10-Q 1 d10q.txt FORM 10-Q SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 FORM 10-Q [X] Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the quarterly period ended July 31, 2001 or [_] Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the transition period from ___ to ___ Commission File Number: 001-15010 CERTICOM CORP. -------------------------------------------------------------- (Exact name of registrant as specified in its charter) Yukon Territory, Canada Not Applicable ----------------------- -------------------- (Province or other (I.R.S. Employer jurisdiction of Identification No.) incorporation) 25821 Industrial Boulevard Hayward, California 94545 ------------------------------------------------------------------------------- (Address of principal executive offices) (Zip Code) (510) 780-5400 ----------------------------------------- (Registrant's telephone number, including area code) Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No ___ As of August 31, 2001, there were 31,423,004 of registrant's common shares, no par value, outstanding. i TABLE OF CONTENTS

Unless otherwise indicated, all information in this Form 10-Q gives effect to the 2-for-1 split of the Company's outstanding common shares, which occurred on July 12, 2000. Certicom(R) and Security Builder(R) are our registered trademarks, and certicom encryption(TM), SSL Plus(TM), WTLS Plus(TM), Certilock(TM), Certifax(TM), MobileTrust(TM), Trustpoint(TM), movian(TM), movianVPN(TM) and movianCrypt(TM) are our trademarks. In this Form 10-Q, the terms "Certicom", "the Company", "we", "us", and "our" refer to Certicom Corp., a Yukon Territory, Canada corporation, and/or its subsidiaries. ii EXCHANGE RATE INFORMATION Unless otherwise indicated, all dollar amounts in this Form 10-Q are expressed in United States dollars. References to "$" or "U.S.$" are to United States dollars, and references to "Cdn.$" are to Canadian dollars. The following table sets forth, for each period indicated, information concerning the exchange rates between U.S. dollars and Canadian dollars based on the inverse of the noon buying rate in the City of New York on the last business day of each month during the period for cable transfers as certified for customs purposes by the Federal Reserve Bank of New York (the "Noon Buying Rate"). The table illustrates how many U.S. dollars it would take to buy one Canadian dollar. On July 31, 2001, the Noon Buying Rate was U.S. $0.6532 per Cdn.$1.00.

_____________ (1) The average of the daily Noon Buying Rates on the last business day of each month during the period. SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS Certain statements contained in this Form 10-Q constitute "forward-looking statements" within the meaning of the United States Private Securities Litigation Reform Act of 1995. When used in this document, the words "may," "would," "could," "will," "intend," "plan," "anticipate," "believe," "estimate," "expect" and similar expressions, as they relate to us or our management, are intended to identify forward-looking statements. Such statements reflect our current views with respect to future events and are subject to certain risks, uncertainties and assumptions. Many factors could cause our actual results, performance or achievements to be materially different from any future results, performance or achievements that may be expressed or implied by such forward-looking statements, including, among others, those which are discussed in "Factors That May Affect Operating Results" beginning on page 19 of this Form 10-Q, in our Annual Report on Form 10-K and in other documents that we file with the Securities and Exchange Commission and Canadian securities regulatory authorities. Should one or more of these risks or uncertainties materialize, or should assumptions underlying the forward-looking statements prove incorrect, actual results may vary materially from those described herein as intended, planned, anticipated, believed, estimated or expected. We do not intend, and do not assume any obligation, to update these forward-looking statements. 1 PART I. FINANCIAL INFORMATION Item 1. Financial Statements CERTICOM CORP. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (In thousands of U.S. dollars, except number of shares)

See accompanying notes to condensed consolidated financial statements. 2 CERTICOM CORP. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands of U.S. dollars, except number of shares and per share data) (Unaudited)

See accompanying notes to condensed consolidated financial statements. 3 CERTICOM CORP. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands of U.S. dollars) (Unaudited)

See accompanying notes to condensed consolidated financial statements. 4 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS Note 1. Basis of Presentation The condensed consolidated financial statements included in this document are unaudited and reflect all adjustments (consisting only of normal recurring adjustments, except as noted) which are, in the opinion of our management, necessary for a fair presentation of the financial position, results of operations and cash flows for the interim periods shown. These condensed consolidated financial statements should be read in conjunction with our consolidated financial statements and notes thereto, Management's Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report on Form 10-K for the fiscal year ended April 30, 2001 and Management's Discussion and Analysis of Financial Condition and Results of Operations contained in Item 2 of this Form 10-Q. The results of operations for the three months ended July 31, 2001 are not necessarily indicative of the results for the entire fiscal year ending April 30, 2002. Revenue Recognition and Deferred Revenues We recognize software licensing revenue in accordance with all applicable accounting regulations including the American Institute of Certified Public Accountants Statement of Position (SOP) 97-2, "Software Revenue Recognition," as amended by SOP 98-4 and SOP 98-9. Following the requirements of SOP 97-2, we recognize license revenues when all of the following have occurred: . we have signed a non-cancelable license agreement with the customer; . delivery of the software product to the customer has occurred; . the amount of the fees to be paid by the customer are fixed or determinable; and . collection of these fees is probable. If an acceptance period is contractually provided, license revenues are recognized upon the earlier of customer acceptance or the expiration of that period. In instances where delivery is electronic and all other criteria for revenue recognition has been achieved, the product is considered to have been delivered when the customer either takes possession of the software via a download or the access code to download the software from the Internet has been provided to the customer. Our software does not require significant production, customization or modification. SOP 97-2, as modified, generally requires revenue earned on software arrangements involving multiple elements such as software products, upgrades, enhancements, post contract customer support, or PCS, installation and training to be allocated to each element based on the relative fair values of the elements. The fair value of an element must be based on evidence that is specific to the vendor. If evidence of fair value does not exist for all elements of a license agreement and PCS is the only undelivered element, then all revenue for the license arrangement is recognized ratably over the term of the agreement. If evidence of fair value of all undelivered elements exists but evidence does not exist for one or more delivered elements, then revenue is recognized using the residual method. Under the residual method, the fair value of the undelivered elements is deferred, and the remaining portion of the arrangement fee is recognized as revenue. When arrangements require us to deliver specified additional upgrades the entire fee related to the arrangement is deferred until delivery of the specified upgrade has occurred, unless we have vendor-specific objective evidence of fair value for the upgrade. Fees related to contracts that require us to deliver unspecified additional products are deferred and recognized ratably over the contract term. Revenue from consulting and training services are recognized using the percentage-of-completion method for fixed fee development arrangements or as the services are provided for time-and-materials arrangements. The fair value of professional services, maintenance and support services have been determined using specific objective evidence of fair value based on the price charged when the elements are sold separately. Revenues for 5 maintenance and support service are deferred and recognized ratably over the term of the support period. Revenues from professional services are recognized when the services are performed. In June 2001, we converted our enabling technologies products primarily to subscription-based licenses. In addition, our trust services and enterprise application software product lines are accounted for under the subscription model. Subscription licenses provide our customers with rights to use our software for a specified period of time. Customers are entitled to use the license and receive certain customer support services over the license term. In addition, depending on the type of license, our customers have access to unspecified upgrades on an "if and when available" basis. We expect the average duration of the subscription licenses to be between one and two years. Under subscription licenses, we bill our customers for the current year's product and service fees. The billed product and service fees are recognized as revenues ratably over the billed period, generally one year. Deferred revenues generally result from the following: deferred maintenance and support service, cash received for professional services not yet rendered and license revenues deferred relating to arrangements where we have received cash and are required to deliver either unspecified additional products or specified upgrades for which we do not have vendor-specific objective evidence of fair value. Impairment of Long-Lived Assets We evaluate the recoverability of our property and equipment and intangible assets in accordance with SFAS 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of." SFAS No. 121 prescribes the accounting treatment for long-lived assets, identifiable intangibles and goodwill related to those assets when there are indications that the carrying value of those assets may not be recoverable. SFAS 121 requires recognition of impairment of long-lived assets in the event the net book value of such assets exceeds the future undiscounted cash flows attributable to such assets. Accordingly, we evaluate asset recoverability at each balance sheet date or when an event occurs that may impair recoverability of the asset. Research and Product Development Cost We expense all research and development costs as they are incurred. Scientific research tax credits are recognized at the time the related costs are incurred and recovery is reasonably assured. We have capitalized certain costs associated with the filing of approximately fifty patent applications in various jurisdictions. These patent filings relate to Elliptic Curve Cryptography, or ECC, various mathematical computational methodologies, security protocols and other cryptographic inventions. Once granted, we amortize the individual patent cost over three years. We capitalize patents not yet granted at their cost less a provision for the possibility of the patent not being granted or abandoned. Reclassifications Certain reclassifications have been made in the 2001 financial statement presentation to conform to the 2002 presentation. Note 2. Net Loss per Common Share Basic net loss per common share is computed using the weighted average number of common shares outstanding during the period. Diluted net loss per common share is computed using the weighted average number of common shares outstanding during the period and, when dilutive, potential common shares from options and warrants to purchase common shares, using the treasury stock method. The following potential common shares have been excluded from the calculation of diluted net loss per share for all periods presented because the effect would have been anti-dilutive: 6

The weighted average exercise price of stock options was $3.47 and $9.04 at July 31, 2001 and 2000, respectively. The purchase price of restricted stock was $38.94. The exercise price of outstanding warrants was Cdn.$38.13 per share ($24.91 based on the exchange rate on July 31, 2001). Note 3. Comprehensive Income (Loss) Other comprehensive income refers to revenues, expenses, gains and losses that under U.S. generally accepted accounting principles are recorded as an element of shareholders' equity but are excluded from net income. The following table sets forth the components of comprehensive loss for the three months ended July 31, 2001 and 2000, respectively (in thousands of U.S. dollars):

Note 4. Impairment of Goodwill and Other Intangibles In connection with our restructuring program announced on June 4, 2001, we performed an impairment assessment of the identifiable intangibles and goodwill recorded in connection with the acquisitions of DRG Resources Group, Inc. and Uptronics, Inc. We performed the assessment primarily due to changes in the economy, the overall decline in the industry growth rates, and our lower actual and projected operating results, including those related to our acquisitions of DRG Resources Group, Inc. and Uptronics Inc. As a result, we recorded an impairment of goodwill and other intangible assets of $9.4 million, measured as the amount by which the carrying amount exceeded the present value of the estimated future cash flows for goodwill. The assumptions supporting the cash flows, including the discount rate, were determined using our best estimates as of June 4, 2001. We will continue to assess the recoverability of the remaining goodwill and other intangible assets periodically in accordance with our policy. Note 5. Restructuring Costs On June 4, 2001, we announced a restructuring program to prioritize our initiatives, reduce costs not directly associated with selling and product development, decrease discretionary spending and improve efficiency. This restructuring program includes a reduction of our full-time employee headcount, consolidation of excess facilities and reengineering of certain business functions. As a result of the restructuring program, we recorded restructuring costs of approximately $9.5 million for the three months ended July 31, 2001. We recorded restructuring expenses in the following areas: 1) reduction in workforce; 2) consolidation of excess facilities and non-productive property and equipments; and 3) elimination of deferred compensation. 7 We reduced our work force by approximately 30% across all business functions and geographic regions. We recorded an estimated charge of approximately $2.1 million relating primarily to severance and fringe benefits. We recorded a restructuring charge of approximately $5.1 million for property and equipment that will be disposed of or removed from operations and excess facilities relating primarily to non-cancelable lease costs under the assumption that we will not be able to sublease certain of our excess facilities in next two years. In connection with the acquisition of DRG Resources Group, Inc., we recorded approximately $7.7 million of deferred compensation expense in connection with shares subject to restriction under employment agreements signed with the former owners of DRG Resources Group, Inc. These amounts are being amortized over an eighteen months period. As a result of the restructuring program in June 2001, certain former owners of DRG Resources Group, Inc. left our company. The unvested shares that were restricted under the terms of these employment agreements were immediately vested upon terminations of the related employees. As a result, approximately $2.3 million of deferred compensation charges were recorded in the first quarter of fiscal 2002. In the first quarter of fiscal 2002, we paid approximately $1.6 million in cash for restructuring costs related to certain employee severance and other employee payments. The accrued restructuring and related expenses during the three months ended July 31, 2001 were comprised of the following (in thousands of U.S. dollars):

As of July 31, 2001, we anticipated paying these balances in the next 24 months. Note 6. Segment Information and Significant Customer We operate in one reportable segment. We are a developer, manufacturer and vendor of digital information security products, technologies and services within the industry segment of electronic commerce. Information about our geographic operations is given below (in thousands of U.S. dollars):

One of our customers accounted for approximately 11% of our revenue in the first quarter of fiscal 2002 and one of our customers accounted for approximately 24% of our revenue in the first quarter of fiscal 2001. Note 7. Public Offering and Stock Split In May 2000, we completed a public offering of 2,500,000 common shares at a per share price of $23.15 in the United States and Canada for an aggregate offering price of approximately $57.9 million. Our net proceeds from the offering were approximately $51.5 million after deducting underwriting discounts and commissions and offering expenses. In March 2001, we issued 4,000,000 of our common shares in Canada and the United States at a per share price of Cdn.$12.50 (approximately$8.14 based on the exchange rate on April 30, 2001). The common shares have not 8 been registered under the United States Securities Act of 1933, as amended. The gross proceeds of this offering were Cdn.$50.0 million (approximately $32.5 million based on the exchange rate on April 30, 2001). After deducting underwriting discounts and commissions and offering expenses, the net proceeds of this offering were Cdn.$47.2 million (approximately $30.8 million based on the exchange rate on April 30, 2001). On July 12, 2000, we completed a two-for-one split of our outstanding common shares. All share and per share amounts in this document have been adjusted to give effect to this split. Note 8. Stock Option Repricing In March 2000, the FASB issued Interpretation No. 44, "Accounting for Certain Transactions involving Stock Compensation," an interpretation of APB Opinion No. 25, "Accounting for Stock Issued to Employees," which, among other things, requires variable-award accounting for repriced options from the date the options are repriced until the date of exercise. This interpretation became effective on July 1, 2000 to cover specific events that occur after December 15, 1998. On March 17, 1999, our Board of Directors approved the exchange of options to acquire an aggregate of 1,106,240 of our common shares for options having a right to acquire 382,914 common shares. Because these options were repriced after December 15, 1998, they are covered by the interpretation. Accordingly, these options will be accounted for as variable until the date they are exercised, forfeited or expire unexercised. Additional compensation cost will be measured for the full amount of any increases in share price after July 1, 2001 and will be recognized over the remaining vesting period. Any adjustment to the compensation cost for further changes in share price after the options vest will be recognized immediately. Stock compensation amortization expense of $111 thousand was recorded for the three months ended July 31, 2000. As of July 31, 2001, price of our common shares was less than the exercise price of the repriced stock options. As a result, a credit of approximately $311 thousand was recorded to stock compensation amortization expenses in the first quarter of fiscal 2002. Deferred compensation expense related to this repricing of options was $0 at the end of first quarter of fiscal 2002. On July 6, 2001, we announced voluntary stock option exchange program to be offered to employees in which employees will be able to exchange current outstanding options for new options to be issued no sooner than six months and one day after the end of the exchange period. For existing options with exercise prices over $23.00, program participants will receive one new option for each two options tendered for exchange. For options with exercise prices between $10.00 and $22.99, program participants will receive two new options for each three options tendered for exchange. Options with exercise prices below $10.00 may not be voluntarily tendered for exchange under this new program. Each of the new options will have a vesting schedule whereby 25% will vest immediately upon issue, and the balance will vest monthly on a prorated basis for 24 months. The new options will be exercisable for a period of 5 years from the date of grant. Note 9. Contingencies We are subject to legal proceedings and claims that arise in the ordinary course of our business. While management currently believes the amount of ultimate liability, if any, with respect to these actions will not materially affect the financial position, results of operations, or liquidity of our company, the ultimate outcome of any litigation is uncertain. Were an unfavorable outcome to occur, the impact could be material to us. One of our suppliers, East West Imports, Inc. dba California Computers, has filed suit against us in the Superior Court of the State of California, County of Alameda, for payment of approximately $200,000 plus costs, attorney fees, and interest. The focus of our dispute is whether or not a number of personal computers and peripheral items were actually received by us. Both parties are attempting to ascertain the proper amount owed, and we anticipate a settlement on fair and reasonable terms is likely to occur shortly. In the event that no such settlement is reached within a reasonable time, we intend to vigorously defend any litigation over disputed amounts. In such case there can be no assurance that we will be successful in doing so, or that such disputes will not have a material adverse impact on us. 9 Note 10. Recent Accounting Pronouncement In July 2001, the FASB issued SFAS No. 141, "Business Combinations". SFAS No. 141 requires that all business combinations be accounted for under the purchase method for business combinations initiated after June 30, 2001 for which the date of acquisition is July 1, 2001 or later. Use of the pooling-of-interest method is no longer permitted. In July 2001 the FASB issued SFAS No. 142, "Goodwill and Other Intangible Assets". SFAS No. 142 requires that goodwill no longer be amortized to earnings, but instead be periodically reviewed for impairment. SFAS No. 142 must be adopted starting with fiscal years beginning after December 15, 2001. The impact of adopting SFAS 141 and SFAS 142 has not been determined. In August 2001, the FASB issued SFAS No. 143 "Accounting for Asset Retirement Obligations". This statement addresses Financial accounting and reporting for obligations associated with the retirement of tangible long lived assets and for the associated asset retirement costs. SFAS No. 143 is effective for financial statements issued for fiscal years beginning after June 15, 2002. The impact of adopting SFAS 143 has not been determined. Note 11. Subsequent Events On August 17, 2001, we announced that we would further reduce our workforce by approximately 25% by the end of the second quarter of fiscal 2002. On August 30, 2001, we issued and sold Cdn.$13.5 million (approximately $8.7 million based on the exchange rate on August 30, 2001) aggregate principal amount of 7.25% senior unsecured convertible notes (the "Notes") on a private placement basis. The Notes are convertible by the holders thereof, without payment of additional consideration, into an equal principal amount of 7.25% senior convertible unsecured subordinated debentures (the "Debentures") at any time and automatically at 5:00 pm (Toronto time) on the earlier of (i) the fifth business day after a receipt is issued by the last of the relevant securities regulatory authorities in Canada for a final prospectus qualifying the issuance of the Debentures on the conversion of the Notes, and (ii) August 30, 2002. The Debentures mature on August 30, 2004 and are convertible into our common shares at the holder's option at any time before the close of business on the earlier of August 30, 2004 and the last business day before the date specified for redemption at a conversion price of Cdn.$3.85 per common share. The net proceeds from the offering will be used for working capital and general corporate purposes. 10 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operation Certain statements contained in this Form 10-Q constitute "forward-looking statements" within the meaning of the United States Private Securities Litigation Reform Act of 1995. When used in this document, the words "may," "would," "could," "will," "intend," "plan," "anticipate," "believe," "estimate," "expect" and similar expressions, as they relate to us or our management, are intended to identify forward-looking statements. Such statements reflect our current views with respect to future events and are subject to certain risks, uncertainties and assumptions. Many factors could cause our actual results, performance or achievements to be materially different from any future results, performance or achievements that may be expressed or implied by such forward- looking statements, including, among others, those which are discussed in "Factors That May Affect Operating Results" beginning on page 19 of this Form 10-Q, in our Annual Report on Form 10-K and in other documents that we file with the Securities and Exchange Commission and Canadian securities regulatory authorities. Should one or more of these risks or uncertainties materialize, or should assumptions underlying the forward-looking statements prove incorrect, actual results may vary materially from those described herein as intended, planned, anticipated, believed, estimated or expected. We do not intend, and do not assume any obligation, to update these forward-looking statements. Overview We are a leading provider of information security software and services, specializing in solutions for mobile e-business. Our products and services are specifically designed to address the challenges imposed by a wireless data environment. We offer comprehensive solutions that incorporate our efficient encryption technology and are based on industry standards for information security that utilize public-key cryptography. We believe that the addition of our products to wireless infrastructures will help to build the trust and confidence necessary for the success of mobile e-business. Historically, we have focused on the development and marketing of cryptographic and information security protocol toolkits. Today, our comprehensive product offering includes an enabling technologies suite, which allows original equipment manufacturers, or OEMs, to develop secure e-business applications; our trust services, which provide OEMs and enterprises with the necessary public-key infrastructure, or PKI, management tools and certificate services to authenticate users and servers; and our enterprise application software, which provides virtual private network, or VPN, security and strong personal digital assistant, or PDA, data security for enterprises wanting to enable a mobile workforce. In addition, we provide consulting and systems integration services to assist our customers in designing and implementing efficient security solutions. Our products and services solve difficult security problems for the world's leading providers of computing and communication products. OEM customers integrate our enabling technologies into their hardware and software products, then sell the finished products to consumers or enterprise customers. In addition, we sell our enterprise application software directly to Fortune 1000 companies. We were founded in 1985 and are governed by the laws of the Yukon Territory, Canada. We determined that commencing May 1, 1999 our functional currency was the U.S. dollar and, accordingly, we began measuring and reporting our results of operations in U.S. dollars from that date. We changed our functional currency as we derive a majority of our revenues and incur a significant portion of our expenses in U.S. dollars. On January 26, 2000, we acquired all the outstanding shares of common stock of Trustpoint, a corporation based in Mountain View, California. Trustpoint is a private developer of PKI products. OEMs use PKI products to develop authentication and certification applications and services. In connection with this acquisition, we issued 201,120 of our common shares in exchange for all of the outstanding shares of Trustpoint and we also assumed Trustpoint's outstanding employee stock options. The transaction was accounted for as a purchase and, accordingly, the total consideration of approximately $10.5 million has been allocated to the tangible and intangible assets acquired based on their respective fair values on the acquisition date. Trustpoint's results of operations have been included in the consolidated financial statements from the date of acquisition. As a result of our acquisition of Trustpoint, we recorded goodwill and other intangible assets of approximately $10 million. These amounts will be amortized over a three to five year period. On September 12, 2000, we completed our acquisition of DRG Resources Group, Inc., a corporation based in Redwood City, California. DRG Resources Group, Inc. is an e-commerce security consulting company. In 11 connection with this acquisition, we issued 397,595 of our common shares in exchange for all of the outstanding shares of DRG Resources Group, Inc. and we also assumed DRG Resources Group, Inc.'s outstanding stock options. The transaction was accounted for as a purchase and, accordingly, the total consideration of approximately $18.0 million has been allocated to the tangible and intangible assets acquired based on their respective fair values on the acquisition date. The results of operations of DRG Resources Group, Inc. have been included in the consolidated financial statements from the date of acquisition. As a result of our acquisition of DRG Resources Group, Inc., we recorded goodwill, deferred compensation expense, and other intangible assets of approximately $17.9 million. As a result of our restructuring program in June 2001, certain former owners of DRG Resources Group, Inc. left our company. Our consolidated financial statements contained in this Form 10-Q are reported in U.S. dollars and are presented in accordance with U.S. generally accepted accounting principles, or U.S. GAAP. The following discussion and analysis relates to our financial statements that have been prepared in accordance with U.S. GAAP. Results of Operations Although we have experienced substantial growth in revenues in recent periods, we have incurred substantial operating losses since our inception and we expect to incur substantial operating losses for the foreseeable future. As of July 31, 2001, we had an accumulated deficit of approximately $127.5 million as determined in accordance with U.S. GAAP. We expect to incur additional losses for the foreseeable future, and we may never achieve profitability. The following table sets out, for the periods indicated, selected financial information from our consolidated financial statements as a percentage of revenue. Three months ended July 31, ------------------------------- 2001 2000 ------------- ------------ Consolidated Statement of Operations Data: (%) (%) Revenues: Products .......................... 37 87 Services .......................... 63 13 Total revenues .................. 100 100 Cost of revenues: Products .......................... 3 5 Services .......................... 88 (1) 22 Total costs ..................... 91 27 Operating expenses: Sales and marketing ............... 220 60 Product development and engineering 109 48 General and administrative ........ 105 51 Depreciation and amortization ..... 141 54 Goodwill impairment ............... 368 - Restructuring costs ............... 375 - Total operating expenses ........ 1,318 213 Loss from operations ................. (1,309) (140) Other income: Interest income ................... 28 18 Interest expense .................. - (8) Total other income (expense) .... 28 10 Loss before provision for income taxes (1,281) (130) Provision for income taxes ........... - 2 ------- ------ Net loss ............................. (1,281) (132) ======= ====== ____________ Note: (1) Includes the amortization of deferred compensation expense in connection with the acquisition of DRG Resources Group, Inc. for three months ended July 31, 2001. 12 Revenues We recognize software licensing revenue in accordance with all applicable accounting regulations including the American Institute of Certified Public Accountants Statement of Position (SOP) 97-2, "Software Revenue Recognition," as amended by SOP 98-4 and SOP 98-9. Following the requirements of SOP 97-2, we recognize license revenues when all of the following have occurred: . we have signed a non-cancelable license agreement with the customer; . delivery of the software product to the customer has occurred; . the amount of the fees to be paid by the customer are fixed or determinable; and . collection of these fees is probable. If an acceptance period is contractually provided, license revenues are recognized upon the earlier of customer acceptance or the expiration of that period. In instances where delivery is electronic and all other criteria for revenue recognition has been achieved, the product is considered to have been delivered when the customer either takes possession of the software via a download or the access code to download the software from the Internet has been provided to the customer. Our software does not require significant production, customization or modification. SOP 97-2, as modified, generally requires revenue earned on software arrangements involving multiple elements such as software products, upgrades, enhancements, post contract customer support, or PCS, installation and training to be allocated to each element based on the relative fair values of the elements. The fair value of an element must be based on evidence that is specific to the vendor. If evidence of fair value does not exist for all elements of a license agreement and PCS is the only undelivered element, then all revenue for the license arrangement is recognized ratably over the term of the agreement. If evidence of fair value of all undelivered elements exists but evidence does not exist for one or more delivered elements, then revenue is recognized using the residual method. Under the residual method, the fair value of the undelivered elements is deferred, and the remaining portion of the arrangement fee is recognized as revenue. When arrangements require us to deliver specified additional upgrades the entire fee related to the arrangement is deferred until delivery of the specified upgrade has occurred, unless we have vendor-specific objective evidence of fair value for the upgrade. Fees related to contracts that require us to deliver unspecified additional products are deferred and recognized ratably over the contract term. Revenue from consulting and training services are recognized using the percentage-of-completion method for fixed fee development arrangements or as the services are provided for time-and-materials arrangements. The fair value of professional services, maintenance and support services have been determined using specific objective evidence of fair value based on the price charged when the elements are sold separately. Revenues for maintenance and support service are deferred and recognized ratably over the term of the support period. Revenues from professional services are recognized when the services are performed. In June 2001, we converted our enabling technologies products primarily to subscription-based licenses. In addition, our trust services and enterprise application software product lines are accounted for under the subscription model. Subscription licenses provide our customers with rights to use our software for a specified period of time. Customers are entitled to use the license and receive certain customer support services over the license term. In addition, depending on the type of license, our customers have access to unspecified upgrades on an "if and when available" basis. We expect the average duration of the subscription licenses to be between one and two years. Under subscription licenses, we bill our customers for the current year's product and service fees. The billed product and service fees are recognized as revenues ratably over the billed period, generally one year. 13 Deferred revenues generally result from the following: deferred maintenance and support service, cash received for professional services not yet rendered and license revenues deferred relating to arrangements where we have received cash and are required to deliver either unspecified additional products or specified upgrades for which we do not have vendor-specific objective evidence of fair value. We operate in one reportable segment. We derive our revenues from a variety of sources that we generally classify as products and services. We earn products revenues from one-time base license fees or technology access fees, royalties, and hardware products. Our hardware products are manufactured by third parties to our specifications and resold by us to our customers. In addition, we earn revenues on a transaction basis through the sale of our authentication service offerings, which are primarily digital certificates. Services revenues are derived from the performance of contracted services for customers, maintenance, and support and training fees. We negotiate most of our customer contracts on a case-by-case basis. Prior to June 2001, most of our contracts (other than our contracts for professional services or hardware sales) include provisions for us to receive an up-front license fee and royalties. Our royalties for software licenses for mobile and wireless devices vary based on a number of factors, including the size of the contract and the nature of the contract, the customer, the device and the application. In June 2001, we converted our enabling technologies products primarily to subscription-based licenses. In addition, our trust services and enterprise application software product lines are accounted for under the subscription model. Under our subscription license model, we expect a significant percent of customers to renew their licenses upon license expiration. The change from perpetual licenses to subscription licenses has impacted our reported quarterly and annual revenues and will continue to do so on a going-forward basis as subscription license revenue will be amortized over the term of the subscription license. In the past, the majority of our perpetual license revenues have been recognized in the quarter of product delivery. Therefore, a subscription license order will result in substantially less current-quarter revenue than an equal- sized order for a perpetual license. We invoice our customers upfront for the full amount of a twelve-month subscription license period and collect the invoice within our standard payment terms. Although we expect that over the long term our cash flow from operations under the subscription license model will be equal to or greater than under the perpetual license model, in the near term we expect our cash flow from operations to decrease and deferred revenue to increase. The following table sets forth our revenues by category and by geography for the periods indicated: Three months ended July 31, ------------------------------ 2001 2000 ----------- ----------- Products 37% 87% Services 63 13 --- --- Total revenue 100% 100% === === U.S. revenue 75% 87% Canadian revenue 21 1 International (non-Canadian/US) revenue 4 12 --- --- Total revenue 100% 100% === === Total revenues for the three months ended July 31, 2001 were $2.5 million, a 50% decrease from $5.1 million for the three months ended July 31, 2000. The decrease was primarily attributable to our transition from the perpetual license model to the subscription license model. Under our new subscription license model, only a fraction of the total value of the contract is recorded as revenue in the quarter when the contract is signed and products are delivered. The remainder of the total value is recognized ratably over the term of the contract. In addition, the decrease was due to decreased sale size as larger companies deferred their purchases due to capital constraints under the current difficult economic environment. One of our customers accounted for approximately 11% of our revenue in the first quarter of fiscal 2002 and one of our customers accounted for approximately 24% of our revenue in the first quarter of fiscal 2001. 14 Products revenues were $1.0 million for the three months ended July 31, 2001, a 78% decrease compared to $4.4 million for the three months ended July 31, 2000. The decrease was expected due to a portion of our new contracts being recognized using our subscription license model. Under our new subscription license model, we recognize revenue ratably over the term of the contract whereas under the perpetual license model we recognize revenue when the product is delivered. In addition, the decrease in revenue was also due to a reduction in the number of deals with large companies as large companies deferred their purchases due to capital constraints. Services revenues were $1.6 million for the three months ended July 31, 2001, a 143% increase compared to $0.7 million for the three months ended July 31, 2000. The increase in services revenue was due to an increase in contract development work by our professional services organization, a larger customer base, and to a lesser extent, increases in maintenance fees. Cost of Revenues Cost of revenues consists of cost of products and services. Our cost of products consists primarily of the component cost of our hardware products manufactured by third parties to our specifications as well as the procured costs of third-party hardware technology. Cost of services consists primarily of costs related to professional services activities. These expenses include salaries, travel and related expenses, and amortization of deferred compensation expense in connection with the acquisition of DRG Resources Group, Inc. Total cost of revenues increased 70% to $2.3 million for the three months ended July 31, 2001 compared to $1.4 million for the three months ended July 31, 2000. Cost of products was $76,000 for the three months ended July 31, 2001, a 67% decrease compared to $232,000 for the same period of fiscal 2001. The decrease in cost of products in the first quarter of fiscal 2002 was primarily due to the lower hardware costs as a result of lower hardware sales. Cost of service was $2.2 million for the three months ended July 31, 2001, a 98% increase over $1.1 million for the three months ended July 31, 2000. This increase was primarily a result of the increase in the number of professional services providers, the deferred compensation expense in connection with the acquisition of DRG Resources Group, Inc. and launch of our trust services product offerings. Operating Expenses Our operating expenses consist of sales and marketing, product development and engineering, general and administrative expenses, depreciation and amortization, and goodwill impairment and restructuring costs. Sales and Marketing Sales and marketing expenses consist primarily of employee salaries and commissions, related travel, public relations and corporate communications costs, trade shows, marketing programs and market research. Sales and marketing expenses were $5.6 million for the three months ended July 31, 2001 compared to $3.0 million for the same period in fiscal 2001, an increase of 85%. These increased expenses in fiscal 2002 were primarily due to an increase in personnel costs and sales and marketing programs. Product Development and Engineering Product development and engineering expenses consist primarily of employee salaries, sponsorship of cryptographic research activities at various universities, participation in various cryptographic, wireless and e-business standards associations and related travel and other costs. We have capitalized certain costs associated with the filing of patent applications in various jurisdictions. These patent filings are in the areas of ECC, various mathematical computational methodologies, security protocols and other cryptographic inventions. Once granted, we amortize the individual patent cost over three years. We capitalize patents not yet granted at their cost less a provision for the possibility of the patent not being granted or abandoned. 15 Our product development and engineering expenses were $2.8 million for the three months ended July 31, 2001 compared to $2.4 million for the same period in fiscal 2001, an increase of 14%. These increases were the result of the addition of personnel and related costs necessary to support new and on-going product development in the first quarter of fiscal 2002. General and Administrative General and administrative expenses consist primarily of salaries and other personnel-related expenses for executive, financial, legal, information services and administrative functions, and amortization of stock compensation expense. For the three months ended July 31, 2001, general and administrative expenses increased 3% to $2.7 million compared to $2.6 million for the same period in fiscal 2001. This increase was primarily due to the growth in personnel and office space in California. Depreciation and Amortization Depreciation and amortization represent the allocation to income of the cost of fixed assets and intangibles including patents cost over their estimated useful lives. Depreciation and amortization increased 31% to $3.6 million for the three months ended July 31, 2001 compared to $2.7 million for the three months ended July 31, 2000. This increase was due to additions to our property and equipment assets. Impairment of Goodwill and Other Intangibles In connection with our restructuring program announced on June 4, 2001, we performed an impairment assessment of the identifiable intangibles and goodwill recorded in connection with the acquisitions of DRG Resources Group, Inc. and Uptronics, Inc. We performed the assessment primarily due to changes in the economy, the overall decline in the industry growth rates, and our lower actual and projected operating results, including those related to our acquisitions of DRG Resources Group, Inc. and Uptronics, Inc. As a result, we recorded impairment of goodwill and other intangible assets of $9.4 million, measured as the amount by which the carrying amount exceeded the present value of the estimated future cash flows for goodwill. The assumptions supporting the cash flows, including the discount rate, were determined using our best estimates as of June 4, 2001. We will continue to assess the recoverability of the remaining goodwill and other intangible assets periodically in accordance with our policy. Restructuring Costs On June 4, 2001, we announced a restructuring program. This restructuring program included a reduction of our full-time employee headcount in most functional areas, consolidation of excess facilities a reduction in discretionary expenses and restructuring of certain business processes and functions. As a result of the restructuring program, we recorded approximately $9.5 million of restructuring costs for the three months ended July 31, 2001. We recorded restructuring expenses in the following areas: 1) reduction in workforce; 2) consolidation of excess facilities and non-productive property and equipments; and 3) elimination of deferred compensation. We reduced our workforce by approximately 30% across all business functions and geographic regions. We recorded an estimated charge of approximately $2.1 million relating primarily to severance and fringe benefits. We recorded a restructuring charge of approximately $5.1 million for excess facilities relating primarily to non-cancelable lease costs under the assumption that we will not be able to sublease certain of our excess facilities in next two years. 16 In connection with the acquisition of DRG Resources Group, Inc., we recorded approximately $7.7 million of deferred compensation expense in connection with shares subject to restriction under employment agreements signed with the former owners of DRG Resources Group, Inc. These amounts are being amortized over an eighteen month period. As a result of the restructuring program in June 2001, certain former owners of DRG Resources Group, Inc. left our company. The unvested shares that were restricted under the terms of these employment agreements were immediately vested upon terminations of the related employees. As a result, approximately $2.3 million of deferred compensation charges were recorded in the first quarter of fiscal 2002. In the first quarter of fiscal 2002, we paid approximately $1.6 million in cash for restructuring costs related to certain employee severance and other employee payments. The accrued restructuring and related expenses during the three months ended July 31, 2001 were comprised of the following (in thousands of U.S. dollars): Accrued ---------------------------- Current Non-current --------- ----------- Work force reduction.................. $ 525 $ - Consolidation of excess facilities.... 1,191 1,102 ------ ------ Total restructuring expenses ...... $1,716 $1,102 ====== ====== As of July 31, 2001, we anticipated paying these balances in the next 24 months. Interest and Other Income (Expense) For the three months ended July 31, 2001, interest income was $0.7 million compared to interest income of $1.0 million for the same period in fiscal 2001. This decrease resulted from a decrease in the amount of cash and marketable securities invested and lower interest rates on the short-term investments for the quarter ended July 31, 2001 compared to the quarter ended July 31, 2000. As of the end of fiscal year 2000, we had borrowed $10 million from Sand Hill Capital II, LP (Sand Hill). In connection with this financing, we issued a warrant which entitles Sand Hill to purchase 30,000 of our common shares at an exercise price of Cdn$38.13 per share (U.S.$24.91 based on the exchange rate on July 31, 2001) until April 27, 2005. The warrant was valued at $423,000 at the time of issuance based on the Black-Scholes option valuation model. In the first quarter of fiscal 2001, we recorded a one-time, non-cash interest expense of $0.4 million related to the warrant issued to Sand Hill. The value of the warrant was charged to interest expense in the first quarter of fiscal 2001 as the loan was re-paid with proceeds from our public offering in May 2000. Provision for Income Taxes We pay taxes in accordance with U.S. federal, state and local tax laws and Canadian federal, provincial and municipal tax laws. Income tax was $80 thousand for the three months ended July 31, 2000. We do not expect to pay significant corporate income taxes in both Canada and the United States in the foreseeable future because we have significant tax credits and net operating loss carryforwards for Canadian, U.S. federal and U.S. state income tax purposes. Financial Condition, Liquidity and Capital Resources In May 2000, we completed a public offering of 2,500,000 common shares at a per share price of $23.15 in the United States and Canada for an aggregate offering price of approximately $57.9 million. Our net proceeds from the offering were approximately $51.5 million after deducting underwriting discounts and commissions and offering expenses. On April 27, 2000, we borrowed $10 million from Sand Hill, at the prime rate of interest plus 3%. As partial consideration for making advances to us under this credit facility, we granted Sand Hill a warrant to purchase up to 30,000 of our common shares at an exercise price of Cdn.$38.13 per share ($24.91 based on the exchange rate on July 31, 2001) until April 27, 2005. We repaid the loan and interest on May 5, 2000, using a portion of the proceeds received from our public offering, and terminated this facility. In March 2001, we issued 4,000,000 of our common shares in Canada and the United States at a per share price of Cdn.$12.50 (approximately $8.17 based on the exchange rate on July 31, 2001). The common shares have not been registered under the United States Securities Act of 1933, as amended. The gross proceeds of this offering were 17 Cdn.$50.0 million (approximately $32.7 million based on the exchange rate on July 31, 2001). After deducting underwriting discounts and commissions and offering expenses, the net proceeds of this offering were Cdn.$47.2 million (approximately $30.8 million based on the exchange rate on July 31, 2001). On August 30, 2001, we issued and sold Cdn.$13.5 million (approximately U.S.$8.7 million based on the exchange rate on August 30, 2001) aggregate principal amount of 7.25% senior unsecured convertible notes (the "Notes") on a private placement basis. The Notes are convertible by the holders thereof, without payment of additional consideration, into an equal principal amount of 7.25% senior convertible unsecured subordinated debentures (the "Debentures") at any time and automatically at 5:00 pm (Toronto time) on the earlier of (i) the fifth business day after a receipt is issued by the last of the relevant securities regulatory authorities in Canada for a final prospectus qualifying the issuance of the Debentures on the conversion of the Notes, and (ii) August 30, 2002. The Debentures mature on August 30, 2004 and are convertible into our common shares at the holder's option at any time before the close of business on the earlier of August 30, 2004 and the last business day before the date specified for redemption at a conversion price of Cdn.$3.85 per common share. At July 31, 2001, total cash and available-for-sale marketable securities were $33.1 million, excluding $2.0 million of restricted cash. For the three months ended July 31, 2001, net cash used in operating activities was $11.3 million. Net cash used in operating activities was primarily due to our net loss of $32.6 million, which included total non-cash charges of $21.3 million. The non-cash charges included $3.6 million of depreciation and amortization, $9.4 million of impairment of goodwill and other intangibles, $7.9 million of non-cash restructuring costs, and $0.5 million of stock compensation expense. For the three months ended July 31, 2001, net cash provided by investing activities was $9.6 million. Net cash provided by investing activities was primarily due to $18.9 million of net sales and maturities of marketable securities, available for sale. The cash generated from sales and maturities of marketable securities, available for sale, was offset by $9.3 million of capital expenditures for property, equipment and patents. These consisted primarily of $7.7 million of leasehold improvements and related costs and $1.1 million of software. For the three months ended July 31, 2001, net cash provided by financing activities was $1.5 million. Net cash provided by financing activities was primarily due to the issuance of common shares, including these related to the exercise of stock options. We lease premises totaling approximately 111,000 square feet in Hayward, California. These leases expire on July 31, 2007. Through July 31, 2001, we have capitalized leasehold improvements and related construction costs totaling approximately $11.5 million for our Hayward facilities. In addition, we do not anticipate any additional expenses subsequent to July 31, 2001 to complete the build-out of our Hayward facilities. We also have a lease for approximately 30,300 square feet of office space in Mississauga, Ontario, which expires on December 25, 2009. Currently, our Canadian offices occupy this space. We recently signed a ten-year lease for approximately 130,000 square feet located at 1980 Matheson Boulevard East, Mississauga, Ontario. At this time, the facility is being constructed at our expense and we expect the total cost will be approximately $8.1 million. Through July 31, 2001, we have capitalized leasehold improvements and related construction costs totaling approximately $2.7 million for the facility. In addition, we anticipate incurring approximately an additional $5.4 million subsequent to July 31, 2001 to complete the build-out of the facility. If the landlord intends to sell the leased premises, we have a right of first refusal with respect of any sale of this property on terms to be negotiated. In the fall of 2001, we intend to relocate our Canadian operations from their current location to this new facility and to sublease our current Canadian office space and approximately 40,000 square feet space of new site, although there is no assurance that we will be able to do so or at rates equal to our current obligations under the respective leases. The annual rental fee for the new site varies between approximately Cdn.$10.85 to Cdn.$13.05 per square foot ($7.09 to $8.52 per square foot based on the exchange rate on July 31, 2001) over the life of the lease. We began paying rent on this lease in May 2001. We also have a lease for approximately 6,000 square feet in Herndon, Virginia that expires on October 5, 2007, and we occasionally execute month-to-month leases for short-term office space. The total annual base rent for all facilities is approximately $3.1 million. In June 2001, we converted our enabling technologies products primarily to subscription-based licenses. In addition, our trust services and enterprise application software product lines are accounted for under the subscription model. Subscription licenses provide our customers with rights to use our software for a specified period of time. Customers are entitled to use the license and receive certain customer support services over the license term. In addition, depending on the type of license, our customers have access to unspecified upgrades on an "if and when available" basis. We expect the average duration of the subscription licenses to be between one and two years. In addition, we expect a significant percent of customers to renew their licenses upon license expiration. The change from perpetual licenses to subscription licenses has impacted our reported quarterly and annual revenues and will continue to do so on a go- forward basis, as subscription license revenue will be amortized over the term of the subscription license. In the past, the majority of our perpetual license revenues have been recognized in 18 the quarter of product delivery. Therefore, a subscription license order will result in substantially less current-quarter revenue than an equal-sized order for a perpetual license. We invoice our customers upfront for the full amount of a twelve-month subscription license period and collect the invoice within our standard payment terms. Although we expect that over the long term our cash flow from operations under the subscription license model will be equal to or greater than under the perpetual license model, in the near term we expect our cash flow from operations to decrease and deferred revenue to increase. We believe our current cash and cash equivalents and marketable securities position will be sufficient to meet our liquidity needs for the near term. In the future, we may need to raise additional funds through public or private financings, strategic partnerships, as well as collaborative relationships, borrowings and other available sources. There can be no assurance that additional or sufficient financing will be available, or, if available, that it will be available on acceptable terms. If we raise funds by issuing additional equity securities, the percentage of our stock owned by our then current shareholders will be reduced. If adequate funds are not available, we may be required to significantly curtail one or more of our research and development programs or commercialization efforts or to obtain funds through arrangements with collaborative partners or others on less favorable terms. Factors That May Affect Operating Results We operate in a dynamic, rapidly changing environment that involves risks and uncertainties. You should carefully consider the risks described below and the other information in this Form 10-Q. These risks and uncertainties are not the only ones facing us. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also impair our business operations. If any of the following risks actually occur, our business, financial condition or results of operations could be materially harmed. Risks Related to Our Company We have a limited operating history and have incurred losses since inception and anticipate incurring losses for the foreseeable future Although we have been engaged in the cryptographic security industry since 1985, we did not ship our first commercial toolkit or enter the U.S. market until 1997. Accordingly, our business operations are subject to all of the risks inherent in a new business enterprise, such as competition and viable operations management. These risks and uncertainties are often worse for a company engaged in new and evolving product markets. Since our inception, we have incurred substantial net losses. As of July 31, 2001, we had an accumulated deficit of approximately $127.5 million (as determined in accordance with U.S. generally accepted accounting principles). We expect to incur additional losses for the foreseeable future and we may never achieve profitability. If we do achieve profitability, we may not be able to sustain it. You should not consider our historical growth indicative of our future revenue levels or operating results. Our success will depend in large part upon our ability to generate sufficient revenue to achieve profitability and to maintain existing customer relationships and develop new customer relationships. Because our quarterly operating results are subject to fluctuations, period-to- period comparisons of our operating results are not necessarily meaningful and you should not rely on them as an indication of future performance Our quarterly operating results have historically fluctuated and may fluctuate significantly in the future. Accordingly, our operating results in a particular period are difficult to predict and may not meet the expectations of securities analysts or investors. If this were to occur, our share price would likely decline significantly. Factors that may cause our operating results to fluctuate include: . our transition to a subscription license business model; . the level of demand for our products and services as well as the timing of new releases of our products; . our dependence in any quarter on the timing of a few large sales; 19 . our ability to maintain and grow a significant customer base; . the fixed nature of a significant portion of our operating expenses, particularly personnel, research and development, and leases; . costs related to the opening or expansion of our facilities; . unanticipated product discontinuation or deferrals by our OEM customers; . changes in our pricing policies or those of our competitors; . currency exchange rate fluctuations; and . timing of acquisitions, our effectiveness at integrating acquisitions with existing operations and related costs. Accordingly, we believe that quarter-to-quarter comparisons of our results of operations are not necessarily meaningful. You should not rely on the results of one quarter as an indication of our future performance. Our revenues are difficult to predict We derive our revenue primarily from sales of our products and services to our OEM customers. Our sales vary in frequency, and OEM customers may or may not purchase our products and services in the future. The sale to, and implementation by, OEMs of our products and services typically involve a lengthy education process, along with significant technical evaluation and commitment of capital and other resources by them. This process is also subject to the risk of delays associated with (a) their internal budgeting and other procedures for approving capital expenditures, (b) deploying new technologies and (c) testing and accepting new technologies that affect key operations. As a result, the sales and implementation cycles associated with many of our products and services are generally lengthy, and we may not succeed in closing transactions on a timely basis, if at all. If orders expected from a specific customer for a particular period are not realized, our revenues could fail to materialize. In addition, our customers may defer the purchase of, or stop using, our products and services at any time, and certain license agreements may be terminated by the customer at any time. We negotiate most of our customer contracts on a case-by-case basis, which makes our revenues difficult to predict. Our existing customer contracts typically provide for base license fees, technology access fees and/or royalties based on a per-unit or per-usage charge or a percentage of revenue from licensees' products containing our technology. In June 2001, we converted our enabling technologies products to primarily subscription-based licenses. Additionally, a number of our large contracts provide that we will not earn additional royalty revenues from those contracts until these customers' shipments exceed certain thresholds. As a result, our revenues are not recurring from period to period, which makes them more difficult to predict. In addition, estimating future revenue is difficult because we generally ship our products soon after an order is received and, as such, we do not have a significant backlog. Our expense levels are based, in part, on our expectations of future revenues and are largely fixed in the short term. We may not be able to adjust spending in a timely manner to compensate for any unexpected shortfall in revenues. The recent introduction of a subscription business model may result in a decrease in our reported revenue and cash flow from operations In June 2001, we converted our enabling technologies products to primarily subscription-based licenses. In addition, our trust services and enterprise application solutions product lines are accounted for under the subscription model. Subscription licenses provide our customers with rights to use our software for a specified period of time. Customers are entitled to use the license and receive certain customer support services over the license term. In addition, depending on the type of license, our customers have access to unspecified upgrades on an "if and when available" basis. We expect the average duration of the subscription licenses to be between one and two years. In addition, we expect a significant percent of our customers to renew their licenses upon license expiration. The change from perpetual licenses to subscription licenses will impact our reported quarterly and annual revenues on a going-forward basis, as subscription license revenue will be amortized over the term of the 20 subscription license. In the past, the majority of our perpetual license revenues have been recognized in the quarter of product delivery. Therefore, a subscription license order will result in substantially less current-quarter revenue than an equal-sized order for a perpetual license. We expect to invoice our customers upfront for the full amount of a twelve-month subscription license period and collect the invoice within our standard payment terms. Although we expect that over the long term our cash flow from operations under the subscription license model will be equal to or greater than under the perpetual license model, in the near term we expect our cash flow from operations to decrease and deferred revenue to increase. The current economic downturn has reduced demand for our products and services, increased the average length of our sales cycle and may adversely affect future revenue The majority of our revenue has been, and is expected to continue to be, derived from customers in the United States. Recent economic indicators, including growth in gross domestic product, reflect a decline in economic activity in the United States. Some reports have indicated an even more significant decline in spending by corporations in the area of information technology, which includes the encryption technology market. While we cannot specifically correlate the impact of macro-economic conditions on our sales activities, we believe that the economic conditions in the United States have resulted in decreased demand in our target markets and, in particular, have increased the average length of our sales cycles. To the extent that the current downturn continues or increases in severity, or results in a similar downturn worldwide, we believe demand for our products and services, and therefore future revenue, will be reduced. Our restructuring of operations may not achieve the results we intend and may harm our business In June 2001, we announced a restructuring of our business, which included a reduction in work force of approximately 30% as well as other steps to reduce expenses. In August 2001, we announced additional workforce reductions to further reduce costs to a level commensurate with our expected revenues. The planning and implementation of our restructuring has placed, and may continue to place, a significant strain on our managerial, operational, financial and other resources. Additionally, the restructuring may negatively affect our employee turnover, recruiting and retention of important employees. If we are unable to implement our restructuring effectively or if we experience difficulties in effecting the restructuring, our expenses could increase more quickly than we expect. If we find that our restructuring activities announced in June and August do not sufficiently decrease the growth of our expenses, we may find it necessary to implement further streamlining of our expenses, to perform further reductions in work force or to undertake another restructuring of our business. If our restructuring activities are not successful in effectively reducing our expenses or result in the loss of key personnel or employee morale, our business, financial condition and results of operations would be materially adversely affected. A limited number of customers account for a high percentage of our revenue and the failure to maintain or expand these relationships could harm our business Five customers comprised approximately 42% of our revenue for the fiscal year ended April 30, 2001, and approximately 31% of our revenue for the fiscal year ended April 30, 2000. For the three months ended July 31, 2001, five customers accounted for approximately 37% of our revenue. One of our customers accounted for approximately 11% of our revenue in the first quarter of fiscal 2002 and one of our customers accounted for approximately 24% of our revenue in the first quarter of fiscal 2001. The loss of one or more of our major customers, the failure to attract new customers on a timely basis, or a reduction in usage and revenue associated with the existing or proposed customers would harm our business and prospects. We are contractually obligated to complete certain leasehold improvements We lease premises totaling approximately 111,000 square feet in Hayward, California. This lease expires on July 31, 2007. Through July 31, 2001, we have capitalized leasehold improvements and related construction costs totaling approximately $11.5 million for our Hayward facilities. In addition, we do not anticipate any additional expenses subsequent to July 31, 2001 to complete the build-out of our Hayward facilities. In addition, we have signed a ten-year lease for approximately 130,000 square feet located at 1980 Matheson Boulevard East, Mississauga, Ontario. At this time, the facility is being constructed at our expense and we expect the total cost will be approximately $8.1 million. Through July 31, 2001, we have capitalized leasehold 21 improvements and related construction costs totaling approximately $2.7 million for the facility. In addition, we anticipate incurring approximately an additional $5.4 million subsequent to July 31, 2001 to complete the build-out of the facility. We may be unable to find sub-tenants to sublease currently leased and vacant space In March 2000, we entered into a lease covering 68,000 square feet of office space adjacent to our then existing 43,000 square foot Hayward facility. The term of this new lease is seven years at an initial monthly rent of approximately $61,000, with 3% annual increases. The lease on our prior Hayward facility expires in July 2007 and provides for current monthly base rent payments of approximately $54,000, increasing to approximately $57,000 in March 2002 and approximately $60,000 in March 2004. In August 2001, we relocated our Hayward operations to the new facility. We intend to sublease our prior 43,000 square foot Hayward office space, although there can be no assurance that we will be able to do so or at rates equal to our current obligations under the lease. We recently signed a ten-year lease for approximately 130,000 square feet located at 1980 Matheson Boulevard East, Mississauga, Ontario. If the landlord intends to sell the leased premises, we have a right of first refusal with respect of any sale of this property on terms to be negotiated. In the fall of 2001, we intend to relocate our Canadian operations from their current location to this new facility and to sublease our current Canadian office space and approximately 40,000 square feet space located at 1980 Matheson Boulevard East, Mississauga, Ontario, although there can be no assurance that we will be able to do so or at rates equal to our current obligations under the lease. The annual rental fee for the new site varies between approximately Cdn.$10.85 to Cdn.$13.05 per square foot ($7.09 to $8.52 per square foot based on the exchange rate on July 31, 2001) over the life of the lease. We began paying rent on this lease in May 2001. We are currently searching for tenants to sublease our current Hayward and Mississauga spaces and portion of our new Mississauga space. We may not be able to find suitable sub-tenants to occupy this space in a timely manner in the future, if at all, or otherwise sublease these properties without a loss. If we are unable to find suitable sub-tenants, we may experience greater than anticipated operating expenses in the future, which could materially adversely affect our financial condition and operating results. Our success depends on an increase in the demand for digital signatures in m-business transactions and ECC-based technology becoming accepted as an industry standard For handheld devices, many of the advantages our ECC-based technology has over conventional security technology are not applicable to a transaction that does not involve the creation of a digital signature on a handheld device. Currently, the vast majority of e-business and m-business transactions do not involve such digital signatures. Participants in mobile e-business have only recently begun to require client digital signatures in some applications, such as enterprise data access and certain high-value transactions. Unless the number of mobile e-business transactions involving client digital signatures increases, the demand for our products and services, and consequently, our business, financial condition and operating results could be materially adversely affected. In order for our business to be successful, ECC technology must become accepted as an industry standard. This has not happened to date, and may never happen. The technology of our principal competitor, RSA Security Inc., is and has been for the past several years, the de facto standard for security over open networks like the Internet. The patent related to this competing technology expired in September 2000, making this technology freely available. The free availability of such security technology could significantly delay or prevent the acceptance of ECC as a security standard. Some of our products are new, unproven and currently generate little or no revenue In late 2000 and early 2001, we launched our PKI products, CA service and VPN client software product. We continue to invest in and develop future versions of these products which add features and functionality and to support our current versions of these products. We cannot predict the future level of acceptance, if any, of these new products, and we may be unable to generate significant revenue from these products. 22 We have only recently begun to sell directly to enterprise customers, and we may not be successful in developing the products and services necessary to serve this new customer base We have recently started to expand our sales efforts to encompass sales of certain products directly to enterprises other than OEMs. The expansion of our direct sales efforts will require that we attract, hire, train, manage and adequately compensate a larger group of professionals. We may not be successful in expanding and managing our sales effort or that the revenues produced by our direct sales will offset our increased expenses. These non-OEM, or enterprise, customers will require different products, support services and integration services than our existing OEM customer base. We may not be successful in developing the products and services necessary to serve this new customer base. Our business depends on continued development of the Internet and the continued growth of m-business Our future success is substantially dependent upon continued growth in Internet usage and the acceptance of mobile and wireless devices and their use for m-business. The adoption of the Internet for commerce and communications, particularly by individuals and companies that have historically relied upon alternative means of commerce and communication, generally requires the understanding and acceptance of a new way of conducting business and exchanging information. In particular, companies that have already invested substantial resources in other means of conducting commerce and exchanging information may be reluctant or slow to adopt a new, Internet-based strategy that may make their existing infrastructure obsolete. To the extent that individuals and businesses do not consider the Internet to be a viable commercial and communications medium, our business may not grow. Furthermore, building a wireless-based strategy requires significant investment. Many companies may not have resources and capital to build the infrastructure required to support a wireless-based strategy. If this infrastructure build out does not occur, our revenue may not grow. In addition, our business may be harmed if the number of users of mobile and wireless devices does not increase, or if e-business and m-business do not become more accepted and widespread. The use and acceptance of the Internet and of mobile and wireless devices may not increase for any number of reasons, including: . actual or perceived lack of security for sensitive information, such as credit card numbers; . traffic or other usage delays on the Internet; . competing technologies; . governmental regulation; and . uncertainty regarding intellectual property ownership. Capacity constraints caused by growth in the use of the Internet may impede further development of the Internet to the extent that users experience delays, transmission errors and other difficulties. If the necessary infrastructure, products, services and facilities are not developed, if the Internet does not become a viable and widespread commercial and communications medium, or if individuals and businesses do not increase their use of mobile and wireless devices for mobile e-business, our business, financial condition and operating results could be materially adversely affected. We have recently issued convertible notes, and our increased debt may place restrictions on our operations and limit our growth On August 30, 2001, we issued and sold Cdn.$13.5 million (approximately U.S.$8.7 million based on the exchange rate on August 30, 2001) aggregate principal amount of 7.25% senior unsecured convertible notes (the "Notes") on a private placement basis. The Notes are convertible by the holders thereof, without payment of additional consideration, into an equal principal amount of 7.25% senior convertible unsecured subordinated debentures (the "Debentures") at any time and automatically at 5:00 p.m. (Toronto time) on the earlier of (i) the fifth business day after a receipt is issued by the last of the relevant securities regulatory authorities in Canada for a final prospectus qualifying the issuance of the Debentures on the conversion of the Notes, and (ii) August 30, 2002. The Debentures mature on August 30, 2004 and are convertible into our common shares at the holder's option at any time before the close of business on the earlier of August 30, 2004 and the last business day before the date specified for redemption at a conversion price of Cdn.$3.85 per common share. 23 Our total liabilities on a consolidated basis as at July 31, 2001 were approximately $17.3 million. The level of our indebtedness could have important consequences on our ability to operate and grow our business including the following: (i) our ability to obtain additional financing in the future could be restricted: (ii) our cash flow from operations dedicated to the payment of the principal of, an interest on, our indebtedness will not be available for other purpose; (iii) our flexibility in planning for, or reacting to, changes in our business and market conditions could be restricted. In addition, we may be more highly leveraged than certain of our competitors which might place us at a competitive disadvantage, and we could be more vulnerable in the event of further downturns in our business. We may not generate the required cash flow to service our debt We will be required to make our first payment of interest on the Debentures on February 28, 2002. Annual cash interest requirements on the Debentures will be approximately Cdn.$978,750 (approximately $633,085 based on the exchange rate on August 30, 2001) There can be no assurance that we will achieve or sustain profitability or positive cash flow from operating activities, we may not be able to meet our debt service or working capital requirements or to obtain additional capital required in order to execute our business plan. We must manage our growth Despite our recent workforce reductions, we have experienced a period of significant growth in our sales and personnel that has placed strain upon our management systems and resources. Subject to future prevailing economic conditions, we may pursue potential market opportunities. Our growth has placed, and will place, demands on our management and operational resources, particularly with respect to: . training, supervising and retaining skilled technical, marketing and management personnel; . expanding our treasury and accounting functions and information systems to meet the demands of a growing company; . strengthening our financial and management controls in a manner appropriate for a larger enterprise; . maintaining a cutting edge research and development staff; . developing and managing a larger, more complex international organization; and . preserving our culture, values and entrepreneurial environment. Our revenue may not continue to grow at a pace that will support our planned costs and expenditures. To the extent that our revenue does not increase at a rate commensurate with these additional costs and expenditures, our results of operations and liquidity would be materially adversely affected. Our management has limited experience managing a business of our size and, in order to manage our growth effectively, we must concurrently develop more sophisticated operational systems, procedures and controls. If we fail to develop these systems, procedures and controls on a timely basis, it could impede our ability to deliver products in a timely fashion and fulfill existing customer commitments and, as a result, our business, financial condition and operating results could be materially adversely affected. Acquisitions could harm our business We acquired Consensus Development Corporation and Uptronics Incorporated in fiscal year 1999, Trustpoint in fiscal year 2000, and DRG Resources Group, Inc. in fiscal year 2001. We may acquire additional businesses, technologies, product lines or services in the future either in the United States or abroad. Acquisitions involve a number of risks, potentially including: 24 . disruption to our business; . inability to integrate, train, retain and motivate key personnel of the acquired business; . diversion of our management from our day-to-day operations; . inability to incorporate acquired technologies successfully into our products and services; . additional expense associated with completing an acquisition and amortization of any acquired intangible assets; . impairment of relationships with our employees, customers and strategic partners; and . inability to maintain uniform standards, controls, procedures and policies. In addition, we may not be able to maintain the levels of operating efficiency that any acquired company achieved or might have achieved separately. Successful integration of the companies we acquire will depend upon our ability to eliminate redundancies and excess costs. As a result of difficulties associated with combining operations, we may not be able to achieve cost savings and other benefits that we might hope to achieve with these acquisitions. We may satisfy the purchase price of any future acquisitions through the issuance of our common shares, which may result in dilution to our existing shareholders. We may also incur debt or assume liabilities. We cannot assure you that we will be able to obtain any additional financing on satisfactory terms, or at all. Incurring debt or assuming additional liabilities would make us more vulnerable to economic downturns and may limit our ability to withstand competitive pressures. The terms of any additional indebtedness may include restrictive financial and operating covenants, which could limit our ability to compete and expand our business. Our business strategy also includes entering into strategic investments and joint ventures with other companies. These transactions are subject to many of the same risks identified above for acquisitions. Our success depends on attracting and retaining skilled personnel Our success is largely dependent on the performance of our management team and other key employees. Our success also depends on our ability to attract, retain and motivate qualified personnel. Most of our key technical and senior management personnel are not bound by employment agreements. Loss of the services of any of these key employees would harm our business, financial condition and operating results. We do not maintain key person life insurance policies on any of our employees. Competition for qualified personnel in the digital information security industry is intense, and finding and retaining qualified personnel in the San Francisco Bay Area and the Greater Toronto Area are difficult. We believe there are only a limited number of individuals with the requisite skills to serve in many of our key positions, and it is becoming increasingly difficult to hire and retain such persons. Competitors and others have in the past and may attempt in the future to recruit our employees. A major part of our compensation to our key employees is in the form of stock option grants. A prolonged depression in our share price could make it difficult for us to retain employees and recruit additional qualified personnel. In addition, the volatility and current market price of our common shares may make it difficult to attract and retain personnel. We face risks related to our international operations We are currently in the process of expanding our international operations. For the three months ended July 31, 2001 and the fiscal year ended April 30, 2001, we derived approximately 4% and 10%, respectively, of our revenue from international operations. An important component of our long-term strategy is to further expand into international markets, and we must continue to devote resources to our international operations in order to succeed in these markets. To date, we have limited experience in international operations and may not be able to compete effectively in international markets. This expansion is expected to involve opening foreign sales offices, which may 25 cause us to incur substantial costs. International sales and operations may be limited or disrupted by increased regulatory requirements, the imposition of government and currency controls, export license requirements, political instability, labor unrest, transportation delays and interruptions, trade restrictions, changes in tariffs and difficulties in staffing and coordinating communications among international operations. In addition, these foreign markets may require us to develop new products or modify our existing products. There can be no assurance that we will be able to manage effectively the risks associated with our international operations or that those operations will contribute positively to our business, financial condition or operating results. We face risks related to intellectual property rights We rely on one or more of the following to protect our proprietary rights: patents, trademarks, copyrights, trade secrets, confidentiality procedures and contractual provisions. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy and may succeed in copying aspects of our product designs, products or trademarks, or obtain and use information we regard as proprietary. Preventing the unauthorized use of our proprietary technology may be difficult in part because it may be difficult to discover such use. Stopping unauthorized use of our proprietary technology may be difficult, time-consuming and costly. In addition, the laws of some countries in which our products are licensed do not protect our products and services and related intellectual property to the same extent as the laws of Canada, the United States and countries of the European Union. While we believe that at least some of our products are covered by one or more of our patents and these patents are valid, a court may not agree if the matter is litigated. There can be no assurance that we will be successful in protecting our proprietary rights and, if we are not, our business, financial condition and operating results could be materially adversely affected. The industry in which we compete has many participants who own, or claim to own, intellectual property. We indemnify our licensees against third-party intellectual property claims based on our technology. At this time, we are defending one of our licensees for a claim filed against them by Leon Stambler. Claims relating to intellectual property by any third-party business, individual or university, whether or not with merit, could be time-consuming to evaluate, result in costly litigation, cause shipment delays for products or the cessation of the use and sale of products or services, or require us to obtain licenses by paying license fees and/or royalties to the owners of the intellectual property. Such licensing agreements, if required, may not be available on royalty or other terms acceptable to us. Any of these situations could materially adversely affect our business, financial condition and operating results. We also currently license third party technology for use in some of our products and services. These third party technology licenses may not continue to be available on commercially reasonable terms or may not be available at all. Our business, financial condition and operating results could be materially adversely affected if we lose the right to use certain technology. We are engaged in joint development projects with certain companies. One of these projects has resulted in the issuance of jointly owned patents. There is a risk that the companies with which we are working could decide not to commercialize the joint technology and that we may be unable to commercialize joint technology without their consent and/or involvement. We belong to certain organizations that set standards. As part of the standards process, the participants are requested to file statements identifying any patents they consider to be essential to implementation of the standard. As such, we may be required to disclose and license patents that we own which are necessary for practice of the standard. Further, to provide products that are compliant with standards that have been adopted or will be adopted in the future, we may have to license patents owned by others. As a part of some standards processes, other companies have disclosed patents that they believe are required to implement those standards. We cannot assure you that we will be able to gain licenses to these patents, if needed, on terms acceptable to us. Such licensing requirements may materially adversely affect the value of our products, and, consequently, our business, financial condition and operating results. 26 Our products could have defects which could delay their shipment, harm our reputation and increase costs Our products are highly complex and, from time to time, may contain design defects that are difficult to detect and correct. Errors, failures or bugs may be found in our products after commencement of commercial shipments. Even if these errors are discovered, we may not be able to correct such errors in a timely manner or at all. The occurrence of errors and failures in our products could result in damage to our reputation, lost revenue and the loss of, or delay in achieving, market acceptance of our products, and correcting such errors and failures in our products could require significant expenditure of capital by us. The sale and support of these products may entail the risk of product liability or warranty claims based on damage to such equipment. In addition, the failure of our products to perform to customer expectations could give rise to warranty claims. Our insurance may not cover or its coverage may be insufficient to cover any such claims successfully asserted against us, and therefore the consequences of such errors, failures and claims could have a material adverse effect on our business, financial condition and operating results. System interruptions and security breaches could harm our business We are in the process of constructing a secure data center for issuing certificates. We will depend on the uninterrupted operation of that data center. We will need to protect this center and our other systems from loss, damage, or interruption caused by fire, power loss, telecommunications failure or other events beyond our control. In addition, most of our systems and the data center are located, and most of our customer information is stored, in the San Francisco Bay Area, which is susceptible to earthquakes. Any damage or failure that causes interruptions in our data center and our other computer and communications systems could materially adversely affect our business, financial condition and operating results. Our success also depends upon the scalability of our systems. Our systems have not been tested at the usage volumes that we expect will be required in the future. As a result, a substantial increase in demand for our products and services could cause interruptions in our systems. Any such interruptions could materially and adversely affect our ability to deliver our products and services and our business, financial condition and operating results. Although we intend to periodically perform, and retain accredited third parties to perform, evaluations of our operational controls, practices and procedures, we may not be able to meet or remain in compliance with our internal standards or those set by these third parties. If we fail to maintain these standards, we may have to expend significant time and money to return to compliance, and our business, financial condition and operating results could be materially adversely affected. We will retain certain confidential customer information in our planned data center. It is important to our business that our facilities and infrastructure remain secure and be perceived by the marketplace to be secure. Despite our security measures, our infrastructure may be vulnerable to physical break-ins, computer viruses, attacks by hackers or other disruptive problems. It is possible that we may have to expend additional financial and other resources to address these problems. Any physical or electronic break-ins or other security breaches or compromises of the information stored at our planned data center may jeopardize the security of information stored on our premises or in the computer systems and networks of our customers. In such an event, we could face significant liability and damage to our reputation, and customers could be reluctant to use our products and services. Such an occurrence could also result in adverse publicity and adversely affect the market's perception of our products and services, which could materially adversely affect our business, financial condition and operating results. We must continue to develop and maintain strategic and other relationships One of our business strategies has been to enter into strategic or other collaborative relationships with many of our OEM customers to develop new technologies and leverage their sales and marketing organizations. We may need to enter into additional relationships to execute our business plan. We may not be able to enter into additional, or maintain our existing, strategic relationships on commercially reasonable terms. As a result, we may have to devote substantially more resources to the development of new technology and the distribution, sales and marketing of our security products and services than we would otherwise. The failure of one or more of our strategic relationships could materially adversely affect our business, financial condition and operating results. 27 We compete with some of our customers We regularly license some of our products to customers who compete with us in other product categories. For example, we license our Security Builder(R) cryptographic toolkit to Baltimore Technologies for incorporation into its UniCERT(TM) product, which competes with our Trustpoint(TM) product line. This potential conflict may deter existing and potential future customers from licensing some of our component products, most notably our Security Builder(R) cryptographic toolkit. We expect to compete with a greater number of our customers as we further expand our product line. Our share price has been, and will likely continue to be, volatile The market price of our common shares has declined significantly in recent months, and we expect that the market price of our common shares may fluctuate substantially as a result of variations in our quarterly operating results. These fluctuations may be exaggerated if the trading volume of our common shares is low. In addition, due to the technology-intensive and emerging nature of our business, the market price of our common shares may fall dramatically in response to a variety of factors, including: . announcements of technological or competitive developments; . acquisitions or entry into strategic alliances by us or our competitors; . the gain or loss of a significant customer or strategic relationship; . changes in estimates of our financial performance; . changes in recommendations from securities analysts regarding us, our industry or our customers' industries; and . general market or economic conditions. This risk may be heightened because our industry is new and evolving, is characterized by rapid technological change and is susceptible to the introduction of new competing technologies or competitors. In addition, equity securities of many technology companies have experienced significant price and volume fluctuations. These price and volume fluctuations are sometimes unrelated to the operating performance of the affected companies. Volatility in the market price of our common shares could result in securities class action litigation. This type of litigation, regardless of the outcome, could result in substantial costs to us as well as a diversion of our management's attention and resources. We have limited financial resources and may require additional financing that may not be available on acceptable term or at all We may require additional equity or debt financing in the future. There can be no assurance that we will be able to obtain on satisfactory terms, or at all, the additional financing required to compete successfully. Failure to obtain such financing could result in the delay or abandonment of some or all of our business plans, which could have a material adverse effect on our business, financial condition and operating results. Risks Related to Our Industry Public key cryptographic technology is subject to risks Our products and services are largely based on public-key cryptographic technology. With public-key cryptographic technology, a user has both a public-key and a private-key. The security afforded by this technology depends on the integrity of a user's private-key and on it not being stolen or otherwise compromised. The integrity of private keys also depends in part on the application of certain mathematical principles such as factoring and elliptic curve discrete logarithms. This integrity is predicated on the assumption that solving problems based on these principles is difficult. Should a relatively easy solution to these problems be developed, then the security of 28 encryption products using public-key cryptographic technology could be reduced or eliminated. Furthermore, any significant advance in techniques for attacking cryptographic systems could also render some or all of our products and services obsolete or unmarketable. Even if no breakthroughs in methods of attacking cryptographic systems are made, factoring problems or elliptic curve discrete logarithm problems can theoretically be solved by computer systems that are significantly faster and more powerful than those currently available. In the past, there have been public announcements of the successful decoding of certain cryptographic messages and of the potential misappropriation of private keys. Such publicity could also adversely affect the public perception as to the safety of public-key cryptographic technology. Furthermore, an actual or perceived breach of security at one of our customers, whether or not due to our products, could result in adverse publicity for us and damage to our reputation. Such adverse public perception or any of these other risks, if they actually occur, could materially adversely affect our business, financial condition and operating results. Our future success will depend upon our ability to anticipate and keep pace with technological changes The information security industry is characterized by rapid technological change. Technological innovation in the marketplace, such as in the areas of mobile processing power or wireless bandwidth, or the development of new cryptographic algorithms, may reduce the comparative benefits of our products and could materially adversely affect our business, financial condition and operating results. Our inability, for technological or other reasons, to enhance, develop and introduce products in a timely manner in response to changing market conditions, industrial standards, customer requirements or competitive offerings could result in our products becoming obsolete, or could otherwise have a material adverse effect on our business, financial condition and operating results. Our ability to compete successfully will depend in large measure on our ability to maintain a technically competent research and development staff and to adapt to technological changes and advances in the industry, including providing for the continued compatibility of our products with evolving industry standards and protocols. We face significant competition, which could harm our ability to maintain or increase sales of our products or reduce the prices we can charge for our products We operate in a highly competitive industry. Many of our competitors have greater name recognition, larger customer bases and significantly greater financial, technical, marketing, public relations, sales, distribution and other resources than we do. We anticipate that the quality, functionality and breadth of our competitors' product offerings will improve, and there can be no assurance that we will be able to compete effectively with such product offerings. In addition, we could be materially adversely affected if there were a significant movement towards the acceptance of open source solutions or other alternative technologies that compete with our products. We expect that additional competition will develop, both from existing businesses in the information security industry and from new entrants, as demand for information products and services expands and as the market for these products and services becomes more established. Moreover, as competition increases, the prices that we charge for our products may decline. If we are not able to compete successfully, our business, financial condition and operating results could be materially adversely affected. Our most significant direct competitors include RSA Security, Inc., VeriSign, Inc., Baltimore Technologies plc, and Entrust Inc. Our business could be adversely affected by United States and foreign government regulation The information security industry is governed by regulations that could have a material adverse effect on our business. Both the U.S. and Canadian governments regulate the export of cryptographic equipment and software, including many of our products. It is also possible that laws could be enacted covering issues such as user privacy, pricing, content, and quality of products and services in these markets. Such regulations and laws could cause us to compromise our source code protection, minimize our intellectual property protection, negatively impact our plans for global expansion, and consequently materially adversely affect our business. Risks Related to Our Corporate Charter; Limitations on Dividends The anti-takeover effect of certain of our charter provisions could delay or prevent our being acquired Our authorized capital consists of an unlimited number of common shares and an unlimited number of preferred shares issuable in one or more series. Although we currently do not have outstanding any preferred shares, 29 our board of directors has the authority to issue preference shares and determine the price, designation, rights, preferences, privileges, restrictions and conditions, including voting and dividend rights, of these shares without any further vote or action by shareholders. The rights of the holders of common shares will be subject to, and may be adversely affected by, the rights of holders of any preferred shares that may be issued in the future. The issuance of preferred shares, while providing desirable flexibility in connection with possible acquisitions and other corporate purposes, or the issuance of additional common shares could make it more difficult for a third party to acquire a majority of our outstanding voting shares. This could deprive our shareholders of a control premium that might otherwise be realized in connection with an acquisition of our company. Our shareholder rights plan could delay or prevent our being acquired We have adopted a shareholder rights plan. The provisions of this plan could make it more difficult for a third party to acquire a majority of our outstanding voting shares, the effect of which may be to deprive our shareholders of a control premium that might otherwise be realized in connection with an acquisition of our company. We do not currently intend to pay any cash dividends on our common shares in the foreseeable future We have never paid or declared any cash dividends on our common shares and we currently intend to retain any future earnings to finance the development and expansion of our business. We do not anticipate paying any cash dividends on our common shares in the foreseeable future. In addition, any dividends paid to residents of the United States would be subject to Canadian withholding tax, generally at the rate of 15%. Item 3. Quantitative and Qualitative Disclosure About Market Risk Foreign Exchange Risk Currency fluctuations may materially adversely affect us. In fiscal 2000, approximately 33% of our total operating expenses were paid in currencies other than the U.S. dollars. In fiscal 2001, approximately 29% of our total operating expenses were paid in currencies other than the U.S. dollar. Fluctuations in the exchange rate between the U.S. dollar and such other currencies may have a material adverse effect on our business, financial condition and operating results. In particular, we may be materially adversely affected by a significant strengthening of the Canadian dollar against the U.S. dollar. We currently do not use financial instruments to hedge operating expense in foreign currencies. We intend to assess the need to utilize financial instruments to hedge currency exposures on an ongoing basis. Interest Rate Risk We hold a significant portion of our cash in interest-bearing instruments and are exposed to the risk of changing interest rates. The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our investments without significantly increasing risk. We place our investment with high credit quality issuers and, by policy, limit the amount of the credit exposure to any one issuer. All highly liquid investments with a maturity of less than three months at the date of purchase are considered to be cash equivalent. All investments with maturities of three months or greater are classified as available-for-sale and considered to be short-term investments. Some of the securities that we have invested in may be subject to market risk. This means that a change in prevailing interest rates may cause the principal amount of the investment to fluctuate. We believe that the immediate 100 basis point move in interest rates would not materially affect the fair market value of our portfolio. To minimize this risk, we maintain our portfolio of cash equivalent and short-term investments in a variety of securities, including commercial paper, medium-term notes, and corporate bonds. As of July 31, 2001, our interest rate risk was further limited by the fact that approximately 99% of our investments mature in less than one year. We do not use any derivative instruments to reduce our exposure to interest rate fluctuations. 30 PART II. OTHER INFORMATION Item 1. Legal Proceedings The nature of our business subjects us to numerous regulatory investigations, claims, lawsuits and other proceedings in the ordinary course of our business. The results of these legal proceedings cannot be predicted with certainty. There can be no assurance that these matters will not have a material adverse effect on our results of operations in any future period, depending partly on the results for that period, and a substantial judgment could have a material adverse impact on our financial condition. In April 2000 we received a letter on behalf of Carnegie Mellon University asserting that it owns the trademark "CERT", and that it believes our use of the stock symbol "CERT" will cause confusion with and/or dilute its purported trademark. Although we intend to defend our use of the stock symbol "CERT" vigorously, there can be no assurance that we will be successful in doing so, or that this dispute with the University will not have a material adverse impact on us. We have also received a letter on behalf of Geoworks Corporation asserting that it holds a patent on certain aspects of technology that are part of the WAP standard. Our WTLS Plus(TM) toolkit may be used to implement WAP-compliant technology. After an internal investigation based upon the description of Geoworks' purportedly patented technology provided by GeoWorks, it is our belief that our toolkits do not include implementation of the Geoworks technology. We have also become aware of a letter circulated on behalf of a Mr. Bruce Dickens asserting that he holds a patent on certain aspects of technology that are implemented within certain portions of the SSL standard. After an internal investigation, it is our belief that we do not implement any validly patented technology. We have received a letter on behalf of eSignX Corporation drawing our attention to a patent which it purports to hold on certain aspects of technology related to the use of WAP-enabled portable electronic authorization devices for approving transactions. The letter states that, based upon a review of a press release announcing our Trustpoint(TM) PKI product, that our product may be covered by eSignX's patent. We have conducted an initial investigation and due to the vague description of the suggested infringement by our products, we were unable to determine the validity of such suggestions. We have requested further elaboration from eSignX, and so far none has been provided. Although we intend to vigorously defend any litigation that may arise in connection with these matters, there can be no assurance that we will be successful in doing so, or that such disputes will not have a material adverse impact on us. In addition, we have become aware of a lawsuit commenced by Mr. Leon Stambler against one of our customers and certain other parties asserting that Mr. Stambler holds patents on certain aspects of technology related to online transactions. Although we have not been named in this legal action, under the terms of the license agreement we have entered into with this customer, we have agreed to defend and are currently defending our customer against any claim that our licensed product, when used within the scope of the license agreement, infringes any U.S. or Canadian patent and to indemnify the customer in certain circumstances for related costs and expenses it incurs as a result of such a claim. We had previously reviewed the Stambler patent and prepared documentation indicating a possible prior use of the subject matter purportedly claimed in the referenced patent. We continue to investigate the scope of protection afforded by the claims detailed in the complaint and effect, if any, of these claims on the products supplied by Certicom. Continued litigation is likely to be expensive and time-consuming. There can be no assurance that such asserted patent will not have a material adverse impact on us. One of our suppliers, East West Imports, Inc. dba California Computers, has filed suit against us in the Superior Court of the State of California, County of Alameda, for payment of approximately $200,000 plus costs, attorney fees, and interest. The focus of our dispute is whether or not a number of personal computers and peripheral items were actually received by us. Both parties are attempting to ascertain the proper amount owed, and we anticipate a settlement on fair and reasonable terms is likely to occur shortly. In the event that no such settlement is reached within a reasonable time, we intend to vigorously defend any litigation over disputed amounts. In such case there can be no assurance that we will be successful in doing so, or that such disputes will not have a material adverse impact on us. 31 Item 6. Exhibits and Reports on Form 8-K (a) Index to Exhibits None (b) Reports on Form 8-K None 32 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on this 14th day of September 2001. Certicom Corp. By: /s/ Richard P. Dalmazzi ----------------------- Richard P. Dalmazzi President, Chief Executive Officer and Director (Principal Executive Officer) /s/ Gregory M. Capitolo ----------------------- Gregory M. Capitolo Vice President, Finance, Chief Financial Officer and Secretary (Principal Financial and Accounting Officer) 33

CERTICOM CORP 10-Q