Ken, NT to get its' money back...AVICI SYSTEMS INC
Form: S-1 Filing Date: 5/18/2000
judging by the cash burn, cash on hand and sales numbers, they needed the $$$
Net revenues -- $ -- $ 504k
Cost of revenues -- -- 429k
net 75k
risks...We may experience a
reluctance by our prospective customers to replace or expand their current
infrastructure solutions, which may be supplied by one or more of these
competitors, with our products. In addition, these competitors have
significantly broader product lines than we do and may bundle their products
with other networking products in a manner that may discourage prospective
customers from purchasing our TSR. In order to compete effectively, we must
deliver a product that is superior in meeting the needs of carriers and that:
. scales easily and efficiently with minimum disruption to the network;
. interoperates with existing network designs and equipment vendors;
. provides extremely high network reliability;
. provides high performance interfaces and high speed packet processing
capabilities;
. reduces complexity by decreasing the need for overlapping equipment;
. provides effective network management; and
. provides a cost-effective solution for our target customers.
Many of our current and potential competitors have greater selling and
marketing, technical, manufacturing, financial and other resources, more
customers, greater market recognition and more established relationships and
alliances in the industry. As a result, these competitors may be able to
develop, enhance and expand their product offerings more quickly, adapt more
swiftly to new or emerging technologies and changes in customer demands,
devote greater resources to the marketing and sale of their offerings, pursue
acquisitions and other opportunities more readily and adopt more aggressive
pricing policies.
36
Intellectual Property
Our success and ability to compete are dependent on our ability to develop
and maintain the proprietary aspects of our technology and operate without
infringing on the proprietary rights of others. We rely on a combination of
patents, copyrights, trademarks, trade secret laws, and contractual
restrictions on disclosure and other methods to protect the proprietary
aspects of our technology. These legal protections afford only limited
protection for our technology. We presently have 13 patent applications
pending in the United States and we cannot be certain that patents will be
granted based on these or any other applications, or that, even if issued, the
patents will adequately protect our technology. We seek to protect our source
code for our software, documentation and other written materials under trade
secret and copyright laws, and we seek to limit disclosure of our intellectual
property by requiring employees, consultants and any third-party with access
to our proprietary information to execute confidentiality agreements with us.
Since our inception, we have incurred significant losses. As of March 31,
2000, we had an accumulated deficit of $99.0 million. Our operating activities
to date have been primarily devoted to research and development, including the
design and development of our proprietary ASICs and software, and system
testing the TSR. During this period, we have also built our administrative,
marketing and sales organizations and developed strategic relationships with
systems integrators, customers and vendors. We have not achieved profitability
on a quarterly or an annual basis and anticipate that we will continue to
incur significant operating losses in the foreseeable future. We have a
lengthy sales cycle for our products and, accordingly, we expect to incur
significant sales and other expenses before we realize the related revenue. We
expect to incur significant sales and marketing, research and development and
general and administrative expenses as we expand our business and, as a
result, we will need to generate significant revenues to achieve and maintain
profitability.
The TSR became commercially available in the fourth quarter of 1999. We
currently market the TSR to major carriers in North America through a direct
sales force. We have recently begun to market our products internationally
through systems integrators and distributors. We currently provide product
installation and customer field support through our internal customer service
organization. However, we plan to supplement our professional services staff
with resources from a third-party support organization.
We currently generate revenue from sales of our TSR, which is our only
product. We recognize revenue from product sales upon shipment, provided that
a purchase order has been received or a contract has been executed, there are
no uncertainties regarding customer acceptance, the sales price is fixed and
determinable and collectibility is deemed probable. If uncertainties regarding
customer acceptance exist, revenue is recognized when these uncertainties are
resolved. Amounts collected or billed prior to satisfying revenue recognition
criteria are recorded as deferred revenue. We also expect to generate revenue
in the future from support and maintenance as well as installation and
service. We will defer revenue from support and maintenance contracts and
recognize it ratably over the period of the related agreements. We expect to
recognize revenue from installation and other services as the work is
performed. We record an estimate of warranty liability for parts and labor on
our products at the time we recognize revenue.
23
All of our revenue through March 31, 2000 has been recognized from a single
customer. We have also shipped our TSR to a limited number of other customers,
although any revenues from these shipments have been deferred as of March 31,
2000 in accordance with our revenue recognition policy. We expect that in the
foreseeable future, substantially all of our revenues will continue to depend
on sales of our TSR to these customers and a limited number of potential new
customers. Generally, these customers are not contractually committed to
purchase any minimum quantities of products from us. Enron Broadband Services
and Williams Communications have agreed to future minimum purchases of the TSR
totaling $45.0 million through 2001, subject to successful completion of field
trials. Additionally, while there has been no commitment to purchase equipment
for deployment, the TSR has successfully completed laboratory testing at AT&T
and has been selected by AT&T for field trials. We expect these field trials
to be completed by the end of 2000. Any future commitments for deployment
orders will be dependent upon the successful completion of these field trials.
We cannot assure you that these trials will be successful or that future
orders will be placed.
We outsource our manufacturing operations to contract manufacturers that
assemble and test our products in accordance with our specifications.
Accordingly, a significant portion of our cost of revenues involves payment to
these entities. Our cost of revenues also includes payments to LSI Logic,
which develops several of our proprietary ASICs. These proprietary ASICs are
very complex and LSI Logic is currently our sole source supplier for them. Our
cost of revenues also includes overhead costs associated with our
manufacturing, mainly material procurement. Warranty costs and inventory
provisions will be expensed as cost of revenues.
Research and development expenses consist primarily of salaries and related
employee costs, prototype, equipment and materials costs and third-party costs
and fees related to the development and prototyping of our proprietary
technology, including our ASICs. We expense research and development costs as
incurred. We expect our research and development expenses to increase in
absolute dollars as we continue to invest in next generation products and
features in response to customer demand. In particular, we anticipate
significant expenditures in the second quarter of 2000 for prototype equipment
for internal use and other related costs.
Sales and marketing expenses consist primarily of salaries and related
employee costs, sales commissions, travel, public relations and other costs
associated with marketing material and tradeshows. We expect that sales and
marketing expenses will increase in absolute dollars in the future as we hire
additional sales and marketing personnel, establish sales offices in new
locations domestically and internationally and initiate additional marketing
programs.
General and administrative expenses consist primarily of salaries and
related costs for executive, finance, legal, facilities, human resources and
information technology personnel and professional fees. We expect that general
and administrative expenses will increase in absolute dollars as we add
personnel and incur additional costs related to the growth of our business and
operation as a public company.
In March 2000, we recorded a non-cash charge for deferred stock compensation
of approximately $18.5 million in connection with restricted stock and stock
options granted to employees through March 31, 2000 at prices subsequently
deemed to be below fair market value on the dates of grant. We are amortizing
the deferred stock compensation over the vesting periods of the applicable
options and the repurchase periods for the restricted stock. Options granted
are typically subject to a four-year vesting period. Restricted stock grants
are generally subject to our right to repurchase the stock, which lapses over
a four-year period or, if earlier, immediately upon the closing of this
offering. Accordingly, the remaining deferred compensation expense related to
these shares of restricted stock will be recognized in the quarter in which
this offering closes. Options granted to nonemployees are remeasured each
period using the Black-Scholes option pricing model and result in compensation
expense based on the shares vesting in that period. Stock-based compensation
expense for the year ended December 31, 1999 was $2.2 million and for the
three months ended March 31, 2000 was $2.9 million. The unamortized balance of
deferred stock compensation at March 31, 2000 was $14.1 million and is
expected to be amortized to expense as follows: $6.1 million in the remaining
nine months ended December 31, 2000, $4.6 million in 2001, $2.4 million in
2002 and $1.0 million in 2003.
24
We expect to record an additional non-cash deferred compensation charge of
approximately $11.8 million for 1,176,650 options granted from April 1, 2000
through May 15, 2000. These grants have been made on terms consistent with
prior grants. The deferred compensation related to these grants will be
expensed over the option vesting period. We expect to continue to grant
options through the closing of this offering at exercise prices which may
subsequently be deemed to be below fair market value.
Results of Operations
Three Months Ended March 31, 1999 and 2000
Net Revenues. We first recognized revenue in the three months ended March
31, 2000. Net revenues were $504,000 for the three months ended March 31,
2000, all of which was from a single customer.
Cost of Revenues. Cost of revenues was $429,000, or 85.1% of net revenues,
for the three months ended March 31, 2000. Due to the high cost of starting up
production, cost of revenues as a percentage of net revenues in the three
months ended March 31, 2000 was higher than we anticipate once volume
production is attained.
Research and Development. Research and development expenses increased by
$3.3 million from $8.0 million for the three months ended March 31, 1999 to
$11.3 million for the three months ended March 31, 2000. This increase was due
mainly to an increase in the number of research and development personnel,
offset by the completion of a research and development contract subsequent to
the three months ended March 31, 1999.
Sales and Marketing. Sales and marketing expenses increased by $833,000 from
$915,000 for the three months ended March 31, 1999 to $1.7 million for the
three months ended March 31, 2000. This increase was due mainly to the hiring
of additional sales and marketing personnel and increased marketing expenses.
General and Administrative. General and administrative expenses increased
slightly by $21,000 from $736,000 for the three months ended March 31, 1999 to
$757,000 for the three months ended March 31, 2000.
Stock-Based Compensation. Stock-based compensation increased by $2.6 million
from $297,000 for the three months ended March 31, 1999 to $2.9 million for
the three months ended March 31, 2000. This increase was due primarily to
shares of restricted stock and stock options granted subsequent to the three
month period ended March 31, 1999 in connection with our increased hiring
efforts.
Interest Income, Net. Interest income, net of interest expense, increased by
$212,000 from $65,000 for the three months ended March 31, 1999 to $277,000
for the three months ended March 31, 2000 as a result of higher interest
income from increased invested cash balances, partially offset by an increase
in interest expense on capital leases.
Years Ended December 31, 1997, 1998 and 1999
Net Revenues. We did not recognize any revenue during any of these years.
Cost of Revenues. We did not have any cost of revenues during any of these
years.
Research and Development. Research and development expenses increased from
$4.2 million in 1997 to $27.4 million in 1998 to $36.8 million in 1999. These
increases were due mainly to an increase in the number of research and
development personnel and contract research and development costs associated
with the development of the TSR.
Sales and Marketing. Sales and marketing expenses in 1997 were not material.
These expenses increased from $1.6 million in 1998 to $5.6 million in 1999 due
to the addition of sales and marketing personnel and additional marketing
expenses.
25
General and Administrative. General and administrative expenses increased
from $858,000 in 1997 to $2.0 million in 1998 to $3.0 million in 1999 due to
the addition of administrative personnel as well as increased facilities,
information systems and other expenses necessary to support our growing scale
of operations.
Stock-Based Compensation. Stock-based compensation expense decreased from
$325,000 in 1997 to $60,000 in 1998 and increased to $2.2 million in 1999 in
connection with restricted stock and stock options granted during that period
at prices subsequently deemed to be below fair market value on the date of
grant. This increase was due primarily to stock options granted in 1999.
Interest Income, Net. Interest income, net of interest expense, increased
from $188,000 in 1997 to $939,000 in 1998 and decreased to $844,000 in 1999.
The increase from 1997 to 1998 is primarily due to the increase in interest
earned on available cash balances, offset by interest expense charges on
capital leases. The decrease from 1998 to 1999 is due to higher interest
expense charges resulting from increases in leased capital equipment over
modestly higher interest earned on invested balances.
Net Operating Loss and Tax Credit Carryforwards
We have not recorded a provision for income taxes because we experienced net
losses from inception through March 31, 2000. As of December 31, 1999, we had
net operating loss and tax credit carryforwards of approximately $73.2 million
and $2.4 million, respectively. These carryforwards will expire at various
dates through 2019, if not utilized. Utilization of the net operating losses
and tax credits may be subject to a substantial annual limitation due to the
ownership change limitations contained in the Internal Revenue Code and
similar state provisions. The annual limitation may result in the expiration
of the net operating loss and credits before utilization. Due to the
uncertainty that exists regarding the recoverability of the associated
deferred tax assets, a full valuation allowance has been recorded against
these assets.
Liquidity and Capital Resources
Since our inception, we have financed our operations through private sales
of equity securities and, to a lesser extent, equipment lease financing. From
inception through May 15, 2000, we raised approximately $168 million in a
series of preferred stock financings. During the three months ended March 31,
2000, we used $14.8 million in cash for operating activities. In 1999, we used
$41.0 million in cash for operating activities, compared to $25.7 million used
in 1998 and $3.9 million used in 1997. The increase in cash usage resulted
principally from the ongoing research and development costs of the TSR during
these periods, including increased personnel and material costs. We expect
research and development costs to increase as we enhance the functionality of
our TSR and develop new complementary products. We also will continue to
increase our investment in capital assets as we expand our operations.
At March 31, 2000, our primary sources of liquidity were $24.1 million in
cash and cash equivalents and $7.7 million in investments. In April and May of
2000, we generated $44.5 million in a preferred stock financing. Our purchases
of property and equipment were $1.9 million for 1997, $7.5 million in 1998,
$4.6 million in 1999 and $630,000 for the three months ended March 31, 2000,
and consisted primarily of purchases of application software and computer
equipment, including workstations and servers to support our increased
research and development activities. We financed $1.7 million, $4.8 million
and $4.4 million through capital lease arrangements during 1997, 1998 and
1999, respectively. We expect capital expenditures to increase as we further
expand our research and development efforts and as our employee base grows.
The timing and amount of future capital expenditures will depend primarily on
our future growth. We expect to spend approximately $5.0 million in 2000 for
computer equipment, including application software, workstations and servers.
We anticipate that this equipment will be financed by capital leases.
We have a master lease agreement with a leasing company that is also a
preferred stockholder. This agreement provided for up to $12.0 million of
lease financing on specific types of equipment. The equipment
26
leased under this agreement remains the property of the lender at the end of
the term. However, due to the length of the contract terms, the leases are
recorded as capital lease obligations. Our remaining availability under the
original lease line expired in January 2000. In May 2000 we entered into a one
year $6.0 million extension to the agreement.
We have also borrowed $1.3 million in 1998 under a term-loan agreement with
the same lender for software purchases. We are required to repay this loan in
30 monthly installments of approximately $49,000, including principal and
interest. Repayment began in July 1999, with a final payment in the amount of
$187,500 due at the end of the term.
Additionally, we expect that working capital requirements will increase
significantly as product sales increase, creating larger customer receivable
balances and the need to build inventory in advance of shipment.
We believe that the net proceeds from this offering, together with our
existing cash balances and available capital lease financing, will be
sufficient to meet our operating and capital requirements for at least the
next 12 months. However, we could be required, or could elect, to raise
additional funds during that period and we may need to raise additional
capital in the future. We may not be able to obtain additional capital on
terms favorable to us or at all. The issuance of additional equity or equity-
related securities will be dilutive to our stockholders.
Recent Accounting Pronouncements
In March 2000, the FASB issued Interpretation No. 44, "Accounting for
Certain Transactions Involving Stock Compensation--an Interpretation of APB
Opinion No. 25." The interpretation clarifies the application of APB Opinion
No. 25 in specified events, as defined. The interpretation is effective July
1, 2000, but covers certain events occurring during the period after December
15, 1998, but before the effective date. To the extent that events covered by
this interpretation occur during the period after December 15, 1998, but
before the effective date, the effects of applying this interpretation would
be recognized on a prospective basis from the effective date. Accordingly,
upon initial application of the final interpretation, (a) no adjustments would
be made to the financial statements for periods before the effective date and
(b) no expense would be recognized for any additional compensation cost
measured that is attributable to periods before the effective date. We expect
that the adoption of this interpretation would not have any effect on the
accompanying financial statements.
In December 1999, the Securities and Exchange Commission issued Staff
Accounting Bulletin No. 101, "Revenue Recognition." This bulletin summarizes
views of the Staff on applying generally accepted accounting principles to
revenue recognition in financial statements. We believe that our current
revenue recognition policy complies with the guidelines in the bulletin.
In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative Instruments
and Hedging Activities," which establishes accounting and reporting standards
for derivative instruments, including derivative instruments embedded in other
contracts, and for hedging activities. We do not currently engage in trading
market risk sensitive instruments or purchasing hedging instruments or "other
than trading" instruments that are likely to expose us to market risk, whether
interest rate, foreign currency exchange, commodity price or equity price
risk. We may do so in the future as our operations expand domestically and
abroad. We will evaluate the impact of foreign currency exchange risk and
other derivative instrument risk on our results of operations when
appropriate. We will adopt SFAS No. 133 as required by SFAS No. 137, "Deferral
of the effective date of the FASB Statement No. 133," in fiscal year 2001. The
adoption of SFAS No. 133 is not expected to have a material impact on our
financial condition or results of operations.
27
BUSINESS
Overview
We provide high-speed data networking equipment that enables
telecommunications companies and Internet service providers to intelligently
transmit high volumes of information across their fiber optic networks. Our
high-performance solution is a critical building block for telecommunications
companies and Internet service providers, referred to as carriers, that are
creating next-generation optical networks to address the increasing data
traffic across the Internet. The Avici Terabit Switch Router, known as the
TSR, is designed to cost-effectively provide high-speed/high-volume capacity,
carrier-class reliability and in-service scalability, or the ability to
incrementally add capacity to the network without disrupting network
performance. Our TSR also optimizes bandwidth by dynamically managing and
prioritizing network traffic, thereby bringing intelligence to the carriers'
networks and enabling carriers to provision new revenue-generating services,
such as video streaming and Voice-over-Internet Protocol, or VoIP. Our TSR
provides these benefits through our proprietary technologies, including our
application specific integrated circuits, or ASICs, distributed system
architecture and Composite Links. Currently, the TSR is deployed in a segment
of The National Transparent Optical Network, an Internet initiative known as
SuperNet. In addition, Enron Broadband Services and Williams Communications
have agreed to future purchases of the TSR, subject to successful completion
of field trials. The TSR has successfully completed laboratory testing at AT&T
and has been selected by AT&T for field trials. We have also shipped the TSR
to a limited number of other customers and prospective customers.
Industry Background
Demand for Data Services is Fueling Network Growth
Data traffic over today's communications networks is growing at an
exponential rate, far exceeding the growth in voice traffic. Ryan Hankin and
Kent, an industry research firm, estimates that North American data traffic
reached 350,000 terabytes per month in December 1999, compared to 50,000
terabytes per month for voice traffic in the same period. This proliferation
of data traffic is being driven by a number of factors, including increases
in:
. the number of Internet users worldwide, which according to
International Data Corporation, an industry research firm, is expected
to increase from approximately 144 million at the end of 1998 to
approximately 602 million by the end of 2003; and
. business use of the Internet for applications such as e-commerce, video
streaming and virtual private networks, or VPNs.
To keep pace with the growing demand, transmission speeds have increased from
kilobits per second to megabits per second to gigabits per second. Pioneer
Consulting LLC, an industry research firm, estimates that peak-hour Internet
bandwidth demand in North America alone will grow from 0.33 terabits per
second in 1999 to 17.92 terabits per second in 2004, representing a compound
annual growth rate exceeding 120%.
Limitations of the Existing Public Network Infrastructure
The existing public networks are largely built on technologies that were
originally designed to provide only voice services. These networks are based
on circuit switch technology, which dedicates a line, or circuit, for the
duration of a call even while there are pauses in the conversation. Although
adequate for voice traffic, circuit switch technology is inefficient for the
transmission of large volumes of data traffic, which tends to occur in large,
intermittent bursts. As data traffic carried over the existing network
infrastructure began to increase, carriers increased the capacity of their
networks by overlaying devices designed to increase data transmission rates
and that are based on network standards such as Synchronous Optical Network,
or SONET.
28
At the same time, carriers also sought to increase the efficiency of data
transmission through their networks by adopting packet switching technologies,
such as Asynchronous Transfer Mode, or ATM, and Internet Protocol, or IP,
which divide data traffic into individual packets and transmit them
independently over the network. These packet-switching technologies enable
carriers to use data packets from multiple senders to fill existing capacity
in a circuit, thereby substantially reducing the bandwidth wasted using
circuit switch technology. With much of the growth in data traffic
attributable to the increasing use of the Internet, IP has become the
predominant standard for transmitting data across networks. Nevertheless,
carriers have been forced to adopt and deploy multiple protocols and a variety
of devices within their networks in an effort to manage the proliferation of
IP-based data services. The following diagram illustrates the limitations of
the existing public network infrastructure:
[DIAGRAM APPEARS HERE]
[Symmetric diagram with wavy line at center representing the fiber cable, which
is labeled "Carrier Optical Transport." Aligned on the horizontal axis extending
from each of the left and right sides of the "Carrier Optical Transport" wavy
line is a box with caption reading "DWDM and Optical Switches." Connected by a
bold line to both of the "DWDM and Optical Switches" boxes is a brick wall with
star-shaped icons on either side. Underneath each brick wall is the caption
"Mismatch Between Transmission Speeds" with arrows pointing from the caption to
both sides of the brick wall. Seven lines lead from each of the outside star-
shaped icons to a vertical row of boxes with the caption "Existing Carrier
Equipment" above. From top to bottom, the boxes are labeled as follows: "Gigabit
Routers," "VoIP Gateways," "SONET," "Digital Subscriber Line Aggregation,"
"ATM," "Gigabit Ethernet" and "Cable Modem Termination."]
The advent of Dense Wave Division Multiplexing, or DWDM, an optical
technology that multiplies the amount of data that can be carried over
existing fiber optic lines, has provided carriers with substantial raw
capacity in the core of their optical networks. The widespread deployment of
DWDM technology by carriers has now shifted their focus away from the
deployment of additional fiber lines toward packet switch equipment that can
transmit and route data in volumes and at speeds that take advantage of the
expanded bandwidth enabled by DWDM. Carriers are therefore primarily focusing
on routers, devices designed to forward IP-based data packets, as the
equipment of choice for harnessing the benefits of DWDM.
Limitations of Existing Routers
Optical transmission capacity is increasing at a greater rate than the
transmission capacities of routers. This has created a chasm between the
capabilities of existing routers and the optical transmission network and has
produced bottlenecks in the public network. This chasm results in large part
because of the limited ability of existing router architectures to adapt to
the evolving and increasing bandwidth demands of carriers. For example,
current router offerings employ a centralized architecture, which inherently
limits the number of interfaces available and, accordingly, the ability to
incrementally increase the bandwidth capacity of a router. This limitation
requires that carriers either cluster multiple routers to emulate the
functionality of a single large router with greater capacity or undertake
large-scale upgrades, known as forklift upgrades, to address the increases in
optical transmission speeds.
The following diagram illustrates the growing chasm between router speeds
and optical transmission capacities as well as the periodic deployment of new
core router equipment and the redeployment of existing core routers to the
edge of the carrier network.
29
[DIAGRAM APPEARS HERE]
[Diagram with cloud labeled "Carrier Optical Transport" at the center. To the
right of the "Carrier Optical Transport" cloud is a caption reading "Transport
Evolution Over Time," with a vertical arrow pointing down from the caption.
Within the "Carrier Optical Transport" cloud is a vertical row of three boxes,
each labeled "DWDM and Optical Switches." Horizontal lines extend to the left
from each of the three boxes, and the lines are labeled "OC-12," "OC-48" and
"OC-192," respectively. A star-shaped icon indicates the intersection of each
of these horizontal lines with the "Carrier Optical Transport" cloud. The lines
then continue to the left, with the respective labels "OC-3," "OC-12" and "OC-
48," and connect to three boxes aligned vertically, each containing two disks
representing routers. The disks within each box increase in size from top to
bottom. An arrow leads from the top box down and to the left, and connects to
another box containing two slightly larger disks representing routers. An arrow
leads from the middle box down and to the left, to another box with two slightly
larger disks representing routers. The caption "Router Deploym |
