that TSPs must perform in order to provide a service or set of services to end-users. TSPs position T3AS systems (installed at the network boundary between the long distance telephone company and the local telephone company) in combination with Remote Modules (installed on DS1 services at the boundary between the local telephone company and the-end user) to immediately determine whether reported troubles are in their network. This enables the telephone companies to reduce their mean-time-to-restore, since responsibility for problems is immediately localized to the responsible telephone company, and repair crews that would have been dispatched unnecessarily can now focus on troubles that really are their responsibility. When dispatching repair crews is necessary, the T3AS system can localize the problem to allow more efficient deployment. 4 As a result, the total number of work crews in the field is reduced, thereby reducing the number of inadvertent interruptions of operational circuits and the subsequent initiation of new trouble reports. Through acquistion and internal development, the Company has added network management software products and services that are complementary to ADA's network element product line, customer base, and focus on Network Performance Management. STRATEGY The Company seeks to maintain its leadership position as a supplier of network performance management systems for high-speed telecommunication service providers and to become a leading provider of OS solutions for network management of telecommunications networks by: 1. FOCUSING SALES AND MARKETING EFFORTS ON TSPs WITH LARGE NETWORKS. ADA's initial sales have been to the RBOCs and their affiliates, all of which, have a compelling need to improve the quality and reduce the cost of their services. Competitive pressures are forcing telephone companies to move toward a centralized network management infrastructure that uses integrated test and performance monitoring systems. The Company has broadened Aits target market with applications that are appropriate for CAPs, long distance telephone companies, and other telephone service providers. 2. DEVELOPING PRODUCTS FOR NETWORK BOUNDARY APPLICATIONS. The initial application for the Company's products has been at the network boundary between the long distance telephone company and the local telephone company. Installation of the T3AS system at these boundaries allows the local telephone company to quickly determine if a reported trouble is within its network. It also allows the local telephone companies to continuously monitor their circuits and react to degradation of the signal before service is affected. With the Company's Remote Module, a DS1 NIU, the boundary between the local telephone company and the end-user can now be continuously and nonintrusively monitored. The combination of these two products' capabilities enables telephone companies to improve their ability to address the increasingly competitive business environment. 3 DEVELOPING AND ENHANCING PRODUCTS AND SERVICES TO ADDRESS OS. The Company is extending its current product line and market to address selected applications within the OS function. OS are computer software-based systems that provide operations support for telecommunications functions. The OS market is very large and its applications have historically been addressed by companies such as AT&T and Bellcore. Some of the older products from these suppliers, called "legacy systems," can no longer provide telephone companies with the real-time information that is needed to manage complex high-speed telecommunications networks. The market for intelligent network management systems has become fragmented, and the Company perceives a need for solutions that address the OS applications of testing, surveillance, performance monitoring and traffic management, among others. 4 EXPANDING TO OTHER APPLICATIONS. The Company believes that there are additional applications for ADA's product line that extend its utility to the network boundaries between the telephone companies and other users, such as corporate customers, cellular telephone companies, cable television companies, and other telephone service providers. 5 DEVELOPING PRODUCTS TO ADDRESS NEW TRANSMISSION STANDARDS. The Company intends to extend its current products and develop new products to accommodate new telecommunication transmission standards such as SONET and SDH optical transmission standards, which are expected to receive broad acceptance in the North America and international markets, respectively. 5 PRODUCTS NETWORK SYSTEMS AND SENSORS T3AS SYSTEM The Company's first product, the T3AS system, is an integrated test and performance monitoring system for high-speed telecommunications networks. The T3AS system connects to the network at boundaries where many telephone circuits are combined, and where access to individual circuits or groups of circuits is often difficult. The Company believes its T3AS system is the only permanently-installed network management system remotely accessing circuits at the DS3 and DS1 rates that provides an integrated suite of test and performance monitoring capabilities, including performance monitoring of DS3 and DS1 circuits and testing of embedded DS1, DS0 and subrate circuits. (Each DS3 circuit contains 28 DS1 circuits and 672 DS0 circuits. Each DS1 circuit contains 24 DS0 circuits. A DS0 circuit provides basic voice telephone service.) The T3AS system interfaces with the TSPs network management OS using industry- standard interfaces and protocols. T3AS also interfaces with digital cross-connect systems in the telephone network to provide additional test capability when circuit access is provided through such systems. The T3AS system supports up to 48 DS3 circuits, or 1,120 DS1 circuits when accessing the network at the DS1 rate of transmission. A fully configured T3AS system occupies two seven-foot telephone equipment racks. The T3AS system can be configured to meet the specific needs of a customer by selecting an appropriate set of modules from a set of standard modules. List prices for T3AS systems, including recommended spare modules, can range from approximately $60,000 to $650,000, depending on the number and mix of standard modules selected by the customer. T3AS DISTRIBUTED SYSTEM The Company's Distributed System allows individual High-Speed or Low-Speed Subsystems to be installed at locations remote from the T3AS Base System. The Distributed System supports applications where the number of DS3 or DS1 circuits at a particular remote location does not warrant the cost of a full T3AS system, such as at network boundaries with fewer than six DS3 circuits or 140 DS1 circuits between a local telephone company and a long distance telephone company, and at network boundaries between the local telephone company and the end-user. Users can easily upgrade their existing T3AS systems by adding Distributed System hardware modules and software. LOW-SPEED SUBSYSTEM The Low-Speed Subsystem expands the Company's product line by providing test and performance monitoring capabilities for DS1 circuits. This subsystem is intended for network boundaries where circuits cross at the DS1 rate. The Low-Speed Subsystem units are interchangeable with the High-Speed Subsystem units in the T3AS racks. Each Low-Speed Subsystem has a capacity of 140 DS1 circuits and can be deployed in a Distributed System to share administration and test resources with the other subsystems of the T3AS Base System. T3AS CENTRALIZED TEST SYSTEM The T3AS platform was designed to be a highly flexible, scalable platform that enables TSPs to use the system in a traditional testhead configuration. Telephone networks that employ digital cross-connect systems or SONET add-drop multiplexers require test access for circuits that are transported within those systems. The T3AS Centralized Test System consists of the Test Resource Subsystem and the Administration Subsystem, in addition to application software to provide this capability. The T3AS's full complement of test suites is available to TSP network management centers. This product is installed where test access is highly critical and efficient use of network resources is important. 6 PROTOCOL ANALYSIS ACCESS SYSTEM The T3AS platform can be configured to provide access to broadband circuits that are provisioned for advanced data services such as frame relay, SMDS or ATM. Surveillance and testing capabilities in broadband networks may not be as automated as they are in traditional telephone networks. Diagnosing troubles within the network often requires coordination among multiple organizations and dispatches to customer sites. PAAS provides circuit testing and connects circuits to a protocol analyzer for more detailed troubleshooting. T3AS PAAS provides a cost-effective method to access circuits from a centralized network management center. REMOTE MODULE ADA's Remote Module is an intelligent DS1 NIU that non-intrusively monitors the performance of DS1 circuits. Installed at network boundaries between the local TSP and the end-user, the Remote Module enables the service provider to determine whether circuit troubles originated in the service provider's network or in the end-user's network. When installed at the local service provider's network boundary at the customer premises, and in tandem with a T3AS system at the network boundary between the long distance telephone company and the local service provider, the Remote Module provides a unique end-to-end view of the DS1 circuit. This view of service-level performance is critical to improve service quality and reliability and to reduce costs. Telephone network management centers can view a DS1 circuit within their network and beyond the boundaries of their network, and can quickly identify and isolate failures from the performance monitoring information available. NETWORK MANAGEMENT SOFTWARE GRAPHICAL TEST ASSISTANT The Graphical Test Assistant (GTA) is a graphical test front-end system to T3AS and CTS for DS0, DS1 and DS3 testing. GTA provides simple point-and-click access to all T3AS and CTS testing functionality on a Windows NT or Windows 95 platform. While primarily designed for service providers without test OS, GTA also complements existing test OS by augmenting functionality. SECTIONALIZER Sectionalizer is the driving force behind ADA's Network Boundary Sectionalization application. This software presents a simple graphical representation of the DS1 circuit and highlights the portion of the circuit that is responsible for degradation in performance. Sectionalizer also provides second-by-second information regarding circuit performance and stores up to 30 days of circuit history for use by network management personnel to research intermittent circuit troubles. The intelligence of network elements like the T3AS and the Remote Module, in combination with Sectionalizer software, enables TSPs to take a proactive perspective in managing their networks. This is the first time that answers to identified troubles can be seen in minutes, rather than hours. TRAFFIC DATA COLLECTION AND ENGINEERING Traffic Data Collection and Engineering (TDC&E) is a software application that provides the capability to collect traffic data from a variety of existing network elements, in addition to emerging network elements such as ATM switches. TDC&E supports all major traffic engineering functions and lends an accurate, quantifiable reporting mechanism to marketing and quality assurance functions. FAULT MANAGEMENT SYSTEM Fault Management System (FMS), is an alarm and network surveillance OS that is used in combination with other OS software installed in TSP networks. This application is designed to receive and analyze information about managed network elements. Key features of this system include real-time event and alarm acquisition, event processing and correlation, and historical fault analysis and reporting. In addition, automated responses can be programmed based upon selected event occurrences. FMS provides operational system features to manage the state of a multi-network-element, multi-vendor hybrid network. 7 CUSTOMERS The Company sells its products and services to the telecommunications service provider network management market which consists of the seven RBOCs and their local telephone company affiliates, the ITOCs, CAPs, CLECs, the interexchange carriers, and enterprise networks. The Company's network systems products conform to the North American transmission standard. Countries which conform to this standard include the United States, Canada, Taiwan, Korea and, at the DS1 level or below, Japan. The Company's initial marketing efforts have focused on the RBOCs. Accordingly, at present the Company's customer base is highly concentrated. To date, substantially all of the Company's revenues have been derived from five RBOCs. To date, six of the seven RBOCs, Ameritech, BellSouth, NYNEX, Pacific Bell, Southwestern Bell and U S WEST, have qualified and deployed the Company's T3AS products. The Company has sold equipment to one ITOC, Sprint Central Telephone-Nevada and two CAPs, and has stepped up its sales and marketing efforts aimed at ITOCs, CAPs and long distance telephone companies. Additionally, one system has been sold through a distributor and deployed at the government telephone company in Taiwan. The acquisition of ACD has brought new ITOC and CAP customers to the Company, such as GTE, Metropolitan Fiber Systems, Teleport Communications Group, Intelcom Group Access Services, and Frontier Communications. The SSN acquisition added Nortel and Bell Sygma as customers for the Company's OS design services. BellSouth, U S WEST, Ameritech and Southwestern Bell have entered into purchase contracts with the Company. The other two RBOCs and Sprint Central Telephone-Nevada purchase the Company's products under standard purchase orders. Since the BellSouth, U S WEST, Ameritech and Southwestern Bell contracts may be terminated at their convenience, the Company believes that selling to its customers under these contracts is not materially different than purchasing under purchase orders. The RBOCs are significantly larger than the Company and may be able to exert a high degree of influence over the Company. In addition, a small number of customers has historically accounted for substantially all of the Company's revenue in any given fiscal period. The seven RBOCs are NYNEX, Bell Atlantic, BellSouth, Ameritech, Southwestern Bell, U S WEST and Pacific Bell. An RBOC may have several local telephone company affiliates within its territory. Prior to selling products to an RBOC, a vendor must first undergo a product qualification process for its product with the RBOC. The Company typically spends from six to 18 months discussing its T3AS products with a potential customer prior to the customer agreeing to put the product through its qualification process. Although the qualification process for a new product varies somewhat among these prospective customers, the Company's experience is that the process often takes a year or more and generally consists of the following phases: - LABORATORY EVALUATION. The product's function and performance are tested against all relevant industry standards, including Bell Communications, Inc. ("Bellcore") standards. This process can take from two weeks to three months depending on a variety of factors. - FIELD TRIAL. A number of telephone lines are equipped with the product for simulated operation in a field trial lasting from three weeks to three months. These field trials are used to evaluate performance, to assess the ease of installation and to establish troubleshooting procedures. The RBOCs grant conditional product approval upon successful completion of a field trial, enabling field personnel to order limited quantities of the product under one-time approvals. - FIRST OFFICE APPLICATION. In a first office application, live circuits are placed on the T3AS system. The system is then used on live circuits for periods ranging from one to six months to verify functionality and operation. - PRODUCT SELECTION AND DEPLOYMENT. Prior to product selection and deployment which may take from one to four months, the RBOC develops and implements a variety of methods and procedures that cover ordering, stocking, installation, maintenance, returns and all other activities associated with the use of the product. The loss of one or more of the Company's major customers, the reduction of orders or a delay in deployment of the Company's products could materially and adversely affect the Company's business, operating results and financial condition. Further, any failure on the part of any of the RBOCs to maintain their approval of the Company's products, failure of any of the RBOCs to deploy the Company's products or any attempt by any of the RBOCs to seek out alternative suppliers could have a material adverse effect on the Company's business, operating results and financial condition. In addition, there can be no assurance that the Company's products will be approved by new customers, 8 or that such approval will not be significantly delayed. Furthermore, RBOC work force reductions and staff reassignments have in the past delayed or indefinitely postponed the product approval process and the Company expects such reductions and reassignments to continue in the future. There can be no assurance that the impact of such reductions and reassignments will not have a material adverse effect on the Company's business, operating results and financial condition. TECHNOLOGY The T3AS system consists of a real-time OS and an extensive suite of proprietary applications software that is executed on proprietary distributed processing hardware. The operating system implements the distributed processing functionality of T3AS by linking, in a maximum capacity system, more than 350 dedicated microprocessors in a real-time computing environment. The T3AS software architecture is designed to enable new system features and capabilities to be installed easily through field software upgrades. Up to 145 simultaneous users can be supported by the T3AS system. All performance monitoring parameters and telephone circuit tests have been verified for compliance with Bellcore-published technical requirements, by Bellcore, and also independently verified by the Company's customers. The Company's software and hardware architecture facilitates important system capabilities such as fault tolerance and hitless access. Fault tolerance provides a one-to-one redundant circuit path that provides backup for each DS3 and DS1 circuit. DS3 and DS1 circuits may be transferred from the online main path to the redundant standby path without disruption of the embedded data streams. Transfers are accomplished automatically if a hardware or software malfunction is detected in the T3AS system. Transfers can also be accomplished manually when telephone company personnel initiate maintenance actions. "Hitless access" is an industry term used to describe a method of obtaining access to a low-speed circuit embedded in a high-speed circuit without affecting any other circuit embedded in the high-speed circuit. In the T3AS system, the Company's proprietary technology provides access to the DS3 circuit, any embedded DS1 circuit, DS0 circuit, or other subrate circuit, without affecting any other circuit within the DS3 circuit. The Company has submitted contributions to the appropriate working groups within the T1El and T1M1 standards bodies to standardize the two new status signals for sectionalization of network trouble on DSl circuits. RESEARCH AND PRODUCT DEVELOPMENT The Company believes its future success will depend in part on its ability, on a cost-effective and timely basis, to continue to enhance T3AS products, to develop and introduce new products for the telephone network test and performance-monitoring market and other markets, to address new industry transmission standards and changing customer needs and to achieve broad market acceptance for its products. Therefore, the Company intends to continue to make significant investments in research and product development. Product line extensions require the Company to work closely with its current and potential customers. Using feedback received from such customers, the Company identifies and then develops new products and enhancements to its existing products that the Company believes will increase their usefulness or extend their application. Examples of product extensions of the T3AS include CTS, PAAS, Distributed System and the Low-Speed subsystem. In addition, the Company continually seeks to reduce the manufacturing cost of its products by taking advantage of advances in hardware technology. Finally, new technologies, such as SONET, SDH, Frame Relay, ATM, and the newly-created standard for testing of DS3 circuits, are the focus of significant research and product development activity at ADA. The Company anticipates that the SONET and SDH optical transmission standards will become the industry standards over the coming years for the North American and international networks, respectively. The Company's current T3AS products do not address either the SONET or SDH transmission standards. The market for the Company's products is characterized by rapid technological advances, evolving industry transmission standards, changes in customer requirements and frequent new product introductions and enhancements. The introduction of telecommunications network test and performance monitoring products involving superior technologies or the evolution of alternative technologies or new industry transmission standards could render the Company's existing 9 products, as well as products currently under development, obsolete and unmarketable. The Company believes its future success will depend in part upon its ability, on a cost-effective and timely basis, to continue to enhance its products, to develop and introduce new products for the telecommunications network test and performance monitoring market and other markets, to address new industry transmission standards and changing customer needs and to achieve broad market acceptance for its products. The Company intends to extend its current products and develop new products to accommodate such new transmission standards and other advances in technology, as they evolve. The widespread adoption of SONET and/or SDH as industry transmission standards before the Company is able to successfully develop a product which addresses such transmission standards could in the future adversely affect the sale and deployment of the Company's products. Any failure by the Company to anticipate or respond on a cost-effective and timely basis to technological developments, changes in industry transmission standards or customer requirements or any significant delays in product development or introduction could have a material adverse effect on the Company's business. There can be no assurance that the Company will be able to successfully develop new products to address new industry transmission standards and technological changes or to respond to new product announcements by others or that such products will achieve market acceptance. In fiscal 1994, 1995, and 1996, the Company spent $5.3 million, $5.8 million and $7.4 million, respectively, on internal research and development efforts. MANUFACTURING AND SUPPLIERS The Company's manufacturing operations consist primarily of material planning and procurement, final assembly, module testing, burn-in, final system testing and quality control. The Company procures all components from outside manufacturers and believes it has good relationships with its suppliers. All final assembly and tests are completed by the Company at its production facility. The Company utilizes contract manufacturing (both consignment and turnkey operations) for the assembly of certain sub-assemblies, including printed circuit board modules. The Company also purchases sub-assemblies that have been modified to the Company's specifications from original equipment manufacturers. In January 1997, the Company acheived ISO 9001 certification for its headquarters facility in San Diego, California. The Company was formerly registered to the internationally recognized ISO 9001 standards by Bellcore, its registrar. ISO 9001 Quality Standards were developed by the International Organization for Standardization. It is a quality system standard for ensuring a total quality management system in engineering and manufacturing. The scope of the Company's registration is for the design and manfacture of telecommunications network performance management products, including associated software that help telecommunications providers manage their networks. All products are rigorously tested prior to shipment to customers. All printed circuit board modules are tested individually and as part of a system. The Company's quality control program is modeled to support the Bellcore standards. To date, the Company has not experienced significant field failures. In the event there are material deficiencies or defects in the design or manufacture of the Company's systems or if the Company's systems become incompatible with existing third-party network equipment, the affected products could be subject to a recall. The Company has experienced two significant product recalls in its history. There can be no assurance that the Company will not experience product recalls in the future. The cost of any subsequent product recall could have a material adverse effect on the Company's business, operating results and financial condition. In addition, the Company could materially suffer from the potential negative publicity associated with a recall. Generally, the Company uses industry standard components for its products. Some components, however, including VLSI ASICs, are custom made to the Company's specifications. Certain components used in the Company's T3AS and Remote Module products, including its VLSI ASICs, are currently available from only one source and other components are available from only a limited number of sources. The Company has no supply agreements and generally makes its purchases with purchase orders. Further, certain components require an order lead time of up to one year. Other components that currently are readily available may become difficult to obtain in the future. Failure of the Company to order sufficient quantities of these components in advance could prevent the Company from increasing production of products in response to customer orders in excess of amounts projected by the Company. In the past, the Company has experienced delays in the receipt of certain of its key components, which have resulted in delays in product deliveries. There can be no assurance that delays in key component and product deliveries will not occur in the future. The inability to obtain sufficient key components as required or to develop alternative sources if and as required in the future could result in delays or reduction in product shipments, which in turn could have a material adverse effect on the Company's customer relationships and operating results. 10 Additionally, the Company uses third-party subcontractors for the manufacture of its subassemblies. This reliance on third-party subcontractors involves several risks, including the potential absence of adequate capacity, the unavailability of or interruption in access to certain process technologies and reduced control over product quality, delivery schedules, manufacturing yields and costs. Shortages of raw materials to or production capacity constraints at the Company's subcontractors could negatively affect the Company's ability to meet its production obligations and result in increased prices for affected parts. To procure adequate supplies of certain components, the Company must make advance commitments to purchase relatively large quantities of such components in a number of circumstances. The Company believes, however, that by relying on a limited number of suppliers, it is in a better position to control quality, reduce manufacturing costs and improve product standardization. To procure adequate supplies of certain components, the Company must make advance commitments to purchase relatively large quantities of such components in a number of circumstances. At December 31, 1996, the Company had open noncancellable purchase commitments of approximately $3.4 million covering several different components. A large portion of the Company's purchase commitments consist of custom parts, some of which are sole source such as VLSI ASICs, for which there is no alternative use or application. The inability of the Company to incorporate such components in its products could have a material adverse effect on the Company's business, operating results and financial condition. MARKETING, SALES AND CUSTOMER SUPPORT The Company markets its products to the RBOCs, their local telephone company affiliates, ITOCs, CAPs and long distance companies through an experienced direct sales force that works closely with senior management as well as the network management departments of these customers as part of the sales effort. As of February 28, 1997, the Company's sales organization consisted of 9 professionals, including 8 regional sales managers and one vice president. Each of the regional sales managers operates from a site located near his or her strategic responsibility. The sales managers are located in Arizona, Colorado, Georgia, Illinois, Indiana, Kansas, New York and Texas. The Company also provides engineering and installation services ("E&I") for customers. These services are performed at the customer site and involve assisting the customer with the installation of the Company's products into the customers network structure. These services are performed by customer support field applications and field support engineers. All service, repair and technical support of the Company's products are performed in-house. The Company also provides comprehensive on-site field support to its customers. The Company offers technical support to its customers on a 24-hours-a-day, 7-days-a-week basis. The Company's standard hardware warranty is two years. Its standard software warranty is one year. BACKLOG At December 31, 1996, ADA had a firm backlog of approximately $1,885,000. All of the Company's backlog at December 31, 1996 is expected to be filled during fiscal 1997. At December 31, 1995, ADA had a firm backlog of approximately $5,047,000. Customers have placed orders quarterly and the Company has been operating in a book-and-ship mode, a trend the Company anticipates will continue. There can be no assurance that the current level of backlog will continue. In addition, since orders constituting the Company's current backlog are subject to changes in delivery schedules, the backlog is not necessarily an indication of future revenue. In certain cases, ADA may permit orders to be canceled without penalty where management believes it may be in the best interests of ADA to do so. There have been no cases to date where ADA's management believed it to be in the best interests of the Company to permit customers to cancel outstanding orders and the Company does not currently expect to permit customers to cancel any such orders in the future. To date, cancellation of system orders has not been material. 11 COMPETITION Although other competititors provide partial testing and monitoring solutions to the telecommunications network management market, the Company believes there are currently no competitors that provide an integrated comprehensive solution to performance monitoring and testing of the DS3 circuit as does the Company's T3AS system. The Company believes the principal competitive factors in this market are conformance with Bellcore and other industry transmission standards and specifications; product features, including price, performance and reliability; technical support; and the maintenance of close working relationships with customers. There can be no assurance that the Company will compete successfully in the future with respect to these factors. Although the Company believes that there are fewer than 10 current competitors that provide partial solutions to either performance monitoring or testing of the DS1 or DS0 circuits that make up the DS3 circuit, this market is fiercely competitive. Such competitors and prospective competitors include a number of companies, such as manufacturers of DS1 test and monitoring equipment, manufacturers of NIUs, manufacturers of digital cross-connect test and performance monitoring equipment and manufacturers of large transmission equipment. Many of these companies manufacture products that are directly competitive with the Company's Low-Speed Subsystems, T3AS Centralized Test Systems and Remote Module, and many of these competitors have significantly greater technical, financial, manufacturing, and marketing resources than the Company. In addition, the Company believes there are an increasing number of current competitors in the OS market that provide OS applications for testing, surveillance, performance monitoring and traffic management of telecommunications functions. In each of the NIU, CTS and OS markets, competition is expected to increase significantly in the future. For instance, the NIU market is fiercely competitive with respect to price, product features, established suppliers, and conformance with industry standards. In the OS market, improved technologies and tool sets have made the barriers to entry in this market relatively small. Several of the Company's competitors have long-established relationships with the Company's current and prospective customers. There can be no assurance that the Company will have the financial resources, technical expertise or manufacturing, marketing, distribution and support capabilities to compete successfully in the future. PROPRIETARY RIGHTS ADA relies on a combination of technical leadership, trade secret, copyright and trademark protection and non-disclosure agreements to protect its proprietary rights. Although the Company has pursued and intends to continue to pursue patent protection of inventions that it considers important and for which such protection is available, the Company believes its success will be largely dependent on its reputation for technology, product innovation, affordability, marketing ability and response to customer's needs. Currently, the Company has six U.S. patents granted and two U.S. patent applications allowed. One of the granted patents relates to the Company's Remote Module product. Additionally, the Company has nine pending U.S. patent applications and two international (Patent Cooperation Treaty) applications on file covering various circuit and system aspects of its products. There can be no assurance that the Company will be granted additional patents or that, if any patents are granted, they will provide the Company's products with significant protection or will not be challenged. The Company believes that the rapid rate of technological change and the relatively long development cycle for integrated circuits are also significant factors in the protection of the Company's proprietary position. The Company's proprietary VLSI ASICs incorporate unique system architectures and circuit approaches that have been developed through a broad, in-depth understanding of the telephone network. Availability of these proprietary devices, knowledge and experience of the Company's personnel, new product development, market recognition and product support are key factors in the protection of the Company's proprietary position. As part of its confidentiality procedures, the Company generally enters into non-disclosure agreements with its employees and suppliers, and limits access to and distribution of its proprietary information. Despite these precautions, it may be possible for a third party to copy or otherwise obtain and use the Company's technology without authorization. Accordingly, there can be no assurance that the Company will be successful in protecting its proprietary technology or that ADA's proprietary rights will preclude competitors from developing products or technology equivalent or superior to that of the Company. The telecommunications industry is characterized by the existence of a large number of patents and frequent litigation based on allegations of patent infringement. The Company is not aware of any infringement by its products or 12 technology of the proprietary rights of others. There can be no assurance that third parties will not assert infringement claims against the Company in the future or that any such assertions will not result in costly litigation or require the Company to obtain a license to intellectual property rights of such parties. There can be no assurance that any such licenses would be available on terms acceptable to the Company, if at all. Further, litigation, regardless of outcome, could result in substantial cost to and diversion of efforts by the Company. Any infringement claims or litigation against the Company could materially and adversely affect the Company's business, results of operations and financial condition. Moreover, the laws of some foreign countries do not protect the Company's proprietary rights in the products to the same extent as do the laws of the United States. EMPLOYEES As of Feb 28, 1997, ADA had approximately 219 full-time employees, including 127 in engineering, 44 in sales, marketing and customer support, 25 in operations and 23 in finance and administration. The success of the Company is dependent, in part, on its ability to attract and retain highly qualified personnel. Competition for such personnel is intense and the inability to attract and retain additional key employees or the loss of one or more current key employees could adversely affect the Company. There can be no assurance that the Company will be successful in hiring or retaining requisite personnel. The Company's President and Chief Executive Officer, Mr. Peter Savage, the Company's Vice President, Systems Engineering, Mr. Paul Hartmann, and the Company's Vice President, Customer Support, Mr. Donald O'Connor, have entered into severance arrangements with the Company. No other member of the Company's senior management is subject to an employment arrangement with the Company. The Company's employees are not represented by any collective bargaining agreements, and the Company has never experienced a work stoppage. The Company believes that its employee relations are good. RISKS AND UNCERTAINTIES CONCENTRATION OF MAJOR CUSTOMERS; TELEPHONE COMPANY QUALIFICATION REQUIREMENTS. The market for the Company's products currently consists of the seven RBOCs, other local telephone companies, CAPs and long distance telephone companies. The Company's marketing efforts to date have focused on the RBOCs which accounted for 73% of the Company's revenue in 1996. Accordingly, at present the Company's customer base is highly concentrated and there can be no assurance that its customer base will become less concentrated. Further, the Company's customers are significantly larger than the Company and may be able to exert a high degree of influence over the Company. The loss of one or more of the Company's major customers, the reduction of orders, or a delay in deployment of the Company's products could materially and adversely affect the Company's business, operating results and financial condition. Prior to selling products to a telephone company, a vendor must first undergo a product qualification process for its products with the telephone company. Although the qualification process for a new product varies somewhat among these prospective customers, the Company's experience is that the process often takes a year or more. Currently, six of the seven RBOCs have qualified and deployed the Company's T3AS products. Any failure on the part of any of the RBOCs or other telephone companies to maintain their qualification of the Company's T3AS products, failure of any of the RBOCs or other telephone companies to deploy the Company's T3AS products, or any attempt by any of the RBOCs or other telephone companies to seek out alternative suppliers could have a material adverse effect on the Company's business, operating results and financial condition. BellSouth, Ameritech, Southwestern Bell and U S West have entered into purchase contracts with the Company. Other RBOCs, independent telephone companies, and other telephone service providers purchase the Company's products under standard purchase orders. Since the RBOC contracts may be terminated at the convenience of the RBOC, the Company believes that the purchase contracts are not materially different than purchasing under purchase orders. There can be no assurance that the Company's products will be qualified by new customers, or that such qualification will not be significantly delayed. Furthermore, telephone company work force reductions and staff reassignments have in the past delayed the product qualification process, and the Company expects such reductions and reassignments to continue in the future. There can be no assurance that such reductions and reassignments will not have a material adverse effect on the Company's business, operating results and financial condition. 13 HIGH DEPENDENCE ON SINGLE PRODUCT LINE. The majority of the Company's revenue to date has been derived from the sale of T3AS products and services. The Company expects that a majority of its revenue will continue to be derived from T3AS products and services in the near term. However, the Company is investing in the expansion of its product lines through the enhancement, development and marketing of its NIU, CTS, PAAS, and OS products. Failure by the Company to enhance either its existing T3AS products and services including CTS and PAAS. or its NIU and OS products, and to develop new product lines and new markets could materially and adversely affect the Company's business, operating results and financial condition. There is no assurance that the Company will be able to develop and market new products and technology or otherwise diversify its source of revenue. COMPETITION. The Company believes there are currently no competitors that provide an integrated comprehensive solution to performance monitoring and testing of the DS3 circuit as does the Company's T3AS system. The Company believes the principal competitive factors in this market are conformance with Bellcore and other industry transmission standards and specifications; product features, including price, performance and reliability; technical support; and the maintenance of close working relationships with customers. There can be no assurance that the Company will compete successfully in the future with respect to these factors and others that may arise. Although the Company believes that there are fewer than 10 current competitors that provide partial solutions to either performance monitoring or testing of the DS1 or DS0 circuits that make up the DS3 circuit, this market is fiercely competitive. Such competitors and prospective competitors include a number of companies, such as manufacturers of DSI test and monitoring equipment, manufacturers of NIUs, manufacturers of digital cross-connect test and performance monitoring equipment and manufacturers of large transmission equipment. Many of these companies manufacture products that are directly competitive with the Company's Low-Speed Subsystems, T3AS Centralized Test Systems and Remote Module, and many of these competitors have significantly greater technical, financial, manufacturing, and marketing resources than the Company. In addition, the company believes that there are an increasing number of current competitors in the OS market that provide OS applications for testing, surveillance, performance monitoring and traffic management of telecommunications functions. In each of the NIU, CTS and OS markets, competition is expected to increase significantly in the future. For instance, the NIU market is fiercely competitive with respect to price, product features, established suppliers, and conformance with industry standards, and in the OS market, improved technologies and tool sets have made the barriers to entry in this market relatively small. Additionally, several of the Company's competitors have long-established relationships with the Company's current prospective customers. In addition, product price reductions resulting from market share penetration initiatives or competitive pricing pressures could have a material and adverse effect on the Company's business, operating results, and financial condition. There can be no assurance that the Company will have the financial resources, technical expertise or manufacturing, marketing, distribution and support capabilities to compete successfully in the future. MANAGEMENT OF CHANGING BUSINESS. As a result of acquisitions in 1996, the Company obtained additional office space and hired additional personnel in both Terre Haute, Indiana and British Columbia, Canada to support the business operations of the new products, services and technologies acquired. The Company faces significant management challenges related to the integration of the operations, products and technologies acquired as well as the management of separate geographic locations. In 1996, the Company formed two strategic business units: the Network Systems and Sensors business unit and the Network Management business unit. The business units are synergistic with the evolution of the Company from a single product line to multiple product lines. The Network Systems and Sensors business unit is built around the Company's T3AS products and services including CTS and PAAS, as well as the Remote Module product. The Network Management business unit focuses on OS products including TDC&E, FMS and OS design services all acquired through acquisitions, as well as GTA and Sectionalizer. There can be no assurance that the Company will be successful in managing its new business unit structure. The Company is currently transitioning portions of the OS design service business to a product-oriented business. This transition will likely place a significant strain on the Company's management, information systems and operations and there can be no assurance that such a transition can be successfully managed. The acquisitions and resultant growth in the Company's infrastructure have placed, and are expected to continue to place, a significant strain on the Company's management, information systems and operations. The strain experienced to date has chiefly been in hiring sufficient numbers of qualified personnel to support the expansion of the business. The Company is not able to forecast additional strains that may be placed on the Company's management, information systems and operations as a result of the acquisitions or in the future. The Company's potential inability to manage its changing business effectively could have a material adverse effect on the Company's business, results of operations, and financial condition. MERGERS. Of the eight major TSPs currently involved in merger transactions, six are customers of the Company. Several of the mergers involve companies that purchase network systems, software and services from the Company's competitors. Consequently, the completion of certain of these mergers may result in the loss of business and customers for the Company. Additionally, the impact of capital spending constraints during the merger transitions could have a material adverse effect on the Company's business, operating results and financial condition. 14 RAPID TECHNOLOGICAL CHANGE AND DEPENDENCE ON NEW PRODUCTS. The market for the Company's products is characterized by rapid technological advances, evolving industry standards, changing regulatory environments, changes in customer requirements, and frequent new product introductions and enhancements. The introduction of telephone network test and performance-monitoring products involving superior technologies or the evolution of alternative technologies or new industry transmission standards, such as ATM, Frame Relay and SONET, could render the Company's existing products, as well as products currently under development, obsolete and unmarketable. The Company believes its future success will depend in part upon its ability, on a cost-effective and timely basis, to continue to enhance its current products, to develop and introduce new products for the telephone network test and performance-monitoring market, the OS market, and other markets, to address new industry transmission standards and changing customer needs, and to achieve broad market acceptance for its products. In particular, the Company anticipates that the SONET and SDH optical transmission standards will become the industry transmission standards over the coming years for the North American and international networks, respectively. The Company's current T3AS products do not address either the SONET or SDH transmission standard. The Company intends to extend its current products and develop new products to accommodate such new transmission standards, as they evolve. The widespread adoption of SONET and/or SDH as industry transmission standards before the Company is able to successfully develop a product which addresses such transmission standards could adversely affect the sale and deployment of the Company's T3AS products. Any failure by the Company to anticipate or respond on a cost-effective and timely basis to technological developments, changes in industry transmission standards or customer requirements, or any significant delays in product development or introduction could have a material adverse effect on the Company's business. There can be no assurance that the Company will be able to successfully develop new products to meet customer requirements, to address new industry transmission standards and technological changes or to respond to new product announcements by others, or that such products will achieve market acceptance. DEPENDENCE ON SUPPLIERS AND SUBCONTRACTORS; NEED TO MAKE ADVANCE PURCHASE COMMITMENTS. Certain components used in the Company's T3AS products and Remote Module product, including its VLSI ASICs and other components, are available from a single source. The Company has no supply agreements and generally makes its purchases with purchase orders. Further, certain components require an order lead time of up to one year. Other components that currently are readily available may become difficult to obtain in the future. Failure of the Company to order sufficient quantities of these components in advance could prevent the Company from increasing production in response to customer orders in excess of amounts projected by the Company. In the past, the Company has experienced delays in the receipt of certain of its key components, which have resulted in delays in product deliveries. There can be no assurance that delays in key component and part deliveries will not occur in the future. The inability to obtain sufficient key 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 in turn could have a material adverse effect on the Company's customer relationships and operating results. Additionally, the Company uses third-party subcontractors for the manufacture of its subassemblies. This reliance on third-party subcontractors involves several risks, including the potential absence of adequate capacity, the unavailability of or interruption in access to certain process technologies, and reduced control over product quality, delivery schedules, manufacturing yields and costs. Shortages of raw materials or production capacity constraints at the Company's subcontractors could negatively affect the Company's ability to meet its production obligations and could result in increased prices for affected parts. To procure adequate supplies of certain components, the Company must make advance commitments to purchase relatively large quantities of such components in a number of circumstances. A large portion of the Company's purchase commitments consists of custom parts, some of which are sole-source such as VLSI ASICs, for which there is no alternative use or application. The inability of the Company to incorporate such components in its products could have a material adverse effect on the Company's business, operating results and financial condition. PRODUCT RECALL. Producers of telecommunications network equipment, including test access and performance monitoring systems such as those being marketed by the Company, are often required to meet rigorous standards imposed by Bellcore, the research and development entity created following the divestiture of AT&T to provide ongoing engineering support to the RBOCs. In addition, the Company must meet specialized standards imposed by its customers. The Company's systems are also required to interface in a complex and changing environment with telecommunication network equipment made by numerous suppliers. In the event there are material deficiencies or defects in the design or manufacture of the Company's systems, or if the Company's systems become incompatible with existing third-party network equipment, the affected products could be subject to a recall. The Company has experienced two significant product recalls in its history and there can be no assurance that the Company will not 15 experience any product recalls in the future. The cost of any subsequent product recall and associated negative publicity could have a material adverse effect on the Company's business, operating results and financial condition. GOVERNMENT REGULATION. The majority of the Company's customers operate within the telecommunications industry which is subject to regulation in the United States and other countries. Most of the Company's customers must receive regulatory approvals in conducting their businesses. Although the telecommunications industry has recently experienced government deregulation, there is no assurance this trend will continue. In fact, recent regulatory rulings have affected the ability of the Company's customers to enter new markets and deliver new services which could impact their ability to make significant capital expenditures. The effect of regulatory rulings by federal and state agencies on the Company's customers may adversely impact the Company's business, operating results and financial condition. PROPRIETARY TECHNOLOGY. The Company relies on a combination of technical leadership, trade secret, copyright and trademark protection and non-disclosure agreements to protect its proprietary rights. Although the Company has pursued and intends to continue to pursue patent protection of inventions that it considers important and for which such protection is available, the Company believes its success will be largely dependent on its reputation for technology, product innovation, affordability, marketing ability and response to customer's needs. Currently, the Company has nine U.S. patents granted and two U.S. patent applications allowed. One of the granted patents relates to the Company's Remote Module product. Additionally, the Company has nine pending U.S. patent applications and two international (Patent Cooperation Treaty) applications on file covering various circuit and system aspects of its products. There can be no assurance that the Company will be granted additional patents or that, if any patents are granted, they will provide the Company's products with significant protection or will not be challenged. As part of its confidentiality procedures, the Company generally enters into non-disclosure agreements with its employees and suppliers, and limits access to and distribution of its proprietary information. Despite these precautions, it may be possible for a third party to copy or otherwise obtain and use the Company's technology without authorization. Accordingly, there can be no assurance that the Company will be successful in protecting its proprietary technology or that ADA's proprietary rights will preclude competitors from developing products or technology equivalent or superior to that of the Company. The telecommunications industry is characterized by the existence of a large number of patents and frequent litigation based on allegations of patent infringement. The Company is not aware of infringement by its products or technology of the proprietary rights of others. There can be no assurance that third parties will not assert infringement claims against the Company in the future or that any such assertions will not result in costly litigation or require the Company to obtain a license to intellectual property rights of such parties. There can be no assurance that any such licenses would be available on terms acceptable to the Company, if at all. Further, litigation, regardless of outcome, could result in substantial cost to and diversion of efforts by the Company. Any infringement claims or litigation against the Company could materially and adversely affect the Company's business, results of operations and financial condition. Moreover, the laws of some foreign countries do not protect the Company's proprietary rights in the products to the same extent as do the laws of the United States. DEPENDENCE ON KEY PERSONNEL. The success of the Company is dependent, in part, on its ability to attract and retain highly qualified personnel. Competition for such personnel is intense and the inability to attract and retain additional key employees or the loss of one or more current key employees could adversely affect the Company. There can be no assurance that the Company will be successful in hiring or retaining requisite personnel. VOLATILITY OF STOCK PRICE. The Company's future earnings and stock price may be subject to significant volatility, particularly on a quarterly basis. Any shortfall in revenue or earnings from levels expected by public market analysts and investors could have an immediate and significant adverse effect on the trading price of the Company's common stock. Fluctuation in the Company's stock price may also have an effect on customer decisions to purchase the Company's products which could have a material adverse effect on the Company's business, operating results and financial condition, 16 ITEM 2. PROPERTIES The Company currently maintains its headquarters in a leased facility in San Diego, California, which contains all development, engineering, assembly, marketing and administrative functions, in 38,987 square feet of space in one building. The lease expires in fiscal 1999. The Company also leases additional office facilities in Terre Haute, Indiana, and Vancouver, British Columbia, both of which house product development and customer support operations. The Company leases 12,600 and 25,604 square feet of space in Terrre Haute and Vancouver, respectively. The Terre Haute lease expires in September 1997, and the Vancouver lease expires in December 1999. The Terre Haute lease includes an option to extend the lease term one year from the September 1997 expiration date. The Company believes that its existing facilities will be adequate to meets its needs through 1997. ITEM 3. LEGAL PROCEEDINGS None. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS STOCK MARKET INFORMATION Applied Digital Access' Common Stock is listed on the NASDAQ National Market and is traded on the over the counter market under the symbol "ADAX." The following table set forth the high and low sales prices the Company's common stock for the periods indicated.
1996 High Low ---- ---- --- First Quarter $17.00 $ 9.50 Second Quarter 19.00 9.75 Third Quarter 11.75 6.25 Fourth Quarter 8.75 4.75 1995 High Low ---- ---- --- First Quarter $30.50 $ 13.00 Second Quarter 16.75 10.25 Third Quarter 17.50 10.50 Fourth Quarter 15.00 10.00
There were 247 shareholders of record as of February 28, 1997. DIVIDEND POLICY Applied Digital Access has not declared or paid any cash dividends on it Common Stock to date. The Company currently intends to retain all earnings, if any, to fund the development and growth of its business and therefore does not anticipate paying any cash dividends within the foreseeable future. 17 ITEM 6. SELECTED FINANCIAL DATA
(Dollars in thousands) 1992 1993 1994 1995 1996 ---- ---- ---- ---- ---- Revenue $ 7,453 $ 14,259 $ 35,597 $ 20,470 $ 24,422 Gross Profit 2,914 7,125 20,791 11,753 11,813 Operating Expenses: Research and development 3,181 3,902 5,335 5,807 7,356 In process research and development related to acquistions - - - - 3,286 Sales and marketing 1,916 2,406 3,363 4,234 6,312 General and administrative 1,416 1,354 2,337 2,985 3,576 ----- ----- ----- ----- ----- Total operating expenses 6,513 7,662 11,035 13,026 20,530 Net income (loss) (3,621) (619) 10,620 759 (7,120) ------- ----- ------ --- ------- Net income (loss) per share $ (4.96) $ (.75) $ .88 $ .06 (.59) -------- ------- ------- ------ ---- Net income (loss) per share, $ (.46) $ (.07) $ .88 $ .06 (.59) supplementary (1) -------- ------- ------- ------ ---- Weighted average number of shares and commom share equivalents (1) 730 820 12,091 12,848 12,084 Weighted average number of shares and common share equivalents, supplementary (1) 7,914 8,693 12,091 12,848 12,804 Working Capital $ 3,082 $ 2,251 26,081 36,728 31,229 Total assets 5,389 6,878 48,919 49,936 45,972 Long-term debt 431 117 82 49 33
(1) See Note 2 to the Financial Statements, a copy of which is attached hereto as Exhibit 13.1. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 14 through 17 of the Annual Report is incorporated herein by reference. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Financial Statements on pages 18 through 22 and the Notes to Financial Statements on pages 23 through 29 of the Annual Report are incorporated herein by reference. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Identification of Directors. The information under the caption "Election of Directors," appearing in the Proxy Statement, is incorporated herein by reference. Identification of Executive Officers. The information under the headings "Executive Officers," appearing in the Proxy Statement, is incorporated herein by reference. Compliance with Section 16(a) of the Exchange Act. Based solely upon a review of Forms 3, 4 and 5 and amendments thereto furnished to the Registrant and upon written representations of all individuals required to file forms pursuant to Section 16(a), the Registrant knows of no such individual that failed to file Forms 3, 4 and 5 on a timely basis during the last fiscal year. ITEM 11. EXECUTIVE COMPENSATION The information under the headings "Executive Compensation and Other Information," appearing in the Proxy Statement, is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information under the headings "Principal Shareholders" and "Common Stock Ownership of Management," appearing in the Proxy Statement, is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information under the heading "Certain Transactions," appearing in the Proxy Statement, is incorporated herein by reference. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. FINANCIAL STATEMENTS The following financial statements of the Company, included in the 1996 Annual Report to Shareholders for the year ended December 31, 1996 are incorporated herein by reference as required under Item 8 of this annual report on Form 10-K: 18 Report of Independent Accountants Balance Sheets at December 31, 1995 and December 31, 1996 Statements of Operations for the years ended December 31, 1994, 1995 and 1996 Statements of Shareholders' Equity for the years ended December 31, 1994, 1995 and 1996 Statements of Cash Flows for the years ended December 31, 1994, 1995 and 1996 Notes to Consolidated Financial Statements 2. FINANCIAL STATEMENT SCHEDULES The following financial statement schedules are included in Item 14 (d): Report of Independent Accountants Schedule II - Valuation and Qualifying Accounts All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. (b) REPORTS ON FORM 8-K No reports on Form 8-K have been filed during the last quarter of the period covered by this report. (c) EXHIBITS EXHIBIT PAGE NUMBER NUMBER ------ ------ 2.1(6) Asset Purchase Agreement between Applied Digital Access, -- Inc. and Applied Computing Devices, Inc. dated February 29, 1996 2.2(8) Asset Purchase Agreement between Applied Digital Access, -- Inc. and MPR Teltech, Ltd. dated July 16, 1996 3.1(1) Amended and Restated Articles of Incorporation (Exhibit 3.3). -- +3.2(1) Amended and Restated Bylaws of the Company as amended -- (Exhibit 3.4). Form of Written Consent of Holders of Series A, Series B, Series C, Series -- 10.1(1) D and Series E Preferred Stock to Conversion effective immediately prior to the closing. 10.1(1) Registration Rights Agreement by and between the -- Company and certain shareholders of the Company, dated May 22, 1992 as amended pursuant to the Amendment to Registration Rights Agreement dated April 9, 1993. 10.2(1) Series A Preferred Stock Purchase Agreement by and -- between the Company and the purchasers identified on Exhibit A to the Agreement, dated August 17, 1987 as amended and restated on December 24, 1987. 10.3(1) Series B Preferred Stock Purchase Agreement by and -- between the Company and the purchasers identified on Exhibit A to the Agreement, dated January 20, 1989. 19 EXHIBIT PAGE NUMBER NUMBER ------ ------ 10.4(1) Modification Agreement and Consent by and between the -- Company and the holders of the Company's Series A Preferred Stock, dated January 20, 1989. 10.5(1) Supplemental Series B Preferred Stock Purchase -- Agreement by and between the Company and the Purchasers identified on Exhibit A to the Agreement, dated January 30, 1989. 10.6(1) Stock Purchase and Capital Contribution Agreement by -- and between the Company and the purchasers identified on Exhibit A to the Agreement, dated February 28, 1991. 10.7(1) Series D Preferred Stock Purchase Agreement by and -- between the Company and the purchasers identified on Exhibit A to the Agreement, dated March 13, 1991. 10.8(1) Capital Contribution Agreement by and between the -- Company and the persons identified on Exhibit A to the Agreement, dated March 13, 1991. 10.9(1) Series E Preferred Stock Purchase Agreement by and -- between the Company and the purchasers identified on Exhibit A to the Agreement, dated May 22, 1992, as amended pursuant to the Amendment No. One to Series E Preferred Stock Purchase Agreement dated July 22, 1992 and the Amendment to Series E Preferred Stock Purchase Agreement dated April 9, 1993. 10.10(1) Modification Agreement and Consent by and between the -- Company and the holders of the Company's Series A Preferred Stock, Series B Preferred Stock, Series C Preferred Stock and Series D Preferred Stock, dated May 22, 1992. 10.11(1) Standby Loan Facility Agreement by and between -- the Company and the purchasers identified on Exhibit A to the Agreement, dated April 9, 1993, as amended pursuant to an Amendment to Standby Loan Facility Agreement dated April 9, 1993. Related form of Note and form of Warrant. 10.12(1) Lease for the Company's facilities at 9855 Scranton -- Road, dated June 15, 1993. 10.13(1) Master Equipment Lease Agreement dated July 8, 1988 -- by and between the Company and Comdisco, Inc., as amended. 10.14(1) Warrant Agreement, dated July 8, 1988 by and -- between the Company and Comdisco, Inc., as amended. 10.15(1) Warrant Agreement dated August 15, 1991 by and -- between the Company and Comdisco, Inc. 10.16(1) Agreement dated July 1, 1991 by and between the -- Company and BellSouth Services Incorporated, as amended (with certain confidential portions omitted). 10.17(1) Manufacturing Agreement dated April 30, 1993 by and -- between the Company and Comptronix Corporation. 10.18(1) Manufacturing Agreement dated November 19, 1993 -- by and between the Company and Arrow Electronics, Inc. (with certain confidential portions omitted). 20 EXHIBIT PAGE NUMBER NUMBER ------ ------ 10.19(1) Software License Agreement dated January 16, 1992 by -- and between the Company and GCOM (with certain confidential portions omitted). 10.20(1) Master Agreement for Operations Systems Modifications -- for the Integration of Network Elements, dated June 17, 1991 by and between the Company and Bellcore, as amended. 10.21(1) Addendum #1 to Master Agreement for Operations Systems -- Modifications for the Integration of Network Elements, dated June 17, 1991 by and between the Company and Bellcore dated July 10, 1991. 10.22(1) Addendum #2 to Master Agreement for Operations Systems -- Modifications for the Integration of Network Elements, dated June 17, 1991 by and between the Company and Bellcore dated November 19, 1993. 10.23(1) Addendum #3 to Master Agreement for Operations Systems -- Modification for the Integration of Network Elements dated June 17, 1991 by and between the Company and Bellcore dated December 27, 1993. 10.24(1) Sales Representative Agreement dated October 11, 1991 -- by and between the Company and Taiwan Victory Technology Corporation (with certain confidential portions omitted). +10.25(1) The Company's 1988 Stock Option Plan, as amended. -- +10.26(1) The Company's Restricted Stock Purchase Plan, as amended. -- +10.27(1) 1988 Stock Option Plan Form of Incentive Stock -- Option Agreement. +10.28(1) 1988 Stock Option Plan Form of Non-Qualified Stock -- Option Agreement. +10.29(1) 1988 Stock Option Plan Form of Stock Purchase Agreement. -- 10.30(1) Stock Option Agreement dated May 22, 1991, by and -- between the Company and the Boundary Fund. 10.31(1) Stock Purchase Agreement dated September 30, -- 1991, by and between the Company and the Boundary Fund. +10.32(1) Stock Option Agreement dated May 22, 1991, by and between -- the Company and Richard E. Pospisil. +10.33(1) Stock Purchase Agreement dated December 23, 1993, -- by and between the Company and Richard E. Pospisil. +10.34(1) Consulting Services Agreement dated July 11, 1993 -- by and between the Company and Thomas L. Engdahl. +10.35(1) Settlement Agreement and General Release dated -- June 11, 1993 by and between the Company and Thomas L. Engdahl, as amended. +10.36(1) Stock Pledge Agreement dated August 10, 1993 by -- and between the Company and Thomas L. Engdahl. +10.37(1) Promissory Note Secured by Stock Pledge Agreement -- dated August 10, 1993 executed by Thomas L. Engdahl in favor of the Company. +10.38(1) Severance Agreement dated November 27, 1990 by -- and between the Company and Peter P. Savage. 21 EXHIBIT PAGE NUMBER NUMBER ------ ------ +10.39(1) Promissory Note dated June 12, 1992 executed -- by Peter Savage in favor of the Company. +10.40(1) Severance Agreement dated June 20, 1988 by and -- between the Company and Paul R. Hartmann. +10.41(1) Management Team Incentive Compensation Plan. -- +10.42(1) The Company's 1994 Stock Option/Stock Issuance Plan. -- +10.43(1) 1994 Stock Option/Stock Issuance Plan Form -- of Stock Option Agreement. +10.44(1) 1994 Stock Option/Stock Issuance Plan Form of -- Stock Issuance Agreement. +10.45(1) 1994 Employee Stock Purchase Plan. -- +10.46(1) 1994 Stock Purchase Plan Form of Stock Purchase Agreement. -- 10.47(1) Form of Employee Proprietary Information Agreement. -- +10.48(1) Form of Indemnification Agreements between the Company -- and each of its directors. +10.49(1) Form of Indemnification Agreements between the Company -- and each of its officers. 10.50(1) Binary Software License Agreement dated March 7, -- 1989 between the Company and Software Components Group, Inc., as amended. 10.51(2) General Purchase Agreement dated April 11, 1994 -- between the Company and U.S. West Communications, Inc. (with certain confidential portions omitted) (Exhibit 10.1). 10.52(3) Reinstatement Agreement dated September 22, 1994 -- between the Company and BellSouth Telecommunications Incorporated (with certain confidential portions omitted) (Exhibit 10.2). 10.53(3) Purchase Agreement with Telecommunications Products -- and Related Services between the Company and Ameritech Services, Inc. (with certain confidential portions omitted) (Exhibit 10.3). 10.54(4) First Amendment to Office Lease dated September 23, -- 1994 between the Company and Sorrento Tech Associates. +10.55(4) Settlement Agreement and General Release dated -- January 17, 1995 between the Company and Charles H. Divine. 10.56(5) Purchase Agreement for Telecommunications Products -- and Related Services between Southwestern Bell Telephone Company and Applied Digital Access, Inc., dated September 8, 1995 (with certain confidential portions omitted) (Exhibit 10.1). +10.57(7) Apllied Digital Access 1994 Stock Option/Stock -- Issuance Plan, as amended. +10.58(7) Applied Digital Access 1994 Employee Stock -- Purchase Plan, as amended +10.59(7) Applied Digital Access 1996 Non-Qualified Option Plan -- 22 EXHIBIT PAGE NUMBER NUMBER ------ ------ 10.60(9) Master Agreement between Northern Telcom, Ltd. -- and Applied Digital Access, Inc. dated July 16, 1996 10.61(9) Stock Purchase Agreement between Applied Digital -- Access, Inc. and MPR Teltech, Ltd. dated July 16, 1996. 10.62(9) License Agreement between Northern Telcom, Ltd. -- and Applied Digital Access, Inc. 10.63(9) Second Amendment to Lease between Sorrento -- Tech Associates and Applied Digital Access, Inc. dated August 8, 1996 10.64(9) Lease Agreement between Rose Hulman Institute of -- Technology, through its authorized leaseing agent, Ragle and Company, and Applied Digital Access, Inc. dated September 15, 1996. 10.65(9) Agreement for Extension of Term, Amendement No. -- 2 to General Purchasing Agreement between US WEST Communications, Inc. and Applied Digital Access, Inc. dated August 15, 1996 10.66 Sublease agreement between Applied Digital Access, -- Inc. and ENOVA Corporation dated December 9, 1996 10.67 First Amendment to Sublease between Applied -- Digital Access and ENOVA Corporation dated January 24, 1997 10.68 Agreement for Extension of Term, Amendement No. 3 to -- General Purchasing Agreement between US WEST Communications, Inc. and Applied Digital Access, Inc. dated January 30, 1997 10.69 Office Lease Agreement between 2725321 Canada Inc. -- and Applied Digital Access - Canada, Inc. dated January 1, 1997. 11.1 Statement regarding computation of earnings per share. 13.1 Applied Digital Access, Inc., 1996 Annual Report to Shareholders. 23.1 Consent of Coopers & Lybrand L.L.P. 24.1 Power of Attorney. (See page 25). 27.1 Financial Data Schedule + Management contract or compensatory plan. (1) Incorporated by reference to the Company's Registration Statement on Form S-1 (No. 33-75258), as amended. (2) Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1994 (File No. 0-23698). (3) Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1994 (File No. 0-23698). (4) Incorporated by reference to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1995 (File No. 0-23698). (5) Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1995 (File No. 0-23698). (6) Incorporated by reference to the Company's Current Report on Form 8-K dated March 15, 1996 (File No. 0-23698). (7) Incorporated by reference to the Company's Registration Statement on Form S-8 (No. 333-08297), as amended (8) Incorporated by reference to the Company's Current Report on Form 8-K dated July 31, 1996 (File No. 0-23698). 23 (9) Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1996 (File No. 0-23698). Supplemental Information Copies of the Registrant's Proxy Statement for the Annual Meeting of shareholders to be held May 20, 1997 and copies of the form of proxy to be used for such Annual Meeting were furnished to the Commission prior to the time they were distributed to the shareholders. 24 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. APPLIED DIGITAL ACCESS, INC. Date: March 29, 1997 By: /s/ Peter P. Savage ------------------------ Peter P. Savage President and Chief Executive Officer POWER OF ATTORNEY Know all men by these presents, that each person whose signature appears below constitutes and appoints Peter P. Savage or James L. Keefe, his or her attorney-in-fact, with power of substitution in any and all capacities, to sign any amendments to this Annual Report on Form 10-K, and to file the same with exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that the attorney-in-fact or his or her substitute or substitutes may do or cause to be done by virtue hereof. 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 in the capacities and on the dates indicated. SIGNATURE TITLE DATE - --------- ----- ---- /s/ Peter P. Savage President, Chief Executive March 29, 1997 - --------------------- (Peter P. Savage) Officer and Director (Principal Executive Officer) /s/ James L. Keefe Vice President, Finance and March 29, 1997 - --------------------- (James L. Keefe) Administration, Secretary, Chief Financial Officer (Principal Financial and Accounting Officer) /s/ Kenneth E. Olson Director March 29, 1997 - ---------------------- (Kenneth E. Olson) /s/ Christopher B. Paisley Director March 29, 1997 - --------------------------- (Christopher B. Paisley) /s/ Edward F. Tuck Director March 29, 1997 - ----------------------- (Edward F. Tuck) 25 EX-10.71 2 SUBLEASE SUBLEASE This Sublease is entered into by and between APPLIED DIGITAL ACCESS, a California corporation, Sublessor, and ENOVA CORPORATION, a California corporation, Sublessee, under that certain Lease dated June, 1993, entered into by Sorrento Tech Associates, a California limited partnership, as Lessor, and Sublessor under this Sublease as Lessee, as amended by that certain First Amendment to Lease dated as of September 23, 1994, and as further amended by that certain Second Amendment to Lease dated as of August 8, 1996. A copy of the Lease, First Amendment to Lease and Second Amendment to Lease, collectively hereinafter known as the Master Lease, are attached hereto as Exhibit "A." 1. INCORPORATION OF AND ASSUMPTION OF MASTER LEASE OBLIGATIONS Except as specifically provided in this Sublease to the contrary, this Sublease is subject to all of the terms and conditions of the Master Lease in Exhibit "A." Except as specifically provided in this Sublease to the contrary, Sublessee agrees to assume and perform the obligations of Sublessor and Lessee in said Master Lease, but only to the extent said obligations arise from or relate to the Premises subleased pursuant to this Sublease. Sublessee shall not commit or permit to be committed on the Premises any act or omission which shall violate any term or condition of the Master Lease. In the event of the termination of Sublessor's interest as Lessee under the Master Lease, for any reason, then this Sublease shall terminate coincidentally therewith without any liability of Sublessor to Sublessee, subject however to Lessor's agreement to grant to Sublessee the quiet enjoyment of the Premises subleased set forth below in Lessor's Consent. Sublessor and Sublessee agree that Sublessee does not assume any obligations with regard to the following sections of the Master Lease: Lease 2.5 Rentable Area Defined 2.6 Building Rentable Area 5 Additional Charges for Expenses 6.2 Security Deposit 7 Construction [Tenant Improvements] 16.2 Tenant's Liability Insurance (Sublessee will provide evidence of self-insurance) 16.3 Form of Policies (Sublessee will provide evidence of self-insurance) 18.6 Assumption of Obligations 22.4 Payment of Sums Due 30.2 Financial Statements 30.10 Holding Over First Amendment 3. Security Deposit 5. Brokers Commission 1 Second Amendment 3. Acceptance of Expansion Area 6. Security Deposit 8. Broker Commissions 2. PREMISES Sublessor leases to Sublessee and Sublessee hires from Sublessor the following described Premises together with the appurtenances described in the Master Lease, situated in the City of San Diego, County of San Diego, State of California and described as: 9855 Scranton Road, Suite 100, approximately 23,381 square feet of Building 5 of the San Diego Tech Center as shown on Exhibit "B" attached hereto and incorporated by this reference. 3. RENTAL Sublessee shall pay to Sublessor as rent for the Premises in advance on the first day of each calendar month of the term of this Sublease without deduction, offset, prior notice or demand, in lawful money of the United States, the sum of Twenty-Seven Thousand One Hundred Twenty-One Dollars Ninety-Six Cents ($27,121.96). If the commencement date is not the first day of the month, or if the Sublessee termination date is not the last day of the month, a prorated monthly installment shall be paid at the then current rate for the fractional month during which the Sublease commences and/or terminates. In the event Sublessee continues to occupy the space after September 1, 1997, the monthly rental rate will be $28,291.01. Sublessee shall be responsible for their separately metered electricity. By executing this Sublease, Sublessor hereby acknowledges receipt of $27,121.96 as the first month's rental. 4. TERM (a) The term of this Sublease shall be for a period of six months commencing on January 1, 1997, and ending on June 30, 1997. (b) After June 30, 1997 Sublessee shall have the right to occupy the Premises on a month to month basis through December 31,1997, and shall have the right to terminate anytime during that period with thirty (30) days written notice. (c) In the event Sublessor is unable to deliver possession of the Premises at the commencement of the term, Sublessor shall not be liable for any damage caused thereby, and this Sublease shall be voidable at Sublessee's sole discretion. If the sublease is voided by Sublessee, 2 Sublessee shall not be liable for any rent due under the terms of the Sublease. If Sublessee, with Sublessor's consent, takes possession prior to the commencement of the term, Sublessee shall do so subject to all of the covenants and conditions hereof except for the obligation to pay rent for the period prior to and ending upon the commencement of the term as stated herein. 5. USE Sublessee shall use the Premises for general office uses and for no other purpose without the prior written consent of Sublessor, which consent shall not be unreasonably withheld. 6. TENANT IMPROVEMENTS Sublessee shall accept the premises in "as-is" condition, broom clean. Any improvements must be approved by Landlord and Sublessor per Section 10 of the Master Lease. 7. NOTICES All notices or demands of any kind required or desired to be given by Sublessor or Sublessee thereunder shall be in writing and shall be deemed delivered forty-eight (48)hours after depositing the notice or demand in the United States mail, certified or registered, postage prepaid, addressed to the Sublessor or Sublessee respectively at the addresses set forth after their signatures at the end of this Sublease. All rent and other payments due under the Sublease shall be made by Sublessee to Sublessor at the same address. Dated: 12/11/96 Dated: 12/9/96 Sublessor: Sublessee: Applied Digital Access, Enova Corporation, a California corporation a California corporation By: /s/ Peter Savage By: /s/ David R. Kuzma President Senior Vice President 9855 Scranton Road 101 Ash Street San Diego, CA 92121 San Diego, CA 92101 LESSOR'S CONSENT The undersigned, Lessor under the Master Lease attached as Exhibit "A," hereby consents to the subletting of the Premises described herein on the terms and conditions contained in this Sublease. This consent shall apply only to this Sublease and shall not be deemed to be a consent to any other Sublease. Lessor hereby provides to Sublessee the right to remain in the subleased 3 premises under the same terms and conditions set forth in this Sublease in the event of Sublessor's default. Dated: 12/12/96 Lessor: Sorrento Tech Associates, a California limited partnership By: Barnes Canyon RPF Realty Corp. a Connecticut corporation, General Partner By: /s/ Mark S. Knapp Mark S. Knapp Vice President EX-10.72 3 FIRST AMENDMENT TO SUBLEASE FIRST AMENDMENT TO SUBLEASE THIS FIRST AMENDMENT TO SUBLEASE ("Amendment") is made as of this 24th day of January 1997, by and between APPLIED DIGITAL ACCESS, a California corporation ("Sublessor"), and ENOVA CORPORATION, a California corporation ("Sublessee"), with reference to that certain Sublease being entered into by and between Sublessor and Sublessee concurrently herewith and executed by Sublessee on December 9, 1996 ("Sublease"). For the purposes of this Amendment, the term "Sublease" shall mean, collectively, the Sublease and this Amendment and the capitalized terms used herein shall have the meanings ascribed to them in the Sublease unless otherwise indicated. Except as modified as provided herein, the Sublease shall remain in full force and effect. To the extent that there is any conflict between this Amendment and the Sublease, the provisions of this Amendment shall prevail. NOW, THEREFORE, in consideration of covenants, terms and conditions herein set forth and for other good, valuable and sufficient consideration, receipt of which is hereby acknowledged, the parties hereto agree as follows: 1. MASTER LANDLORD'S OBLIGATIONS. It shall be the obligation of Master Landlord to (i) provide or cause to be provided all services and repairs to be provided by Landlord under the terms of the Master Lease and (ii) to satisfy all obligations and covenants of Master Landlord made in the Master Lease. Sublessee acknowledges that Sublessor's obligation to perform services, provide utilities, make repairs and carry insurance shall be satisfied only to the extent that the Master Landlord under the Master Lease satisfies those same obligations; provided, however, Sublessor, upon written notice by Sublessee, shall diligently attempt to enforce all obligations of Master Landlord under the Master Lease. 2. LATE PAYMENT CHARGES AND INTEREST. Any payment of rent or other amount from Sublessee to Sublessor under the Sublease which is not paid within 10 (ten) days from the date due shall accrue interest from the date due until the date paid at a rate equal to ten percent (10%) per year; provided, however, that if a court of competent jurisdiction determines the above rate exceeds the highest lawful rate of interest, then at the maximum rate permitted by law. If any installment of rent for the subleased Premises is not paid promptly on the first of the month, or otherwise when due, Sublessee shall pay to Sublessor a late payment charge equal to five percent (5%) of the amount of such delinquent payment of rent, in addition to the installment of rent then owing. This Section 3 shall not relieve Sublessee of Sublessee's obligation to pay any amount owing hereunder at the time and in the manner provided. 3. USE -- COMPLIANCE WITH LAWS. At its own expense, Sublessee will procure, maintain in effect and comply with all conditions of any and all permits, licenses and other governmental and regulatory approvals required for Sublessee's use of the Subleased Premises. 4. ASSIGNMENT AND SUBLETTING. Sublessee shall not sell, assign, encumber, sublease or otherwise transfer by operation of law or otherwise the subleased Premises or the Sublease without Sublessor's consent, which consent, based upon the short term nature of this Sublease, may be withheld or conditioned by Sublessor in its sole and arbitrary discretion. Any such sale, assignment, encumbrance, sublease or other transfer in violation of the terns of the Sublease shall be void and shall be of no force or effect. 5. INDEMNITY. Except to the extent caused by the negligence or willful misconduct of the Master Landlord, the "Related Parties" (as defined in Paragraph 22.2 of the Master Lease), and/or Sublessor, Sublessee will indemnify, defend (by counsel reasonably acceptable to Sublessor and which may include in-house attorneys), protect and hold Sublessor harmless from and against any and all liabilities, claims, demands, losses, damages, costs and expenses (including attorneys' fees) arising out of or relating to those items referred to in Section 22.2 (a) through (g) of the Master Lease or arising out of or related to any breach or default under the Master Lease caused by the Sublessee's breach or default under the sub-lease. 6. BROKERAGE COMMISSION. Each party warrants to the other that there are no brokerage commissions or fees payable in connection with the Sublease except to Colliers Iliff Thorn and Sentre Partners. Each party also agrees that payment of the brokerage commissions will be made by the Sublessor. Each party further agrees to indemnify and hold the other party harmless, from any cost, liability and expense (including attorneys' fees) which the other party may incur as the result of any claim for a fee or commission by any broker or finder claiming through the indemnifying patty in connection with this Sublease. 7. ATTORNEYS' FEES. In the event either party shall bring any action or proceeding for damages or for an alleged breach of any provision of the Sublease, to recover rents or to enforce, protect or establish any right or remedy under the Sublease, the prevailing party shall be entitled to recover reasonable attorneys' fees and court costs as part of such action or proceeding. IN WITNESS WHEREOF, the parties hereto have executed one (1) or more copies of this Sublease, effective as of the last date written below. "SUBLESSOR" "SUBLESSEE" APPLIED DIGITAL ACCESS, ENOVA CORPORATION, a California corporation a California corporation /S/ JAMES KEEFE /S/ DAVID R. KUZMA James Keefe, Chief Financial Officer David R. Kuzma, Senior Vice President ACCEPTED AND AGREED TO: "LANDLORD" SORRENTO TECH ASSOCIATES, a California limited partnership By: Barnes Canyon RPF Realty Corp. a Connecticut corporation, General Partner By: /S/ MARK S. KNAPP Mark S. Knapp Vice Presiden EX-10.73 4 LEASE AGREEMENT ---------------------------------------------- LEASE BETWEEN: 2725321 CANADA INC. LANDLORD AND: APPLIED DIGITAL ACCESS - CANADA, INC. TENANT ---------------------------------------------- IMPERIAL SQUARE LAKE CITY BURNABY, BRITISH COLUMBIA ---------------------------------------------- 8630 - 8654 Commerce Court Burnaby, British Columbia EX-10.74 5 AGREEMENT FOR EXTENSION OF TERM AGREEMENT NO. RGDCR45709 AGREEMENT FOR EXTENSION OF TERM (AMENDMENT NO. 3) This Agreement for Extension of Term is entered into by and between U S WEST Business Resources, Inc., a Colorado corporation, with offices for transaction of business located at 188 Inverness Drive West, Englewood, Colorado 80112, as agent for U S WEST Communications, Inc. ("Customer") and Applied Digital Access, Inc., with offices for transaction of business located at 9855 Scranton Road San Diego, California 92121 ("Supplier"). RECITALS Customer and Supplier entered into that certain agreement styled " General Purchasing Agreement," dated February 15,1994, as amended by Amendment No.1 dated February 1,1996, and Amendment No. 2 dated August 17,1996 (the "Agreement"); The term of the Agreement will automatically expire on February 16, 1997 (the "Expiration Date"); and Customer and Supplier wish to extend the term of the Agreement beyond the Expiration Date under the terms and conditions hereof. AGREEMENT In consideration of mutual promises and advantages to the parties, the parties incorporate by reference and agree to the accuracy of the above recitals and further agree that the Agreement shall not expire on the Expiration Date, but shall automatically renew for an additional four (4) month period commencing on February 17,1997, and will automatically expire on June 16, 1997. All other terms and conditions of the Agreement remain unchanged and shall all continue in full force and effect. The term "Customer" as used herein may be applicable to one or more parties and the singular shall include the plural. If there shall be more than one party referred to as Customer herein, then their obligations shall be several, not joint. The parties intending to be legally bound have executed this Agreement for Extension of Term as of the dates set forth below in multiple counterparts each of which is deemed an original but all of which together shall constitute one and the same instrument. U S WEST BUSINESS RESOURCES, INC., APPLIED DIGITAL ACCESS, INC. AS AGENT FOR U S WEST COMMUNICATIONS, INC. By /s/ Peggy J. Berggren By /s/ James L. Keefe - ------------------------- ---------------------- (Authorized Signature) (Authorized Signature) Peggy J. Berggren James L. Keefe - ----------------- --------------- (Print or Type Name or Signatory) (Print or Type Name or Signatory) Contract Agent Chief Financial Officer - -------------- ---------------------- (Title) (Title) January 30,1997 January 30,1997 - --------------- ----------------- (Execution Date) (Execution Date) 1 CONFIDENTIAL. DISCLOSURE AND DISTRIBUTE SOLELY TO THOSE INDIVIDUALS WHO HAVE A NEED TO KNOW. IMPERIAL SQUARE LAKE CITY BURNABY, BRITISH COLUMBIA LEASE THIS INDENTURE made as of January 1, 1997 pursuant to the LAND TRANSFER FORM ACT, PART 2 BETWEEN: 2725321 CANADA INC., c/o PPM Real Estate Managers (Canada) Limited, 440 - 1090 West Georgia Street, Vancouver, British Columbia, V6E 3V7 (the "LANDLORD") OF THE FIRST PART AND: APPLIED DIGITAL ACCESS - CANADA, INC., 9855 Scranton Road, San Diego, California, U.S.A., 92121 (the "TENANT") OF THE SECOND PART ARTICLE 1 DEFINITIONS AND INTERPRETATION DEFINITIONS 1.1 The parties agree that the following words shall have the meanings set forth below and used in this Lease. ADDITIONAL RENT means all amounts payable by the Tenant hereunder excluding Basic Rent; AGREEMENT TO LEASE means the agreement between the parties hereto pursuant to which they have entered into this Lease; AREA OF THE DEMISED PREMISES means as of the date hereof the number of square feet set out in Schedule "A" hereto subject to revision in accordance with such Schedule; BASIC RENT means the fixed annual rental payable pursuant to paragraph 3.1 hereof; BUILDING means the building situate upon the Lands within which the Demised Premises are located; COMMENCEMENT DATE means the date on which the Term commences, as set out in paragraph 2.1; COMMON AREAS AND FACILITIES means those portions of the Development and the facilities therein or thereon from time to time not occupied by the Tenant or other tenants as their exclusive premises or otherwise designated by the Landlord as being for the benefit of or for use by the Tenant in common with others entitled to the use or benefit of the same; DEMISED PREMISES means those premises described in Schedule "A" attached hereto; DEVELOPMENT means the Lands and the Project; GST means the Goods and Services Tax contained in Part IX of the EXCISE TAX ACT, S.C. 1990, or any similar tax in substitution therefor or addition thereto; LANDS means those certain parcels or tracts of land located in the Municipality of Burnaby, in the Province of British Columbia, and more particularly described in Schedule "B" attached hereto; OPERATING COSTS means an amount equivalent to the total amount (without duplication) paid or payable whether by the Landlord or others on behalf of the Landlord for managing, operating and maintaining the Development including all of the component parts thereof such as are in keeping with maintaining the standard of a first class industrial complex including without limiting the generality of the foregoing, all repairs and replacements required for such maintenance, other than repairs to and replacements of the structure of the Building and other buildings on the Project, the costs of providing electricity, water, gas, fuel and other services and utilities (including heating and air-conditioning) not otherwise paid by the tenants of the Project, the costs of painting interior areas not normally rented to tenants and the costs of painting and otherwise maintaining the outside of the Building (including the roof thereof) and all other buildings on the Project (other than those parts for which the Tenant is responsible), the costs of maintaining roadways and parking areas lying in or adjacent to the Project, snow removal, landscape maintenance, refuse removal and other costs in connection with the maintenance of the Common Areas and Facilities, sprinkler protection, fire, casualty, liability, rental and other insurance costs (including self-insurance premiums not in excess of normal insurance costs), security protection, the amount of all salaries, wages, fringe benefits and other employment costs or payments made paid to employees engaged in the maintenance or operation of the Project, amounts paid to independent contractors for or in relation to any services in connection with such maintenance or operation, the cost of direct supervision and of management and other indirect expenses to the extent allocable to the maintenance and operation of the Project, the reasonable rental value of and costs associated with 2 (having regard to the rentals prevailing from time to time for similar space) space utilized by the Landlord or its property manager in connection with the management, operation or maintenance of the Project and all other expenses paid or payable by the Landlord in connection with the operation of the Development and all of the component parts thereof together with a fee for the administration and management of the Project equal to the actual cost paid by the Landlord to a third party to administer and manage the Project (which shall be a commercially reasonable fee, having regard to the nature of the management services performed and the operation of the Project as a first class industrial complex) or, if the Landlord itself manages the Project, a fee equal to the amount the Landlord might reasonably pay to a third party for the administration and management of the Project, but Operating Costs shall not include interest on debt or capital retirement of debt or any amounts directly chargeable by the Landlord to any tenant or tenants as otherwise provided herein. For greater certainty, Operating Costs shall not include the cost of structural and roof repairs or replacements (other than relating to the roof membrane, asphalt or insulation, which will be included in Operating Costs). If the Landlord sells 100% of a legally subdivided portion of the Development, as of the date of sale, the Operating Costs shall be determined on the basis of the legally subdivided portion of Development retained by the Landlord; PROJECT means the improvements constructed or to be constructed on the Lands from time to time, including without limitation, the Building; PROPORTIONATE SHARE means the fraction, the numerator of which is the Area of the Demised Premises and the denominator of which is the aggregate area in square feet of all rentable premises from time to time physically existing in the Project, whether actually rented or not, including the Demised Premises; RENT means Basic Rent, Additional Rent and all other amounts payable to the Landlord hereunder; TAXES means an amount equal to all taxes, rates, duties, levies and assessments whatsoever, whether municipal, provincial, parliamentary or otherwise, levied, imposed or assessed against the Lands and the Project or upon the Landlord on account thereof, or from time to time, levied, imposed or assessed for education, schools and local improvements and including all costs and expenses incurred by the Landlord in good faith in contesting, resisting or appealing any such taxes, rates, duties, levies or assessments, but excluding Tenant's Taxes and excluding income or profits taxes upon the income of the Landlord to the extent that such taxes are not levied in lieu of taxes, rates, duties, levies and assessments against the Lands and Project or upon the Landlord on account thereof; TENANT'S TAXES means without limitation all taxes, licences, rates, duties and assessments imposed or levied by lawful authority in respect of the use or occupancy of the Demised Premises by the Tenant relating to or in respect of personal property in the Demised Premises or the Building or the Project and all other business and trade 3 fixtures, machinery and equipment, cabinetwork, furniture and movable partitions owned or installed by the Tenant at the expense of the Tenant or being the property of the Tenant in the Demised Premises or the Building or the Project, or relating to or in respect of improvements to the Demised Premises built, made or installed by the Tenant or the Landlord or at the Landlord's or Tenant's request, whether any such taxes are payable by law by the Tenant or by the Landlord and whether such taxes are included by lawful authority in the taxes, licences, rates, duties and assessments imposed or levied on or with respect to the Lands or the Project. "Tenant's Taxes" shall also include any and all penalties or other like charges for late payment thereof; TERM means the term of this Lease, as set out in paragraph 2.2, plus if any extension thereof is provided for herein and such extension right (or rights) is exercised by the Tenant in accordance herewith, the period of such exercised extension (or extensions). SCHEDULES 1.2 The provisions of Schedules hereto are incorporated herein and form part of this Lease. GOVERNING LAW 1.3 This Lease shall be construed and governed by the laws of the province in which the Demised Premises are located, and each of the parties hereto severally attorns to the jurisdiction of the courts of such province. Should any provisions of this Lease be illegal or unenforceable it should be considered separate and several from the Lease and its remaining provisions shall remain in force and be binding upon the parties hereto as though the illegal or unenforceable provision had never been included. HEADINGS 1.4 The headings in this Lease form no part of this Lease and shall be deemed to have been inserted for convenience of reference only. INTERPRETATION 1.5 Unless the context otherwise requires, the word "Landlord" wherever it is used herein shall be construed to include and shall mean the Landlord, its successors and/or assigns, the word "Tenant" shall be construed to include and shall mean the Tenant and the executors, administrators, successors and/or assigns of the Tenant and when there are two or more Tenants or two or more persons bound by the Tenant's covenants herein contained their obligations hereunder shall be joint and several, the word "Tenant" and the personal pronoun "it" relating thereto and used therewith shall be read and construed as Tenants, and "his", "her", "its" or "their" respectively, as the number and gender of the party or parties referred to each require and the number of the verb agreeing therewith, shall be construed and agree with the said word or pronoun so substituted. 4 USE OF "HEREIN", "HEREOF", ETC. 1.6 In this Lease, "herein", "hereof", "hereby", "hereunder", "hereto", "hereinafter" and similar expressions refer to this Lease and not to any particular paragraph, section or other portion thereof, unless there is something in the subject matter or context inconsistent therewith. Paragraphs referred to by number are the paragraphs so numbered in this Lease. TERMS AS COVENANTS 1.7 All terms of this Lease and obligations of the parties hereunder shall be deemed to be covenants of the parties hereto, whether or not so stated in this Lease. ARTICLE 2 DEMISE, TERM AND USE DEMISE 2.1 In consideration of the rents, covenants, conditions and agreements hereinafter reserved and contained on the part of the Tenant to be paid, observed and performed the Landlord does demise and lease unto the Tenant all and singular the Demised Premises, upon the terms and conditions herein contained. The Tenant acknowledges that the Demised Premises are leased on an "as is, where is" basis, and that the Landlord is not required to expend any money or perform any work with respect to the same. TERM 2.2 TO HAVE AND TO HOLD the Demised Premises for and during the term (the "Term") of three years commencing on January 1, 1997 (the "Commencement Date") and ending on December 31, 1999. USE 2.3 The Demised Premises shall be used by the Tenant for the purpose of administrative office, research and manufacturing of electronic equipment and for no other use whatsoever without the prior written consent of the Landlord, which consent may be withheld by the Landlord, acting reasonably. USE OF COMMON AREAS AND FACILITIES, ETC. 2.4 In addition to the leasehold interest herein granted, the Tenant shall have and the Landlord hereby grants to the Tenant its employees, agents, customers and invitees, in common with the Landlord and all other persons authorized by the Landlord from time to time, a licence over the Common Areas and Facilities for the purpose of gaining access to and better using the Demised Premises, provided however that this right shall in no way restrict the 5 Landlord from maintaining or improving the Common Areas and Facilities or of changing the location of or adding to the Building or any other building on or constructing a new building or buildings on the Lands. Without limiting the generality of the foregoing, but subject to the above limitations, the Tenant shall have the following rights in common with all others from time to time entitled thereto: (a) the right to use the driveways situate upon the Lands hereto for the purpose of ingress and egress from the Demised Premises; and (b) the right to park its passenger motor vehicles and those of its employees and customers upon the Lands subject always, however, to any restrictions thereon which the Landlord may from time to time impose (which the Landlord may do) including, without limitation the designation of parking spaces for the exclusive use of other tenants of the Project and their employees and customers. POSSESSION 2.5 DELETED. EXAMINATION OF DEMISED PREMISES 2.6 The Tenant shall examine the Demised Premises and the Building before taking possession hereunder and such taking of possession will be, in the absence of agreement in writing to the contrary, evidence that on the Commencement Date the Demised Premises and the Building were in good order and satisfactory condition. No promise of the Landlord to alter, remodel or improve the Demised Premises or the Building and no representation respecting the condition of the Demised Premises or the Building has been made by the Landlord other than those contained herein or made a part hereof. OVERHOLDING 2.7 If at the expiration of the Term of this Lease the Tenant shall hold over with the consent of the Landlord, the tenancy of the Tenant thereafter shall, in the absence of written agreement to the contrary, be from month-to-month only at a rental per month equal to one-tenth of the Rent payable for the year immediately preceding such expiration, payable monthly in advance on the first day of each month and shall be subject to all other terms and conditions of this Lease. 6 ARTICLE 3 RENT AND OTHER PAYMENTS BASIC RENT 3.1 YIELDING AND PAYING THEREFOR yearly and every year during the said Term set out in paragraph 2.2 (for clarity, not inclusive of extensions thereof if any are provided for herein) as Basic Rent unto the Landlord the sum of $307,248.00 in lawful money of Canada to be paid in advance in equal consecutive monthly instalments of $25,604.00 on the first day of each and every month during the Term (but not any extensions thereof) to the Landlord, but subject however to the provisions of paragraph 5 of Schedule "F" hereto. If the Term commences on any day other than the first or ends on any day other than the last day of a calendar month, the Basic Rent and Additional Rent for the fractions of a month at the commencement and at the end of the Term shall be adjusted on a per diem basis. PAYMENTS TO LANDLORD 3.2 All payments required to be made to the Landlord by the Tenant under or in respect of this Lease shall be made in lawful currency of Canada, to the agent of the Landlord, PPM Real Estate Managers (Canada) Limited at the address set out on page 1 hereof or at such place or places or other agent as the Landlord may designate in writing. ADDITIONAL RENT 3.3 All amounts payable by the Tenant pursuant to paragraphs 4.3, 4.4 and 4.5 hereof shall be payable as Additional Rent. In addition, all sums paid or expenses incurred hereunder by the Landlord, which ought to have been paid or incurred by the Tenant, or for which the Landlord hereunder is entitled to reimbursement from the Tenant, and any interest owing to the Landlord hereunder may be recovered by the Landlord as Additional Rent by any and all remedies available to it for the recovery of Rent in arrears. PAYMENTS TO OTHERS 3.4 If the Tenant is required hereunder to make any payments other than to the Landlord, the Tenant shall make such payments promptly and before any interest or penalty for non-payment attaches thereto. In addition, the Tenant shall produce to the Landlord from time to time at the request of the Landlord evidence satisfactory to the Landlord acting reasonably of the due payment by the Tenant of all payments required to be made by the Tenant under this Lease. INTEREST ON OVERDUE AMOUNTS 3.5 The Tenant shall pay to the Landlord interest at the rate of six percent (6%) per annum over the prime rate being charged by the Landlord's bank, from time to time on all payments of rent and other sums required to be made under the provisions of this Lease which 7 have become overdue so long as such payments remain unpaid, provided that the provisions of this paragraph shall not limit any other rights or remedies of the Landlord. DISPUTES 3.6 In the event of a dispute as to the amount of Operating Costs, or the inclusion of any cost, expense or amount in Operating Costs, then such dispute shall be referred to the Landlord's auditor, whose decision shall be final and binding upon the parties hereto. DEPOSIT 3.7 The Landlord hereby acknowledges receipt from the Tenant of the sum of $73,011.09 (the "Deposit"), which shall be applied firstly toward Rent and GST thereon for the second month of the Term, with the balance to be held by the Landlord without interest as security for the payment of Rent and performance of the Tenant's obligations under this Lease. If at any time the Tenant is in default of its obligations hereunder, the Landlord may, either before or after terminating this Lease, apply the whole or any part of the Deposit to cure such default or to compensate the Landlord for any loss or expense incurred by the Landlord as a result thereof, and such application of the Deposit shall be without prejudice to the Landlord's right to pursue any other remedy set forth in this Lease or available at law. If the whole or any part of the Deposit is so applied by the Landlord, the Tenant will forthwith pay to the Landlord a sufficient amount to restore the Deposit to the amount thereof prior to such application by the Landlord. If the Tenant promptly pays all Rent as it falls due and performs all of its obligations under this Lease, the Landlord will repay the Deposit to the Tenant within 60 days after the termination of this Lease. The Landlord may deliver and assign the Deposit to any purchaser of the Landlord's interest in the Demised Premises and thereupon the Landlord will be discharged of any further liability with respect to such Deposit. ARTICLE 4 MISCELLANEOUS COVENANTS OF THE TENANT The Tenant covenants with the Landlord as follows: PAY RENT 4.1 The Tenant shall, during the Term, pay unto the Landlord the Basic Rent hereby reserved in the manner hereinbefore mentioned without any set-off or deduction whatsoever save as specifically provided for herein, together with all GST payable in respect of this Lease as and when required to do so by the Landlord. PAY TENANT'S TAXES 4.2 The Tenant shall pay all Tenant's Taxes on or before the due date thereof. If the Tenant neglects or refuses to pay any Tenant's Taxes, the Landlord may, at its option, pay 8 the same and recover the amount paid by all remedies available to it for the recovery of Rent in arrears. PAY UTILITIES 4.3 The Tenant shall pay all rates and charges for water, gas and electric light and/or power, heating, fuel, telephone or other utilities supplied to or used in the Demised Premises as separately metered or separately invoiced by the supplier thereof, and, if not so separately metered or invoiced, the Tenant's Proportionate Share of such rates and charges; PROVIDED HOWEVER that if the Landlord, acting reasonably, determines that an allocation of such rates or charges on a Proportionate Share basis would not be equitable, the Landlord may allocate such rates and charges on a reasonable basis amongst the various tenants of the Building or of the Development, and the Tenant shall pay its share of the same as reasonably determined by the Landlord. PAY PROPORTIONATE SHARE OF TAXES 4.4 The Tenant shall during and in respect of the Term pay its Proportionate Share of Taxes. The Tenant's Proportionate Share of Taxes shall be estimated by the Landlord for such period as the Landlord may determine (not to exceed 12 months) and the Tenant shall pay the same to the Landlord in equal monthly instalments together with the regular monthly instalments of Basic Rent as set out in paragraph 3.1. The Landlord shall furnish to the Tenant an estimate of the Proportionate Share of Taxes payable by the Tenant during the period so determined by the Landlord. At the end of such period, the Landlord shall furnish the Tenant with a statement showing the actual amount of the Proportionate Share of Taxes paid and payable by the Tenant and if an overpayment has been made by the Tenant, the Landlord shall credit such amount to the Tenant's Proportionate Share of Taxes for the ensuing period and if there is no ensuing period such amount shall be paid to the Tenant and if an amount remains owing to the Landlord in respect of the Tenant's Proportionate Share of Taxes, the Tenant shall forthwith pay such amount to the Landlord. PAY PROPORTIONATE SHARE OF OPERATING COSTS 4.5 The Tenant shall during and in respect of the Term pay its Proportionate Share of Operating Costs as follows: the Tenant's Proportionate Share of Operating Costs shall be estimated by the Landlord for such period as the Landlord may determine (not to exceed 12 months) and the Tenant shall pay the same to the Landlord in equal monthly instalments together with the regular monthly instalments of Basic Rent as set out in paragraph 3.1. The Landlord shall furnish to the Tenant an estimate of the Proportionate Share of Operating Costs payable by the Tenant during the period so determined by the Landlord. At the end of such period, the Landlord shall furnish the Tenant with a statement showing the actual amount of the Proportionate Share of Operating Costs paid and payable by the Tenant, and the Landlord and Tenant covenant and agree each with the other that if an overpayment of the Tenant's Proportionate Share of Operating Costs has been made by the Tenant, the Landlord shall credit such amount to the Tenant's Proportionate Share of Operating Costs for the ensuing period and if there is no ensuing period such amount shall be paid to the Tenant and if an amount remains 9 owing to the Landlord in respect of the Tenant's Proportionate Share of Operating Costs, the Tenant shall forthwith pay such amount to the Landlord. NO NUISANCE 4.6 The Tenant shall not at any time during the Term, use, exercise or carry on or permit or suffer to be used, exercised or carried on, in or upon the Demised Premises or any part thereof any noxious, noisome or offensive act, trade, business, occupation or calling, and no act, matter or thing whatsoever shall at any time during the Term be done in or upon the Demised Premises or any part thereof which shall or may be or grow to the annoyance, nuisance, damage or disturbance of the occupiers or owners of the Lands, Project or adjoining land and properties. COMPLY WITH LAWS, ETC. 4.7 The Tenant shall comply promptly at its expense with all laws, ordinances, regulations, requirements and recommendations which may be applicable to the Tenant or to the manner of use of the Demised Premises, and shall comply with any and all federal, provincial, civic, municipal and other authorities or association of insurance underwriters or agents and all notices in pursuance of same and whether served upon the Landlord or the Tenant. Without limiting the generality of the foregoing, the Tenant shall comply fully with the provisions of Schedule "D" hereto. COMPLY WITH RULES AND REGULATIONS 4.8 The Tenant shall observe and comply with the rules and regulations attached hereto as Schedule "C" with such reasonable variations, modifications and additions as shall from time to time be made by the Landlord and any other and further reasonable rules and regulations that may be made by the Landlord and communicated to the Tenant in writing, and the Tenant shall cause its agents, servants or employees to observe and comply with the same. All such rules and regulations shall be read as forming part of the terms and conditions of this Lease as if the same were embodied herein as covenants of the Tenant, and the Tenant's failure to keep and observe such rules and regulations shall constitute a breach of this Lease. GOODS, CHATTELS, ETC. NOT TO BE REMOVED 4.9 The Tenant agrees that all goods, chattels and fixtures when moved into the Demised Premises shall not except in the normal course of business, be removed from the Demised Premises until all Rent due or to become due during the Term of this Lease and all utility charges are fully paid. The Tenant further covenants and agrees that if the Tenant shall at any time be in default under any of the terms, covenants or agreements contained herein, the Landlord shall have a lien on all of the Tenants goods, chattels and fixtures located in the Demised Premises, but excluding however electronic data storage equipment, backup tapes and software media, as security against loss or damage resulting from any such default, and such goods, chattels and fixtures shall not be removed from the Demised Premises by the Tenant until such default is cured unless the Landlord directs otherwise. 10 USE OF DEMISED PREMISES 4.10 The Tenant shall not use the Demised Premises nor suffer or permit the Demised Premises to be used for any other purpose than that provided for in paragraph 2.3, nor shall the Tenant use the Demised Premises in any way which will impair the efficient and proper operation of the sprinkler system in the Building. CONTINUOUS OCCUPATION 4.11 The Tenant shall commence the use of the Demised Premises referred to in paragraph 2.3 within 30 days from the Commencement Date and shall carry on such use continuously during the Term. SIGNS 4.12 The Tenant shall not, without the Landlord's prior written permission, paint, display, inscribe, place or affix any sign, picture, advertisement, notice, lettering or direction on any part of the outside of the Building or the Project or visible from the outside of the Building or the Project or in any corridor, hallway, entrance or other public part of the Building or Project; PROVIDED THAT the Landlord shall prescribe a uniform pattern for identification signs for tenants to be placed on the outside of the main door leading into the Demised Premises; FURTHER PROVIDED THAT at the request of the Tenant and at the Tenant's expense, the Landlord shall cause such a sign to be placed in position. PEACEFUL SURRENDER 4.13 The Tenant shall, at the expiration or sooner termination of the said Term, peaceably surrender and yield up unto the Landlord the Demised Premises with the appurtenances, together with all fixtures or erections which at any time during the said Term shall be made therein or thereon (other than tenant's or trade fixtures removed pursuant to paragraph 4.15 or Alterations which the Landlord requires to be removed pursuant to paragraph 7.2(b)) in good and substantial repair and condition, reasonable wear and tear and damage by fire or other insured peril excepted, and deliver to the Landlord all keys to the Demised Premises which the Tenant has in its possession. CONDITION AT EXPIRATION 4.14 The Tenant shall immediately before the expiration or sooner termination of the Lease wash the floors, windows, doors, walls and woodwork of the Demised Premises. The Tenant further covenants that the Tenant will not upon such expiration or sooner termination leave upon the Demised Premises any rubbish or waste material and will leave the Demised Premises in a clean and tidy condition. Without limiting the generality of the foregoing, the Tenant shall ensure that all trade fixtures and other items which the Tenant has the right or obligation hereunder to remove from the Demised Premises are fully removed, and any damaged caused by such removal is fully made good, on or before the last day of the Term. 11 REMOVAL OF FIXTURES 4.15 Subject to paragraph 4.9 hereof the Tenant may at the expiration of the Term hereby granted, take, remove and carry away from the Demised Premises all fixtures, fittings, shelving, counters or other articles upon the Demised Premises in the nature of trade or tenants' fixtures, but the Tenant shall in such removal do no damage to the Demised Premises, or shall make good any damage which the Tenant may occasion thereto; PROVIDED THAT the Tenant shall not remove or carry away from the Demised Premises any part of the Building or any plumbing, heating, air-conditioning or ventilating plant or equipment or other Building services; PROVIDED FURTHER that notwithstanding anything herein contained the Landlord shall have the right upon the termination of this Lease by effluxion of time or otherwise to require the Tenant to remove its installations, alterations, additions, partitions and fixtures or anything in the nature of leasehold improvements made or installed by the Tenant or by the Landlord on behalf of the Tenant and to make good any damage caused to the Demised Premises by such removal. USE OF WASHROOMS 4.16 The Tenant shall keep and maintain the washrooms in a sanitary condition, and shall not use the washrooms, or suffer or permit its customers, licensees, invitees, servants, agents, or employees to use the washrooms for any purpose other than the purpose for which they were designed. OVERLOADING 4.17 The Tenant shall not do or suffer or permit any waste or damage, disfigurement or injury to the Demised Premises or the fixtures and equipment thereof or permit or suffer any overloading of any floor thereof, and shall not place in, on or about the Demised Premises any fixtures, equipment, machinery or materials of a weight beyond the capacity for which the Building is designed, or to the extent that will cause damage to the Building or cause excessive vibration. The Tenant shall repair any damage done to the Demised Premises or the Building by reason of any excessive weight placed in the Demised Premises or excessive vibration caused in the Demised Premises. NUISANCE AND WASTE 4.18 The Tenant shall not cause or suffer or permit any oil or grease or any harmful, objectionable, dangerous, poisonous or explosive matter or substance to be discharged into the Demised Premises or the Building or the Development or into the driveways, common areas, ditches, water courses, culverts, drains or sewers in or adjacent thereto, and will take all reasonable measure for insuring that any effluent discharged will not be corrosive, poisonous or otherwise harmful, or cause obstruction, deposit or pollution within the Demised Premises, or the Building, or the Development or the driveways, common areas, ditches, water courses, culverts, drains, or sewers thereof. Without limiting the generality of the foregoing, the Tenant shall comply fully with the provisions of Schedule "D" hereto. 12 ACCESS 4.19 The Tenant shall not permit any vehicles belonging to the Tenant, its customers, invitees, licensees, agents or servants to cause obstruction on any roads, driveways or common areas in the neighbourhood of the Development or prevent the ingress or egress to all other tenants in the Building and the Development and will use its best endeavours to ensure that persons doing business with the Tenant and its servants and workers shall not permit any vehicles to cause such obstruction as aforesaid. USE OF YARD AREAS 4.20 The Tenant shall not place, nor suffer or permit its customers, invitees, licensees, agents or servants to place any materials in the yard or yards of the Project or the adjacent driveways, parking or common areas thereof and shall cause no obstruction to vehicles operating on the said adjacent driveways, parking or common areas. NO AUCTION 4.21 The Tenant shall not at any time permit any sale by auction to be held within the Demised Premises or upon the Lands or any part thereof. ESTOPPEL CERTIFICATES 4.22 To provide within 15 calendar days of the request and at the cost of the Landlord (such cost to be reasonable) an estoppel certificate for the Landlord, addressed to the Landlord and any potential buyer or mortgagee, binding upon the Tenant, in the Landlord's standard form containing such statements as the Landlord may reasonably require with reasonable promptness upon request by the Landlord. LANDLORD MAY PERFORM TENANT'S COVENANTS 4.23 If the Tenant shall fail to perform or cause to be performed each and every one of the covenants and obligations of the Tenant in this Lease contained the Landlord shall have the right (but shall not be obligated) to perform or cause the same to be performed and to do or cause to be done such things as may be necessary or incidental thereto (including without limiting the foregoing, the right to make repairs, installations, erections and expend moneys) and all payments, expenses, charges, fees and disbursements, including reasonable solicitors' fees and disbursements, incurred or paid by or on behalf of the Landlord in respect thereof shall be paid by the Tenant to the Landlord forthwith. 13 ARTICLE 5 LANDLORD'S COVENANTS The Landlord covenants with the Tenant as follows: QUIET ENJOYMENT 5.1 The Tenant, paying the Rent hereby reserved and performing the covenants herein on the Tenant's part contained, shall and may peaceably possess and enjoy the Demised Premises for the Term hereby granted without any interruption or disturbance from the Landlord or any other person or persons lawfully claiming by, from or under the Landlord; SUBJECT ALWAYS to the terms, covenants and conditions contained in this Lease. TAXES 5.2 The Landlord shall pay or cause to be paid Taxes subject to contribution by the Tenant as provided in paragraph 4.4 hereof. MANAGEMENT, OPERATION AND MAINTENANCE 5.3 The Landlord acting reasonably shall manage, operate, maintain, repair and replace the Project and Lands subject to the cost and expense thereof being contributed to by the Tenant as provided in paragraph 4.5 hereof. ARTICLE 6 INSURANCE AND INDEMNITY TENANT INSURANCE 6.1 The Tenant shall, at its expense, provide and maintain in force during the Term: (a) plate glass insurance, for the benefit of the Landlord and the Tenant, covering all plate glass in the Demised Premises, including plate glass windows and doors, in an amount equal to the full insurable value thereof; (b) owned automobile insurance with respect to all motor vehicles owned by the Tenant and operated in its business; (c) comprehensive general liability of not less than $3,000,000.00 per occurrence and property damage insurance, including fire, tenant's legal liability insurance, for the benefit of injury or death to one or more persons, or property damage, occurring in the Demised Premises or the Building or on the Development; and 14 (d) insurance in respect of fire and such other perils as are from time to time defined in the usual extended coverage endorsement covering the Tenant's leasehold improvements, trade fixtures and furniture and equipment to the full insurable value thereof. DETAILS OF POLICIES 6.2 All policies of insurance required to be maintained by the Tenant shall have the following provisions or characteristics: (a) all insurance shall be effected with insurers and brokers and upon terms and conditions satisfactory to the Landlord, acting reasonably; (b) to the extent applicable, all policies of insurance shall contain a waiver of subrogation clause in favour of the Landlord and shall also contain a clause requiring the insurer not to cancel or change the insurance without first giving the Landlord 30 days' prior written notice thereof; and (c) all policies of insurance shall be written to protect the Landlord and its mortgagees, if any, and the Tenant, notwithstanding any act or neglect of such parties which might otherwise result in the forfeiture of such policies or any of them. PROOF OF INSURANCE 6.3 The Tenant shall provide, upon request, proof of new or continued insurance to the Landlord at least 7 days prior to the expiration date recited in any of the Tenant's insurance policies, such proof to be in form and content satisfactory to the Landlord, acting reasonably. The Tenant agrees that if it does not provide or maintain in force such insurance, the Landlord may, but shall not be obligated to, take out the necessary insurance and pay the premium therefor for periods of one year at a time, and the Tenant shall pay to the Landlord as Additional Rent the amount of such premium immediately on demand. In the event the Landlord takes out insurance as aforesaid, the Landlord shall in no way be responsible for the sufficiency of such insurance. PRIORITY OF CLAIMS 6.4 If both the Landlord and the Tenant have claims to be indemnified under any such insurance, the indemnity shall be applied first to the settlement of the claim of the Landlord and the balance, if any, to the settlement of the claim of the Tenant. ACTS CONFLICTING WITH INSURANCE 6.5 The Tenant shall not do or permit to be done any act or thing which may render void or voidable or conflict with the requirements of any policy or policies of insurance, including any regulations of fire insurance underwriters applicable to such policy or policies, whereby the Demised Premises or the Building or the Development are insured or which may cause any increase in premium to be paid in respect of any such policy. If any such policy or 15 policies is or are cancelled by reason of any act or omission of the Tenant, the Landlord shall have the right at its option to terminate this Lease forthwith by giving written notice of termination to the Tenant, and if the premium to be paid in respect of any such policy is increased by any act or omission of the Tenant (including the use of the Demised Premises described in paragraph 2.3), the Tenant shall pay to the Landlord the amount by which said premium shall be so increased. INDEMNITY TO THE LANDLORD 6.6 The Tenant shall indemnify and save harmless the Landlord from any and all liabilities, damages, costs, claims, suits or actions arising out of: (a) any breach, violation or non-performance of any covenant, condition or agreement in this Lease set forth and contained on the part of the Tenant to be fulfilled, kept, observed or performed; (b) any occurrence in, upon, about or at the Demised Premises, except to the extent caused by the negligence or wilful misconduct of the Landlord; (c) any and all costs incurred by the Landlord in making good any damage caused to the Development including the furnishing and amenities thereof as a result of the negligent or wilful act or omission of the Tenant or any person for whom the Tenant is in law responsible; and (d) any injury to any licensee, invitee, agent or employee of the Tenant, including death resulting at any time therefrom, occurring in or about the Development, except to the extent caused by the negligence or wilful misconduct of the Landlord; and this indemnity shall survive the expiry or sooner termination of this Lease. FURTHER INDEMNITY 6.7 Notwithstanding anything to the contrary herein contained, if the Project or the Building or any part thereof or any appurtenance thereto, becomes damaged or destroyed through the negligence or wilful act or omission of the Tenant or any person for whom the Tenant is in law responsible, then all necessary repairs, replacements or alterations shall at the sole option of the Landlord, be made either by the Landlord or the Tenant, but in any event, the expense thereof shall be borne by the Tenant who shall pay the same to the Landlord forthwith on demand and the same shall be collectible by the Landlord from the Tenant as if Rent in arrears; the provisions of paragraph 7.1(c) shall apply to this paragraph if the Tenant is required to carry out the repairs, replacements or alterations pursuant to this paragraph. LANDLORD NOT RESPONSIBLE FOR INJURIES, LOSS, DAMAGE 6.8 The Landlord shall not be responsible in any way for any injury (including death) to any person or for any loss of or damage to any property belonging to the Tenant or to other occupants of the Demised Premises or to their respective customers, invitees, 16 licensees, agents, servants or any other persons from time to time attending at the Demised Premises while such person or property is in or about the Building or Development or any roadways, parking areas, lawns, sidewalks, steps, truckways, platforms, corridors, or stairways in connection therewith, including without limiting the foregoing, any loss of or damage to any such property caused by theft or breakage, or by steam, water, rain or snow which may leak into, issue or flow from any part of the Building or Development or any adjacent or neighbouring lands or premises or from any other place or quarter or for any loss of or damage caused by or attributable to the condition or arrangement of any electric or other wiring or for any damage caused by smoke or anything done or omitted to be done by the Landlord or by any other tenant of premises in the Building or the Project or for any other loss whatsoever with respect to the Demised Premises and/or any business carried on therein. NO LIABILITY FOR INDIRECT DAMAGES 6.9 Under no circumstances shall the Landlord be liable for indirect or consequential damage or damages for personal discomfort, illness or death by reason of the non-performance or partial performance of any covenants of the Landlord herein contained including, without limiting the generality of the foregoing, the heating of the Demised Premises or the operation of the air-conditioning equipment, plumbing or other equipment in the Building or the Demised Premises. LANDLORD INSURANCE 6.10 The Landlord shall take out and keep in force during the Term insurance with respect to the Development except for the leasehold improvements in the Demised Premises. The insurance to be maintained by the Landlord shall be in respect of periods and to amounts and on terms and conditions which from time to time are insurable at a reasonable premium and which are normally insured by reasonably prudent owners of properties similar to the Development, all as from time to time determined at reasonable intervals by insurance advisors selected by the Landlord, and whose opinion shall be conclusive. Unless and until the insurance advisors shall state that any such perils are not customarily insured against by owners of properties similar to the Development, the perils to be insured against by the Landlord shall include, without limitation, public liability, boilers and machinery and fire and extended perils and may include at the option of the Landlord losses suffered by the Landlord in its capacity as Landlord through business interruption. ARTICLE 7 REPAIRS AND ALTERATIONS REPAIRS 7.1 (a) The Tenant shall, during the Term and at the Tenant's sole cost and expense, well and sufficiently renew, rebuild, repair, replace, operate, maintain, paint and keep the Demised Premises, with the appurtenances and all fixtures including plumbing, electrical, heating, air-conditioning and other facilities and systems, in good and 17 substantial repair when, where and so often as need shall be, reasonable wear and tear and damage by fire and other risks against which the Landlord is insured only excepted. (b) The Landlord and its agents shall have the right at all reasonable times during the Term, to enter the Demised Premises to examine the condition thereof, and the Tenant shall well and sufficiently repair and make good the Demised Premises according to notice from the Landlord, such repairs to be made as expeditiously as possible but in any event within the time provided for by the Landlord. (c) The Tenant shall, when necessary and whether upon receipt of notice from the Landlord or not, effect and pay for such repairs, replacements or alterations as may be the responsibility of the Tenant under this Lease by the use of contractors or other qualified workers designated or approved by the Landlord in writing. If the Tenant fails to comply with the Landlord's request to effect such repairs, replacements or alterations within the time provided for by the Landlord, then the Landlord may cause such repairs, replacements or alterations to be undertaken. In that event, or in the event that the Landlord elects to make the repairs, replacements or alterations referred to in paragraph 6.7, then the Landlord shall be entitled to recover from the Tenant a fee of supervision for the carrying out of such repairs, replacements or alterations, such fee to be an amount equal to 15% of the moneys expended or of the cost of repairs, replacements or alterations carried out by or under the supervision of the Landlord, which amount shall be in addition to the cost of such work or moneys expended, and the cost of such work or moneys expended together with the said fee shall be collectible by the Landlord from the Tenant as if Rent in arrears. The Rent hereunder shall in no wise abate while such repairs, replacements or alterations are being made by reason of loss or interruption of the business of the Tenant because of the prosecution of any such work. (d) The Tenant shall throughout the term operate and maintain the heating, ventilating, air-conditioning and humidity control equipment (herein referred to as "HVAC") within or serving the Demised Premises in such a manner as to maintain reasonable conditions of temperature, air circulation and humidity within the Demised Premises as determined by the Landlord. The Tenant shall comply with such reasonable rules and regulations as the Landlord shall make from time to time respecting the maintenance, repair and operation of the HVAC and shall, upon the request of the Landlord and at the cost of the Tenant, obtain and maintain throughout the term a preventative maintenance contract for the HVAC with a maintenance company acceptable to the Landlord. ALTERATIONS 7.2 (a) The Tenant shall not without the prior written consent of the Landlord, which consent shall not be unreasonably withheld, make any installations, alterations, repairs or improvements in or to the Demised Premises (collectively "Alterations"). The Tenant shall submit to the Landlord detailed plans and specifications of any Alterations when applying for consent, and the Landlord reserves the right to recover from the 18 Tenant the cost of having its architects or engineers examine such plans and specifications. The Landlord may require that any or all work to be done, or materials to be supplied hereunder shall be done or supplied by the Landlord's contractors and/or workers provided that the cost of such work or materials shall be reasonable or by contractors and/or workers engaged by the Tenant but first approved by the Landlord. In any event, any or all work to be done or materials to be supplied hereunder shall be at the sole cost and expense of the Tenant and shall be done and supplied and paid for in the manner and according to such terms and conditions, if any as the Landlord may prescribe. Any connections of apparatus to the electrical system other than a connection to an existing base receptacle shall be deemed to be an Alteration within the meaning of this paragraph. No connection to an existing base receptacle shall be made if such connection would, if made, overload the capacity of such receptacle. (b) Any Alterations, business and trade fixtures, machinery and equipment, cabinet work, furniture or immovable partitions attached to the Demised Premises in any way other than by their own weight and all plumbing or wiring installed by or on behalf of the Tenant shall be deemed to become the Landlord's property forthwith upon their being so attached. Notwithstanding the foregoing, the Landlord may by written notice to the Tenant at least 60 days prior to the expiry of the Term elect to require the Tenant to remove all or any part of the Alterations, business and trade fixtures, machinery and equipment, cabinet work, furniture or immovable partitions owned or installed by the Tenant at the expiration of this Lease, in which case such removal shall be done at the Tenant's expense and the Tenant shall, at its expense, repair any damage to the Demised Premises caused by such removal. If the Tenant does not remove such property forthwith upon written notice from the Landlord, the Landlord may remove the same, and the cost of such removal and the cost of repairing any damage to the Demised Premises occasioned thereby shall be paid to the Landlord by the Tenant forthwith upon demand, and the Landlord will not be responsible for any loss or damage to such property caused by such removal. (c) The Tenant shall promptly pay all charges incurred by the Tenant for any work, materials or services that may be done, supplied or performed in respect of the Demised Premises and shall forthwith discharge any liens at any time filed against the Lands or any part thereof and shall keep the Lands free from liens. If the Tenant fails to do so, the Landlord may, but shall be under no obligation to, pay into Court the amount required to obtain a discharge of any such lien in the name of the Tenant and any amount so paid together with all disbursements and costs in respect of such proceedings on a solicitor and client basis shall be forthwith due and payable by the Tenant to the Landlord as Additional Rent. The Tenant shall allow the Landlord to post and keep posted on the Demised Premises any notices that the Landlord may desire to post under the provisions of applicable builders' or mechanics' lien or other legislation. (d) The Tenant shall not without the prior written consent of the Landlord put up any window drapes, blinds, awnings or other similar things or cover the floors with anything other than loose rugs. 19 NOTICE OF ACCIDENTS, DEFECTS, ETC. 7.3 The Tenant shall give the Landlord prompt written notice of any damage to or defect in the heating and air-conditioning apparatus, water pipes, gas pipes, telephone lines, electric light or other wires or other casualty. CARE OF DEMISED PREMISES 7.4 (a) The Tenant shall take good care of the Demised Premises and keep same in a clean, tidy and healthy condition. (b) The Tenant shall at its own expense be responsible for and shall maintain and replace from time to time as may be reasonably necessary during the Term of this Lease all light fixtures, bulbs, tubes, ballasts, starters and fuses in the Demised Premises. Notwithstanding the foregoing, the Landlord shall have the right to attend to such maintenance and replacements, but the expense thereof shall remain the responsibility of the Tenant. (c) The Tenant shall at its own expense replace or repair, under the direction and to the reasonable satisfaction of the Landlord, the glass, locks and trimmings of the doors and window in or upon the Demised Premises which become damaged or broken. (d) The Tenant shall not allow any ashes, refuse, garbage or other loose or objectionable material to accumulate in or about the Demised Premise. (e) The Tenant shall place in containers of a type approved by the Landlord all garbage and refuse and such containers shall be deposited for pick-up at such times and places as are designated in writing from time to time by the Landlord. (f) The Tenant shall maintain in good operating condition and to the satisfaction of the Landlord the water, sewer and gas connections and all other mechanical systems in the Demised Premises and shall keep the same in clean and good working order. It is understood and agreed that in case the said fixtures and equipment or any part thereof shall be damaged or destroyed or become incapable of performing their function, the Tenant shall repair or replace the same to the satisfaction of the Landlord. (g) The Tenant shall make all repairs and replacements to the Demised Premises made necessary by reason of burglary or attempted burglary. (h) The Tenant shall heat the Demised Premises at all reasonable times and shall maintain such heat at a temperature required to prevent damage of any nature or kind whatsoever to the Demised Premises, and if damage does occur to the Demised Premises due to the Tenant's failure to heat, the Tenant agrees to pay for the repairs arising thereby. (i) The Tenant shall keep well painted the painted portions of the interior of the Demised Premises. 20 LANDLORD'S RIGHT TO DO WORK 7.5 (a) The Landlord shall have the right to make additions to and/or improvements or installations in and/or repairs to the Building and/or the Project and/or the Common Areas and Facilities and whenever reference is made in this Lease to the Building or the Project or the Common Areas and Facilities, it shall mean the Building and/or Project and/or the Common Areas and Facilities as the same may be changed, added to or improved from time to time and in relation to any such additions, improvements, installations, or repairs the Landlord may cause such reasonable obstructions of and interference with the use or enjoyment of the Project, the Building, the Demised Premises and/or Common Areas and Facilities as may be reasonably necessary for the purposes aforesaid and may interrupt or suspend the supply of electricity, water or other services when necessary and until said additions, improvements, installations or repairs shall have been completed, there shall be no abatement in Rent nor shall the Landlord be liable by reason thereof. (b) The Landlord and any persons authorized by the Landlord shall have the right to use, install, maintain and/or repair pipes, wires, ducts or other installations in, under or through the Demised Premises for or in connection with the supply of any services to the Demised Premises or any other premises in the Building. Such services shall include, without limiting the generality of the foregoing, gas, electricity, water, sanitation, telephone, heating, air-conditioning and ventilation. There shall be no abatement of Rent while such use, installation, maintenance and/or repair is being carried out, by reason of loss or interruption of the business of the Tenant because of the prosecution of any such work. (c) The Landlord and any persons authorized by the Landlord shall have the right to enter upon the Demised Premises to make such decorations, repairs, alterations, improvements or additions as it may deem advisable and the Landlord or any persons authorized by the Landlord shall be allowed to take all material into and upon the Demised Premises that may be required therefor. There shall be no abatement of Rent while such decorations, repairs, alterations, improvements or additions are being made by reason of loss or interruption of the business of the Tenant because of the prosecution of any such work. (d) The Landlord shall provide reasonable advance notice prior to exercising its rights under the preceding provisions of this paragraph 7.05 save in the case of a real or apprehended emergency, when no such notice shall be required, and all additions, improvements, installation or repairs performed by the Landlord under the preceding provisions of this paragraph 7.05 shall be made as expeditiously as reasonably possible and in a manner which interferes as little as possible with the Tenant's permitted use of the Demised Premises. 21 LANDLORD'S RIGHT TO INSPECT AND DISPLAY SIGN 7.6 During the Term hereby created any person or persons may inspect the Demised Premises and all parts thereof at all reasonable times on producing a written order to that effect signed by the Landlord or its agents. In addition, the Landlord shall have the right during the last three months of the Term to show the Demised Premises to prospective tenants during normal business hours upon reasonable advance notice and to place upon the Demised Premises a notice of reasonable dimensions and reasonably placed so as not to interfere with the business of the Tenant, stating that the Demised Premises are for rent and further provided that the Tenant will not remove such notice or permit the same to be removed and will co-operate with the Landlord in the showing of the Demised Premises. LANDLORD'S REPAIRS 7.7 The Landlord covenants with the Tenant: (a) subject to Article 9, to keep in a good and reasonable state of repair, and consistent with the general standards of buildings of similar age, character and comparable location in British Columbia: (i) the Building (other than the Demised Premises and premises of other tenants) including the foundation, roof, exterior walls including exterior glass portions thereof, the systems for interior climate control, the elevators, entrances, stairways, corridors and lobbies and washrooms and other Common Areas and Facilities from time to time provided for use in common by the Tenant and other tenants of the Building and the systems provided for bringing utilities to the Demised Premises; and (ii) the structural members or elements of the Building; and (b) to repair defects in construction performed or installations made by the Landlord in the Demised Premises and damage in respect of fire or other perils against which the Landlord is required to or has in fact maintained insurance coverage hereunder. ARTICLE 8 TRANSFER AND ASSIGNMENT ASSIGNING OR SUBLETTING 8.1 The Tenant shall not assign this lease or sublet, part with or share possession of the Demised Premises or by licence permit any other person or corporation to occupy the Demised Premises in whole or in part and shall not mortgage this Lease or any right hereunder or interest herein (herein a "Transfer") without the prior written consent of the Landlord, which consent, subject as hereinafter provided shall not be unreasonably withheld. At the time that the Tenant requests the consent of the Landlord, the Tenant shall deliver to the Landlord 22 such information in writing as the Landlord may reasonably require respecting the proposed assignee, subtenant, occupant or licensee (herein the "Transferee") including without limitation: (a) the identity of the proposed Transferee; (b) the specific terms and conditions of such proposed assignment, sublease or other dealing; (c) the names and addresses of the beneficial owners of the shares of any proposed corporate Transferee; (d) current information on the financial affairs and business experience of the proposed Transferee, including references; and (e) such other information as the Landlord may reasonably require. Within 15 days of receiving all of the information required as set out above, the Landlord shall by written notice advise the Tenant that the Landlord consents or does not consent to the Transfer or, alternatively, that the Landlord has elected to exercise its right under paragraph 8.4. NO RELEASE 8.2 In no event shall any Transfer, whether the Landlord has consented to the same or not, release or relieve the Tenant from its obligations to perform fully all of the terms, covenants and conditions of this Lease on its part to be performed and in any event the Tenant shall be liable for the Landlord's reasonable costs incurred in connection with the Tenant's request for consent. CHANGE OF CONTROL 8.3 If the Tenant is a non-reporting or closely held company, any change in control of such company shall be deemed to be a Transfer for the purposes hereof. RIGHT OF LANDLORD TO TERMINATE 8.4 Notwithstanding anything to the contrary herein contained, upon the Landlord receiving a request from the Tenant to consent to a Transfer, the Landlord shall have the right to terminate this Lease with respect to the portion of the Demised Premises which is the subject of the Transfer, such right to be exercised by written notice within 15 days of the Landlord receiving all of the information required pursuant to paragraph 8.1. Should the Landlord exercise its right of termination as aforesaid, the Tenant shall have a further period of 15 days from receipt of the Landlord's notice to withdraw its request for consent to the Transfer, failing which this Lease shall terminate with respect to the portion of the Demised Premises which is the subject of the Transfer as of the date set out in the Landlord's notice of termination (which shall be not less than 30 nor more than 60 days from the date of such 23 notice), and the Tenant shall pay Rent to the date of termination for such portion of the Demised Premises, following which this Lease shall cease with respect to such portion and all obligations hereunder (save such as have arisen prior to the date of termination) shall cease. SALE BY LANDLORD 8.5 In the event of a sale or conveyance by the Landlord of the Lands on which the Building is located or in the event of an assignment of this Lease by the Landlord, then to the extent such purchaser or assignee assumes the obligations of the Landlord hereunder the same shall operate to release the Landlord from any future liability upon any of the covenants or conditions, express or implied, herein contained on the part of the Landlord, and in such event the Tenant agrees to look solely to the responsibility of the successor in interest of the Landlord. If any security is given by the Tenant to secure performance of the Tenant's covenants hereunder, the Landlord may transfer such security, to the purchaser of the reversion and thereupon the Landlord shall be discharged from any further liability in reference thereto. ARTICLE 9 DAMAGE OR DESTRUCTION DAMAGE OR DESTRUCTION WITHOUT TERMINATION 9.1 If during the Term hereby demised or any extension thereof the Demised Premises shall be damaged or destroyed by a peril or perils in respect of which the Landlord is insured, the Rent shall abate in proportion to that part of the Demised Premises rendered unfit for occupancy bears to the whole of the Demises Premises until the Demised Premises are rebuilt; and the Landlord agrees that it will with reasonable diligence repair the Demised Premises unless the Tenant is obligated to repair under the terms hereof or unless this Lease is terminated as hereinafter provided; subject always to the provisions of paragraph 9.2 or 9.3. DAMAGE OR DESTRUCTION WITH TERMINATION 9.2 If the Demised Premises or the Building of which the Demised Premises form a part or the Project are damaged or destroyed by any cause whatsoever and if in the opinion of the Landlord reasonably arrived at, the Demised Premises cannot be repaired, rebuilt or made fit for the purposes of the Tenant or any other premises in the Building or the Project cannot be repaired, rebuilt or made fit for the purposes of other tenants, in either case within 90 days of the damage or destruction, the Landlord may, at its option, terminate this Lease by giving the Tenant within 30 days of such damage or destruction notice of termination and thereupon the Basic Rent, Additional Rent and any other payments for which the Tenant is liable under this Lease shall be apportioned and paid to the date of such damage or destruction and the Tenant shall immediately deliver up possession of the Demised Premises to the Landlord; PROVIDED THAT notwithstanding the termination of this Lease as in this paragraph set forth, the Tenant shall remain liable for any outstanding obligations of the Tenant under this Lease as at the time of such termination. 24 DAMAGE OR DESTRUCTION OF BUILDING 9.3 If the Building or part thereof shall be damaged or destroyed and such damage or destruction, in the opinion of the Landlord, materially interferes with the enjoyment of the Demised Premises by the Tenant, the Rent in respect of the Demised Premises shall abate in proportion to such interference during the period such interference shall continue. ARTICLE 10 DEFAULT AND RE-ENTRY RE-ENTRY 10.1 (a) It is hereby expressly agreed that if and whenever the Rent hereby reserved, or any part thereof, shall be unpaid for seven days after the date on which the same ought to have been paid, although no formal demand shall have been made therefor, or in case of the breach or non-performance of any of the covenants or agreements herein contained on the part of the Tenant which breach or non-performance continues for a period of 15 days after written notice from the Landlord, or if the Demised Premises are vacated or become vacant or remain unoccupied for five days or are not used for the purpose specified then and in any of such cases the Landlord shall have the immediate right to re-enter and take possession of the Demised Premises whereupon, at the Landlord's option, the balance of the Term shall be forfeit and the Landlord may remove all persons and property from the Demised Premises and such property so removed may be stored wherever the Landlord chooses at the Tenant's cost and expense. (b) Should the Landlord elect to re-enter, as herein provided, or should it take possession pursuant to legal proceedings or pursuant to any notice provided for by law, it may either terminate this Lease or it may from time to time without terminating this Lease make such alterations and repairs as may be necessary in order to relet the Demised Premises, and may relet the Demised Premises or any part thereof for such term or terms (which may be for a term extending beyond the Term of this Lease) at such rental or rentals and upon such other terms and conditions as the Landlord in its sole discretion may deem advisable; upon each such reletting, all rents received by the Landlord from such reletting for the unexpired portion of the Term shall be applied, first, to the payment of any indebtedness other than Rent due hereunder from the Tenant to the Landlord; secondly, to the payment of any costs and expenses of such reletting, including brokerage fees and solicitors' fees and of costs of such alterations and repairs; thirdly, to the payment of Basic Rent and Additional Rent due and unpaid hereunder and the residue, if any, shall be held by the Landlord and applied in payment of future Rent as the same may become due and payable hereunder. If such rents received from such reletting during any month are less than that required to be paid during that month by the Tenant hereunder, the Tenant shall pay all such deficiency to the Landlord. Such deficiency shall be calculated and paid monthly. No such re-entry 25 or taking possession of the Demised Premises by the Landlord shall be construed as an election on its part to terminate this Lease unless a written notice of such intention be given to the Tenant or left on the Demised Premises. Notwithstanding any such reletting without termination, the Landlord may at any time thereafter elect to terminate this Lease for such breach. Should the Landlord at any time terminate this Lease for any breach, in addition to any other remedies it may have it may recover from the Tenant all damages it may incur by reason of such breach, including the cost of re-entering the Demised Premises, reasonable solicitors' fees and including the worth at the time of such termination of the excess, if any, of the amount of rent charges equivalent to Rent reserved in this Lease for the remainder of the Term over the then reasonable rental value of the Demised Premises for the remainder of the Term, all of which amounts shall be immediately due and payable by the Tenant to the Landlord. BANKRUPTCY 10.2 If the Term hereby granted shall be at any time seized or taken in execution or in attachment by any creditor of the Tenant or if the Tenant shall make any assignment for the benefit of creditors, or becoming bankrupt or insolvent shall take the benefit of any Act that may be in force for bankrupt or insolvent debtors, or if the Tenant should abandon the Demised Premises then in any such case the said Term shall at the option of the Landlord, immediately become forfeited and void and the then current month's Rent and Rent for the three months next following shall immediately become due and payable and in such case it shall be lawful for the Landlord at any time thereafter to re-enter into or upon the Demised Premises, or any part thereof, and the same to have again, repossess and enjoy as of its former estate anything herein contained to the contrary notwithstanding, and neither this Lease nor any interest therein nor any estate created hereby shall pass to or enure to the benefit of any trustee in bankruptcy or any receiver or any assignee for the benefit of creditors or otherwise by operation of law. For the purposes of section 65.2(3)(a) of the BANKRUPTCY AND INSOLVENCY ACT (Canada) the Tenant acknowledges that the six months rent referred to therein shall mean six months Rent hereunder calculated from the date on which the repudiation of this Lease takes effect pursuant to such Act. WAIVER OF EXEMPTION FROM DISTRESS 10.3 In consideration of the premises and of the leasing and letting by the Landlord to the Tenant of the Demised Premises for the Term hereby created (and it is upon that express understanding that these presents are entered into), notwithstanding anything contained in any Statute or in any Statute which may hereafter be passed, none of the goods or chattels of the Tenant at any time during the continuance of the Term hereby created on the Demised Premises shall be exempt from levy by distress for Rent in arrears by the Tenant as provided for in any such Statute or any amendment or amendments thereto upon any claim being made for such exemption by the Tenant or on distress being made by the Landlord this covenant and agreement may be pleaded as an estoppel against the Tenant in any action brought to test the right to the levying upon any such goods as are named as exempted in any such Statute or amendment or amendments thereto; the Tenant waives, as the Tenant hereby does, all and every benefit that could or might have accrued to the Tenant under and by virtue of any such statute or any amendment or amendments thereto but for this covenant. 26 FOLLOW CHATTELS 10.4 In case of removal by the Tenant of the goods and chattels of the Tenant from the Demised Premises, the Landlord may follow the same for 30 days or such longer period of time as may be permitted by law. OVERLOOKING AND CONDONING 10.5 Any condoning, excusing or overlooking by the Landlord of any default, breach or non-observance by the Tenant at any time or times in respect of any covenant, proviso or condition herein contained shall not operate as a waiver of the Landlord's rights hereunder in respect of any subsequent default, breach or non-observance nor as to defeat or affect in any way the rights of the Landlord hereunder in respect of any subsequent default, breach or non-observance. ARTICLE 11 SUBORDINATION SUBORDINATION 11.1 The Tenant covenants and agrees with the Landlord that the Tenant shall from time to time upon the written request of the Landlord, enter into an indenture: (a) subordinating the Term hereby demised and the rights of the Tenant hereunder to any mortgage, including any deed of trust and mortgage and all indentures supplemental thereto, or any ground lease, present or future, which includes the Demised Premises; or at the option of the Landlord (b) agreeing that the Term hereby demised shall be prior to any such mortgage, including any deed of trust and mortgage and all indentures supplemental thereto, or ground lease, provided if the Tenant fails to execute any such indenture with reasonable promptness upon request by the Landlord, the Tenant hereby irrevocably authorizes and appoints the Landlord as its attorney to execute the same on the Tenant's behalf. Notwithstanding any such postponement or subordination as aforesaid, the Tenant agrees that its obligations under this Lease shall remain in full force and effect notwithstanding any action at any time taken by a mortgagee or head landlord of the Lands or any part thereof to enforce the security of any such mortgage, including any deed of trust and mortgage and all indentures supplemental thereto, or ground lease; PROVIDED ALWAYS however, that any postponement or subordination given hereunder shall reserve to the Tenant the right to continue in possession of the Demised Premises under the Terms of this Lease so long as the Tenant shall not be in default hereunder. 27 ARTICLE 12 NOTICES NOTICES 12.1 Any notice, advice, document or writing required or contemplated by any provision hereof shall be given in writing and if to the Landlord, either delivered personally or transmitted by facsimile to an officer of the Landlord's agent, PPM Real Estate Managers (Canada) Limited or mailed by prepaid mail addressed to the Landlord care of PPM Real Estate Managers (Canada) Limited at the following address: PPM Real Estate Managers (Canada) Limited 440 - 1090 West Georgia Street Vancouver, British Columbia V6E 3V7 (facsimile number: (604) 682-5425) with a copy to: PPM Real Estate Managers (Canada) Limited 1200, 141 Adelaide Street West Toronto, Ontario M5H 3L9 (facsimile number: (416) 362-1431) Attention: Senior Vice-President and if to the Tenant, either delivered personally to the Tenant (or to an officer of the Tenant, if a corporation) or mailed by prepaid mail addressed to the Tenant at the Demised Premises, or if an address of the Tenant is shown in the description of the Tenant above, to such address. Every such notice, advice, document or writing shall be deemed to have been given when delivered personally, upon the usual confirmation of transmission and receipt if sent by facsimile, or if mailed as aforesaid, upon the fifth day after being mailed save and except in the event of a labour dispute or other disruption affecting postal service occurring within five days of the date of mailing in which event notice will not be deemed to have been received until actually received. The Landlord may from time to time by notice in writing to the Tenant designate another address as the address to which notices are to be mailed to it, or specify with greater particularity the address and persons to which such notices are to be mailed and may require that copies of notices be sent to an agent designated by it. The Tenant may, if an address of the Tenant is shown in the description of the Tenant above, from time to time by notice in writing to the Landlord, designate another address as the address to which notices are to be mailed to it, or specify with greater particularity the address to which such notices are to be mailed. 28 ARTICLE 13 MISCELLANEOUS PROVISIONS UNAVOIDABLE FAILURES OR DELAYS 13.1 Notwithstanding anything to the contrary in the Lease contained, if either party hereto shall be bona fide delayed or hindered in or prevented from the performance of any term, covenant or act required hereunder by reason of strikes, labour troubles inability to procure materials or services, failure of power, restrictive governmental laws or regulations, riots, insurrection, sabotage, rebellion, war, act of God, or other reason whether of a like nature or not, not the fault of the party delayed in performing work or doing acts required under the terms of this Lease, then performance of such terms, covenants or acts shall be extended for a period equivalent to the period of such delay. The provisions of this paragraph shall not operate to excuse the Tenant from the prompt payment of Basic Rent, Additional Rent, or any other amounts which it is required by the terms of this Lease to pay. This paragraph shall not be construed to include in the reasons for any such delays, financial impecuniosity or incapacity. ENTIRE AGREEMENT 13.2 This Lease and the Schedules (including the rules and regulations) attached hereto and which form part hereof set forth all the covenants, promises, agreements, conditions and understandings, between the Landlord and the Tenant concerning the Demised Premises and there are no covenants, promises, agreements, conditions or understandings, either oral or written, between them other than are herein set forth. Except as herein otherwise provided, no subsequent alteration, amendment, change or addition to this Lease shall be binding upon the Landlord or the Tenant unless in writing and signed by each of them except the rules and regulations adopted and promulgated by the Landlord and in accordance with the provisions of this Lease. SUBDIVISION 13.3 The Tenant will at the request of the Landlord and at no expense to the Tenant execute all consents, sign all subdivision plans and do all things necessary to permit the subdivision of the Lands. REGISTRATION 13.4 The Tenant shall not have the right to register this Lease without the prior consent of the Landlord, which consent may be withheld in the Landlord's sole discretion, and the Landlord shall not be obliged to deliver this Lease in registrable form. Should the Landlord consent to such registration, or should the Landlord require this Lease to be registered, then the parties shall re-execute this Lease in registrable form and such registration and the preparation of any plan necessary therefore shall be done by and at the sole cost and expense of the party desiring to register this Lease. 29 NET LEASE INTENT 13.5 The Tenant acknowledges and agrees that it is intended that this Lease shall be a completely carefree net lease for the Landlord except as expressly herein set out and that the Landlord shall not be responsible during the Term hereof for any costs, charges, expenses and outlays of any nature whatsoever arising from or relating to the Demised Premises, or the contents thereof and without limiting the generality of the foregoing, the Tenant shall be liable for the payment of all charges, impositions and expenses of every nature and kind relating to the Demised Premises and the contents thereof and its Proportionate Share of all charges, impositions, and expenses of every nature and kind relating to those parts of the Building, Project and Lands not intended for leasing and the Tenant covenants with the Landlord accordingly. TIME OF ESSENCE 13.6 Time shall be of the essence of this Lease. BINDING EFFECT 13.7 This Lease and everything herein contained shall enure to the benefit and be binding upon the heirs, executors, administrators, successors, assigns and other legal representatives, as the case may be of each of the parties hereto, subject to the granting of consent by the Landlord as provided in paragraph 8.1 to any assignment or sublease. RELOCATION OF DEMISED PREMISES 13.8 DELETED. IN WITNESS WHEREOF the parties hereto have executed this Lease as of the day and year first above written. The Corporate Seal of ) 2725321 CANADA INC. ) was affixed in the presence of: ) ) /s/ Mary B. Aubrey ) - ----------------------- ) C/S Mary B. Aubrey ) Vice President ) ) /s/ Paul A. Brundage ) - ----------------------- ) Paul A. Brundage ) Vice President ) 30 The Corporate Seal of APPLIED ) DIGITAL ACCESS - CANADA, INC. ) was affixed in the presence of: ) ) /s/ James L. Keefe ) - ----------------------- ) C/S James L. Keefe, Chief Financial Officer ) ) ) ) - ----------------------- ) Authorized Signatory ) 31 SCHEDULE "A" Referred to in the attached Lease made as of January 1, 1997 between 2725321 CANADA INC. as Landlord, and APPLIED DIGITAL ACCESS - CANADA, INC. as Tenant. The Demised Premises are that part of the Building situate on the Lands legally described in Schedule "B" hereto. The Demised Premises are shown outlined in heavy black line on the sketch plan attached to this Schedule "A". The Demised Premises shall exclude the outside face of all perimeter walls of the Demised Premises but shall include windows and doors in the perimeter wall. In calculating the Area of the Demised Premises or of the Building the calculation shall be computed by measuring from the exterior surface of the Building, in the case of exterior walls, and to the centre of partitions that separate the Demised Premises from adjoining rentable areas or Common Areas and Facilities. There shall be no deduction for vestibules or other recesses inside the building line or for columns, ducts, projection or other structural elements necessary to the Building. The Demised Premises includes all installations, fixtures, furnishings and amenities located within the Demised Premises. The Area of the Demised Premises is hereby estimated to be 25,604 square feet, provided the Landlord may have the Area of the Demised Premises measured by its architect or engineer, and if the same is different from the figure set forth above then Basic Rent and the Tenant's Proportionate Share shall be adjusted accordingly, such adjustment to be retroactive to the Commencement Date. [ATTACH SKETCH PLAN OF BUILDING] [NOTE: OUTLINE THE DEMISED PREMISES IN HEAVY BLACK LINE] SCHEDULE "B" Referred to in the attached Lease made as of January 1, 1997 between 2725321 CANADA INC. as Landlord, and APPLIED DIGITAL ACCESS - CANADA, INC. as Tenant. LEGAL DESCRIPTION OF LANDS Lots A and B District Lot 10 Group 1, New Westminster District Plan 72477 MUNICIPAL ADDRESS OF DEMISED PREMISES 8630 - 8654 Commerce Court Burnaby, B.C. V5A 4N6 SCHEDULE "C" Referred to in the attached Lease made as of January 1, 1997 between 2725321 CANADA INC. as Landlord, and APPLIED DIGITAL ACCESS - CANADA, INC. as Tenant. RULES AND REGULATIONS 1. Tenants shall not burn any trash or garbage in or about the Demised Premises or anywhere within the confines of the Lands. 2. Tenants shall not keep or display any merchandise on or otherwise obstruct any part of the Lands except as is specifically permitted in this Lease. 3. Floors shall not be overloaded. 4. All loading and unloading of merchandise, supplies, materials, garbage, refuse and other chattels shall be made only through or by means of such doorways as the Landlord shall designate in writing from time to time. 5. Tenants shall in connection with their advertising in relation to the business carried on in the Demised Premises use and promote the name IMPERIAL SQUARE LAKE CITY or such other name as the Landlord may from time to time designate and in using such name in any advertisement, sign, poster, printing or other writing tenants will print, write or designate the same in a manner to be determined from time to time by the Landlord and in no other manner. Tenant shall not use such name in regard to any business other than their business upon the Demised Premises. Tenants agree that they will not carry on or permit to be carried on any business in the Demised Premises under a name or style other than their own name or call or permit the Demised Premises or any business carried on therein to be called any name other than their own name, without the prior written consent of the Landlord. 6. Tenants shall, upon written notice from the Landlord, within five days furnish the Landlord with the current Provincial License Number of any vehicle owned or used by employees of tenants. 7. Tenants shall not bring upon their premises any equipment, motor or any other thing which may damage the Building or the Project. 8. No merchandise, supplies, materials, garbage, refuse or other chattels shall be allowed to remain on any common area, and must at all time be contained within the Demised Premises. 9. The Tenant shall not use or occupy in any manner whatsoever the area of recess, if any, between the lease line of the Demised Premises and the store front of the Demised Premises, and the Landlord reserves the entire control over such area. 10. Wherever any window area is not used for the purpose of entrances, offices or show areas, the Tenant must construct at its own expense, enclosures or decorative screens as specified and approved by the Landlord, so as to protect the windows in that area from damage. 11. If any additional locks or bolts of any kind shall be placed upon any of the doors or windows of the Demised Premises, or if any changes shall be made in existing locks or mechanisms thereof, the Tenant shall provide the Landlord with a duplicate key or keys so as to allow the Landlord access to the Demised Premises as and when required. The Tenant shall at the end of the Term or renewal term as the case may be, return to the Landlord all keys to the Demises Premises and to all other areas of the Building or the Project which may have been supplied to the Tenant. 12. No animals or motor vehicles shall be brought into the Demised Premises or the Building. 13. DELETED. 14. The doors and windows or other apertures that reflect or admit light or air into the passageways or into any portion of the Demised Premises or the Building shall not be covered or obstructed by the Tenant in any manner whatsoever. 15. Windows shall not be left open so as to admit rain or snow. 16. It shall be the responsibility of the Tenant to prevent any person from throwing objects out of windows or into the ducts or stairwells of the Demised Premises or the Building, and the Tenant shall pay for any cost, damage or injury resulting from any such act or acts. 17. Keys or other devices which are made available to the Tenant for the purpose of providing access to the exterior doors of the Building shall not be duplicated and shall be returned to the Landlord immediately upon termination of this Lease. The foregoing rules and regulations as from time to time amended, are not necessarily of uniform application but may be waived in whole or in part in respect of other tenants without affecting their enforceability with respect to the Tenant or the Demised Premises. For the benefit and welfare of all or any tenants of premises upon the Lands as it may exist from time to time, the Landlord shall have the right to issue further Rules and Regulations and such further Rules and Regulations shall thereupon be binding on all tenants. 2 SCHEDULE "D" Referred to in the attached Lease made as of January 1, 1997 between 2725321 CANADA INC. as Landlord, and APPLIED DIGITAL ACCESS - CANADA, INC. as Tenant. HAZARDOUS SUBSTANCES DEFINITIONS 1. In this Schedule "D": "HAZARDOUS SUBSTANCE" means: (a) any radioactive material; (b) any explosive; (c) any substance that, if added to any water, would degrade or alter or form part of a process of degradation or alteration of the quality of that water to the extent that it is detrimental to its use by man or by any animal, fish or plant; (d) any solid, liquid, gas or odour or combination of any of them that, if emitted into the air, would create or contribute to the creation of a condition of the air that: (i) endangers the health, safety or welfare of persons or the health or animal life; (ii) interferes with normal enjoyment of life or property; or (iii) causes damage to plant life or to property; (e) any toxic substance; (f) any substance declared to be hazardous or toxic under any Law, Regulation or Order (as defined below) now or hereafter enacted or promulgated by any governmental authority having jurisdiction over the Landlord, the Tenant, the Demised Premises or the Development of which the Demised Premises form a part; and (g) any other substance which is or may become hazardous, dangerous or toxic to persons or property; "LAWS" means all applicable federal, provincial, state, municipal, or local laws, by-laws, statutes, or ordinances, including, without limitation, the following: the Canadian ENVIRONMENTAL PROTECTION ACT, the British Columbia WASTE MANAGEMENT ACT and other applicable laws relating to the environment, occupational safety, product liability and transportation; "REGULATIONS" mean all rules, regulations or the like promulgated under or pursuant to any Laws; and "ORDERS" mean all applicable orders, decisions, or the like rendered by any ministry, department or administrative or regulatory agency. TENANT'S COVENANT AS TO USE 2. Without limiting the generality of the covenants of the Tenant in the Lease contained, the Tenant covenants and agrees that the Tenant will not bring upon the Demised Premises or any part thereof any Hazardous Substances and if at any time, notwithstanding the foregoing covenant of the Tenant, there shall be any Hazardous Substances upon the Demised Premises or a part thereof whether or not brought thereupon by the Tenant, the Tenant shall, at its own expense: (a) immediately give the Landlord notice specifying the nature and location of the Hazardous Substances and thereafter give the Landlord from time to time written notice of the extent and nature of the Tenant's compliance with the following provisions of this paragraph; (b) promptly remove the Hazardous Substances from the Demised Premises in a manner which conforms with all Laws, Regulations and Orders governing the movement of the same and the reasonable requirements of the Landlord in connection with the movement; and (c) if requested by the Landlord, obtain at the Tenant's cost and expense from an independent consultant designated or approved by the Landlord verifying the complete and proper removal thereof from the Demised Premises or, if such is not the case, reporting as to the extent and nature of any failure to comply with the foregoing provisions of this paragraph. COMPLIANCE WITH LAWS 3. Without limiting the generality of the covenants of the Tenant in the Lease contained, the Tenant shall, at its own cost and expense, comply with all Laws, Regulations and Orders from time to time in force relating to the Landlord, the Tenant, the business of the Tenant, the Demised Premises or the Development relating to Hazardous Substances and the protection of the environment and shall immediately give written notice to the Landlord of the occurrence of any event in the Demised Premises or on the Development which is in breach of any such Laws, Regulations or Orders or a contravention thereof and, if the Tenant shall, either alone or with others, cause the occurrence of such event, the Tenant shall, at its own expense: 2 (a) immediately give the Landlord notice of the occurrence and the contravention and thereafter give the Landlord from time to time written notice of the extent and nature of the Tenant's compliance with the following provisions of this paragraph; (b) promptly remedy the contravention in a manner which conforms with all Laws, Regulations and Orders governing the movement of the same; and (c) if requested by the Landlord, obtain at the Tenant's cost and expense from an independent consultant designated or approved by the Landlord verifying the complete and proper remedying of the contravention or, if such is not the case, reporting as to the extent and nature of any failure to comply with the foregoing provisions of this paragraph. The Tenant shall, at its own expense, remedy any damage to the Demised Premises and the Development caused by such event within the Demised Premises or by the performance of the Tenant's obligations under this paragraph as a result of such occurrence. If the Tenant fails to do so, the Landlord may at its option remedy the damage, and may recover its cost and expenses of so doing from the Tenant as Additional Rent under the Lease. If any governmental authority having jurisdiction shall require the clean-up of any Hazardous Substances held, released, spilled, abandoned or placed upon the Demised Premises or the Development or released into the environment by the Tenant in the course of the Tenant's business or as a result of the Tenant's use or occupancy of the Demised Premises, then the Tenant shall, at its own expense, prepare all necessary studies, plans and proposals and submit the same for approval, provide all bonds and other security required by governmental authorities having jurisdiction and carry out the work required and shall keep the Landlord fully informed and provide to the Landlord full information with respect to the proposed plans and comply with the Landlord's reasonable requirements with respect to such plans. The Tenant agrees that if the Landlord determines, in its own discretion, that the Landlord, its property or its reputation is placed in any jeopardy by the requirement for any such work, the Landlord may itself undertake such work or any part thereof at the cost and expense of the Tenant. ENQUIRIES BY LANDLORD 4. The Tenant hereby authorizes the Landlord to make enquiries from time to time of any government or governmental agency with respect to the Tenant's compliance with any and all laws and regulations pertaining to the Tenant, the Tenant's business and the Demised Premises including without limitation Laws, Regulations and Orders pertaining to Hazardous Substances and the protection of the environment; and the Tenant covenants and agrees that the Tenant will from time to time provide to the Landlord such written authorization as the Landlord may reasonably require in order to facilitate the obtaining of such information. Without limiting the generality of the foregoing, the Landlord shall have the right, during the last 3 months of the Term, to cause an independent environmental audit or assessment of the Demised Premises or the Building to be performed, and if such audit or assessment indicates 3 the presence of Hazardous Substances the Tenant shall bear the cost of such audit or assessment, together with the cost of the clean-up, removal, containment, treatment, detoxification or neutralization, as the case may be, of such Hazardous Substances. EVENT OF DEFAULT 5. The presence of any Hazardous Substances in the Demised Premises without the prior written approval of the Landlord shall be considered to be an event of default for the purposes of the Lease. OWNERSHIP OF HAZARDOUS SUBSTANCES 6. If the Tenant shall bring or create upon the Development or the Demised Premises any Hazardous Substance or if the conduct of the Tenant's business shall cause thereto be any Hazardous Substance upon the Development or the Demised Premises then, notwithstanding any rule of law to the contrary, such Hazardous Substance shall be and remain the sole and exclusive property of the Tenant and shall not become the property of Landlord notwithstanding the degree of affixation of the Hazardous Substance or the goods containing the Hazardous Substance to the Demised Premises or the Development and notwithstanding the expiry or earlier termination of this Lease. SURVIVAL OF COVENANTS 7. The obligations of the Tenant hereunder relating to Hazardous Substances shall survive the expiry or earlier termination of this Lease save only that, to the extent that the performance of those obligations requires access to or entry upon the Demised Premises or the Development or any part thereof, the Tenant shall have such entry and access only at such times and upon such terms and conditions as the Landlord may from time to time specify; and the Landlord may, at the Tenant's cost and expense, itself or by its agents, servants, employees, contractors and subcontractors, undertake the performance of any necessary work in order to complete such obligations of the Tenant; but having commenced such work, the Landlord shall have no obligation to the Tenant to complete such work. 4 SCHEDULE "E" Referred to in the attached Lease made as of January 1, 1997 between 2725321 CANADA INC. as Landlord, and APPLIED DIGITAL ACCESS - CANADA, INC. as Tenant. INDEMNITY AGREEMENT THIS AGREEMENT made as of January 1, 1997, BETWEEN: APPLIED DIGITAL ACCESS, INC., 9855 Scranton Road, San Diego, ---------------------------- California, U.S.A. 92121 (hereinafter called the "Covenantor") AND: 2725321 CANADA INC., c/o PPM Real Estate Managers (Canada) Limited, ------------------- 1090 West Georgia Street, Vancouver, B.C. V6E 3V7. (hereinafter called the "Landlord") In consideration of the Landlord entering into the lease (the "Lease") made as of January 1, 1997 between the Landlord and APPLIED DIGITAL ACCESS - CANADA, INC. (the "Tenant") and of other good and valuable consideration, the receipt and sufficiency of which is hereby acknowledged by the Covenantor, the Covenantor hereby represents and warrants to the Landlord that it is financially interested in the affairs of the Tenant and covenants and agrees with the Landlord as follows: 1. The Covenantor is financially interested in the affairs of the Tenant, and the granting of this Indemnity Agreement is in the best interests of the Covenantor. 2. The Covenantor shall indemnify and save harmless the Landlord in respect of any default by the Tenant in the carrying out of each and every one of the Tenant's covenants and agreements in the Lease set out. 3. If any default is made by the Tenant under the Lease the Covenantor shall on demand of the Landlord forthwith remedy such default. 4. The Covenantor shall indemnify and save harmless the Landlord with respect to all losses, costs, expenses, claims, liabilities and damages that may be suffered or incurred by the Landlord by reason of or relating to, directly or indirectly, any default by the Tenant under the Lease. 5. This indemnity is absolute and unconditional. 6. The Landlord shall not be bound or required to proceed against the Tenant or any other obliged person or to have recourse to or exhaust any security from time to time held by it for the performance of the covenants or agreements of the Tenant in the Lease contained or to pursue any other remedy whatsoever which may be available to the Landlord before proceeding against the Covenantor. 7. The obligations of the Covenantor under this Agreement shall extend to the Term of the Lease and any overholding by the Tenant and to any renewal or extension of the Term of the Lease, whether such renewal or extension is entered into by the Tenant or by an assignee of the Tenant. 8. No proceeding under this Agreement and no recovery made as a result thereof will be a bar or a defence to any further proceeding under this Agreement. 9. The Covenantor waives the right to receive notice of any default by the Tenant under the Lease. 10. The obligations of the Covenantor under this Agreement shall in no way be released, discharged, reduced or otherwise affected by: (a) modifications, releases or discharges granted to the Tenant in respect of its obligations to keep, observe or perform its covenants and agreements under the Lease; (b) any agreement or other dealing between the Landlord and the Tenant having the effect of amending or altering the Lease or the obligations of the Tenant thereunder; (c) any neglect, delay or forbearance of the Landlord in demanding, requiring or enforcing the keeping, observance or performance by the Tenant of any of its covenants or agreements under the Lease or by the Covenantor of any of its obligations under this Agreement; (d) granting any extension of time, waivers, or indulgences; (e) any assignment of the Lease or subletting by the Tenant or any trustee in bankruptcy, receiver or other successor or any consent of the Landlord to any assignment or subletting; (f) bankruptcy, insolvency or dissolution of the Tenant or the Covenantor; (g) any other compromising, modifying or releasing of the Tenant's obligations under the Lease through the operation of any statute or law; 2 (h) any event or occurrence which would have the effect at law of terminating or rendering unenforceable any covenants or agreements of the Tenant in the Lease contained or of the Covenantor hereunder; (i) any failure by the Landlord to give notice to the Covenantor of any default by the Tenant under the Lease; (j) any re-entry by the Landlord onto the premises demised under, or termination of, the Lease; (k) any change in the constitution of the Tenant, if a partnership; or (l) any other matter, thing, act or omission of the Landlord whatsoever. 11. Without limiting the generality of the foregoing, the Covenantor shall be bound by the terms and provisions of the Lease in the same manner as though the Covenantor were the tenant named in the Lease. 12. Except in the case of a surrender accepted by the Landlord, if the lease is terminated, or if the Lease is disclaimed pursuant to any statute, or if the Lease is repudiated by the Tenant pursuant to the provisions of the BANKRUPTCY AND INSOLVENCY ACT (Canada), then and in any of such cases at the option of the Landlord to be exercised at any time within 6 months thereafter the Covenantor shall execute and deliver a new lease of the premises demised under the Lease between the Landlord as landlord and the Covenantor as tenant for a term equal in duration to the residue of the Term of the Lease remaining unexpired immediately prior to the effective date of such termination, disclaimer or repudiation. Such new lease shall contain the same landlord's and tenant's obligations respectively and the same covenants, obligations and agreements, terms and conditions in all respects (including the proviso for re-entry) as are contained in the Lease. If the Covenantor fails to execute and deliver a new lease as aforesaid, the Covenantor shall be deemed to have executed and delivered the same. 13. The benefit of the Covenantor's covenants herein may, from time to time, be assigned, collaterally, conditionally or otherwise, to any other entity to whom the Landlord assigns the benefits of the Lease and such other assignee shall be entitled to enforce the provisions hereof against the Covenantor as though such assignee were the original contracting party hereto with the Covenantor. 14. This Agreement shall extend to and be binding upon the Covenantor, its heirs, executors, administrators, successors and assigns and shall enure to the benefit of and may be enforced by the Landlord, its successors and assigns and any mortgagee, chargee, or other encumbrancer of all or any part of the premises demised under the Lease. 15. This Agreement shall be construed in accordance with the laws of the Province of British Columbia. 3 IN WITNESS WHEREOF this Agreement has been executed by the Covenantor as of the day and year first above written. The Corporate Seal of APPLIED ) DIGITAL ACCESS, INC. ) was hereunto affixed in the presence of: ) ) ) C/S - --------------------------------------- ) ) ) - --------------------------------------- ) ) 4 SCHEDULE "F" Referred to in the attached Lease made as of January 1, 1997 between 2725321 CANADA INC. as Landlord, and APPLIED DIGITAL ACCESS - CANADA, INC. as Tenant. SPECIAL PROVISIONS 1. EXTENSION OF TERM - Provided the Tenant has not been in default in the performance of its obligations pursuant to the Lease, and provided the Tenant is Applied Digital Access - Canada, Inc. and is itself in possession of the whole of the Demised Premises or has sublet the Demised Premises, or a portion thereof, in accordance with the Lease, the Tenant will have the right to extend the Term, upon giving the Landlord notice of its intention to do so no earlier than March 31, 1999 and no later than June 30, 1999, for a further period of two years (the "Extended Term") upon the same terms and conditions as are set out in the Lease, except that: (a) there will be no further right to extend the Term following the expiration of the Extended Term; (b) any requirement on the Landlord's part to do any Landlord's Work or pay to the Tenant any construction allowance, inducement, loan or other amount in connection with the Lease or improvements in the Demised Premises, and any right of first refusal, will not apply during the Extended Term; and (c) the annual Basic Rent shall be mutually agreed upon between the Landlord and the Tenant based upon the current market Basic Rent for comparably sized and improved premises in similar buildings in the area, as designated by the Landlord as at October 1, 1999, provided that the annual Basic Rent for the Extended Term shall not be less than the annual Basic Rent payable by the Tenant for the last 12 months of the initial Term, and provided further that if the parties are unable to agree to such annual Basic Rent by no later than 30 days prior to the expiry of the initial Term, then the annual Basic Rent shall be determined by arbitration in accordance with the COMMERCIAL ARBITRATION ACT of British Columbia as then in force and applying the criteria set out above. If the annual Basic Rent has not been determined by the commencement of the Extended Term, the Tenant shall pay Basic Rent at the rate applicable to overholding as set out in the Lease, and within 10 days after the Basic Rent for the Extended Term is determined, the parties shall retroactively adjust the Basic Rent owing from the commencement of the Extended Term. If the Tenant fails to exercise this option to extend the Term in accordance with the foregoing, or if the foregoing conditions are not satisfied, this option to extend shall be null and void. 2. AVAILABLE SPACE - The Landlord shall undertake to use reasonable efforts to keep the Tenant informed on the availability of any space available for lease direct from the Landlord in the Building. Notwithstanding the foregoing, the failure by the Landlord to so inform the Tenant shall not give rise to any liability whatsoever to the Tenant on the part of the Landlord. 3. ACCESS - the Tenant shall have access to the Demised Premises 24 hours per day each and every day of the year throughout the Term, except for unforeseen Building emergencies, and subject to the Landlord's security procedures. The Tenant shall have the right to have heating, ventilating, air-conditioning, hydro and elevator service as it may require outside of normal business hours, upon reasonable request and any reasonable cost(s) related thereto shall be the Tenant's responsibility. 4. PARKING - So long as the Tenant is Applied Digital Access - Canada, Inc. and is itself in occupation of the whole of the Demised Premises or has sublet the Demised Premises, or a portion thereof, in accordance with the Lease, and provided the Tenant has not been in default in the performance of its obligations pursuant to the Lease, the Landlord will make available to the Tenant for its use 51 reserved parking spaces identified by the Tenant's name in a location to be designated by the Landlord from time to time at no cost to the Tenant throughout the Term or any extension thereof. 5. FREE BASIC RENT - Provided the Tenant is in possession of the Demised Premises, has executed the Lease and is not in default thereunder, the Tenant shall not be required to pay Basic Rent for the first month of the Term, provided the Tenant shall pay all Additional Rent provided for in the Lease throughout such period. 2 I N D E X ARTICLE DESCRIPTION PAGE - ------- ----------- ---- ARTICLE 1 DEFINITIONS AND INTERPRETATION 1.1 Definitions............................................1 1.2 Schedules..............................................4 1.3 Governing Law..........................................4 1.4 Headings...............................................4 1.5 Interpretation.........................................4 1.6 Use of "herein", "hereof", etc.........................5 1.7 Terms as Covenants.....................................5 ARTICLE 2 DEMISE, TERM AND USE 2.1 Demise.................................................5 2.2 Term...................................................5 2.3 Use....................................................5 2.4 Use of common areas and facilities, etc................6 2.5 Possession.............................................6 2.6 Examination of Demised Premises........................6 2.7 Overholding............................................6 ARTICLE 3 RENT AND OTHER PAYMENTS 3.1 Basic Rent.............................................7 3.2 Payments to Landlord...................................7 3.3 Additional Rent........................................7 3.4 Payments to Others.....................................7 3.5 Interest on Overdue Amounts............................8 3.6 Disputes...............................................8 3.7 Deposit................................................8 ARTICLE 4 MISCELLANEOUS COVENANTS OF THE TENANT 4.1 Pay Rent...............................................8 4.2 Pay Tenant's Taxes.....................................9 4.3 Pay Utilities..........................................9 4.4 Pay Proportionate Share of Taxes.......................9 4.5 Pay Proportionate Share of Operating Costs.............9 4.6 No Nuisance...........................................10 4.7 Comply with Laws, etc.................................10 4.8 Comply with Rules and Regulations.....................10 4.9 Goods, Chattels, etc. Not to be removed...............11 4.10 Use of Demised Premises...............................11 4.11 Continuous Occupation.................................11 4.12 Signs.................................................11 4.13 Peaceful Surrender....................................11 4.14 Condition at Expiration...............................12 4.15 Removal of Fixtures...................................12 4.16 Use of Washrooms......................................12 4.17 Overloading...........................................12 4.18 Nuisance and Waste....................................13 ARTICLE DESCRIPTION PAGE - ------- ----------- ---- 4.19 Access................................................13 4.20 Use of Yard Areas.....................................13 4.21 No Auction............................................13 4.22 Estoppel Certificates.................................13 4.23 Landlord May Perform Tenant's Covenants...............14 ARTICLE 5 LANDLORD'S COVENANTS 5.1 Quiet Enjoyment.......................................14 5.2 Taxes.................................................14 5.3 Management, Operation and Maintenance.................14 ARTICLE 6 INSURANCE AND INDEMNITY 6.1 Tenant Insurance......................................15 6.2 Details of Policies...................................15 6.3 Proof of Insurance....................................16 6.4 Priority of Claims....................................16 6.5 Acts Conflicting with Insurance.......................16 6.6 Indemnity to the Landlord.............................16 6.7 Further Indemnity.....................................17 6.8 Landlord not Responsible for Injuries, Loss, Damage...17 6.9 No Liability for Indirect Damages.....................17 6.10 Landlord Insurance....................................18 ARTICLE 7 REPAIRS AND ALTERATIONS 7.1 Repairs...............................................18 7.2 Alterations...........................................19 7.3 Notice of Accidents, Defects, etc.....................20 7.4 Care of Demised Premises..............................20 7.5 Landlord's Right to do Work...........................21 7.6 Landlord's Right to Inspect and Display Sign..........22 7.7 Landlord's Repairs....................................23 ARTICLE 8 TRANSFER AND ASSIGNMENT 8.1 Assigning or Subletting...............................23 8.2 No Release............................................24 8.3 Change of Control.....................................24 8.4 Right of Landlord to Terminate........................24 8.5 Sale by Landlord......................................25 ARTICLE 9 DAMAGE OR DESTRUCTION 9.1 Damage or Destruction Without Termination.............25 9.2 Damage or Destruction with Termination................25 9.3 Damage or Destruction of Building.....................26 ARTICLE DESCRIPTION PAGE - ------- ----------- ---- ARTICLE 10 DEFAULT AND RE-ENTRY 10.1 Re-entry 26 10.2 Bankruptcy............................................27 10.3 Waiver of Exemption from Distress.....................27 10.4 Follow Chattels.......................................28 10.5 Overlooking and Condoning.............................28 ARTICLE 11 SUBORDINATION 11.1 Subordination.........................................28 ARTICLE 12 NOTICES 12.1 Notices .............................................29 ARTICLE 13 MISCELLANEOUS PROVISIONS 13.1 Unavoidable Failures or Delays........................30 13.2 Entire Agreement......................................30 13.3 Subdivision...........................................30 13.4 Registration..........................................31 13.5 Net Lease Intent......................................31 13.6 Time of Essence.......................................31 13.7 Binding Effect........................................31 13.8 Relocation of Demised Premises........................32 Schedule "A" Demised Premises Schedule "B" Legal and Municipal Descriptions Schedule "C" Rules and Regulations Schedule "D" Hazardous Substances Schedule "E" Indemnity Agreement Schedule "F" Special Provisions EX-11.1 6 STATEMENT OF EARNING PER SHARE EXHIBIT 11.1 APPLIED DIGITAL ACCESS, INC. ---------------------------- STATEMENT REGARDING COMPUTATION OF NET INCOME (LOSS) PER SHARE (Amounts in thousands, expect per share data)
YEAR ENDED DECEMBER 31, ----------------------- 1994 1995 1996 ---- ---- ---- Net income (loss)........................... $10,620 $759 ($7,120) ======= ==== ======= Reconciliation of weighted average number of shares outstanding to amount used in net income (loss) per share computation: Weighted average number of common share outstanding.................... 10,542 11,806 12,084 Weighted average number of options and warrants outstanding........................ 1,549 1,042 -- ----- ----- ----- Weighted average number of common shares and common share equivalents outstanding.... 12,091 12,848 12,084 ====== ====== ====== Net income (loss) per share................. $0.88 $0.06 ($0.59) ===== ===== ======
- -------------------------------- Computational Notes: See Note 2 to Financial Statements EX-13.1 7 VALUATION AND QUALIFYING ACCOUNTS MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Except for the historical information contained herein, the matters discussed in this Annual Report may contain forward-looking statements which involve risk and uncertainties. Factors that may affect the Company's results of operations are discussed in detail in "Risks and Uncertainties" below, including but not limited to customer delays in reengineering programs, decreased capital expenditures by several of the Company's customers, the impact of reorganizations, restructurings and reductions-in-force at several of the Company's RBOC customers; deregulation of the telecommunications industry; and the highly competitive market surrounding the Company's CTS and NIU products. The Company believes that deregulation and the resulting increased number of competitors providing telecommunications services could result in an expansion of the Company's customer base and increased competition with regard to service levels and costs, ultimately causing an increased demand for the Company's products. However, additional delays in the deployment of the Company's products and continued uncertainty surrounding the telecommunications industry may have a material adverse impact on the Company's business, operating results and financial condition. As a result of the uncertainties faced by the Company's customers, the Company continues to have limited visibility with regard to future customer orders and the timing of such orders. Customers have been placing orders quarterly and the Company has been operating in a book and ship mode. With a small customer base and fluctuating order size, this trend has resulted in quarter-to-quarter revenue fluctuations that are likely to continue for the foreseeable future. While the outlook contained in any forward-looking statements represents management's current judgment on the future direction of the business, the risks and uncertainties discussed herein could cause actual results to differ materially from any future performance suggested herein. The Company undertakes no obligation to revise or update these forward-looking statements to reflect events or circumstances arising after the date hereof. OVERVIEW In October 1996, the U.S. Patent and Trademark Office granted the Company a patent for technology used in the Company's Remote Module product, a unique DS1 Network Interface Unit ("NIU"). The Remote Module, when used with the Company's T3AS Performance Monitoring and Test System, and Sectionalizer Operations Systems ("OS") software, enables service providers to determine whether circuit troubles originated in their network or the customers'. On July 16, 1996, the Company acquired certain assets of MPR Teltech Ltd., ("MPR Teltech") a subsidiary of BC TELECOM, Inc. The assets acquired were part of MPR Teltech's operating unit commonly known as the Special Services Networks division ("SSN"). The Company and its Canadian subsidiary, Applied Digital Access - Canada, Inc. ("ADA-Canada"), acquired the assets for $4.2 million in cash and 150,000 shares of the Company's common stock. The total purchase valuation was $5.3 million. The Company also incurred $.2 million in related acquisition costs. SSN was an operations systems software development group with expertise in development of network management systems for public carriers. SSN developed operations systems ("OS") software primarily for Northern Telecom Limited ("Nortel"). SSN became part of ADA-Canada which provides development services related to network performance management OS software products for the Company and its customers, including Nortel. The Company incurred a $2.1 million one-time charge in the third quarter of 1996 for purchased research and development related to the asset acquisition. In connection with the acquisition, the Company also licensed certain technology from Nortel for Network Performance Management applications. On February 29, 1996, the Company acquired certain assets of Applied Computing Devices, Inc. ("ACD"), a company that developed and marketed OS software used primarily by independent telephone companies to manage certain functions in their networks. The customer set and products of ACD complemented those of ADA, and ADA has continued to market and enhance these products. The Company acquired the assets for $1.7 million in cash and incurred approximately $.2 million in related costs. The assets were acquired at an auction held in Federal Bankruptcy Court, Southern District of Indiana. After filing for bankruptcy in September 1995, ACD did not generate significant revenue. The Company recorded a one-time charge of approximately $1.2 million associated with purchased research and development in the first quarter of 1996 as a result of the acquisition. 1 In February 1996, the settlement of a class action lawsuit filed against the Company and two of its officers in March 1995 was finalized and received court approval. The litigation was settled for $1.5 million, of which the Company was obligated to pay approximately $.4 million with the remainder paid by the Company's directors' and officers' liability insurance carrier. The costs associated with the suit were accrued in 1995. Taking the developments discussed above and the elements discussed elsewhere, both individually and in the aggregate, there can be no assurance that the Company will maintain current revenue or operating results levels or that revenue or operating results will increase. 2 RESULTS OF OPERATIONS The following table sets forth certain statements of operations data as a percent of revenue, for the years ended December 31, 1996, 1995 and 1994.
YEARS ENDED DECEMBER 31, 1996 1995 1994 ---- ---- ---- Revenue................................ 100% 100% 100% Cost of revenue........................ 52% 43% 42% --- --- ---- Gross profit........................... 48% 57% 58% Operating Expenses: Research and development............... 30% 28% 15% Purchased in-process research and development related to 13% - - acquisitions..... Sales and marketing.................... 26% 21% 9% General and administrative............. 5% 14% 7% --- --- --- Total operating expenses............... 84% 63% 31% ---- ---- ---- Operating income (loss)................ (36)% (6)% 27% Other income (expense), net............ 7% 10% 4% --- ---- --- Income (loss) before (29)% 4% 31% income taxes........................... Provision for income taxes............. - - (1)% --- --- ----- Net income (loss)...................... (29)% 4% 30% ===== ===== ===
1996 COMPARED WITH 1995 Revenue totaled $24,422,000 in 1996, a 19% increase from $20,470,000 in 1995. The increase is primarily the result of revenue generated from network management OS software design services and products acquired through acquisitions during 1996. Revenue from the Company's T3AS products and services totaled $18,144,000 in 1996, an 11% decrease from $20,470,000 in 1995. The decrease was the result of lower T3AS sales compared to last year due to decreased capital expenditures by several of the Company's customers, the highly competitive market for the Company's CTS and NIU products, and the impact of regulatory actions on the Company's customers. Revenue from OS services and products totaled $6,278,000 in 1996. The Company did not have any OS product revenue in 1995. In 1996, US WEST, NYNEX, and Northern Telecom accounted for 31%, 23%, and 15% of the Company's revenue, respectively. In 1995, U S WEST, Ameritech, NYNEX and Bell South accounted for 45%, 19%, 18% and 13% of the Company's revenue, respectively. The Company expects that revenue from sales of the T3AS product family and recently acquired OS products and services will account for a majority of the Company's revenue for the foreseeable future. Gross profit totaled $11,813,000 in 1996, a slight increase from $11,753,000 in 1995. Gross profit as a percent of revenue was 48% in 1996 compared to 57% in 1995. The decrease in gross profit as a percent of revenue resulted primarily from a product mix weighted toward lower margin T3AS products and services and lower-margin revenue from OS software design services. The majority of the Company's Canadian subsidiary's operations supported OS software design services. Since the cost of design services revenue includes both direct and indirect costs of supplying the services, the majority of the Canadian subsidiary's operating costs are included in cost of revenue. There can be no assurance that the Company will be able to maintain current gross profit or gross profit as a percent of revenue levels. Factors which may materially and adversely affect the Company's gross profit in the future include its level of revenue, competitive pricing pressures in the telecommunication network management 3 market, new product introductions by the Company or its competitors, potential inventory obsolescence and scrap, possible recalls, production or quality problems, timing of development expenditures, changes in material costs, disruptions in sources of supply, regulatory changes, seasonal patterns of bookings, capital spending, and changes in general economic conditions. Research and development expenses totaled $7,356,000 in 1996, a 27% increase from $5,807,000 in 1995. The increase was primarily due to the addition of research and development personnel as a result of the ACD asset acquisition, increases in depreciation expense, and increases in non-recurring engineering (NRE) expenses due to timing of planned development projects during 1996 compared to 1995. Research and development personnel expenses increased 26% compared to 1995, mostly related to the ACD asset acquisition. The Company believes that its future success depends on its ability to maintain its technological leadership through enhancement of its existing products and development of innovative new products and services that meet customer needs. Therefore, the Company intends to continue to make significant investments in research and product development in association with planned development projects. In 1996, the Company recorded one-time charges for purchased research and development costs related to the ACD asset acquisition and the SSN asset acquisition of $1,186,000 and $2,100,000, respectively. Sales and marketing expenses totaled $6,312,000 in 1996, a 49% increase from $4,234,000 in 1995. The majority of the increase resulted from the addition of technical customer support personnel, the addition of customer support and marketing personnel related to the ACD asset acquisition, and increased promotional expenses. The Company expects that sales and marketing expenses will continue to increase in absolute dollars as the Company continues to hire additional sales, marketing and technical support personnel to support planned product introductions in both the network systems and network management business areas. General and administrative expenses totaled $3,576,000 in 1996, a 20% increase from $2,985,000 in 1995. The majority of the increase is the net result of increased expenses for the amortization of goodwill and intangibles related to the SSN asset acquisition and increased personnel expenses related to this year's acquisitions offset by a decrease in legal expenses compared to 1995 as a result of greater legal expense in 1995 related to the suit settlement. The Company expects that general and administrative expenses will increase in absolute dollars as the Company invests in the expansion of its internal networking capabilities related to the ACD and SSN asset acquisitions and the expected need for additional support personnel. Interest income totaled $1,673,000 in 1996, a 17% decrease from $2,023,000 in 1995. The decrease is the result of a decrease in cash investments during 1996 compared to 1995. In 1996, the Company provided for income taxes related to the operations of the Company's Canadian subsidiary, based on an effective Canadian tax rate of 46%. The Company did not provide for U.S. income taxes in 1996 or 1995 due to net losses for income tax purposes. At December 31, 1996, the Company had federal income tax- loss carry-forwards of approximately $12,987,000 and California state income tax-loss carry-forwards of approximately $5,835,000. The Company's use of approximately $1,166,000 of its federal tax-loss carry-forwards, and $408,000 of its federal and $105,000 of its California tax credit carryforwards are significantly limited as a result of ownership changes associated with equity financings in January 1989 and March 1991. Management is not able to estimate levels of tax deductions which will be generated as a result of these transactions in future periods. See Note 11 of Notes to Financial Statements. As a result of the factors discussed above, the Company incurred a net loss of $7,120,000, or $.59 per share in 1996 compared to net income of $759,000, or $.06 per share in 1995. Excluding $3,286,000 in one-time charges for purchased research and development costs associated with the ACD and SSN asset acquisitions, the Company incurred a net loss of $3,834,000, or $.32 per share in 1996. 4 1995 COMPARED WITH 1994 Revenue totaled $20,470,000 in 1995 a 42% decrease from $35,597,000 in 1994. The decrease is attributable to decreased sales of the Company's T3AS products. In 1995, US WEST, Ameritech, NYNEX and Bell South accounted for 45%, 19%, 18% and 13% of the Company's revenue, respectively. In 1994, U S WEST, Ameritech, NYNEX and Bell South accounted for 36%, 32%, 16% and 14% of the Company's revenue, respectively. The majority of the Company's revenue in 1995 and 1994 was derived from the sale of T3AS products. Factors which may have contributed to the decrease in sales of the Company's products during 1995 include one major customer delaying its reengineering program; decreased capital spending at two of the Company's other customers; seasonal capital spending freezes at one of the Company's customers; reorganizations, restructuring and reductions in force at several of the Company's RBOC customers; the negotiations with labor unions establishing new union contracts at six of the seven RBOC's during 1995; the uncertainties surrounding the telecommunications deregulation bill; and the delay in receiving the FCC's informal assessment on the Company's Remote Module product. Gross profit totaled $11,753,000 in 1995, a 43% decrease from $20,791,000 in 1994. The decrease in gross profit was due primarily to decreased sales of the Company's T3AS products. As a percent of revenue, gross profit was 57% in 1995 compared to 58% in 1994. Research and development expenses totaled $5,807,000 in 1995, a 9% increase from $5,335,000 in 1994. Research and development personnel related expenses increased 19% in 1995 compared to 1994. The increases were primarily the result of the addition of research and development personnel, partially offset by decreases in non-recurring engineering expenses caused by timing of planned development projects compared to 1994. Sales and marketing expenses totaled $4,234,000 in 1995, a 26% increase from $3,363,000 in 1994. The increase in 1995 was primarily the result of increases in technical support, marketing, and sales personnel, increased travel expenses and increased promotional activity offset by lower commission expenses owing to decreased revenue levels. General and administrative expenses totaled $2,985,000 in 1995, a 28% increase from $2,337,000 in 1994. The increase was primarily the result of a non-recurring charge for the settlement of a class action law suit filed against the Company in March 1995, and increased consulting expenses related to the Company's recruiting efforts for additional personnel. The increases were partially offset by decreases in travel and professional services expense. Interest income totaled $2,023,000 in 1995, a 67% increase from $1,212,000 in 1994. The increase was due primarily to an increase in investment income from the investment of cash proceeds from the Company's initial public offering of common stock completed in April 1994, as well as the investment of cash provided from operations. The Company did not provide for income tax expenses in 1995 due to a net loss for income tax purposes. In 1994, the Company's effective tax rate was 3%. The Company's low effective tax rate for 1994 was a result of the utilization of operating loss carryforwards and tax credits and the tax benefit resulting from the recognition of certain deferred tax assets which had previously been reserved for in recognition of concerns over the Company's ability to realize these assets under the Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS No. 109"). SFAS No. 109 allows the Company to utilize available tax-loss carry-forwards as a direct reduction of its income tax expense. During 1994, the Company's income taxes payable were reduced as a result of tax deductions generated from certain stock option transactions which are not reflected in the statement of operations. Under generally accepted accounting principles, such amounts are recorded as additional paid-in capital. As a result of the factors discussed above, 1995 net income totaled $759,000, or $.06 per share, a 93% decrease from net income of $10,620,000, or $.88 per share in 1994. QUARTERLY RESULTS 5 The Company has experienced significant fluctuations in bookings, revenue and operating results from quarter to quarter due to a combination of factors and expects such fluctuations to continue in future periods. Factors that may cause the Company's bookings, revenue and operating results to vary significantly from quarter to quarter include, among others: dependence on a single product lines in the Network Systems and Network Management business units; dependence on a small group of major customers; the timing of significant orders; the timing of shipments; competition and pricing in the telecommunication network management market; new product introductions by the Company or its competitors; possible recalls; production or quality problems; timing of development expenditures; further expansion of marketing and service operations; changes in material costs; disruptions in sources of supply; regulatory changes; seasonal patterns of bookings, capital spending and payment by customers; and changes in general economic conditions. Because of the relatively fixed nature of most of the Company's costs, including personnel and facilities costs, any unanticipated shortfall in revenue in any fiscal quarter would have a proportionately greater impact on the Company's operating income in that quarter and may result in fluctuations in the price of the Company's Common Stock. LIQUIDITY AND CAPITAL RESOURCES Cash and investments totaled $21,461,000 at December 31, 1996 and $31,847,000 at December 31, 1995. The 1996 decrease in cash and investments compared to 1995 is primarily due to cash payments related to the SSN and ACD asset acquisitions, and 1996 operating losses. Net working capital totaled $31,229,000 at December 31, 1996 and $36,728,000 at December 31, 1995. The 1996 decrease in working capital compared to 1995 was primarily the result of cash payments related to the SSN and ACD asset acquisitions. The Company's 1996 operating activities used $2,265,000 in cash primarily as a result of net operating losses. In 1995, operating activities used $4,384,000 in cash due to decreased net income compared to 1994 and increases in accounts receivable and inventory compared to 1994. In 1996, cash used for the ACD and SSN asset acquisitions and related acquisition costs totaled $1,900,000 and $4,456,000, respectively. The majority of tangible assets acquired from ACD and SSN consisted of computer equipment. Cash used for capital expenditures totaled approximately $1,709,000 in 1996 and $1,948,000 in 1995. Most of the capital equipment additions were for the purchase of computer and lab equipment to support the Company's expanded research and development efforts. The Company did not acquire any capital equipment through capital lease arrangements in 1996 or 1995. The Company expects that the level of capital expenditures will increase in 1997 as a result of planned facility moves in Vancouver, British Columbia, Canada, and planned development projects. Assuming no material changes in the Company's current operating plans, the Company believes that cash generated from operations and the total of its cash and investments, will be sufficient to meet its working capital and capital expenditure requirements for at least the next twelve months. Significant additional capital resources, however, may be required to fund acquisitions of complementary businesses, products or technologies. Alternatively, the Company may need to issue additional shares of its capital stock or incur indebtedness in connection with any such acquisitions. At present, the Company does not have any agreements or commitments with respect to any such acquisition. The Company believes the impact of inflation on its business activities has not been significant to date. 6 APPLIED DIGITAL ACCESS, INC. AND SUBSIDIARY CONSOLIDATED BALANCE SHEET
(Dollars in thousands) YEARS ENDED DECEMBER 31, 1996 1995 ASSETS Current Assets: Cash and cash equivalents $ 1,504 $ 1,673 Investments 19,957 25,079 Accounts receivable, less allowance for doubtful accounts of $50 6,798 5,358 Inventory, net 7,363 6,572 Deferred income taxes 130 750 Prepaid expenses and other current assets 1,089 1,296 -------- ------- Total current assets 36,841 40,728 Investment - non-current --- 5,095 Property and equipment, net 4,936 3,361 Intangible assets, net 2,823 --- Deferred income taxes 1,372 752 Total assets -------- ------- $ 45,972 $49,936 ======== ======= LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable $ 2,120 $ 1,820 Accrued expenses 1,491 843 Accrued warranty 1,398 1,305 Current portion of obligations under capital leases 16 32 Deferred revenue 587 --- -------- ------- Total current liabilities 5,612 4,000 Obligation under capital leases, net of current portion 33 49 -------- ------- Total liabilities 5,645 4,049 -------- ------- Commitments and contingency Shareholders' equity: Preferred stock, no par value 7,500,000 shares authorized, no shares issued --- --- Common stock, no par value, 30,000,000 shares authorized, 11.899,216 and 12,255,334 shares issued and outstanding at December 31, 1995 and 1996, respectively 50,631 49,000 Additional paid-in capital 2,492 2,492 Unrealized gain on investments 25 147 Deferred compensation (50) (101) Accumulated deficit (12,771) (5,651) -------- ------- Total shareholders' equity 40,327 45,887 -------- ------- Total liabilities and shareholders' equity $ 45,972 $ 49,936 ======== ========
The accompanying notes are an integral part of the financial statements 7 APPLIED DIGITAL ACCESS, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF OPERATIONS
(Dollars in thousands, except per-share date) YEARS ENDED DECEMBER 31, 1996 1995 1994 Revenue $ 24,422 $ 20,470 $ 35,597 Cost of revenue 12,609 8,717 14,806 -------- ---------- -------- Gross profit 11,813 11,753 20,791 -------- ---------- -------- Operating expenses: Research and development 7,356 5,807 5,335 In-process research and development related to acquisitions 3,286 --- --- Sales and marketing 6,312 4,234 3,363 General and administrative 3,576 2,985 2,337 -------- ---------- -------- Total operating expenses 20,530 13,026 11,035 -------- ---------- -------- Operating income (loss) (8,717) (1,273) 9,756 Interest income 1,673 2,023 1,212 Other income (expenses), net 47 9 (32) -------- ---------- -------- Income (loss) before income taxes (6,997) 759 10,936 Provision for income taxes 123 --- 316 -------- ---------- -------- Net income (loss) $ (7,120) $ 759 $ 10,620 -------- ---------- -------- Net income (loss) per share $ ( .59) $ .06 $ .88 ======== ========== ======== Shares used in per-share computations 12,084 12,848 12,091 ======== ========== ========
The accompanying notes are an integral part of the financial statements 8
DOLLARS IN THOUSANDS CONVERTIBLE PREFERRED STOCK SERIES A SERIES B SERIES C SERIES D SERIES E COMMON STOCK -------- -------- -------- -------- -------- ------------ BALANCE, JANUARY 1, 1994 1,000 $ 5,000 $ 768 $ 7,773 $ 4,664 $ 88 Issuance of 2,590,000 shares of common stock initial public offering, net of costs -- -- -- -- -- 28,357 Conversion of preferred stock into 7,872,199 shares of common stock upon completion of intial public offering (1,000) (5,000) (768) (7,773) (4,664) 19,205 Excercise of stock options and warrants for 592,026 shares of common stock -- -- -- -- -- 95 Issuance of 52,134 shares of common stock under stock purchase plan -- -- -- -- -- 536 Unrealized loss on investments -- -- -- -- -- -- Amoritization of deferred compensation related to stock options -- -- -- -- -- -- Repayment of note receivable -- -- -- -- -- -- Tax effect of options excercised -- -- -- -- -- -- Net income -- -- -- -- -- -- BALANCE, DECEMBER 31, 1994 -- -- -- -- -- 48,281 Excercise of stock options and warrants for 261,662 shares of common stock -- -- -- -- -- 76 Issuance of 62,493 shares of common stock under stock purchase plan -- -- -- -- -- 643 Unrealized gain on investments -- -- -- -- -- -- Amoritization of deferred compensation related to stock options -- -- -- -- -- -- Net income -- -- -- -- -- -- BALANCE DECEMBER 31, 1995 -- -- -- -- -- 49,000 Excercise of stock options for 149,263 shares of common stock -- -- -- -- -- 115 Issuance of 56,857 shares of common stock under stock purchase plan -- -- -- -- -- 428 Unrealized loss on investments -- -- -- -- -- -- Amoritization of deferred compensation related to stock options -- -- -- -- -- -- Issuance of 150,000 shares of common stock in connection with acquisition -- -- -- -- -- 1,088 Net loss -- -- -- -- -- -- BALANCE, DECEMBER 31, 1996 -- -- -- -- -- $ 50,631
DOLLARS IN THOUSANDS NOTES UNREALIZED RECEIVABLE ADDITIONAL GAIN (LOSS) ON DEFERRED FROM COMMON ACCUMULATED PAID-IN CAPITAL INVESTMENTS COMPENSATION SHAREHOLDERS DEFICIT TOTAL --------------- ----------- ------------ ------------ ------- ----- BALANCE, JANUARY 1, 1994 $ 1,043 $ -- $ (205) $ (19) $ (17,030) $ 3,082 Issuance of 2,590,000 shares of common stock initial public offering, net of costs -- -- -- -- -- 28,357 Conversion of preferred stock into 7,872,199 shares of common stock upon completion of intial public offering -- -- -- -- -- -- Excercise of stock options and warrants for 592,026 shares of common stock -- -- -- -- -- 95 Issuance of 52,134 shares of common stock under stock purchase plan -- -- -- -- -- 536 Unrealized loss on investments -- (436) -- -- -- (436) Amoritization of deferred compensation related to stock options -- -- 52 -- -- 52 Repayment of note receivable -- -- -- 19 -- 19 Tax effect of options excercised 1,449 -- -- -- -- 1,449 Net income -- -- -- -- 10,620 10,620 BALANCE, DECEMBER 31, 1994 2,492 (436) 153 -- (6,410) 43,774 Excercise of stock options and warrants for 261,662 shares of common stock -- -- -- -- -- 76 Issuance of 62,493 shares of common stock under stock purchase plan -- -- -- -- -- 643 Unrealized gain on investments -- 583 -- -- -- 583 Amoritization of deferred compensation related to stock options -- -- 52 -- -- 52 Net income -- -- -- -- 759 759 BALANCE DECEMBER 31, 1995 2,492 147 (101) -- (5,651) 45887 Excercise of stock options for 149,263 shares of common stock -- -- -- -- -- 115 Issuance of 56,857 shares of common stock under stock purchase plan -- -- -- -- -- 428 Unrealized loss on investments -- (122) -- -- -- (122) Amoritization of deferred compensation related to stock options -- -- 51 -- -- 51 Issuance of 150,000 shares of common stock in connection with acquisition -- -- -- -- -- 1,088 Net loss -- -- -- -- (7,120) (7,120) BALANCE, DECEMBER 31, 1996 $ 2,492 $ 25 $ (50) $ -- $ (12,771) $40,327
The accompanying notes are an integral part of the financial statements. 9 APPLIED DIGITAL ACCESS, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS ----------
Years Ended December 31, 1996 1995 1994 ---- ---- ---- CASH FLOWS FROM OPERATING ACTIVITIES: Net income (loss) $ (7,120) 759 10,620 Adjustments to reconcile net income (loss) to net cash provided (used) by operating activities: In-process research and development related to acquisitions 3,286 --- --- Depreciation and amortization 1,819 904 708 Amortization of discount or premium on investments 95 119 (132) Amortization of deferred compensation 51 52 52 Change in accounts receivable and inventory reserves (68) 103 133 Changes in operating assets and liabilities Accounts receivable (1,440) (2,792) (150) Inventory (732) (2,232) (3,070) Deferred income taxes --- --- (52) Prepaid expenses and other current assets 207 (327) (825) Accounts payable 300 (440) 381 Accrued expenses 648 (515) 467 Accrued warranty 93 (15) 834 Deferred revenue 587 --- --- ---------- --------- --------- Net cash provided (used) by operating activities (2,265) (4,384) 8,966 ---------- --------- --------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchases of investments (20,923) (33,863) (48,166) Maturities of investments 30,923 38,595 13,419 Purchases of property and equipment (1,709) (1,948) (1,888) Purchase costs related to asset acquisitions (6,356) --- --- Purchase of license agreement (350) --- --- ---------- --------- --------- Net cash provided (used) by investing activities 1,585 2,784 (36,635) ---------- --------- --------- CASH FLOWS FROM FINANCING ACTIVITIES: Principal payments on obligations under capital leases (32) (126) (522) Proceeds from repayment of note receivable from related party --- --- 19 Proceeds from exercise of stock options and warrants 115 76 95 Proceeds from issuance of common stock, net of costs 428 643 28,893 ---------- --------- --------- Net cash provided by financing activities 511 593 28,485 ---------- --------- --------- Net increase (decrease) in cash and cash equivalents (169) (1,007) 816 Cash and cash equivalents at beginning of year 1,673 2,680 1,864 ---------- --------- --------- Cash and cash equivalents at end of year $ 1,504 $ 1,673 $ 2,680 ========== ========= =========
The accompanying notes are an integral part of the financial statements. 10 APPLIED DIGITAL ACCESS, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. NATURE OF OPERATIONS: Applied Digital Access, Inc. and subsidiary (the "Company") designs, engineers and manufactures network test and performance monitoring systems, software and services for the management and test of telecommunication circuits. Current sales are concentrated with "Regional Bell Operating Companies" or affiliated companies in the United States and Canada. The market for the Company's products is characterized by rapid technological advances, evolving industry transmission standards, changes in customer requirements and frequent new product introductions and enhancements. The introduction of telephone network test and performance monitoring products involving superior technologies or the evolution of alternative technologies or new industry transmission standards could render the Company's existing products, as well as products currently under development, obsolete and unmarketable. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary, Applied Digital Access - Holding, Inc. and its wholly-owned subsidiary, Applied Digital Access - Canada, Inc. ("ADA-Canada"). All intercompany transactions and balances have been eliminated. CASH AND CASH EQUIVALENTS Cash and cash equivalents consist of cash and short-term investments with original maturities of 90 days or less when purchased. INVENTORY Inventory is stated at the lower of cost or market using the first-in, first-out method. The Company currently buys certain key components of its products from a limited number of suppliers. Although there are a limited number of suppliers of the components, management believes that other suppliers could provide similar key components on comparable terms. A change in suppliers, however, could cause a delay in manufacturing and a possible loss of sales, which would adversely affect operating results. INVESTMENTS The Company determines the appropriate classification of its debt securities at the time of purchase and re-evaluates such designations at each balance sheet date. Investments are classified as "available for sale" and are carried at their fair value. Realized gains and losses are determined using the specific identification method and are included in other income. Gross unrealized holding gains or losses are excluded from earnings and reported, net of the related tax effect, as a separate component of shareholders' equity. The amortized cost of debt securities is adjusted for the amortization of premiums and accretion of discounts to maturity. Such amortization is included in interest income. Fair value is determined based on quoted market prices. PROPERTY AND EQUIPMENT Property and equipment is stated at cost and depreciated over the estimated useful lives of the assets (3 to 7 years) using the straight-line method. Leased property meeting certain criteria is capitalized and the present value of the related lease payments is recorded as an obligation. Amortization of capitalized leased assets is computed on the straight-line method over the shorter of the lease term or the assets' estimated useful lives. Maintenance and repairs are charged to expense as incurred. Upon the retirement or other disposition, the property and related accumulated depreciation or amortization are removed from the accounts and any resulting profit or loss is reflected in income. 11 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED: INTANGIBLE ASSETS The Company amortizes costs in excess of fair value of net assets of businesses acquired using the straight-line method over 3 to 5 years. Recoverability is reviewed annually or sooner if events or changes in circumstances indicate that the carrying value may exceed fair value. REVENUE RECOGNITION Revenue is generally recognized at the time of shipment or delivery, based on specified shipping terms, or when services have been performed. When customer acceptance criteria are specified in the customer order, revenue recognition is deferred until the acceptance criteria are met. INCOME TAXES Deferred income taxes are recognized for the tax consequences in future years for differences between the tax basis of assets and liabilities ("temporary differences") and their financial reporting amounts at each year end based on enacted tax laws and statutory rates applicable to the periods in which the temporary differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. Income tax expense is the tax payable for the period and the change during the period in deferred tax assets and liabilities. ADVERTISING COSTS Advertising costs are expensed as incurred. Total advertising expense was approximately $88,000, $141,000 and $217,000 for the years ended December 31, 1994, 1995 and 1996, respectively. STOCK-BASED COMPENSATION Statement of Financial Accounting Standards ("SFAS") No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION, encourages, but does not require, companies to record compensation cost for stock-based employee compensation plans at fair value. The Company has chosen to continue to account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES and related interpretations. Accordingly, options granted at below fair market value result in deferred compensation to the extent of the difference between the fair market value at the date of grant and the exercise price. The deferred compensation is charged to earnings ratably over the vesting period. During the three year period ended December 31, 1996, no options were granted at below fair market value. PER SHARE INFORMATION Net income (loss) per share is computed using the weighted average number of common shares and common equivalent shares (when the effect is dilutive) USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from estimates. 12 3. STATEMENTS OF CASH FLOWS:
Non-cash investing and financing activities are as follows: Years Ended December 31, ------------------------ (Dollars in thousands) 1994 1995 1996 ---------------------- ---- ---- ---- Property and equipment acquired with capital lease financing $ 189 $- $ - Conversion of preferred stock upon completion of initial public offering 19,205 - - Issuance of stock in connection with acquisition - - 1,088 Cash payments for interest and income taxes are as follows: Years Ended December 31, ------------------------ (Dollars in thousands) 1994 1995 1996 ---------------------- ---- ---- ---- Interest $ 53 $ 13 $ 7 Income taxes 144 506 -
4. INVESTMENTS: Marketable securities at December 31, 1995 and 1996 consist of obligations of the U.S. Government and its agencies and are summarized as follows:
Years Ended December 31, ------------------------ (Dollars in thousands) 1995 1996 ---- ---- Cost $ 30,027 $ 19,936 Gross unrealized gains 148 57 Gross unrealized losses (1) (36) --------- ------- Estimated fair value $ 30,174 $19,957 ========= =======
5. INVENTORY: Inventory at December 31, 1995 and 1996 consists of the following:
(Dollars in thousands) 1995 1996 ---------------------- ---- ---- Raw materials $3,483 $4,211 Work-in-process 2,314 2,558 Finished goods 1,313 1,063 ------ ------ 7,110 7,832 Less inventory reserve (538) (469) ------ ------ $6,572 $7,363 ====== ======
13 6. PROPERTY AND EQUIPMENT: Property and equipment at December 31, 1995 and 1996 consists of the following:
(Dollars in thousands) 1995 1996 ---------------------- ---- ---- Computers $2,500 $4,254 Machinery, furniture and equipment 2,716 3,614 Purchased computer software 729 894 Leasehold improvements 640 766 ------ ------ 6,585 9,528 Less accumulated depreciation and amortization (3,224) (4,592) ------ ------ $3,361 $4,936 ====== ======
Property and equipment acquired under capital leases totaled approximately $444,000 and $216,000 at December 31, 1995 and 1996, respectively. Accumulated amortization related to assets under capital leases totaled approximately $299,000 and $106,000 as of December 31, 1995 and 1996, respectively. 7. INTANGIBLE ASSETS: Intangible assets at December 31,1996 consist of the following:
(Dollars in thousands) 1996 Goodwill and know-how $2,588 Purchased technology, customer contracts 337 License agreement 350 ------ 3,275 Less accumulated amortization (452) ------ $2,823 ======
8. ACCRUED EXPENSES: Accrued expenses at December 31, 1995 and 1996 consist of the following:
(Dollars in thousands) 1995 1996 ---------------------- ---- ---- Accrued payroll and related costs $ 489 $ 443 Income taxes - 444 Accrued vacation 316 431 Other 38 173 ----- ------ $ 843 $1,491 ===== ======
14 9. COMMITMENTS AND CONTINGENCY: LEASES The Company leases office space and equipment under operating leases. Certain of these leases include renewal or purchase options. Rent expense related to these leases was approximately $288,000, $386,000 and $613,000 for the years ended December 31, 1994, 1995 and 1996, respectively. The Company also leases certain property and equipment under capital leases. Minimum commitments under these leases are as follows:
(Dollars in thousands) Operating Capital Year ending December 31, Leases Lease ------------------------ ------ ----- 1997 $ 788 $20 1998 1,064 20 1999 1,049 15 2000 732 - 2001 756 - Thereafter 1,392 - -------- ------ Total minimum lease payments $5,781 55 ======== ====== Less amounts representing interest (6) ------ Obligations under capital leases 49 Less current portion (16) ------ $33 ======
PURCHASE COMMITMENTS At December 31, 1996, the Company has open purchase commitments of approximately $3,731,000 which include approximately $2,264,000 of cancelable purchase commitments. LEGAL PROCEEDING In March 1995, a class action lawsuit was filed against the Company and two of its officers, one of whom is also a director of the Company, in the U.S. District Court for the Southern District of Southern California. The suit alleged violations of Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934, as amended (the "Act"), arising out of alleged misrepresentations and omissions made by the Company and the named officers. The suit also alleged violation of Section 20(a) of the Act arising out of alleged "control" of the Company by the officer defendants. The suit was brought on behalf of purchasers of the Company's securities during the period October 10, 1994 through March 29, 1995, and sought unspecified damages. In December 1995, the Company entered into a settlement agreement pursuant to which all claims were dismissed with prejudice. The total settlement amount was approximately $1,500,000, of which the Company paid approximately $446,000 with the remaining amount paid by the Company's Directors' and Officers' liability insurance carriers. Obligations of the Company with respect to this matter were provided for in the financial statements during the year ended December 31, 1995 and paid during the year ended December 31, 1996. 10. SHAREHOLDERS' EQUITY: In April 1994, the Company completed the initial public offering of its shares of common stock, at a price of $12.00 per share including 2,200,000 which were sold by the Company and 400,000 which were sold by existing shareholders. In addition, the Company's underwriters also exercised an option to purchase an additional 390,000 15 shares to cover over-allotments. The net proceeds realized by the Company from this offering were $28.4 million after deducting the underwriting discount and expenses payable by the Company related to the offering. Effective upon the closing of the offering, 55,105,577 shares of preferred stock were converted into 7,872,199 shares of common stock after giving effect to the 1-for-7 reverse stock split. In March 1994, the Company's Articles of Incorporation were amended authorizing 30,000,000 shares of common stock, no par value, and 7,500,000 shares of preferred stock, no par value. The preferred stock may be issued from time to time in one or more series with the Board of Directors authorized to fix or alter the designation, powers, preferences and rights of the shares of each series. STOCK COMPENSATION PLANS At December 31, 1996, the Company has stock-based compensation plans which are described below. The Company applies Accounting Principles Board Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES, and related interpretations in accounting for its plans. Accordingly, no compensation cost has been recognized for its fixed stock option plans and its stock purchase plan. Had compensation costs for the Company's stock-based compensation plans been determined based on the fair value at the grant dates for awards in 1995 and 1996 under those plans consistent with the methods of SFAS No. 123, the Company's net income (loss) and earnings per share would have been reduced to the pro forma amounts indicated below:
(Dollars in thousands) 1995 1996 Net income (loss): As reported $ 759 $(7,120) Pro forma (195) (8,352) Net income (loss) per common share: As reported $.06 $(.59) Pro forma (.02) (.69)
FIXED STOCK OPTION PLANS In May 1996, the Company adopted the 1996 Non-Qualified Stock Option Plan (the "1996 Plan"). The 1996 Plan does not affect the 1994 Plan. Under the 1996 Plan, the Company is authorized to issue 400,000 shares of common stock. The 1996 Plan is intended to promote the interests of the Company or its parents or subsidiary corporations. Under the 1996 Plan, eligible individuals may be granted options to purchase shares of the Company's common stock at not less than 85% of the fair market value of such shares on the date of grant. Such options shall be exercisable in one or more installments as specified in the Notice of Grant and have a maximum term of 10 years. Persons eligible to receive stock options under the 1996 Plan are key employees of the Company other than officers who are responsible for the growth and financial success of the Company and consultants and other independent contractors who provide valuable services to the Company. In February 1994, the Company adopted the 1994 Stock Option/Stock Issuance Plan (the "1994 Plan"). The 1994 Plan supersedes and consolidates the 1988 Stock Option Plan and Restricted Stock Purchase Plan (the "1988 Plan"). Outstanding stock options and unvested share issuances under the 1988 Plan were incorporated into and assumed in the 1994 Plan. In May of 1996, the Board of Directors received shareholder approval to increase the authorized shares to 3,800,000 under the 1994 Plan. The 1994 Plan is divided into three separate components: the Discretionary Option Grant Program (the "Discretionary Program"); the Automatic Option Grant Program (the "Automatic Program") and the Stock Issuance Program (the "Issuance Program"). Under the Discretionary Program, eligible individuals may be granted options to purchase shares of the Company's stock at not less than 85% of the fair market value of such shares on the date of grant. Under the Automatic Program, non-employee Directors will automatically be granted options to purchase common stock at 100% of the fair market value on the grant date. Under the Issuance Program, eligible individuals may be allowed to purchase shares of the Company's common stock at discounts from the fair market value of such shares of up to 15%. Such shares may be issued as fully-vested shares or as shares to vest over time and have a maximum term of 10 years (5 years for options granted to a 10% shareholder). Persons eligible to receive stock issuances under the Issuance Program and/or option grants under the Discretionary Program are officers and other key employees of the Company and certain consultants or other 16 independent contractors, as defined in the plan. The individuals eligible to receive option grants under the Automatic Program are individuals who are elected, re-elected or appointed as non-employee Board members. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 1995 and 1996: no dividend yield; expected volatility; risk-free interest rates on or about the date of grant represented by the interest rate on U.S. Treasury Bills with a term of maturity equal to the vesting period of the options, and expected lives of 5 years. The following table summarizes stock option transactions for each of the three years in the period ended December 31, 1996:
Weighted Weighted Average Average Exercise Exercise Shares Price Shares Price Outstanding at January 1, 1994 1,711,492 $.39 44,587 $.14 Granted 319,665 $17.36 --- --- Exercised (509,029) $.18 (17,000) $.14 Canceled (82,384) $.43 --- --- ------------- ------------ Outstanding at December 31, 1994 1,439,744 $4.22 27,587 $.14 Granted 737,025 $12.30 --- --- Exercised (205,068) $.35 (10,500) $.14 Canceled (300,392) $18.30 --- --- -------- ------ ------- ------ Outstanding at December 31, 1995 1,671,309 $5.63 17,087 $.14 Granted 874,887 $9.01 --- --- Exercised (149,261) $.77 --- --- Canceled (598,732) $12.01 --- --- -------- ------ ------ ------ Outstanding at December 31, 1996 1,798,203 $5.54 17,087 $.14 ========= ======
The range of exercise prices of stock options outstanding at December 31, 1996 is as follows:
Options Outstanding Options Exercisable ------------------- ------------------- Weighted Average Weighted Weighted Range of Remaining Average Average Exercise Number Contractual Exercise Number Exercise Prices Outstanding Life Price Exercisable Price $.14 - $.28 366,413 4.81 $.16 362,585 $.16 $.42 - $1.05 325,590 6.57 $.46 268,798 $.45 $2.80 - $6.50 304,142 8.85 $5.67 53,374 $3.07 $6.63 - $8.40 460,504 9.54 $8.05 14,005 $7.35 $11.25 - $16.13 341,554 8.72 $12.65 132,264 $12.29 -------------- ------- ------ --------- -------- ------- $.14 - $16.13 1,798,203 7.77 $5.54 831,026 $2.49 ==== ====== ========= ==== ===== ======= =====
17 At December 31, 1995 and 1996, 571,106 and 1,191,381 shares, respectively, are available for granting of options under the 1994 and 1996 Plans. STOCK PURCHASE PLAN The Amended 1994 Employee Stock Purchase Plan, originally adopted in February 1994 (the "Stock Purchase Plan"), authorizes the Company to issue up to 300,000 shares of common stock to participating employees. The Stock Purchase Plan is intended to provide qualifying employees with the opportunity to acquire an interest in the Company by accumulating amounts for the employees' account through payroll deductions and the periodic application of such amounts to the purchase of shares of the Company's common stock. Under the terms of the Stock Purchase Plan, qualified employees can choose each year to have up to 15% of their annual base earnings withheld to purchase the Company's common stock. The purchase price of the stock will be equal to 85% of the lower fair market value of the common stock on (i) the commencement date of the offering period or (ii) the purchase date. The Stock Purchase Plan terminates on December 31, 2003. Under the Stock Purchase Plan, the Company sold 62,493 and 56,857 shares to employees in 1995 and 1996, respectively. There are 128,516 shares of common stock available for purchase under the Stock Purchase Plan at December 31, 1996. In order to disclose the pro forma net income and earnings per share as required by SFAS No. 123 (see Stock Compensation Plans above), the fair value of the employees' purchase rights is estimated using the Black-Scholes model with the following assumptions for 1995 and 1996: no dividend yield, expected volatility risk-free interest rates on the date of grant represented by the interest rate on U.S. treasury bills with a term of maturity equal to the period from the subscription date to the purchase date. The weighted-average fair value of those purchase rights granted in 1995 and 1996 was $13.89 and $9.56, respectively. 11. INCOME TAXES: The provision for income taxes for the years ended December 31, 1994, 1995 and 1996 are as follows:
(Dollars in Thousands) 1994 1995 1996 ---------------------- ---- ---- ---- Current: Federal $ 897 $ - $ - State 320 - - Foreign - - 123 ---- ---- ---- 1,217 - 123 ----- ---- ---- Deferred: Federal (786) - - State (115) - - Foreign - - - ------ ---- ---- (901) - - ------ ---- ---- $ 316 $ - $123 ======= ==== ====
18 Differences between the statutory rate and the effective tax rate for the year ended December 31, 1994, 1995 and 1996 are as follows:
1994 1995 1996 --------------------------- Taxes at federal statutory rate 34.0% 34.0% (34.0%) Foreign income taxes - % - % 1.8% Net operating loss carryforwards and research and development tax credits (utilized) not utilized (23.4%) (33.0%) 33.0% Change in valuation allowance (13.6%) (33.0%) - % Other 5.9% (1.0%) 1.0% ------- ------- ------ Provision for income taxes 12.9% - % 1.8% ==== ====== =====
The components of the deferred tax assets at December 31, 1995 and 1996 are as follows:
(Dollars in thousands) 1995 1996 ---------------------- ---- ---- Allowances and reserves $ 760 $ 773 Vacation accrual 128 146 Capitalized research and development 723 2,211 Net operating loss carryforwards 2,819 4,774 Tax credits 1,200 1,429 Accelerated depreciation (164) (252) Other 8 10 ------- ------ Total gross deferred tax asset 5,474 9,091 Less valuation allowance (3,972) (7,589) Net deferred tax asset $1,502 $1,502 ===== =====
The Company has recorded a net deferred tax asset of $1,502,000 as of December 31, 1996. Realizability is dependent on generating sufficient taxable income prior to expiration of the net operating loss carryforwards. Although realization is not assured, management believes it is more likely than not that the net deferred tax asset will be realized. The amount of the deferred tax asset considered realizable, however, could be reduced in the near term if estimates of future taxable income during the carryforward period are reduced. At December 31, 1996, the Company has net operating loss carryforwards for federal income tax purposes of approximately $12,987,000, of which $5,161,000 is attributable to disqualifying dispositions of stock options. The Company also has net operating loss carryforwards for California tax purposes of approximately $5,835,000 at December 31, 1996, of which $2,508,000 is attributable to disqualifying dispositions of stock options. The amount attributable to the disposition of stock options will not impact the Company's effective tax rate in future periods as the impact will be reflected as a component of equity when recognized. The Company also has research and development tax credit carryforwards of approximately $1,087,000 for federal and $255,000 for California tax purposes at December 31, 1996. These carryforwards will begin expiring, if unused, in 2003. The Internal Revenue Code (the "Code") imposes limits on the availability of net operating loss carryforwards and certain tax credits that arose prior to certain cumulative changes in a corporation's ownership resulting in a change of control of the Company. The Company's use of approximately $1,166,000 of its federal net operating loss carryforwards and $408,000 of its federal and $105,000 of its California tax credit carryforwards are significantly limited because the Company underwent "ownership-changes" in January 1989 and March 1991. In each year following the change, the Company will be able to offset taxable income by a limited amount of the pre-ownership 19 change carryforwards. This limitation is determined by the value of the Company immediately prior to the ownership change multiplied by the long-term tax-exempt rate. Net operating losses and tax credits that are unavailable in any year as a consequence of this limitation may be carried forward for future use subject to certain restrictions. 12. EMPLOYEE BENEFITS: The Company has a 401(k) defined contribution plan available to all employees who have been with the Company for more than one month. Employees may contribute up to 15% of their salary each year and the Company may elect to make a discretionary contribution to the plan once a year. All plan participants who are employed at the end of the plan year and have completed 1,000 hours of service in that plan year are eligible to receive a share of the employer contribution. Participant's rights to the employer contributions vest 25% per year of service with the participant being fully vested at the end of the fourth year of service. The Company did not make a discretionary contribution in 1994, 1995 or 1996. In 1995, the Company adopted a profit sharing plan available to all employees. The plan provides financial benefits to employees when the Company exceeds certain targeted objectives. The Compensation Committee of the Board of Directors annually determines the maximum amount that is allocated to the plan. Employees are eligible to participate in the plan at the start of the quarter following their employment at the Company. The Company did not make any allocation to the profit sharing plan in 1995 or 1996. 13. CONCENTRATION OF CREDIT RISK: Financial instruments which potentially subject the Company to concentrations of credit risk consist principally of cash and cash equivalents, investments and trade receivables. The Company has approximately $858,000 of cash and cash equivalents in excess of FDIC insured limits at two financial institutions at December 31, 1996. The Company has not experienced any losses on its cash and cash equivalents. All of the Company's investments, all of which mature in 1997, are in obligations of the U.S. Government and its agencies at December 31, 1996. At December 31, 1995 and 1996, the Company's trade receivables are concentrated with "Regional Bell Operating Companies" or affiliated companies in the United States, all of which management believes are large companies with substantial financial resources. Sales are typically made on credit, with terms that vary depending upon the customer and the nature of the product. The Company does not hold collateral to secure payment. Although the Company maintains a reserve for uncollectible receivables that it believes to be adequate, a payment default on a significant sale or customer receivable could materially and adversely affect its operating results and financial condition. Sales to major customers for each year are as follows (% of revenue):
1994 1995 1996 ------------------------ Nynex 16% 18% 23% Bell South 14% 13% 7% US West 36% 45% 31% Ameritech 32% 19% 9% Nortel - - 15%
Sales to an affiliate of a shareholder during the years ended December 31, 1994, 1995 and 1996 were approximately $11,320,000, $3,836,000 and $2,263,000, respectively, of which $186,000 and $140,000 are included in accounts receivable at December 31, 1995 and 1996, respectively. 20 14. ACQUISITIONS: In February 1996, the Company acquired certain assets of Applied Computing Devices, Inc. ("ACD"), a company that developed and marketed operations systems software used primarily by independent telephone companies to manage certain functions in their networks. The customer set and products of ACD complement those of the Company and the Company intends to continue to market and enhance these products. The Company acquired the assets for $1,700,000 in cash and incurred approximately $200,000 in related costs. The assets were acquired at an auction held in Federal Bankruptcy Court, Southern District of Indiana. The transaction, which was accounted for as a purchase, included the acquisition of in-process research and development valued at approximately $1,200,000, property and equipment valued at approximately $377,000 and purchased technology valued at approximately $337,000. The Company recorded a one-time charge in the first quarter of 1996 for the $1,200,000 associated with purchased research and development costs. In July 1996, the Company acquired certain assets of MPR Teltech, a subsidiary of BC TELCOM, Inc. The assets acquired were part of MPR Teltech's operating unit commonly known as the Special Services Network division ("SSN"). The Company and its Canadian subsidiary, ADA-Canada, acquired the assets for $4,200,000 million in cash and 150,000 shares of the Company's common stock, and incurred approximately $200,000 in related costs. SSN was an operations systems software development group with expertise in development of network management systems for public carriers. SSN developed operations systems software primarily for Northern Telecom ("Nortel"). SSN has become part of ADA-Canada and will develop network performance management operations systems software products for the Company and its customers, including Nortel. The transaction, which was accounted for as a purchase, included the acquisition of in-process research and development valued at approximately $2,100,000, property and equipment valued at approximately $900,000 and goodwill and know-how valued at approximately $2,588,000. The Company recorded a one-time charge in the third quarter of 1996 for the $2,100,000 associated with purchased research and development costs. The following condensed pro forma results of operations information has been presented to give effect to the acquisitions as if such transactions had occurred at the beginning of each of the periods presented. The historical results of operations have been adjusted to reflect additional depreciation and amortization expense based upon the value allocated to assets acquired in the purchases. The pro forma results of operations information is presented for information purposes only and is not necessarily indicative of the operating results that would have occurred had the acquisitions been consummated as of the beginning of the periods presented, nor is it necessarily indicative of future operating results.
CONDENSED PRO FORMA RESULTS OF OPERATIONS ----------------------------------------- (AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) (UNAUDITED) Years Ended December 31, 1995 1996 ------------------------------------------------------------------------------------ Revenue $38,747 $29,660 Net loss (8,521) (7,474) Net loss per share (.71) (.61) Weighted average shares used in computation 11,956 12,165
Sales to Canadian customers, generated from both the Company's United States and Canadian operations in fiscal 1997 were $4,351,000, from which operating income of $434,000 was derived. The identifiable assets of the Company's Canadian operations at December 31, 1997 were $970,000 21 APPLIED DIGITAL ACCESS, INC. AND SUBSIDIARY VALLUATION AND QUALIFYING ACCOUNTS For the Years Ended December 31, 1994, 1995 and 1996 ----------
Balance at Beginning Balance at Description Year of Year Additions Deductions End of Year ------------------------------------------------------------------------------------------- Allowance for doubtful accounts 1994 $ 50,000 $ -- $ -- $ 50,000 1995 50,000 -- -- 50,000 1996 50,000 -- -- 50,000 Inventory reserve 1994 301,476 247,661 (114,520) 434,617 1995 434,617 150,000 (47,055) 537,562 1996 537,562 -- (68,092) 469,470
REPORT OF INDEPENDENT ACCOUNTANTS --------------------------------- TO THE BOARD OF DIRECTORS AND SHAREHOLDERS OF APPLIED DIGITAL ACCESS, INC. AND SUBSIDIARY We have audited the accompanying consolidated balance sheets of Applied Digital Access, Inc. and subsidiary as of December 31, 1995 and 1996 and the related consolidated statements of operations, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1996. 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 consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Applied Digital Access, Inc. and subsidiary as of December 31, 1995 and 1996 and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1996, in conformity with generally accepted accounting principles. /s/ Coppers & Lybrand San Diego, California January 18, 1997 22 EX-23.1 8 CONSENT OF INDEPENDENT ACCOUNTANTS CONSENT OF INDEPENDENT ACCOUNTANTS We consent to the incorporation by reference in the Registration Statement of Applied Digital Access, Inc. on Form S-8 of our report dated January 18, 1997 on our audits of the financial statements and financial statement schedule of Applied Digital Access, Inc. as of December 31, 1996 and 1995, and for the years ended December 31, 1996, 1995 and 1994, which report is included in the Annual Report on Form 10-K of Applied Digital Access, Inc. for the year ended December 31, 1996. /s/ Coopers & Lybrand San Diego, California March 31, 1997 EX-27 9 FDS -- WARNING: THE EDGAR SYSTEM ENCOUNTERED ERROR(S) WHILE PROCESSING THIS SCHEDULE.
5 12-MOS DEC-31-1996 1,054 19,957 6,848 (50) 7,363 36,841 9,528 (4,592) 45,972 5,612 0 0 0 50,631 2,467 45,972 24,422 24,422 12,609 12,609 20,530 0 0 (6,997) 123 (7,120) 0 0 0 (7,120) (0.59) (0.59)
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