ITEM 1. BUSINESS
Verity develops, markets and supports software tools and applications that enable individuals, enterprises and publishers to intelligently search, filter and disseminate textual information residing on enterprise networks, online services, the Internet, CD-ROM and other electronic media. The Company believes that growth in the volume and variety of available information has made it increasingly important for individuals, businesses, government agencies and information publishers to be able to search, filter and disseminate information according to their particular criteria. The Company's Topic family of products is designed to address these needs by providing rapid and timely search, retrieval and categorization of archived textual information, as well as real-time monitoring and filtering of information selected from dynamic text files. Users are able to conduct personalized searches across Topic-indexed information stored within multiple sources and formats. Verity's Topic technology has been deployed within the Company's own suite of applications, and also as an embedded feature within broadly distributed third-party software applications, including Lotus Notes and Adobe Acrobat. Verity has recently extended its product line to address the requirements of Internet users, and has licensed its Topic technology to prominent providers of Internet products and online services, including AT&T WorldNet Services, Netscape Communications, NetManage, Quarterdeck and MCI's Delphi Internet, together with Internet publishers, including Cisco Systems, Compaq Computer and Tandem Computer. Topic software has been licensed to approximately 600 corporations, government agencies, software developers, online service providers and Internet publishers.
Verity was incorporated in California in March 1988 and reincorporated in Delaware in September 1995. The Company's principal executive offices are located at 894 Ross Avenue, Sunnyvale, CA 94089, and the telephone number at that address is (408) 541-1500. Verity's home page on the Web can be located at http://www.verity.com.
INDUSTRY BACKGROUND
In recent years, significant advances in computer-based technologies have enabled users to gain access to an unprecedented amount and breadth of information. The increased power and decreased cost of personal computers and workstations, together with the proliferation of networked computing environments and improvements in document authoring software, have dramatically improved a user's ability to electronically produce, publish, store, analyze and rapidly process significant amounts of information. Within large business enterprises, users commonly communicate with each other through e-mail and share and gain access to various information resources through local area networks (LANs), wide area networks (WANs) and the Internet.
A substantial amount of the available electronic information both within the enterprise and on the Internet is "unstructured" textual information. Currently, such information is created and stored electronically in a variety of different formats, including Adobe's Portable Document Format ("PDF"), Microsoft Word, Novell's WordPerfect, Standard Generalized Mark-up Language ("SGML"), Hypertext Mark-up Language ("HTML") or even ASCII. In addition, the physical location or source of unstructured information varies widely, including CD-ROM, Lotus Notes databases, and dynamic information sources such as e-mail, changing text files or newswire feeds.
Historically, there have not been generally available integrated solutions to efficiently search, filter and assimilate the now vast amounts and varieties of unstructured textual information in part due to technical
challenges associated with interpreting unstructured information in its native format. Thus, users desiring access to information residing in a variety of formats and located within multiple sources typically have been required either to export and re-index native documents into a single format comprehensible by their text search and retrieval application, or to conduct duplicate queries with multiple search and retrieval applications.
Most search and retrieval software applications operate by conducting searches for information based upon the particular criteria or "query" specified by the user. However, the query technology historically employed by most applications has been relatively limited in its ability to generate precise results. Simple search solutions have lacked the capacity to express the user's interests and preferences with any significant degree of precision, and more intricate searches have been difficult and time-consuming to construct and modify.
Information consumers increasingly wish to conduct broad "horizontal" searches over vast amounts of information stored in diverse formats and located within disparate sources. They also seek to easily define sophisticated queries that effectively narrow search results to meet their personal needs. Users want to be able to re-use and refine their queries, and to supplement retrospective searches with the capacity to watch dynamic text files and filter out relevant information while performing other tasks. The needs of information consumers are shared by information publishers, who also wish to deliver relevant information to targeted audience segments within a broad base of users, and to present information in an organized, useful format.
The Company believes that, in light of the vastly increased amounts of available electronic information and a significantly increased base of information consumers, a substantial market opportunity exists for solutions addressing the diverse requirements of enterprises, publishers and applications developers to search, filter and disseminate relevant and useful information.
THE VERITY SOLUTION
Verity's tools and applications enable individuals, enterprises and publishers to intelligently search, filter and disseminate unstructured textual information. The Company has deployed its Topic technology in a variety of product offerings, both on a stand-alone basis and as part of third-party applications, to meet the diverse requirements of businesses, government agencies and information publishers. The Company's Topic technology employs multiple search techniques to locate Topic-indexed textual information stored in a variety of formats. Certain of the Company's products also utilize Topic technology to permit search within multiple sources, such as an Adobe Acrobat database and a database of word processing documents, from the same user interface. The Company's products organize and rank the relevance of selected information, thereby enabling users to filter and evaluate information personalized to their specific needs and interests. The Topic system enables users to both interactively query and browse for specific information, and also to deploy software agents to continuously monitor dynamic information streams and automatically notify users of new and relevant information responsive to their specific requests.
The Company originally developed its core Topic technology for use by large government agencies, such as the Central Intelligence Agency and the National Security Agency, to perform complex, customized search and retrieval applications. In the past three years, Verity has enhanced and expanded the Company's Topic family of products and now offers or has under development a number of products designed to address the markets for enterprise, CD-ROM, online and Internet dissemination of electronic information.
Intranet/Enterprise. The Company markets an integrated client/server solution to enterprises such as corporations and government agencies for searching, retrieving and filtering enterprise textual information residing in a variety of word processing and publishing document formats and residing within database management systems, as well as intranet servers deployed within the enterprise.
Development Tools. The Company offers a development toolkit that allows software developers to embed the Company's search-and-retrieval engine within their products.
Internet/Publishing. The Company's Internet products are designed to supplement the hypertext capabilities of standard Web servers to provide Internet publishers with an integrated solution enabling
navigating and searching for the publishers' information. The Company offers an integrated solution for CD-ROM publishers which is designed to provide, from a single Web browser interface, capability for searching over both local CD-ROM and updated Topic-indexed information located on a Web server.
Online. The Company has developed products, primarily for online information publishers and corporate end users, designed to offer personalized information filtering of dynamic document files and "live" newsfeeds. These products are designed to be scalable to support the high data and user volumes associated with large online services.
Groupware. The Company's add-on product for Lotus Notes provides users with advanced searching across data residing within Lotus Notes databases. The Company has under development an add-on product for the Microsoft Exchange Server which is designed to provide users with advanced searching and filtering capabilities across data residing both inside the Microsoft Exchange Server environment and within other Topic-indexed repositories in the enterprise.
PRODUCTS
The Company's products include the following:
Topic Enterprise Server and Topic Client. These products together provide an integrated client/server solution for corporations and government agencies to access enterprise data across popular platforms and formats. Topic Client operates on the Windows 3.1 and Windows 95 graphical user interface (and Verity has under development Macintosh and Motif interfaces), and is designed to search enterprise databases created by the Topic Enterprise Server as well as those created by products from Verity OEM partners such as Adobe Acrobat. Topic Client is also being designed to search enterprise databases created by Lotus Notes (Version 4) as well. Topic Agents is designed to perform retrospective searches, watch proactively for information across multiple data sources and deliver relevant information to the user. The Topic architecture is designed to scale from standalone systems to the enterprise, and is capable of supporting millions of documents and over one thousand simultaneous users.
Topic Developer's Toolkit. The Company's Topic Developer's Toolkit ("TDK") is a software development kit for building and embedding the topic engine into applications and information services. TDK includes a C-callable API (consisting of a library of program routines which can be called or accessed to implement different features of the Company's technology) and sample applications which permit third-party OEM developers to create a customized user interface for the Topic engine.
Topic Internet Server and Topic CD Publisher. These products incorporate the Topic search engine to address requirements of Internet users. Topic CD Publisher is designed to complement the hypertext navigational capabilities of the Web by communicating with standard Web servers via a customizable gateway program. The Topic Internet Server should be useful to businesses and other organizations who seek to publish information internally or externally using the Web, and for information publishers attempting to reach an Internet subscriber base. Verity's Topic CD Publisher product is designed to integrate CD-ROM and World Wide Web publishing, supporting both desktop and remote search and retrieval. Through a standard Web browser interface, Topic CD Publisher provides an integrated solution for searching over both local CD-ROM and remote Internet data.
Topic Agent Server and Topic Newswire Access. These products are designed to provide publishers, online information providers and corporate end users a solution to provide personalized information analysis and filtering of documents. The Topic Newswire Access product is designed to add newswire feeds to Topic databases. The Topic Agent Server is designed to monitor static and dynamic information sources and automatically deliver relevant data directly to users via popular delivery mechanisms such as the Internet, electronic mail, and eventually Topic Client and Lotus Notes. These products are scalable to support the high data and user volumes associated with large online services.
Topic Client for Lotus Notes and Topic for Microsoft Exchange. Topic Client for Lotus Notes supplements the embedded Topic functionality within Lotus Notes with advanced Topic search features such as topics, thesauri and dictionaries. Topic for Microsoft Exchange enables users of Microsoft
Exchange to deploy advanced searching and filtering capabilities across data obtained from outside sources and residing within the Microsoft Exchange Server environment, respectively.
SERVICES
The Company makes available extensive technical support and training services for its customers, and also provides consulting services designed to assist its customers in utilizing Topic software to develop custom search and retrieval applications. As of May 31, 1996, the Company employed 14 people in its technical support organization, 10 people in its consulting group, and 3 people focused on providing training services.
Technical Support and Maintenance. The Company provides post-sale customer support directly through its own technical support engineers, who handle most support calls by telephone. The Company offers annual maintenance contracts to its customers which entitle them to full telephone support service, software updates and bug fixes. The Company also provides its customers access to technical support services by electronic mail and over a bulletin board system.
Consulting. The Company offers consulting services to its enterprise customers, OEMs, VARs and SIs to assist them in designing and deploying Topic applications tailored to meet their particular information search and retrieval needs. Consulting services have typically been offered on a time and materials basis. Since early 1994, consistent with the Company's strategy to de-emphasize its relatively low-margin consulting services business, the Company has reduced headcount in the consulting group. The Company has also significantly streamlined the API for its Topic search engine to reduce the need for specialized consulting services in connection with the incorporation by OEMs and other third parties of the Company's search technology. Revenues derived from consulting services have declined in each of fiscal 1994, 1995, and 1996. However, the Company does not anticipate further material reductions in headcount associated with its consulting business for the foreseeable future.
Training. The Company provides training services at its own training facilities located in Sunnyvale, California, as well as at the facilities of its enterprise customers, VARs and SIs worldwide. The Company also provides training through certain authorized third parties. Verity has developed an extensive set of courses and materials for presentation by its professional instructors. The Company believes its high quality training helps assure increased customer satisfaction while enhancing the Company's ability to make additional sales to its existing customer base. Customers typically pay for training services on a course or fee basis.
CUSTOMERS
Topic software has been licensed directly to approximately 600 corporations, government agencies, software developers, online service providers and Internet publishers.
Through fiscal 1995, the substantial majority of the Company's revenues were derived from the licensing of applications for use by large corporations and government agencies. Since early fiscal 1994, Verity has pursued a strategy to focus on providing more versatile, lower-priced software applications which address a broader set of information media and platforms. The tools, online and Internet markets are rapidly evolving and are characterized by an increasing number of market entrants who have introduced or developed products and services for search and retrieval over private and public networks, online services and the Internet. As is typical in the case of a new and rapidly evolving industry, demand and market acceptance for recently introduced products and services are subject to a high level of uncertainty. There can be no assurance that the use of intelligent information retrieval and filtering technologies will become widespread in these or any markets, or that the Company's products or technologies will achieve market acceptance.
SALES AND MARKETING
The Company's goal is to make its software a de facto standard and the most popular means to search, filter and disseminate information on the desktop, within the enterprise, and beyond the enterprise on the Internet and online services. Verity seeks to tailor its marketing and sales efforts to most effectively reach customers in each of these market segments. The Company pursues opportunities within large organizations
and government agencies through the combined efforts of the Company's direct sales and telesales forces. The Company's products and tools are sold indirectly through a network of VARs, SIs and OEMs.
Direct Sales. Members of the Company's direct sales force are trained to assist enterprise customers to acquire and utilize the Company's suite of tools and products to integrate information residing within the organization over a variety of sources such as word processing documents, relational database document repositories and Internet servers. The Company's direct sales force also targets online service providers and publishers of information stored on both CD-ROM and the Internet. The Company maintains direct sales offices or personnel in a number of cities across the United States, including Sunnyvale, Chicago, Houston, Boston, New York and Washington, D.C. European direct sales operations are located in London, Utrecht, Frankfurt and Paris. Additional information regarding foreign sales and operations is available in Note 13 of Notes to Financial Statements.
Telesales. The Company began a telesales operation in 1995 which has been initially focused on selling the Company's Internet products. The telesales organization can use the Company's search technology to create and host an Internet-based Topic database which demonstrates the Topic search engine operating on data found within the prospective customer's public Web site. The prospect can use the demonstration system for up to two weeks, and can then elect to purchase the product. Although the telesales operation's initial focus is on the Company's Internet products, the Company also plans to offer and sell its other products through the telesales program.
Value Added Resellers and System Integrators. The Company's VARs and SIs frequently distribute the Company's products as part of integrated turnkey solutions for the enterprise and Internet, and often market other products -- such as document management, support automation or Lotus Notes -- which incorporate the Company's search engine. The Company is currently actively seeking to increase its base of VARs and SIs.
Original Equipment Manufacturers. The Company's Topic search technology is sold as an integrated feature of software products offered by OEM providers of software products. These OEMs participate in a variety of markets, including groupware (Lotus and Collabra), document management (Documentum and PC DOCs), support automation (Remedy), resume tracking (Restrac) and publishing (Adobe, Frame and Common Ground). The Company also recently licensed its Topic search technology for use by database management software companies, including Informix and Sybase.
The Company's marketing activities are targeted at building market awareness and identifying prospective customers for enterprise, CD-ROM, Internet/publishing and online services applications. Certain of the Company's OEM contracts provide for brand name exposure in the OEM's packaging of the embedded Topic search technology. The Company believes such exposure helps promote market awareness for Topic products and can create sales opportunities for add-on products to the OEM's installed base. The Company's marketing efforts include participation in tradeshows, conference speaking engagements and direct mail campaigns targeting specific market niches such as the Internet, Lotus Notes, document management and online services. The Company also maintains a home page on the Internet which has been a source of sales leads. As of May 31, 1996, the Company's sales and marketing organizations consisted of 80 employees.
THE VERITY TECHNOLOGY
The Company's core technology was originally developed by the Company for use by large government agencies, such as the Central Intelligence Agency and the National Security Agency, to perform complex, customized search and retrieval applications over stand-alone, host-based systems. Since early in fiscal 1994, the Company has refined and enhanced its core technology, de-emphasized consulting services, and repositioned and modified its product offerings to target the market for embedded search technology, as well as the emerging Internet and online markets. All of the Company's products are generally written in "C", a widely used application programming language, using generally available "C" compilers. Verity technologies address the major aspects of the intelligent search and filtering process, including document indexing, query formulation, and ranking and presentation of results.
Indexing. The Topic engine incorporated in Verity's server products or OEM applications indexes documents automatically based upon user-specified criteria, into a Topic database, or "collection." Collections created through the indexing process contain the results of text analysis performed by the Topic engine, including organized information about document attributes and content. End users with Topic-based applications or standard Web browsers can search those Topic collections available to them. The Topic architecture is designed to permit real-time indexing of arriving documents into a Topic collection, even while users actively search that collection. As a result, the system provides enhanced availability, and is designed to operate during maintenance and back-up.
Query Formulation. The Company's search technology is designed to enable users to formulate and refine queries using a variety of search tools such as keywords, thesauri, dictionaries and concept-based "topics." Once formulated, queries can be used to retrieve archived information with a standard, interactive search. In addition, the same query may be incorporated in an agent deployed to watch and "clip" relevant information arriving in dynamic text files. This "profiling" feature of the Company's query technology is designed to address high user and data volumes, such as those associated with enterprise applications and large online services.
The Topic search engine is designed with an open architecture which employs multiple search techniques and supports incorporation of additional techniques by the Company in future or custom applications. The concept-based "topic" search metaphor is one method by which the Company's products permit construction of sophisticated search requests which can then easily be deployed by users. Users construct a hierarchical "tree" of concepts with weighted branches, which defines a "topic." The topic tree graphically represents relationships among the user's terms, providing increased refinement of typical Boolean or natural language expressions.
Results Presentation. The results obtained through matching queries against document collections are provided with a relevance score calculated by the Topic engine. This score may be presented, along with other available document-attribute information desired by the user, in a customizable results list. The Company is actively developing added functionality designed to enable the organization, or "clustering," of search results according to common threads within the retrieved documents.
PRODUCT DEVELOPMENT
The Company's development efforts are focused on expanding Verity's suite of Topic products, designing enhancements to the Company's core technology, and addressing additional technical challenges inherent in developing new applications on CD-ROM and for online services and the Internet markets. The Company released Topic CD Publisher, Topic Newswire Access, Topic for Microsoft Exchange and Topic Agent Server in early 1996. In addition, the Company plans to undertake development of further enhancements of the search performance, functionality and deployability of its products. The Company is also engaged in research and development relating to enhanced presentation and organization of retrieved information, such as clustering search results. As of May 31, 1996, there were 85 employees on the Company's research and development staff. The Company's research and development expenditures in fiscal 1994, fiscal 1995 and fiscal 1996 were $4.9 million, $5.9 million and $8.5 million, respectively, and represented 29.3%, 37.1% and 27.6% of total revenues, respectively. The Company expects that it will continue to commit substantial resources to product development in the future.
The computer software industry is subject to rapid technological change, changing customer requirements, frequent new product introductions and evolving industry standards that may render existing products and services obsolete. As a result, the Company's position in its existing markets or other markets that it may enter could be eroded rapidly by product advancements by its competitors. The life cycles of the Company's products are difficult to estimate. The Company's future success will depend, in part, upon its ability to enhance existing products and to develop new products on a timely basis. In addition, its products must address increasingly sophisticated customer needs and keep pace with technological developments, conform to evolving industry standards, particularly client/server and Internet communication and security protocols, as well as publishing formats such as HTML. There can be no assurance that the Company will not experience
difficulties that could delay or prevent the successful development, introduction and marketing of new products, or that new products and product enhancements will meet the requirements of the marketplace or achieve market acceptance. If the Company is unable to develop and introduce products in a timely manner in response to changing market conditions or customer requirements, the Company's financial condition and results of operations would be materially and adversely affected.
Software products as complex as those offered by the Company may contain errors that may be detected at any point in the products' life cycles. The Company has in the past discovered software errors in certain of its products and has experienced delays in shipment of products during the period required to correct these errors. There can be no assurance that, despite testing and quality assurance efforts by the Company and by current and potential customers, errors will not be found, resulting in loss of, delay in, market acceptance and sales, diversion of development resources, injury to the Company's reputation, or increased service and warranty costs, any of which could have a material adverse effect on the Company's business, results of operations and financial condition.
COMPETITION
The electronic information search and retrieval software market is intensely competitive. The Company believes the principal competitive factors in such market are product quality, performance and price, vendor and product reputation, product architecture, strategic alliances, functionality and features, ease of use and quality of support. A number of companies offer competitive products addressing certain of the Company's target markets. In the enterprise market, the Company competes with Information Dimensions, Dataware and Excalibur, among others. In the Internet/Publishing market, the Company competes with Folio, Dataware and Fulcrum, among others. Fulcrum is also the Company's principal competitor in the tools market. The Company's principal competitors in the online market are Fulcrum, which currently provides search and retrieval technology for the Microsoft Network, and Logicon. The Company also competes indirectly with database vendors that offer information search and retrieval capabilities with their core database products. In the future, the Company may encounter competition from companies that enhance products such as word processing software, document management systems, groupware applications, Internet products and operating systems to include text search and retrieval features. Also, Microsoft recently announced its intention to market search and retrieval software competitive with the Company's products. Many of the Company's existing competitors, as well as Microsoft and a number of other potential new competitors, have significantly greater financial, technical and marketing resources than the Company. Because the success of the Company's strategy is dependent in part on the success of the Company's strategic partners, competition between the Company's strategic partners and the strategic partners of the Company's competitors, or failure of the Company's strategic partners to achieve or maintain market acceptance could have a material adverse effect on the Company's competitive position. Although the Company believes that its products and technologies compete favorably with respect to the factors outlined above, there can be no assurance that the Company will be able to compete successfully against its current or future competitors or that competition will not have a material adverse effect on the Company's results of operations and financial condition.
PROPRIETARY RIGHTS
To date, the Company has relied upon a combination of copyrights and trade secrets to protect its proprietary technology. The Company generally enters into confidentiality or license agreements with its employees, distributors, customers and potential customers and limits access to and distribution of the source code to its software and other proprietary information. To license its client products, the Company primarily relies on "shrink-wrap" licenses that are not signed by the end user and, therefore, may be unenforceable under the laws of certain jurisdictions. Policing unauthorized use of the Company's products is difficult. There can be no assurance that the steps taken by the Company in this regard will be adequate to prevent misappropriation of its technology or that the Company's competitors will not independently develop technologies that are substantially equivalent or superior to the Company's technology.
In the future, the Company may receive communications from third parties or have other reasons to seek licenses under third-party intellectual property rights. In such cases, the Company may evaluate whether to
obtain such licenses. However, there can be no assurance that such licenses will be available or if such licenses are made available, that the terms will not have a material adverse effect on the Company's results of operations.
Certain technology used in the Company's products is licensed from third parties, generally on a nonexclusive basis. These licenses generally require the Company to pay royalties and to fulfill confidentiality obligations. The Company believes that there are alternative sources for each of the material components of technology licensed by the Company from third parties. However, the termination of any of such licenses, or the failure of the third party licensors to adequately maintain or update their products, could result in delay in the Company's ability to ship certain of its products while it seeks to implement technology offered by alternative sources. Any required replacement licenses could prove costly. Also, any such delay, to the extent it becomes extended or occurs at or near the end of a fiscal quarter, could result in a material adverse effect on the Company's results of operations. While it may be necessary or desirable in the future to obtain other licenses relating to one or more of the Company's products or relating to current or future technologies, there can be no assurance that the Company will be able to do so on commercially reasonable terms or at all. See "Business Risks -- Dependence on Proprietary Technology".
EMPLOYEES
As of May 31, 1996, the Company had a total of 216 employees, including 85 in research and development, 107 in sales, marketing and related customer support services, 20 in administration and 4 in manufacturing. Of these employees, 188 were located in the United States and 28 in Europe. None of the Company's employees is represented by a collective bargaining agreement, nor has the Company experienced any work stoppage. The Company considers its relations with its employees to be good.
The Company is heavily dependent upon its ability to attract, retain and motivate skilled technical and managerial personnel. The loss of services of any of its executive officers or other key employees could have a material adverse effect on the business, operating results or financial condition of the Company. The Company's future success also depends on its continuing ability to identify, hire, train and retain other highly qualified technical and managerial personnel. Competition for such personnel is intense, and there can be no assurance that the Company will be able to attract, assimilate or retain other highly qualified technical and managerial personnel in the future. The inability to attract, hire or retain the necessary technical and managerial personnel could have a material adverse effect upon the Company's business, operating results or financial condition.
DIRECTORS, EXECUTIVE OFFICERS AND KEY EMPLOYEES
As of May 31, 1996, the directors, executive officers and key employees of the Company were as follows:
- - - --------------- (1) Mr. Helgeson was employed in such capacity until July 8, 1996.
(2) Member of the Compensation and Audit Committees.
(3) Mr. Nelson was appointed to this position in August 1996.
Mr. Courtot joined the Company in August 1993 as President and Chief Executive Officer, and was elected Chairman of the Board in August 1995. Prior to joining the Company, Mr. Courtot served as Executive Vice President and General Manager of cc:Mail, a division of Lotus Development Corporation, from May 1991 to June 1992 and as President and Chief Executive Officer of cc:Mail from March 1989 to May 1991. From June 1992 to August 1993, Mr. Courtot worked as an independent consultant on discrete projects and also served as a member of the Board of Directors for two private, high-technology companies. From July 1987 to January 1989, Mr. Courtot served as Executive Vice President and General Manager of Radiology Division, ADAC Laboratories. Prior to that time, Mr. Courtot served as Chief Executive Officer of Thomson-CGR Medical, a producer of radiology and magnetic resonance imaging equipment. Mr. Courtot is a recipient of the Saturday Evening Post Benjamin Franklin Award for his role in a national mammography awareness campaign. Mr. Courtot received an M.S. in Physics and a B.S. in Electrical Engineering from the University of Paris.
Mr. McCauley joined the Company as Chief Financial Officer on a consulting basis in March 1994. In May 1995, Mr. McCauley joined the Company as Vice President, Chief Financial Officer and Secretary. From May 1992 to May 1995, Mr. McCauley was an independent consultant. From 1991 to 1992, Mr. McCauley served as Vice President and Chief Financial Officer of Voicesoft Corporation, a voice processing software developer. From 1989 to 1991, Mr. McCauley served as Executive Vice President, Chief Financial Officer and Treasurer of SemiTest, Inc., a developer of semiconductor manufacturing instrumentation. Mr. McCauley received a B.S. in Accounting from the University of Rhode Island, and is a certified public accountant.
Mr. Helgeson was Vice President, Research & Development, until July 1996, but he is no longer an employee of the Company. Mr. Helgeson joined the Company in July 1995 as Vice President, Research and Development. From 1991 to July 1995, Mr. Helgeson served as Director of Communications Engineering at General Magic, Inc. From 1989 to 1991, Mr. Helgeson served as manager of UNIX and Macintosh software development at cc:Mail. Mr. Helgeson received concurrently a B.A. in French and a B.S. in Biochemistry from the University of California at Berkeley.
Mr. Nelson was a co-founder of the Company and has been employed by Verity since its inception in 1988. He has served in a variety of technical and management positions at Verity, and was appointed in August 1996 to the position of Chief Technology Officer. He received a B.S. in Computer Science from the Massachusetts Institute of Technology.
Mr. Bettencourt joined the Company in July 1995 as Vice President of North American Sales, and was subsequently promoted to Vice President of Worldwide Sales and Marketing. Prior to joining the Company, Mr. Bettencourt served as Vice President of Sales for Versant Object Technology from 1992 to June 1995 and as Director of U.S. Sales for Versant Object Technology from July 1990 to 1992. From December 1988 to July, 1990, Mr. Bettencourt served as Vice President of Sales for Rockwell CMC. Mr. Bettencourt received a B.A. from the University of Santa Clara.
Mr. Moore joined the Company in January 1996 as Vice President, Strategic Investments, General Counsel and Secretary. From August 1986 until joining the Company, Mr. Moore was employed by the law firm of Gray Cary Ware & Freidenrich, at which he was a shareholder since 1991. Mr. Moore received a B.A. in Economics and a J.D. from Stanford University.
Mr. Krausz has served as a director of the Company since May 1988. Mr. Krausz has been a General Partner of U.S. Venture Partners III, U.S.V. Entrepreneur Partners and BHMS Partners III since 1985. Mr. Krausz is a director of EPIC Design Technology, Inc.
Mr. MacDonald has served as a director of the Company since December 1988. From May 1983 until May 1996, Mr. MacDonald was employed by Adobe Systems Incorporated, where he served most recently as Senior Vice President and Chief Operating Officer. Since May 1996, he has served as President and Chief Executive Officer of Active Software. Mr. MacDonald is a director of Network Computing Devices, Inc.
Mr. Waite has served as a director of the Company since May 1988. Mr. Waite has been a General Partner of Olympic Venture Partners II and a Vice President of Northwest Venture Services Corp. since 1987
and a General Partner of Olympic Venture Partners III since 1994. Mr. Waite is a director of CellPro Incorporated.
The Company's Certificate of Incorporation provides that the Board of Directors is divided into three classes serving staggered three year terms. Each class of directors consists of one or two directors. The Class I directors, whose terms will end in 1996, are Steven M. Krausz and Charles P. Waite, Jr.; the Class II director, whose term will end in 1997, is Stephen A. MacDonald; and the Class III director, whose term will end in 1998, is Philippe F. Courtot.
Officers are elected by and serve at the discretion of the Board of Directors. There are no family relationships among the directors or officers of the Company.
ITEM 2.

ITEM 2. PROPERTIES
The Company's principal administrative, sales, marketing, and research and development facilities occupy approximately 96,000 square feet in Sunnyvale, California. The Company's operating lease agreement for this facility commenced in June 1996 and expires in September 2005. The Company's average annual lease payment is scheduled to be approximately $1.1 million. In addition, the Company also leases sales offices in Virginia, England, Netherlands, France and Germany, and a small development office located in England.
ITEM 3.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS.
On March 28, 1996, at a special meeting of stockholders of the Company, a proposal to amend the 1995 Stock Option Plan (the "Option Plan") of the Company to increase the number of shares of Common Stock of the Company authorized for issuance thereunder from 1,910,836 shares to 2,910,836 shares and to impose a limit on the options that may be granted to any employee, was submitted to a vote of the stockholders of the Company.
The proposal was approved by the following vote:
PART II
ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
MARKET PRICE OF COMMON STOCK
The Company's stock has been traded on the Nasdaq National Market since the Company's initial public offering on October 5, 1995 under the Nasdaq symbol VRTY. The following table sets forth, for the periods indicated, the high and low closing sales prices for the Company's common stock as reported by Nasdaq:
HOLDERS OF COMPANY STOCK
The closing sale price for the Common Stock on May 31, 1996 was $39.25.
As of May 31, 1996, there were approximately 308 shareholders of record of the Company's Common Stock and 10,735,000 shares of Common Stock outstanding.
The market price of the Company's Common Stock has fluctuated significantly and is subject to significant fluctuations in the future. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations -- Business Risks."
DIVIDEND POLICY
The Company has never paid cash dividends on its capital stock. The Company currently intends to retain earnings, if any, for use in its business and does not anticipate paying any cash dividends in the foreseeable future.
ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA
SELECTED CONSOLIDATED FINANCIAL DATA
The following selected financial date should be read in conjunction with "Item 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion provides an analysis of the Company's financial condition and results of operations and should be read in conjunction with the "Selected Consolidated Financial Data" and the Note thereto and the Consolidated Financial Statements and the Notes thereto of the Company.
OVERVIEW
Verity develops, markets and supports software tools and applications that enable individuals, enterprises and publishers to intelligently search, filter and disseminate textual information residing on enterprise networks, online services, the Internet, CD-ROM and other electronic media. The Company was founded in 1988, and, historically, derived the substantial majority of its revenue from the licensing of high-priced, custom search and retrieval applications for use almost entirely by large organizations and government agencies. During these years, the Company also generated a substantial portion of its revenues by providing the consulting services required to support these products.
In early fiscal 1994, Verity retained a new Chief Executive Officer and replaced several members of its senior management team. Shortly thereafter, the Company shifted its strategy from the sale of high-priced products requiring significant customization to leveraging the Company's Topic technology to develop a number of new, lower-priced products that address the needs of broader markets. During this period, the Company also focused on building strategic alliances for the primary purpose of expanding the user base of the Company's technology, rather than generating significant revenues. The objectives of the Company's strategy are to establish its software as a de facto standard and to offset lower unit prices for its products with higher sales volumes.
The Company's ongoing implementation of this strategy has involved several significant actions. During recent years, the Company has reduced significantly its average unit license fees. Also, during this period, the Company has devoted significant resources to modify and enhance its core technology to support a broader set of search and retrieval solutions for use on desktop and enterprise-wide systems, and over the Internet. Key engineering efforts in this regard have included the continued enhancement of the functionality of the Company's Topic search engine and the modification of the Topic software to facilitate its incorporation in third parties' information management, publishing and groupware software applications. More recently, the Company's engineering efforts have also resulted in the development of new applications of Topic software for use with CD-ROM, online services and the Internet. The Company's Topic technology is deployed within the Company's own suite of applications, and also as an embedded feature within broadly distributed third-party software applications, such as Lotus Notes, Adobe Acrobat, Frame FrameViewer and Documentum Server and WorkSpace. The Company has also licensed its Topic technology to prominent providers of Internet products and online services, including Netscape Communications, NetManage, Quarterdeck, AT&T WorldNet Services, and MCI's Delphi Internet, together with Internet publishers, including Cisco Systems, Compaq Computer and Tandem Computer.
In connection with its new strategy, the Company has also replaced the majority of its work force and substantially reorganized all of the departments within the Company. While experiencing significant turnover, the Company increased the number of research and development personnel from 29 at the beginning of fiscal 1994 to 85 at the end of fiscal 1996. Given its reduced focus on offering custom solutions, the Company was able to decrease the number of personnel involved in its relatively low-margin consulting business from 29 at the beginning of fiscal 1994 to 10 at the end of fiscal 1996.
Since inception, the Company has incurred significant losses and substantial negative cash flow. Due in part to the transition, the Company experienced declining revenues and increased net losses in fiscal years 1994 and 1995. At May 31, 1996, the Company had cumulative operating losses of $21.4 million, with net losses of $5.1 million, $5.8 million and $313,000 for fiscal years 1994 through 1996, respectively. However, fiscal 1995 and 1996 have produced the first successes of the Company's strategic transition. Although fiscal 1995 revenues were lower than fiscal 1994, fiscal 1995 revenues from software products increased over fiscal 1994. In fiscal 1996, total revenues increased 93% over fiscal 1995 primarily as a result of a 141% increase in
software product revenues. The increase from fiscal 1994 to fiscal 1995 was due principally to revenues derived from licensing new versions of the Company's TDK product and early commercial versions of Internet/publishing products. The increase for fiscal 1996 over the prior year was due principally to revenues from early commercial versions of online and Internet/publishing products, increased revenues from the Company's TDK Toolkit and, to a lesser extent, the Company's enterprise products. Both fiscal 1995 and fiscal 1996 reflects lower consulting revenues than the prior year periods due to intentional reductions in the scope of the Company's lower-margin consulting business. The losses in fiscal 1995 and, to a lesser extent, in fiscal 1996 also reflects significantly larger investments in marketing and sales and research and development than the respective prior year periods, as the Company rebuilt its sales and marketing force and undertook development of a number of new products to implement its new strategy. While it is the Company's goal to increase revenue and generate net income in future periods, no assurance can be given that the Company's strategy will continue to be successful, that the rate of revenue increase experienced by the Company in fiscal 1996 will be experienced in future periods, or that the Company will achieve positive cash flow or profitability.
In March 1996, the Company acquired InSite Computer Technology Limited, a United Kingdom technology company which focused on developing groupware applications for Microsoft Exchange and BackOffice platforms. As a result of the acquisition, Verity incurred a one-time charge against earnings of $381,000 during the quarter ended May 31, 1996, when the transaction was consummated.
The ongoing implementation of the Company's new strategy has placed, and may continue to place, a significant strain on the Company's resources, including its personnel. The Company believes that hiring and retaining qualified individuals at all levels in the Company is essential to its success, and there can be no assurance that the Company will be successful in attracting and retaining the necessary personnel. If Company management is unable to effectively manage its planned transition, identify opportunities in a timely fashion, and evaluate and manage the Company's business and competitive position, the Company's results of operations and financial condition will be materially and adversely affected. Furthermore, there can be no assurance that the Company will introduce new products on a timely basis or that its new or recently introduced products will achieve market acceptance.
The Company's revenues are derived from licenses fees for its software products and fees for services complementary to its products, including software maintenance, consulting and training. Fees for services generally are charged separately from the license fees for the Company's software products. The Company recognizes revenues in accordance with the provisions of American Institute of Certified Public Accountants Statement of Position No. 91-1, Software Revenue Recognition. Accordingly, maintenance revenues from ongoing customer support and product upgrades are recognized ratably over the term of the applicable maintenance agreement, which is typically 12 months. Payments for maintenance fees generally are received in advance and are nonrefundable. Revenues for consulting and training generally are recognized when the services are performed.
RESULTS OF OPERATIONS
The following table sets forth the percentage of revenue represented by certain items in the Company's Consolidated Statements of Operations for the periods indicated:
Revenues
Total revenues decreased 4.3% from $16.6 million in fiscal 1994 to $15.9 million in fiscal 1995 and increased 93.4% to $30.7 million in fiscal 1996. The decline in total revenues from fiscal 1994 to fiscal 1995 was principally due to significant decreases in average unit license fees for the Company's software products and intentional reductions in the scope of its consulting business, partially offset by unit volume increases of certain products. These changes were phased in commencing early in fiscal 1994 as part of a shift in the Company's strategy to focus its business increasingly on providing more versatile, lower-priced software products, as opposed to higher-priced custom applications and associated specialized consulting and training services. The increase in total revenues from fiscal 1995 to fiscal 1996 was due primarily to increased revenues from licensing of Internet/publishing products, online products, tools and, to a lesser extent, enterprise products. Software product revenues increased as a percentage of total revenues from 55.5% in fiscal 1994 to 63.8% in fiscal 1995 and 79.7% in fiscal 1996. Conversely, service and other revenues declined as a percentage of total revenues from 44.5% in fiscal 1994 to 36.2% in fiscal 1995 and 20.3% in fiscal 1996. These changes reflect both increased software product revenues and intentional reductions in the Company's consulting business.
Software product revenues. Software product revenues increased 10.0% from $9.2 million in fiscal 1994 to $10.1 million in fiscal 1995 and increased 141.3% to $24.5 million in fiscal 1996. The increase from fiscal 1994 to fiscal 1995 was due principally to revenues derived from licensing new versions of the Company's TDK product and early commercial versions of Internet/publishing products. Software product revenues in fiscal 1995 represented a significantly increased proportion of overall revenues as compared to fiscal 1994, due to both a higher level of software product revenues and decreased service revenues, particularly decreased consulting revenues. The increase from fiscal 1995 to fiscal 1996 was due primarily to increased revenues from
licensing of Internet/publishing products, online products, tools and, to a lesser extent, enterprise products. Revenues from enterprise products increased principally due to significantly higher sales volumes, which were offset in part by lower average unit license fees.
Service and other revenues. Service and other revenues consists primarily of fees for software maintenance, consulting and training. Service and other revenues decreased 22.2% from $7.4 million in fiscal 1994 to $5.7 million in fiscal 1995 and increased 8.8% to $6.2 million in fiscal 1996. Maintenance revenues increased in fiscal 1996, but these increases were substantially offset by reduced consulting revenues. During fiscal 1994 and fiscal 1995, the Company significantly reduced the scope of its consulting business, but increased headcount slightly in fiscal 1996. The Company does not anticipate further material reductions in headcount associated with its consulting business for the foreseeable future.
Revenue derived from foreign operations accounted for 15.7%, 14.3% and 6.6% of total revenues, respectively, in fiscal 1994, 1995 and 1996, with European operations alone accounting for 12.1% , 11.9% and 5.6%, of total revenues for these periods, respectively. The Company's export sales consist primarily of products licensed for delivery outside of the United States. In fiscal years 1994, 1995 and 1996, export sales accounted for 28.7%, 24.1% and 19.1% of total revenues, respectively. The decreases in foreign operations and export sales as a percentage of revenues resulted primarily from increased domestic revenues.
No single customer accounted for 10% or more of the Company's revenues during fiscal years 1994, 1995 or 1996. However, revenues derived from sales to the federal government and its agencies were 29.3%, 25.5% and 10.5% of total revenues in fiscal years 1994, 1995 and 1996, respectively. Sales to government agencies declined as a percentage of revenues from fiscal 1994 to fiscal 1996, and may decline in the future.
Costs of Revenues
Costs of software products. Costs of software products consist primarily of product media, duplication, manuals, packaging materials, shipping expenses and royalties and, in certain instances, licensing of third-party software incorporated in the Company's products. Costs of software products decreased 13.5% from $720,000 in fiscal 1994 to $623,000 in fiscal 1995 and increased 232.9% to $2.1 millions in fiscal 1996, representing 7.8%, 6.1% and 8.5%, respectively, of software product revenues. The increase in absolute dollars from fiscal 1995 to fiscal 1996 was principally related to the higher level of software product sales. The increase in costs as a percentage of software product revenues was due primarily to the inclusion of purchased software relating to third party software components included in certain products during fiscal 1996.
Costs of service and other. Costs of service and other consist of costs incurred in providing consulting services, customer training, telephone support and product upgrades to customers. Costs of service and other decreased 32.7% from $4.4 million in fiscal 1994 to $2.9 million in fiscal 1995 and decreased 4.8% to $2.8 million in fiscal 1996. As a percentage of service and other revenue, these costs represented 58.9%, 50.9% and 44.6% in fiscal years 1994, 1995 and 1996, respectively. The significant decreases in costs of service and other were directly related to the reductions in headcount associated with the de-emphasis of the Company's consulting business.
Operating Expenses
Research and development. Research and development expenses increased 20.9% from $4.9 million in fiscal 1994 to $5.9 million in fiscal 1995 and increased 44.1% to $8.5 million in fiscal 1996, representing 29.3%, 37.1% and 27.6% of total revenues, respectively. This increase in absolute dollars was primarily due to a significant increase in headcount of research and development personnel focused on development of products addressing Internet/publishing, CDROM, online, and groupware applications. These decreases in research and development expenses as a percentage of total revenue were due primarily to increased total revenues over prior years. The Company intends to continue to allocate substantial resources to research and development, but research and development expenses may vary as a percentage of total revenues.
Acquisition of in-process research and development. In March 1996, the Company acquired InSite Computer Technology Limited, a United Kingdom technology company which focused on developing
groupware applications for Microsoft Exchange and BackOffice platforms. As a result of the acquisition, Verity incurred a one-time charge against earnings of $381,000 during the quarter ended May 31, 1996, when the transaction was consummated. See Note 3 of Notes to Consolidated Financial Statements.
Marketing and sales. Marketing and sales expenses consist primarily of salaries and commissions of sales and marketing personnel, advertising and promotion expenses and pre-sales customer service and support costs. Marketing and sales expenses increased 19.2% from $7.8 million in fiscal 1994 to $9.3 million in fiscal 1995 and increased 60.7% to $14.9 million in fiscal 1996, representing 46.9%, 58.4% and 48.5% of total revenues, respectively. These increases in absolute dollars were primarily related to the Company's expansion of its marketing and sales organization, particularly in the United States and Europe. These decreases in marketing and sales expenses as a percentage to total revenue were due primarily to increased total revenues over prior years. The Company anticipates it will continue to make significant investments in marketing and sales.
General and administrative. General and administrative expenses increased 19.3% from $2.3 million in fiscal 1994 to $2.7 million in fiscal 1995 and increased 26.3% to $3.5 million in fiscal 1996, representing 13.9%, 17.3% and 11.3% of total revenues, respectively. These increases in absolute dollars were primarily due to increases in personnel and professional service fees required to support the Company's expanded operations relative to prior years. The decrease in general and administrative expenses in fiscal 1996 as a percentage of total revenues was due primarily to increased total revenues.
Restructuring charges. During fiscal 1994, the Company recorded a provision for restructuring charges of $1.2 million. The restructuring related primarily to severance payments and losses on vacated office leases associated with the implementation of the Company's change in strategy. As of May 31, 1995, all amounts reserved in connection with the restructuring had been paid.
Income Taxes
As of May 31, 1996, the Company had federal and state net operating loss carryforwards of approximately $16.5 million and $9.0 million, respectively. The Company also had federal and state research and development tax credit carryforwards of approximately $692,000 and $420,000, respectively. These carryforwards expire in the years 2004 to 2011. The Company's initial public offering resulted in a change in ownership as defined under Section 382 of the Internal Revenue Code which limited the annual utilization of net operating loss carryforwards to approximately $4.9 million. See Note 10 of Notes to Consolidated Financial Statements.
The Company has established a valuation allowance against its deferred tax assets due to the uncertainty surrounding the realization of such assets. Management evaluates on a quarterly basis the recoverability of the deferred tax assets and the level of the valuation allowance. At such time as it is determined that it is more likely than not that deferred tax assets are realizable, the valuation allowance will be appropriately reduced. See Note 10 of Notes to Consolidated Financial Statements.
QUARTERLY RESULTS OF OPERATIONS
The Company's quarterly operating results have varied and are expected to vary significantly in the future. These fluctuations may be caused by many factors, including, among others, the size and timing of individual orders; customer order deferrals in anticipation of new products; timing of introduction or enhancement of products by the Company or its competitors; market acceptance of new products; changes in the budgets or purchasing patterns of government agencies; technological changes in search and retrieval, database, networking, or communication technology; competitive pricing pressures; changes in the Company's operating expenses; personnel changes; foreign currency exchange rates; mix of products and services sold; quality control of products sold; and general economic conditions.
A significant portion of the Company's revenues in recent quarters has been derived from relatively large sales to a limited number of customers, and the Company currently anticipates that future quarters will continue to reflect this trend. Sales cycles for these customers can be up to six months or longer. Accordingly,
the cancellation or deferral of even a small number of purchases of the Company's products could have a material adverse effect on the Company's results of operations and financial condition in any particular quarter.
Product revenues are also difficult to forecast because the market for search and retrieval software is uncertain and evolving. In addition, a significant portion of the Company's revenues are derived from royalties based upon sales by third-party vendors of products incorporating the Company's technology. These revenues may be subject to extreme fluctuation and are difficult for the Company to predict. Further, the Company typically generates a large percentage of its quarterly revenues during the last weeks of the quarter. The Company's expense levels are based in part on its expectations as to future revenues and to a large extent are fixed. Therefore, the Company may be unable to adjust spending in a timely manner to compensate for any unexpected revenue shortfall. Accordingly, any significant shortfall of demand in relation to the Company's expectations or any material delay of customer orders would have an almost immediate adverse impact on the Company's operating results and on the Company's ability to achieve profitability.
The Company's revenues, and particularly its software products revenues, increased significantly in the last four fiscal quarters over the prior quarters. Due to the evolving nature of the markets for the Company's products and other factors, however, there can be no assurance that the Company's revenues will continue to increase significantly or at all in future periods.
As a result of the foregoing and other factors, the Company believes that period-to-period comparisons of its results of operations are not necessarily meaningful and should not be relied upon as indications of future performance. Fluctuations in operating results may also result in volatility in the price of the shares of the Company's Common Stock.
The following table sets forth certain unaudited consolidated statements of operations data, both in dollar amount and as a percentage of total revenues, for each of the eight quarters in the period ended May 31, 1996. In the opinion of management, this information has been presented on the same basis as the audited consolidated financial statements appearing elsewhere in this annual report, and all necessary adjustments, consisting only of normal recurring adjustments, have been included in the amounts stated below to present fairly the unaudited quarterly results when read in conjunction with the audited consolidated financial statements of the Company and related notes thereto. The operating results for any quarter should not be relied upon as any necessarily indicative of results for any future period.
- - - --------------- (1) The net loss used in computing net loss per share has been increased by the accretion of the mandatorily redeemable convertible preferred stock to its redemption value.
During fiscal 1995, cost of service and other revenues declined significantly due to the reductions in the Company's consulting business. In fiscal 1996, cost of software product revenues increased both in amount and as a percentage of software product revenues due to software product sales which required the incorporation of certain third-party software products and associated royalty payments.
Operating expenses have generally increased in absolute dollars over the quarters shown as the Company has increased staffing in its research and development functions and sales and marketing functions.
LIQUIDITY AND CAPITAL RESOURCES
Since its inception, the Company has financed its operations primarily through proceeds of approximately $23.6 million from private sales of Preferred Stock, proceeds from its initial public offering and secondary offering of Common Stock and, to a lesser extent, bank credit lines and capital operating leases. The Company completed its initial public offering of Common Stock in October 1995 and realized net proceeds of $32.5 million. In January 1996, the Company completed its secondary offering of Common Stock, which generated net proceeds of $16.5 million. The Company has used a portion of those proceeds to repay borrowings under its line of credit in the amount of $1.6 million. As of May 31, 1996, the Company had $48.0 million in cash and cash equivalents and investments.
The Company's operating activities used cash of $2.3 million, $5.2 million, and $1.2 million in fiscal 1994, 1995 and 1996, respectively. The cash used in operations in fiscal 1994, 1995 and 1996, was accounted for primarily by the Company's net losses reduced in each period by depreciation. In fiscal 1994, accounts receivable decreased by $1.5 million, decreasing cash used in operations. Conversely, accounts receivable increased by $1.3 million and $4.8 million in fiscal 1995 and fiscal 1996, respectively, increasing cash used in operations.
Cash used in investing activities in fiscal 1994, 1995 and 1996 was $1.2 million, $1.1 million and $48.7 million, respectively. In fiscal 1994 and 1995, the investing activities consisted primarily of purchases of property and equipment. In fiscal 1996, the Company invested $44.6 million, net, in marketable securities with its proceeds from the Company's initial public offering and secondary offering of Common Stock, and, to a lesser extent, the sale of Preferred Stock.
Cash provided by financing activities was $2.8 million, $4.4 million, and $52.0 million in fiscal 1994, 1995 and 1996, respectively. For fiscal 1994 and 1995, such financing activities consisted primarily of the sale of Preferred Stock. In fiscal 1996, such financing activities consisted primarily of the proceeds of the Company's initial public offering and secondary offering of Common Stock, and, to a lesser extent, the sale of Preferred Stock.
At May 31, 1996, the Company's principal sources of liquidity were its cash and cash equivalents and short-term investments of $43.4 million. In October 1995, the Company repaid all borrowings under its $2.5 million collateralized line of credit, which expired in November 1995. In December 1995, the Company entered into an agreement with the same bank for a new line of credit. Under the terms of the agreement, the Company has available an unsecured line of credit of $7.5 million, bearing interest at the bank's prime rate, and expiring in September 1997. The line of credit requires compliance with certain financial covenants. See Note 6 of Notes to Consolidated Financial Statements.
Capital expenditures, including capital leases, were approximately $1.4 million, $1.2 million and $3.9 million in fiscal 1994, 1995 and 1996, respectively. These expenditures consisted principally of purchases of property and equipment, primarily for computer hardware and software. In January 1996, the Company signed a lease agreement for a new facility to which the Company relocated in July. The Company will incur leasehold improvements and capital expenditures of approximately $6.0 million.
The Company believes that its current cash and cash equivalents, its bank line of credit, its capital leases and funds generated from operations, if any, will provide adequate liquidity to meet the Company's capital and operating requirements through at least fiscal 1997. Thereafter, or if the Company's spending plans change, the Company may find it necessary to seek to obtain additional sources of financing to support its capital
needs, but there is no assurance that such financing will be available on commercially reasonable terms, or at all.
BUSINESS RISKS
This report includes a number of forward-looking statements which reflect the Company's current views with respect to future events and financial performance. These forward-looking statements are subject to certain risks and uncertainties, including those discussed below that could cause actual results to differ materially from historical results or those anticipated. In this report, the words "anticipates," "believes," "expects," "intends," "future" and similar expressions identify forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof.
History of Losses; Strategic Realignment. Since inception, the Company has incurred significant losses and substantial negative cash flow. At May 31, 1996, the Company had cumulative operating losses of $21.4 million, with net losses of $5.1 million, $5.8 million and $313,000 for fiscal 1994, fiscal 1995, and fiscal 1996, respectively. The Company was founded in 1988, and historically derived the substantial majority of its revenues from the licensing of high-priced, custom search and retrieval applications for use almost entirely by large organizations and government agencies. During these years, the Company also generated a substantial portion of its revenues by providing the consulting services required to support these products. In early fiscal 1994, the Company shifted its strategy to focus increasingly on more versatile, lower-priced software applications which require less specialized consulting. Due in part to this transition, the Company has experienced declining revenues and net losses in each of its last three fiscal years. To achieve revenue growth, the Company must, among other things, continue to increase market acceptance of the Company's technology, achieve significantly increased sales levels, respond effectively to competitive developments, continue to attract, retain and motivate qualified persons, and continue to upgrade its technologies and commercialize products and services incorporating such technologies. There can be no assurance that the Company's strategy will be successful or that the Company will experience increased revenues or become profitable or cash flow positive at any time in the future.
Management of Transition. The Company is experiencing a period of transition and new product introductions that have placed, and will continue to place, a significant strain on its resources, including personnel. During the past two years, management and other personnel have focused on modifying and enhancing the Company's core technology to support a broader set of search and retrieval solutions for use on desktop and enterprise-wide systems, and over online services, the Internet and on CD-ROM. In order for the Company's strategy to succeed, the Company must, among other things, leverage its core technology to develop new product offerings by the Company and by its original equipment manufacturer ("OEM") customers that address the needs of these new markets. Many of the Company's products are still being developed or have only recently been introduced, and there is no assurance that such products will be successfully completed on a timely basis, will achieve market acceptance or will generate significant revenues. Projects relating to these efforts, including the development and commercial deployment of the Company's next generation Search '97 suite of products, including its Agent Server products and groupware products for Microsoft Exchange, continued enhancement of the functionality of the Company's search engine, and technical integration of the Company's products with the products of the Company's strategic partners, when added to the day-to-day activities of the Company, will continue to strain the Company's resources and personnel.
In connection with its new strategy, the Company has also replaced the majority of its work force and substantially reorganized all of the departments within the Company. While experiencing substantial turnover, the Company increased the number of research and development personnel from 29 at the beginning of fiscal 1994 to 85 at May 31, 1996. During the same period, the Company decreased the number of consulting personnel from 29 at the beginning of fiscal 1994 to 10 at May 31, 1996. Continuity of personnel can be an important factor in the successful completion of the Company's development projects, and ongoing turnover in the Company's research and development personnel could materially and adversely impact the Company's development and marketing efforts. The Company believes that hiring and retaining qualified individuals at all
levels in the Company is essential to its success, and there can be no assurance that the Company will be successful in attracting and retaining the necessary personnel. If Company management is unable to effectively manage its planned transition or any subsequent growth, identify opportunities in a timely fashion, and evaluate and manage the Company's business and competitive position, results of operations and financial condition will be materially and adversely affected.
Fluctuations in Operating Results. The Company's quarterly operating results have varied and are expected to vary significantly in the future. These fluctuations may be caused by many factors, including, among others, the size and timing of individual orders; customer order deferrals in anticipation of new products; changes in the budgets or purchasing patterns of government agencies; timing of introduction or enhancement of products by the Company or its competitors; market acceptance of new products; technological changes in search and retrieval, database, networking, or communications technology; competitive pricing pressures; changes in the Company's operating expenses; personnel changes; foreign currency exchange rates; mix of products sold; quality control of products sold; and general economic conditions.
A significant portion of the Company's revenues in recent quarters has been derived from relatively large sales to a limited number of customers, and the Company currently anticipates that future quarters will continue to reflect this trend. Sales cycles for these customers can be up to six months or longer. In addition, like many software companies, the Company has generally recognized a substantial portion of its revenues in the last month of each quarter, with these revenues concentrated in the last weeks of the quarter. Accordingly, the cancellation or deferral of even a small number of purchases of the Company's products could have a material adverse effect on the Company's business, results of operations and financial condition in any particular quarter. To the extent that significant sales occur earlier than expected, operating results for subsequent quarters may fail to keep pace or even decline.
Product revenues are also difficult to forecast because the market for search and retrieval software is uncertain and evolving. Because the Company generally ships software products within a short period after receipt of an order, the Company typically does not have a material backlog of unfilled orders, and revenues in any quarter are substantially dependent on orders booked in that quarter. In addition, a portion of the Company's revenues are derived from royalties based upon sales by third-party vendors of products incorporating the Company's technology. These revenues may be subject to extreme fluctuation and are difficult for the Company to predict. The Company's expense levels are based, in part, on its expectations as to future revenues and to a large extent are fixed. Therefore, the Company may be unable to adjust spending in a timely manner to compensate for any unexpected revenue shortfall. Any significant shortfall of demand in relation to the Company's expectations or any material delay of customer orders would have an almost immediate adverse affect on the Company's operating results and on the Company's ability to achieve profitability.
The Company's revenues, and particularly its software products revenues, increased significantly in fiscal 1996. Due to the evolving nature of the markets for the Company's products and other factors, however, there can be no assurance that the Company's revenues will continue to increase significantly or at all in future periods.
As a result of the foregoing and other factors, the Company believes that period-to-period comparisons of its results of operations are not necessarily meaningful and should not be relied upon as indications of future performance. Fluctuations in operating results may also result in volatility in the price of the shares of the Company's Common Stock.
Developing Market; Unproven Acceptance of the Company's Products. The Company has recently introduced or announced several products addressing a market which has only recently begun to develop, is rapidly evolving and is characterized by an increasing number of market entrants who have introduced or developed products and services addressing search and retrieval requirements over private and public networks, CD-ROM, online services and the Internet. The Company currently plans to commence commercial shipments of its enhanced Search '97 line of products in the Fall 1996. There is no assurance that such products will be developed and released on a timely basis, or that such products will achieve market acceptance.
As is typical in the case of a new and evolving industry, demand and market acceptance for recently introduced products and services are subject to a high level of uncertainty. The software industry addressing the information management requirements of networked systems, CD-ROM, online services and the Internet is young and has few proven products. Moreover, critical issues concerning the commercial use of online services and the Internet (including security, reliability, cost, ease of use and access, and quality of service) remain unresolved and may impact the growth of the Internet and online markets, together with the software standards and electronic media employed in such markets.
The Company's future operating results will depend in substantial part upon its ability to increase the installed base of its Topic intelligent search and filtering technology and to begin to generate significant product revenues from its Topic Enterprise Server, Topic Client, Topic CD Publisher, Topic Internet Server, Topic Agent Server and Topic Newswire Access products, its Search '97 products under development and other products addressing the information retrieval requirements of individuals and corporations from data sources within an enterprise and on CD-ROM, online services and the Internet. The Company's future operating results will also depend upon its ability to successfully market its technology to online and Internet publishers who use such technology to index their published information into Topic collections. To the extent that such publishers do not adopt the Company's technology for indexing their published information, users will be unable to search such information using the Company's search and retrieval products, which in turn will limit the demand for the Company's products.
Because the market for certain of the Company's products and services is new and evolving, it is difficult to assess or predict with any assurance the growth rate, if any, and size of this market. There can be no assurance that the market for the Company's products and services will develop, or that the Company's products or services will achieve market acceptance. If the market fails to develop, develops more slowly than expected or becomes saturated with competitors, or if the Company's products do not achieve significant market acceptance, the Company's business, operating results and financial condition will be materially adversely affected.
A significant element of the Company's strategy is to embed the Topic technology in products offered by the Company's OEM customers. Many of the markets for such products are also new and evolving and, therefore, subject to the same risks faced by the Company in the markets for its own products. In addition, consolidation in the industries served by the Company could, and acquisition or development by any of the Company's significant customers of technology competitive with the Company's would, materially and adversely affect the Company's business and prospects. See "Item 1. Business -- Industry Background."
Dependence on International Operations. In fiscal 1994, fiscal 1995 and fiscal 1996, revenues derived from foreign operations accounted for approximately 15.7%, 14.3% and 6.6% of the Company's total revenues, respectively, with European operations alone accounting for 12.1%, 11.9% and 5.6% of revenues for these periods. The Company's export sales accounted for 28.7%, 24.1% and 19.1% of revenues in fiscal 1994, fiscal 1995 and fiscal 1996, respectively. Accordingly, on a combined basis, foreign operations and export sales accounted for approximately 44.4%, 38.4% and 25.7% of revenues in fiscal 1994, fiscal 1995 an fiscal 1996, respectively. The Company expects that revenues derived from foreign operations and export sales will continue to account for a significant percentage of the Company's revenues for the foreseeable future; however, these revenues may fluctuate significantly as a percentage of revenues from period to period. Certain of these revenues have been derived from sales to foreign government agencies which may be subject to risks similar to those described below.
There are a number of risks inherent in the Company's international business activities, including unexpected changes in regulatory requirements, tariffs and other trade barriers, costs and risks of localizing products for foreign countries, longer accounts receivable payment cycles, potentially adverse tax consequences, limits on repatriation of earnings and the burdens of complying with a wide variety of foreign laws. Additionally, the Company does not engage in hedging activities to protect against the risk of currency fluctuations. Fluctuations in currency exchange rates could cause sales denominated in U.S. dollars to become relatively more expensive to customers in a particular country, leading to a reduction in sales or profitability in that country. Also, such fluctuations could cause sales denominated in foreign currencies to affect a reduction
in the current U.S. dollar revenues derived from sales in a particular country. Furthermore, future international activity may result in increased foreign currency denominated sales and, in such event, gains and losses on the conversion to U.S. dollars of accounts receivable and accounts payable arising from international operations may contribute significantly to fluctuations in the Company's results of operations. The financial stability of foreign markets could also affect the Company's international sales. In addition, revenues of the Company earned in various countries where the Company does business may be subject to taxation by more than one jurisdiction, thereby adversely affecting the Company's earnings. There can be no assurance that such factors will not have an adverse effect on the revenues from the Company's future international sales and, consequently, the Company's results of operations.
Dependence on United States Government and the Risk of Contract Termination. Agencies of the United States government have accounted for a significant portion of the Company's revenues. Specifically, these agencies accounted for approximately 29.3%, 25.5% and 10.5% of revenues in fiscal 1994, fiscal 1995 and fiscal 1996, respectively. Sales to government agencies declined as a percentage of revenues during these periods, and may decline in the future. In recent years, budgets of many government agencies have been reduced, causing certain customers and potential customers of the Company's products to re-evaluate their needs. Such budget reductions are expected to continue over at least the next several years. Future reductions in United States spending on information technologies could have a material adverse effect on the Company's operating results.
Almost all of the Company's government contracts contain termination clauses which permit contract termination upon the Company's default or for convenience of the other contracting party. There can be no assurance such cancellations will not occur in the future, and any such termination could adversely affect the Company's operating results.
Technological Change; Market Acceptance of Evolving Standards. Historically, the Company has derived substantially all of its revenues from the license of custom search and retrieval applications and consulting and other services related to such applications. Recently, the Company has refined and enhanced its core technology to add functionality and facilitate incorporation of the Company's technology in a variety of applications addressing the desktop, CD-ROM, enterprise, online and Internet markets. Nevertheless, the Company expects that for the foreseeable future it will continue to derive the largest portion of its revenues from licensing its technology for enterprise applications.
The computer software industry is subject to rapid technological change, changing customer requirements, frequent new product introductions and evolving industry standards that may render existing products and services obsolete. As a result, the Company's position in its existing markets or other markets that it may enter could be eroded rapidly by product advancements by competitors. The life cycles of the Company's products are difficult to estimate. The Company's future success will depend, in part, upon its ability to enhance existing products and to develop new products on a timely basis. In addition, its products must keep pace with technological developments, conform to evolving industry standards, particularly client/server and Internet communication and security protocols, as well as publishing formats such as Hypertext Markup Language ("HTML"), and address increasingly sophisticated customer needs. There can be no assurance that the Company will not experience difficulties that could delay or prevent the successful development, introduction and marketing of new products, or that new products and product enhancements will meet the requirements of the marketplace and achieve market acceptance. If the Company is unable to develop and introduce products in a timely manner in response to changing market conditions or customer requirements, the Company's financial condition and results of operations would be materially and adversely affected.
In addition, a significant strategy of the Company is to achieve compatibility between the Company's products and the text publication formats the Company believes are or will become popular and widely adopted. The Company invests substantial resources in development efforts aimed at achieving such compatibility. Any failure by the Company to anticipate or respond adequately to technology or market developments could result in a loss of competitiveness or revenue. For instance, to date the Company has focused its efforts on integration with the Adobe PDF and Lotus Notes environments and, more recently, the Microsoft Exchange environment. Should any of these products or technologies lose or fail to achieve
acceptance in the marketplace or be replaced by other products or technologies, the Company's business could be materially adversely affected.
Because one of the Company's strategies is to embed its basic search engine in key OEM application products, the Company's sales of its intelligent search and filtering products depend in part on its ability to maintain compatibility with these OEM applications. There is no assurance that the Company will be able to maintain compatibility with these vendors' products or continue to be the search technology of choice for such OEMs, and the failure to maintain compatibility with or be selected by such OEMs would materially adversely affect the Company's sales. Further, the failure of the products of the Company's key OEM partners to achieve market acceptance could have a material adverse effect on the Company's results of operations.
Software products as complex as those offered by the Company may contain errors that may be detected at any point in the products' life cycles. The Company has in the past discovered software errors in certain of its products and has experienced delays in shipment of products during the period required to correct these errors. There can be no assurance that, despite testing and quality assurance efforts by the Company and by current and potential customers, errors will not be found, resulting in loss of or delay in market acceptance and sales, diversion of development resources, injury to the Company's reputation, or increased service and warranty costs, any of which could have a material adverse effect on the Company's business, results of operations and financial condition. Although the Company generally attempts to limit by contract its exposure to incidental and consequential damages, and to cap the Company's liabilities to its proceeds under the contract, if a court failed to enforce the liability limiting provisions of the Company's contracts for any reason, or if liabilities arose which were not effectively limited, the Company's operating results could be materially and adversely affected.
Dependence on the Internet. The Company's Topic Internet Server product was released in May 1995, and its Topic CD Publisher product was released in early 1996. Sales of the Company's products addressing Internet search requirements will depend to a substantial degree upon the continued use and future expansion of the Internet for text-based information publication and distribution. Because global commerce and online exchange of information on the Internet and other similar open wide area networks are new and evolving, it is difficult to predict with any assurance whether the Internet will prove to be a viable medium for the publication and distribution of information, including, for example, sensitive proprietary information developed and published by private enterprises.
Competition. The electronic information search and retrieval software market is intensely competitive. The Company believes the principal competitive factors in this market are product quality, performance and price, vendor and product reputation, product architecture, strategic alliances, functionality and features, ease of use and quality of support. A number of companies offer competitive products addressing certain of the Company's target markets. In the enterprise market, the Company competes with Information Dimensions, Dataware and Excalibur, among others. In the Internet/Publishing market, the Company competes with Folio, Dataware and Fulcrum, among others. Fulcrum is also the Company's principal competitor in the tools market. The Company's principal competitors in the online market are Fulcrum, which currently provides search and retrieval technology for the Microsoft Network, and Logicon. The Company also competes indirectly with database vendors that offer information search and retrieval capabilities with their core database products. In the future, the Company may encounter competition from companies that enhance products such as word processing software, document management systems, groupware applications, Internet products and operating systems to include text search and retrieval features. Also, Microsoft recently announced its intention to market search and retrieval software competitive with the Company's products. Many of the Company's existing competitors, as well as Microsoft and a number of potential new competitors, have significantly greater financial, technical and marketing resources than the Company. Because the success of the Company's strategy is dependent in part upon the success of the Company's strategic partners, competition between the Company's strategic partners and the strategic partners of the Company's competitors, or failure of the products of the Company's strategic partners to achieve or maintain market acceptance, could have a material adverse effect on the Company's competitive position. There can be no assurance that the Company will be able to compete successfully against its current or future competitors or that competition will not have a material adverse effect on the Company's results of operations and financial condition.
Dependence on Strategic Alliances. The Company is relying on a number of strategic relationships to achieve commercialization of the Company's technologies and leverage the Company's development, sales and marketing resources. Although the Company views these relationships as important factors in development and commercialization of the Company's technologies, a majority of the Company's agreements with its strategic partners or customers do not require future minimum commitments to license the Company's technology, are not exclusive and may be terminated at the convenience of the Company's customer. There can be no assurance that the Company's strategic partners regard their relationship with the Company as strategic to their own respective businesses and operations, that they will not re-assess their commitment to the Company's technologies at any time in the future or that they will not develop their own competitive technology. Further, there can be no assurance that products of the Company's strategic partners will achieve market acceptance or commercial success.
In order to achieve widespread adoption of Topic technology, it will be necessary for third-party developers to create, produce and market applications which employ the Topic search and retrieval technology. A significant component of the Company's strategy is to leverage the Topic technology through the applications of third-party vendors and third-party information publishers. However, no third-party developer is obligated to select or continue to use the Company's Topic technology, and there can be no assurance that Topic technology will be selected or used by any significant number of third-party developers in the future. To assist in the development of third-party applications, the Company has developed and is selling the Topic Developer's Toolkit ("TDK"). There can be no assurance that the TDK will achieve widespread commercial acceptance or will result in the incorporation of Topic technology in commercially successful third-party products.
Dependence on Key Personnel. The Company's performance is substantially dependent on the performance of its executive officers and key employees, many of whom have worked together for only a short period of time. In particular, the services of Philippe Courtot, the Company's Chairman, President and Chief Executive Officer, would be difficult to replace. The Company is heavily dependent upon its ability to attract, retain and motivate skilled technical and managerial personnel. The Company does not have in place key person life insurance policies on any of its employees. The loss of the services of any of its executive officers or other key employees could have a material adverse effect on the business, operating results or financial condition of the Company.
The Company's future success also depends on its continuing ability to identify, hire, train and retain other highly qualified technical and managerial personnel. Competition for such personnel is intense, and there can be no assurance that the Company will be able to attract, assimilate or retain other highly qualified technical and managerial personnel in the future. The inability to attract, hire or retain the necessary technical and managerial personnel could have a material adverse effect upon the Company's business, operating results or financial condition.
Dependence on Proprietary Technology. The Company's success and ability to compete is dependent in part upon its proprietary technology. While the Company relies on trademark, trade secret and copyright law to protect its technology, the Company believes that factors such as the technological and creative skills of its personnel, new product developments, frequent product enhancements, name recognition and reliable product maintenance are more essential to establishing and maintaining a technology leadership position. The Company presently has no patents or patent applications pending. There can be no assurance that others will not develop technologies that are similar or superior to the Company's technology. The source code for the Company's proprietary software is protected both as a trade secret and as a copyrighted work. Despite these precautions, it may be possible for a third party to copy or otherwise obtain and use the Company's products or technology without authorization, or to develop similar technology independently. In addition, effective copyright and trade secret protection may be unavailable or limited in certain foreign countries. To license its client products, the Company primarily relies on "shrink wrap" licenses that are not signed by the end user and, therefore, may be unenforceable under the laws of certain jurisdictions. Despite the Company's efforts to protect its proprietary rights, unauthorized parties may attempt to copy aspects of the Company's products or to obtain and use information that the Company regards as proprietary. Policing unauthorized use of the Company's products is difficult. There can be no assurance that the steps taken by the Company will prevent
misappropriation of its technology or that such agreements will be enforceable. In addition, litigation may be necessary in the future to enforce the Company's intellectual property rights, to protect the Company's trade secrets, to determine the validity and scope of the proprietary rights of others, or to defend against claims of infringement or invalidity. Such litigation could result in substantial costs and diversion of resources and could have a material adverse effect on the Company's business, operating results or financial condition.
Certain technology used by the Company's products is licensed from third parties, generally on a nonexclusive basis. The Company believes that there are alternative sources for each of the material components of technology licensed by the Company from third parties. However, the termination of any of such licenses, or the failure of the third party licensors to adequately maintain or update their products, could result in delay in the Company's ability to ship certain of its products while it seeks to implement technology offered by alternative sources. Any required replacement licenses could prove costly. Also, any such delay, to the extent it becomes extended or occurs at or near the end of a fiscal quarter, could result in a material adverse effect on the Company's quarterly results of operations. While it may be necessary or desirable in the future to obtain other licenses relating to one or more of the Company's products or relating to current or future technologies, there can be no assurance that the Company will be able to do so on commercially reasonable terms or at all.
Possible Volatility of Stock Price. The Company's Common Stock is quoted for trading on the Nasdaq National Market. The market price for the Common Stock may be highly volatile for a number of reasons including future announcements concerning the Company or its competitors, quarterly variations in operating results, announcements of technological innovations, the introduction of new products or changes in product pricing policies by the Company or its competitors, proprietary rights or other litigation, changes in earnings estimates by analysts or other factors. In addition, stock prices for many technology companies fluctuate widely for reasons which may be unrelated to operating results. These fluctuations, as well as general economic, market and political conditions such as recessions or military conflicts, may materially and adversely affect the market price of the Company's Common Stock.
ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Financial Statements and supplemental data of the Company required by this item are set forth at the pages indicated at Item 14(a).
ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information relating to the directors and executive officers of the Company is set forth in Part I of this report under the caption "Directors, Executive Officers and Key Employees of the Registrant."
ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION
The information required by this Item is incorporated by reference from the definitive proxy statement for the Company's 1996 annual meeting of stockholders to be filed with the Commission pursuant to Regulation 14A not later than 120 days after the end of the fiscal year covered by this Form (the "Proxy Statement") under the caption "EXECUTIVE COMPENSATION AND OTHER MATTERS".
ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this Item is incorporated by reference from the Proxy Statement under the captions "STOCK OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT."
ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this Item is incorporated by reference from the Proxy Statement under the captions "CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS" and "EXECUTIVE COMPENSATION AND OTHER MATTERS -- Compensation Committee Interlocks and Insider Participation in Compensation Decisions".
PART IV
ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) The following documents are filed as a part of this Form:
(b) Reports on Form 8-K:
None.
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors Verity, Inc.
We have audited the accompanying consolidated balance sheets of Verity, Inc. and Subsidiaries as of May 31, 1996 and 1995, and the related consolidated statements of operations, changes in stockholders' equity and cash flows for each of the three years in the period ended May 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 Verity, Inc. and Subsidiaries as of May 31, 1996 and 1995, and the consolidated results of their operations and their cash flows for each of the three years in the period ended May 31, 1996, in conformity with generally accepted accounting principles.
COOPERS & LYBRAND L.L.P.
San Jose, California June 21, 1996, except for Note 14 for which the date is July 12, 1996
VERITY, INC.
CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE DATA)
The accompanying notes are an integral part of these consolidated financial statements.
VERITY, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE DATA)
The accompanying notes are an integral part of these consolidated financial statements.
VERITY, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY FOR THE YEARS ENDED MAY 31, 1996, 1995 AND 1994 (IN THOUSANDS)
The accompanying notes are an integral part of these consolidated financial statements.
VERITY, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
The accompanying notes are an integral part of these consolidated financial statements.
VERITY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. NATURE OF OPERATIONS:
Verity, Inc. (the Company) was incorporated in California in March 1988 and reincorporated in Delaware in September 1995. The Company develops, markets and supports software tools and applications that enable individuals, enterprises and publishers to intelligently search, filter and disseminate textual information residing on enterprise networks, on-line services, the Internet, CD-ROM and other electronic media. The Company markets and sells its software and services to commercial end users across many industries and government entities through multiple distribution channels, including direct sales and telesales organizations primarily in the United States, Europe and Australia, and a worldwide network of value added resellers and system integrators. The Company also licenses its software to original equipment manufacturers for use in their applications sold to end users.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
Basis of Consolidation:
The consolidated financial statements include the accounts of Verity, Inc. and its wholly owned subsidiaries and branches in Australia, Canada, France, Germany, the Netherlands and the United Kingdom. All intercompany balances and transactions have been eliminated.
Accounting 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 amount of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Cash and Cash Equivalents:
Investments with an original or remaining maturity of 90 days or less as of the date of purchase are generally considered cash equivalents. The Company maintains the majority of its cash and cash equivalents in demand accounts with two major financial institutions.
Property and Equipment:
Property and equipment are stated at cost and are depreciated on a straight-line basis over the estimated useful lives of the related assets, generally three to five years. Leased assets are amortized on a straight-line basis over the lesser of the estimated useful life or the lease term. Gains and losses upon asset disposal are taken into income in the year of disposition.
Revenue Recognition:
Revenues from the sale of software products are recognized upon delivery of the product if remaining vendor obligations are insignificant and collection of the resulting receivable is probable. Estimated sales returns and provisions for insignificant vendor obligations are recorded upon shipment.
Service and other revenues include software maintenance revenues and other service revenues, primarily from consulting and training. Software maintenance revenues are deferred and recognized ratably over the life of the service contract. Service revenues from consulting contracts are recognized on the percentage of completion basis. Other service revenues are recognized as the related services are performed.
VERITY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Research and Development Costs:
Costs related to research, design and development of products are charged to research and development expense as incurred. Software development costs are capitalized beginning when a product's technological feasibility has been established and ending when a product is available for general release to customers. To date, completing a working model of the Company's products and general release have substantially coincided. As a result, the Company has not capitalized any software development costs since such costs have not been significant.
Income Taxes:
Deferred tax assets and liabilities are determined based on the differences between financial reporting and tax bases of assets and liabilities, measured at tax rates that will be in effect when the differences are expected to reverse. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized.
Investments:
The Company has investments at May 31, 1996 which consist primarily of commercial paper and debt securities. As of the balance sheet date, investments with maturity dates of one year or less are classified as current, and those with maturity dates of greater than one year are classified as long-term.
The Company has classified its investments as available-for-sale. Such investments are recorded at fair value and unrealized gains and losses, if material, are recorded as a separate component of equity, net of tax, until realized. Interest income is recorded using an effective interest rate, with the associated premium or discount amortized to investment income. The cost of securities sold is based upon the specific identification method.
Concentration of Credit Risk:
The Company performs ongoing credit evaluations of its customers' financial condition and generally does not require collateral. The Company maintains allowances for potential losses, and such losses have been within management's expectations. No single customer accounted for more than 10% of the accounts receivable balance at May 31, 1996 and 1995.
Foreign Currency Translation:
The Company translates the accounts of its branches and subsidiaries using historical rates for nonmonetary assets and current rates for monetary assets. Remeasurement gains and losses from the translation of these branches and those that arise from exchange rate changes on transactions denominated in a currency other than the local currency are included in the statements of operations. The Company's foreign branches and subsidiaries use the U.S. dollar as their functional currency as the U.S. parent exclusively funds the branches and subsidiaries' operations with U.S. dollars. The net gain (loss) on foreign currency remeasurement and exchange rate changes for fiscal years 1996, 1995 and 1994 which is included in other income (expense), net on the accompanying statements of operations, was $(24,000), $36,000, and $(260,000), respectively.
Fair Value of Financial Instruments:
Carrying amounts of certain of the Company's financial instruments including cash and cash equivalents, accounts receivable, accounts payable, accrued expenses and other liabilities approximate fair value due to their short maturities. Based upon borrowing rates currently available to the Company for loans with similar terms, the carrying value of capital lease obligations and notes payable approximate fair value.
VERITY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Computation of Net Loss Per Share:
Net loss per share is computed using the weighted average number of shares of common and common stock equivalents outstanding. Common equivalent shares from stock options, warrants and preferred stock are excluded from the computation when their effect is antidilutive, except that, pursuant to the Securities and Exchange Commission Staff Accounting Bulletins, common and common equivalent shares and mandatorily redeemable convertible preferred stock, issued at prices below the public offering price during the twelve months immediately preceding the Company's initial filing date of the registration statement with the Securities and Exchange Commission, have been included in the calculation as if they were outstanding for all periods ending prior to the effectiveness of the Company's October 1995 initial public offering, using the treasury stock method and the initial public offering price.
Recent Pronouncements:
In March 1995, the Financial Accounting Standards Board issued Statement No. 121 (SFAS 121) which establishes accounting standards for the impairment of long-lived assets, certain identifiable intangibles, and goodwill related to those assets which are held and used or disposed of. SFAS 121 will be effective for fiscal years beginning after December 15, 1995. The Company does not anticipate that the adoption of SFAS 121 will have an adverse material effect on the Company's financial position or results of operations.
During October 1995, the Financial Accounting Standards Board issued Statement No. 123 (SFAS 123) which establishes a fair value based method of accounting for stock based compensation plans and requires additional disclosures for those companies who elect not to adopt the new method of accounting. While the Company is studying the impact of the pronouncement, it continues to account for employee stock options under APB Opinion No. 25, "Accounting for Stock Issued to Employees." SFAS 123 will be effective for fiscal years beginning after December 15, 1995.
3. ACQUISITION:
In March 1996, the Company acquired substantially all of the assets of Insite Computer Technology Limited (Insite), a company which has focused on developing groupware solutions, for a total purchase price of approximately $295,000 and assumed liabilities of $208,000. The purchase price has been allocated to the fair value of the tangible assets and in-process research and development in the amounts of $122,000 and $381,000, respectively. The amount of the purchase price allocated to in-process research and development, which had no alternative future use and relates to products for which technological feasibility has not been established, was expensed at the acquisition date. The acquisition has been accounted for as a purchase and the results of Insite's operations have been included in the consolidated financial statements from the date of acquisition.
The operations of the acquired company are not material to the consolidated financial statements of the Company, and accordingly, separate pro forma financial information has not been presented for fiscal years 1996 and 1995 as if Insite had been acquired as of June 1, 1994.
VERITY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
4. INVESTMENTS:
As of May 31, 1996, available-for-sale securities consist of the following (in thousands):
At May 31, 1996, scheduled maturities of investments classified as available-for-sale are as follows (in thousands):
5. PROPERTY AND EQUIPMENT (IN THOUSANDS):
Assets acquired under capital leases included in property and equipment above are as follows (in thousands):
6. BANK LINE OF CREDIT:
The Company has available an unsecured $7,500,000 line of credit under an agreement with a bank which expires on September 30, 1997. Borrowings under the line of credit bear interest at the lender's prime rate (8.25% at May 31, 1996). The agreement requires the Company to comply with certain financial covenants and prohibits the assumption of any major debt, except for equipment leases without the bank's approval. As of May 31, 1996, no borrowings were outstanding under the line of credit.
VERITY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
7. LONG-TERM DEBT AND CAPITAL LEASE OBLIGATIONS:
At May 31, 1996, the Company has long-term debt and capital lease obligations as follows (in thousands):
The capital lease obligations, which expire through December 1999, are collateralized by the related assets. Under the terms of the capital lease obligations, the Company is responsible for property taxes, insurance and maintenance costs.
During fiscal year 1996, the Company sold certain equipment at cost less accumulated depreciation of $147,000 and leased back such equipment. No gain or loss was recognized on the sale.
The equipment notes payable are due between November 1997 and July 1998, bear interest at a rate of 16.4% and are collateralized by the underlying equipment.
Future minimum payments under long-term debt and capital lease obligations, are as follows (in thousands):
8. COMMITMENTS:
The Company leases various facilities and vehicles under noncancelable operating leases expiring through December 1999. Under the terms of the leases, the Company is responsible for taxes, insurance and normal maintenance costs.
The Company has entered into an operating lease agreement for its new primary operating facility which will commence in June 1996 and expire in September 2005. Under the terms of the new lease, the Company will be responsible for taxes, insurance and normal maintenance costs. The Company may extend the lease term for an additional five years by providing written notice of its exercise of this option no later than six months before the expiration of the lease term.
VERITY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
At May 31, 1996, the future minimum rental payments under the operating leases are as follows (in thousands):
Rent expense for fiscal years 1996, 1995 and 1994 was $1,070,000, $986,000 and $1,236,000, respectively.
9. STOCKHOLDERS' EQUITY:
Changes in and Conversion of Mandatorily Redeemable Convertible Preferred Stock:
In August 1995, the Company designated 500,000 shares of its preferred stock as Series H mandatorily redeemable convertible preferred stock and issued 436,000 shares of such preferred stock at $7.50 per share for gross proceeds of $3,267,000.
In October 1995, all outstanding shares of Series A through H mandatorily redeemable convertible preferred stock were converted to shares of the Company's common stock in conjunction with its initial public offering.
Initial Public Offering:
In August 1995, the Company's Board of Directors authorized the reincorporation of the Company in Delaware. As part of this reincorporation, the outstanding shares of the predecessor California corporation's common stock and all classes of its mandatorily redeemable convertible preferred stock were converted automatically into shares of the new Delaware corporation's common and mandatorily redeemable convertible preferred stock. As a result of the reincorporation, the Company's authorized common stock was increased to 30,000,000 shares, with a par value of $.001 per share, and upon the conversion of all outstanding mandatorily redeemable convertible preferred stock and the completion of the Company's initial public offering, the authorized preferred stock was reduced to 2,000,000 shares with a par value of $.001.
In October 1995, the Company successfully completed its initial public offering of common stock. The Company sold 2,999,500 shares of common stock in this offering for $32,505,000, net of issuance costs of $961,000.
In January 1996, the Company successfully completed its second public offering of common stock. The Company sold 500,000 shares of common stock in this offering for $16,509,000, net of issuance costs of $400,000.
1995 Stock Option Plan:
Under the 1988 Stock Option Plan, the Company initially reserved 1,300,000 shares of common stock for issuance to employees, directors and consultants of the Company. In July 1995, the Company adopted the Amended and Restated 1995 Stock Option Plan (which amends and restates the 1988 Stock Option Plan) and reserved an additional 611,000 shares for a total of 1,911,000 shares of the Company's common stock. In March 1996, the Company's stockholders approved a further increase to the number of shares reserved under the 1995 Stock Option Plan from 1,911,000 to 2,911,000 shares of the Company's common stock.
VERITY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Under the terms of the Plan, incentive options may be granted at prices not lower than fair market value at date of grant, while nonqualified options may be granted at prices not lower than 85% of fair market value at the date of grant as determined by the Board of Directors. Options granted under the Plan are exercisable immediately and expire ten years from date of grant.
Common shares purchased under the Plan are subject to the Company's right of repurchase, which generally lapses as to 12.5% of the shares six months from the individual's date of employment and thereafter, ratably over the remainder of a 3 1/2 year period, at the holder's original purchase price. Thereafter, the Company has the right of first refusal to purchase such shares. At May 31, 1996, 866,000 shares of common stock were available for grant under the 1988 Stock Option Plan.
1996 Nonstatutory Stock Option Plan:
In February 1996, the Company's Board of Directors approved the 1996 Nonstatutory Stock Option Plan. Under this plan, the Company has reserved 300,000 shares of common stock for issuance to certain employees and consultants of the Company. The terms of the 1996 Nonstatutory Stock Option Plan are substantially the same as those of the 1995 Stock Option Plan. At May 31, 1996, 85,000 shares of common stock were available for grant under the 1996 Nonstatutory Stock Option Plan.
Activity Under Stock Option Plans:
Activity under the 1995 Stock Option Plan and the 1996 Nonstatutory Stock Option Plan is set forth below:
At May 31, 1996, 1,434,000 shares of common stock, including outstanding common shares exercised under the plans and unexercised common shares under option, are subject to the Company's right of repurchase.
VERITY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
During fiscal year 1996, certain officers of the Company provided four year recourse notes receivable totaling $403,000 bearing interest at approximately 6.5% in exchange for the purchase of a total of 284,000 shares of common stock under option.
Stock Options Issued Outside of the Plan:
In June 1993, the Company's Board of Directors granted an officer of the Company an option outside of the 1995 Stock Option Plan to purchase 365,000 shares of the Company's common stock at $2.00 per share. Such shares upon purchase will be subject to the Company's right of repurchase, which lapses ratably over four years. In addition, the officer was granted an option outside of the Plan for an additional 418,000 shares of the Company's common stock at $2.00 per share. Upon purchase, these shares are also subject to the Company's right of repurchase, which lapses the earlier of the achievement of certain specified Company performance goals or after completion by the officer of seven years of continuous employment. In December 1993, the exercise price for the shares under these options was reduced to $1.15 per share. In August 1994, the officer exercised his right to purchase all of the shares of common stock under option in exchange for a recourse note receivable of $901,000 bearing interest at 7.05% due August 2003. At May 31, 1996, 152,000 shares of common stock are subject to the Company's right of repurchase.
Employee Stock Purchase Plan:
In July 1995, the Company's Board of Directors approved the 1995 Employee Stock Purchase Plan and reserved 250,000 shares of common stock for issuance to eligible employees. The Employee Stock Purchase Plan permits eligible employees to purchase shares of the Company's common stock at 85% of the lesser of fair market value of the common stock on the first day of the offering period or the last day of the purchase period. The initial offering period commenced on the effective date of the offering. At May 31, 1996, 82,000 shares of the Company's common stock have been issued under the plan and 168,000 shares remain available for purchase.
Outside Directors Plan:
In July 1995, the Company's Board of Directors approved the 1995 Outside Directors Plan and reserved 200,000 shares of common stock for issuance to directors of the Company who are not employees of the Company. The Outside Directors Plan provides for the automatic granting of nonqualified stock options to directors of the Company who are not employees of the Company.
Each current outside director will automatically be granted an option to purchase 20,000 shares of common stock at the next annual meeting of stockholders and thereafter, each new outside director will automatically be granted an option to purchase 20,000 shares of the Company's common stock at the following annual meeting. Thereafter, at each annual meeting of the stockholders, outside directors who have previously received options will receive a new option to purchase 5,000 shares of the Company's common stock. The exercise price of the options in all cases will be equal to the fair market value of the Company's common stock on the date of grant. Options granted under the Directors Plan are immediately exercisable but vest over four years and generally must be exercised within ten years. As of May 31, 1996, no options have been granted to outside directors.
VERITY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
10. INCOME TAXES:
The components of the net deferred tax asset are:
The Company has established a valuation allowance against its deferred tax assets due to the uncertainty surrounding the realization of such assets. Management evaluates on a quarterly basis the recoverability of the deferred tax assets and the level of the valuation allowance. At such time as it is determined that it is more likely than not that deferred tax assets are realizable, the valuation allowance will be reduced.
The Company's deferred tax asset related to its net operating loss carryforwards includes the tax benefit derived from the disqualifying dispositions of incentive stock options and the exercise of nonqualified stock options. The benefit, which totaled $850,000 at May 31, 1996, will be credited directly to additional paid-in capital when the Company's deferred tax asset is recognized.
The Company's effective tax rate differs from the statutory federal income tax rate as shown in the following schedule:
During fiscal year 1996, the Company had a current provision for income taxes of $401,000 which was substantially offset by a benefit derived from the utilization of net operating loss carryforwards.
As of May 31, 1996, the Company had approximately $16,500,000 and $8,960,000 of net operating loss carryforwards for federal and California purposes, respectively, to offset future taxable income. The Company also has federal and state research and development tax credit carryforwards of approximately $692,000 and $420,000, respectively, at May 31, 1996. These carryforwards expire in the years 2004 to 2011 if not utilized. The Company's net operating loss and tax credit carryforwards are subject to an annual limitation of approximately $4,900,000 as a result of an ownership change, as defined by tax laws.
11. RELATED PARTY TRANSACTIONS:
During the fiscal years 1996, 1995 and 1994, the Company provided consulting services and sold software product aggregating $54,000, $172,000 and $202,000, respectively to three stockholders. In addition, costs aggregating approximately $27,000 during fiscal year 1994 were charged to the Company by one of the shareholders for the sublease of certain office facilities and equipment, certain other operational support costs and for services performed. These revenues and costs are included in the accompanying statements of operations.
VERITY, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
12. EMPLOYEE BENEFIT PLAN:
The Verity, Inc. 401(k) Plan, as allowed under Section 401(k) of the Internal Revenue Code, provides tax deferred salary deductions for eligible employees. Employees are eligible to participate immediately upon date of hire.
Participants may make voluntary contributions to the plan up to 20% of their compensation. The plan does not provide for Company contributions.
13. BUSINESS SEGMENT, FOREIGN SALES AND OPERATIONS, AND MAJOR CUSTOMERS:
The Company, whose operations consist of a single line of business, develops, markets and supports software tools and applications that enable individuals, enterprises and publishers to intelligently search, filter and disseminate textual information residing on enterprise networks, on-line services, the Internet, CD-ROM and other electronic media.
The Company has sales and marketing operations located outside the United States in the Netherlands, United Kingdom, France, Germany, Canada and Australia. Foreign branch and subsidiary revenues consist primarily of maintenance and consulting services.
13. BUSINESS SEGMENT, FOREIGN SALES AND OPERATIONS, AND MAJOR CUSTOMERS, CONTINUED:
Transfers between geographic areas are recorded at amounts generally above cost and in accordance with the rules and regulations of the respective governing tax authorities. Operating income consists of total net sales less operating expenses, and does not include either interest and other income, net, or income taxes. Identifiable assets of geographic areas are those assets used in the Company's operations in each area.
Included in software product revenues are export sales of approximately $5,861,000, $3,825,000 and $4,771,000 in fiscal years 1996, 1995 and 1994, respectively.
No single customer accounted for 10% or more of the Company's revenue during fiscal years 1996, 1995 and 1994. Revenues from the federal government and its agencies were $3,230,000, $4,056,000 and $4,872,000 for fiscal years 1996, 1995 and 1994, respectively.
14. SUBSEQUENT EVENT:
On July 12, 1996, the Company's Board of Directors approved a plan whereby each individual holding options to purchase the Company's common stock were given a choice to either retain their current option or replace such option with an option for an equal number of shares of common stock with a fair market price of $19.50 per share.
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Shareholders Verity, Inc.:
Our report on the consolidated financial statements of Verity, Inc. and Subsidiaries has been incorporated in this Form 10-K on page 29. In connection with our audits of such financial statements, we have also audited the related financial statement schedule on page 45 of this Form 10-K.
In our opinion, the financial schedule referred to above when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information required to be included herein.
COOPERS & LYBRAND L.L.P.
San Jose, California June 21, 1996, except for Note 14 for which the date is July 12, 1996
SCHEDULE II
VERITY, INC.
VALUATION AND QUALIFYING ACCOUNTS (IN THOUSANDS)
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.
VERITY, INC.
Date: August 12, 1996 By: /s/ Donald C. McCauley
------------------------------------ Donald C. McCauley Chief Financial Officer (Principal Financial and Accounting Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated.
INDEX TO EXHIBITS
- - - --------------- (1) Incorporated by reference from the exhibits with corresponding numbers from the Company's Registration Statement (No. 33-96228), declared effective on October 5, 1996. (2) Incorporated by reference from the exhibits with corresponding numbers from the Company's Registration Statement (No. 33-80567), declared effective on January 17, 1996. (3) Incorporated by reference from the exhibits with corresponding numbers from the Company's Form 10-Q for the quarter ended February 29, 1996. (4) Management contract or compensatory plan covering executive officers and directors of the Company. (5) Confidential Treatment has been granted for portions of these exhibits.