AWARE, INC.
2002 ANNUAL REPORT
ABOUT AWARE
wis Asymmetric Digital Subscriber Line (ADSL) technology for the
we are a leader in the development and marketing of intellectual
wproperty for broadband communications. Our principal offering
wproperty for broadband communications. Our principal offering
we are a leader in the development and marketing of intellectual
telecommunications industry. ADSL enables telephone companies
to use their existing copper telephone lines to offer broadband
services. We license our broadband intellectual property on a
nonexclusive and worldwide basis to semiconductor companies
that manufacture and sell products that incorporate our technology.
Our licensees sell integrated circuits to systems companies that
manufacture and sell broadband communications equipment.
We also offer ADSL test and development products as well as image
compression software products.
ADSL Subscriber
Net Additions by Year
(millions)
18
16
14
12
10
8
6
4
2
0
17.4
12.6
5.2
0.7
1999
2000
2001
2002
Cumulative ADSL
Subscribers by Region
at 12/31/02
(millions)
Asia 17.5 M
Asia 17.5 M
Europe 9.3 M
Europe 9.3 M
US 6.4 M
US 6.4 M
AWARE, INC.
2002 ANNUAL REPORT
Canada 1.6 M
ROW 1.1 M
MESSAGE TO SHAREHOLDERS
Dear Shareholder,
The past year has been challenging for Aware. We were adversely affected by
the overall malaise in the semiconductor and communications industries. A
combination of factors had a negative impact on sales in 2002. These included
depressed pricing for ADSL chipsets and a limited number of new ADSL design
starts at semiconductor companies.
We are beginning to see signs of improvement driven by the steady growth of ADSL
subscribers around the world. During 2002, 17.4 million new ADSL subscribers
were added on a worldwide basis. Today, roughly 3.5% of the world’s one billion
phone lines are served with ADSL. Asia and Europe have led in terms of growth
and market share. Deployments in North America are improving for a number of
reasons, including new regulatory rules that favor broadband deployments by
phone companies. We expect the number of new subscribers will continue to grow
for at least the next fi ve years.
We remain optimistic that this will allow us to return to the growth and profi tability
targets we had set prior to the prolonged downturn we are experiencing.
An important development in the ADSL market occurred in the last twelve months.
The International Telecommunications Union agreed on new standards that
increase customer’s data rates, expand service availability by extending ADSL
reach and improve service reliability, installation effi ciency and support. The fi rst
of these is known as ADSL2, or G.992.3, which sets standards for line diagnostics,
power management, power down and power cut back, reduced framing and on-line
confi guration. A second new standard, known as ADSL2+ or G.992.5, expands
ADSL bandwidth utilization to approximately 2 MHz thereby increasing achievable
data rates to over 24 million bits per second. With these data rates, multiple voice
and data services can be bundled using ADSL, along with video-based services
and broadcast television.
These new standards will profoundly impact the companies that supply ADSL
products and services. We believe that these new standards will rejuvenate the
market as they provide multiple opportunities for revenue and margin growth
across the industry. New standards also represent natural market entry points for
new silicon and equipment suppliers.
We predict that in the next few years, we will see a rapid increase in demand for
products in the residential market that integrate ADSL with video, wireless local
area networking, or network processing. The silicon and equipment suppliers that
will best serve this market will be those able to cost effectively provide multiple
functionalities in their solutions.
Aware has remained focused on making innovations to improve the quality of
our technology and the value we bring to our customers. Our strategy is to
license technology packages that provide our customers fast market entry
with low risk and cost. We invented many of the new ADSL2 and ADSL2+
technologies and were fi rst to develop intellectual property solutions that
comply with these standards.
We recently expanded our capability to include a complete digital chip. We now
offer our customers the ability to rapidly enter the market with chips from Aware
while simultaneously integrating our intellectual property with their own silicon
or packaging technologies. We have also continued to improve our Dr. DSL®
diagnostics technology, which promises to improve the effi ciency of DSL
network operations.
We have been mindful of the resources required to keep Aware in a competitive
posture during the downturn. We have maintained an adequate cash position;
we ended 2002 with more than $47M in cash and investments. We took steps to
reduce operating expenses by reducing employee headcount by approximately
25% in 2002 while continuing to invest in research and development.
Aware’s compression software business has remained robust and profi table.
Our compression solutions focus primarily on electronic identifi cation
applications. These are showing signs of growth due to increased sensitivity
and investments in security. We are developing new compression solutions
based upon the JPEG 2000 standard. We have also continued to invest in next
generation wireless local area networking technologies with an eye towards
emerging standards.
As always, we appreciate the continued support of our shareholders, customers
and employees as we navigate through these diffi cult times. ADSL technology
is continuing to improve and the ADSL market is continuing to expand. With
this backdrop we remain confi dent that our intellectual property, which includes
a portfolio of over 60 patents and patent applications, our commitment to
customer success and the dedication of our employees will return our company
to better days.
Sincerely,
Michael A. Tzannes
Chief Executive Offi cer
John K. Kerr
John K. Kerr
Chairman,
Board of Directors
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
Annual Report Pursuant To Section 13 Or 15(d) Of The
Securities Exchange Act of 1934
For the fiscal year ended December 31, 2002
Commission file number 000-21129
AWARE, INC.
(Exact Name of Registrant as Specified in Its Charter)
Massachusetts
(State or Other Jurisdiction of
Incorporation or Organization)
(I.R.S. Employer Identification No.)
04-2911026
40 Middlesex Turnpike, Bedford, Massachusetts 01730
(Address of Principal Executive Offices)
(Zip Code)
(781) 276-4000
(Registrant’s Telephone Number, Including Area Code)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value $.01 per share
(Title of class)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or
15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that
the registrant was required to file such reports), and (2) has been subject to such filing requirements for the
past 90 days. YES _X_ NO ___
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not
contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ X ]
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2).
YES _X_ NO ___
The aggregate market value of the voting stock held by non-affiliates of the registrant as of June 28, 2002,
based on the closing price of the common stock on June 28, 2002 as reported on the Nasdaq National Market,
was approximately $82,905,660.
The number of shares outstanding of the registrant’s common stock as of March 12, 2003 was 22,698,171.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant’s definitive Proxy Statement to be delivered to shareholders in connection with the
registrant’s Annual Meeting of Shareholders to be held on May 29, 2003 are incorporated by reference into
Part III of this Annual Report on Form 10-K.
AWARE, INC.
FORM 10-K
FOR THE YEAR ENDED DECEMBER 31, 2002
TABLE OF CONTENTS
PART I
Item 1.
Item 2.
Item 3.
Item 4.
Item 5.
Item 6.
Item 7.
Item 7A.
Item 8.
Item 9.
Item 10.
Item 11.
Item 12.
Item 13.
Item 14.
Description of the Business .....................................................................................................
Properties .................................................................................................................................
Legal Proceedings....................................................................................................................
Submission of Matters to a Vote of Security Holders..............................................................
PART II
Market for Registrant’s Common Equity and Related Stockholder Matters ..........................
Selected Financial Data...........................................................................................................
Management’s Discussion and Analysis of Financial Condition and Results
of Operations............................................................................................................................
Quantitative and Qualitative Disclosures About Market Risk .................................................
Consolidated Financial Statements and Supplementary Data ..................................................
Changes in and Disagreements with Accountants on Accounting and Financial
Disclosure ................................................................................................................................
PART III
Directors and Executive Officers of the Registrant .................................................................
Executive Compensation..........................................................................................................
Security Ownership of Certain Beneficial Owners and Management and Related
Stockholder Matters .................................................................................................................
Certain Relationships and Related Transactions......................................................................
Controls and Procedures ..........................................................................................................
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9
9
9
10
10
11
24
25
43
43
44
44
44
45
PART IV
Item 15.
Exhibits, Financial Statement Schedules, and Reports on Form 8-K ......................................
46
Signatures ...............................................................................................................................................................
47
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PART I
ITEM 1. DESCRIPTION OF THE BUSINESS
Company Overview
We are a worldwide leader in the development and marketing of
intellectual property for broadband
communications. We license our intellectual property to semiconductor companies that build integrated circuits
based on our technology. Our principal offering to date has been Digital Subscriber Line (“DSL”) technology for
the telecommunications industry. DSL enables telephone companies to use their existing copper telephone lines to
offer broadband services.
Our principal DSL offering is a technology package for Asymmetric Digital Subscriber Line (“ADSL”). ADSL is a
broadband service that is primarily targeted at residential telephone customers for high-speed Internet access.
ADSL has been standardized for global use by the International Telecommunications Union (“ITU”). Our ADSL
technology package is compliant with applicable ITU standards.
We have complemented our core ADSL technology offering with technologies aimed at enhancing the value of
ADSL to telephone companies. We also have projects underway to develop other forms of DSL, as well as other
broadband technologies. We play an active role in setting standards for broadband technologies so that we can
anticipate and develop technology that meets the needs of changing markets.
During 2001 and 2002, approximately 78% and 64%, respectively, of our revenue came from licensing ADSL
intellectual property. We license our intellectual property worldwide through our direct sales force. Our largest
semiconductor customers in 2002 were Analog Devices, Inc., Infineon Technologies, AG and Intel Corporation.
The remainder of our revenue came from the sale of hardware and software products. Our hardware products
include board-level products that allow customers to make products that require ADSL connectivity, such as ADSL
test equipment. Our hardware products also include system-level products that enable our customers to develop and
test their ADSL products. Our software products compress digital images and data for law enforcement and other
applications.
We are headquartered in Bedford, Massachusetts. Our telephone number is (781) 276-4000, and our website is
www.aware.com. Incorporated in Massachusetts in 1986, we employed 120 people at December 31, 2002. Our
stock is traded on the Nasdaq National Market under the symbol AWRE.
Our website provides a link to a third-party website through which our annual, quarterly and current reports, and
amendments to those reports, are available free of charge. We believe these reports are made available as soon as
reasonably practicable after we electronically file them with, or furnish them to, the SEC. We do not maintain or
provide any information directly to the third-party website, and we do not check its accuracy.
Industry Background
ADSL industry background. ADSL technology allows telephone companies to offer high-speed data services over
their existing telephone networks by connecting their central offices to end users’ residences. Telephone
companies began tests and trials of ADSL technology in the mid 1990s. Commercial deployment of ADSL services
began in modest volumes in 1999, and during the last three years, the rate of deployment of ADSL services
accelerated dramatically, particularly outside of the United States. According to announcements by major telephone
companies and information compiled by Point Topic Ltd., a company that provides analysis of broadband access to
the internet, approximately 5 million, 12 million, and 17 million new ADSL subscribers were added in 2000, 2001,
and 2002, respectively. As of December 31, 2002, there were approximately 36 million global ADSL subscribers of
which approximately 6 million were in the United States and approximately 30 million were in other countries.
Some of the largest suppliers of ADSL service in North America are SBC, Verizon, Bell South, Qwest, Bell
Canada, and Telus. In Europe, some of the largest providers are Deutsche Telekom, France Telecom, Belgacom,
3
British Telecom, Telephonica, Telecom Italia, and Telia. Large Asian providers include Korea Telecom and
Hanaro in Korea; NTT and Yahoo Broadband in Japan; Chunghwa in Taiwan; and China Telecom in China.
In order to enable ADSL service, ADSL equipment must be installed in the central offices of telephone companies
and in end users’ premises. ADSL central office equipment and customer premises modems are available from
numerous telecommunications equipment suppliers. Some of the leading suppliers of ADSL equipment include
Alcatel Alsthom S.A. (“Alcatel”), ECI Telecom, LTD’s Inovia business unit (“Inovia”), Lucent Technologies, Inc.,
NEC Corporation, Samsung Corporation, Siemens AG, Sumitomo Corporation, UT Starcom, Westell Technologies,
Inc., and Comtrend and other Taiwanese modem manufacturers.
Telecommunications equipment suppliers are able to purchase ADSL chipsets from a number of suppliers,
including Analog Devices Inc. (“ADI”), Broadcom Corporation (“Broadcom”), Centillium Communications, Inc.
(“Centillium”), Conexant Systems, Inc. (“Conexant”), GlobespanVirata, Inc. (“GlobespanVirata”), Infineon
Technologies AG (‘Infineon”), ST Microelectronics N.V. (“ST”), and Texas Instruments Incorporated (“TI”).
ADSL chipsets offered by these suppliers are designed to operate in either central office equipment or customer
premises modems.
Semiconductor industry background. During the 1980s and 1990s, the semiconductor industry moved from
vertically integrated companies to horizontally specialized companies. Vertically integrated semiconductor
companies used to perform the entire semiconductor process from design to manufacture to sales. Today the
industry consists of separate companies focused on various horizontal processes within the semiconductor industry.
Horizontal groups within the semiconductor industry now include capital equipment companies, independent
foundries, design automation shops, fabless semiconductor companies, and semiconductor intellectual property
(“IP”) companies.
The semiconductor intellectual property industry has matured and grown over the last five years. The availability of
field-proven technology from independent IP suppliers allows semiconductor manufacturers to achieve greater
financial flexibility, reduce engineering development risks, and reduce the time it takes to get products to market.
Semiconductor intellectual property may be classified into two principal categories:
(cid:131)(cid:3) Horizontal IP consists of designs for: (i) standard chip functions, such as timers and clocks, memory
management, and hardware controllers, (ii) configurable processors and digital signal processors, and (iii)
libraries of intellectual property that are used during the semiconductor manufacturing process.
(cid:131)(cid:3) Vertical IP consists of solutions for specific applications that are usually based on standards or patents.
Examples include ADSL, Code Division Multiple Access (“CDMA”), Universal Serial Bus (“USB”),
Global System for Mobile telecommunications (“GSM”), Global Positioning System (“GPS”), Wireless
Local Area Networking (“WLAN”), and chip-connection technology for Dynamic Random Access
Memory (“DRAM”).
Our intellectual property is focused on Vertical IP for applications involving broadband communications, and in
particular ADSL.
Aware ADSL Intellectual Property
ADSL technology was first created in the late 1980s. ADSL technology expands the usable bandwidth of copper
wire so that telephone companies can offer high-speed data services over their existing telephone networks. ADSL
is a point-to-point technology that connects the end user to a telephone company’s central office. ADSL equipment
is deployed at each end of the copper wire in order to enable the service. ADSL is targeted at the residential market
and is designed to transmit data at speeds more than 100 times faster than 56 kilobits per second (“Kbps”)
voiceband modems. Actual transmission speeds depend on the length and condition of the existing wire.
An ADSL system divides the bandwidth on a copper wire into three segments. The first segment is used for plain
old telephone service (“POTS”). The second segment is used to transmit data upstream from the user to the central
office. The third segment is used to transmit data downstream from the central office to the user.
4
Full-rate ADSL was first standardized in 1995 by the American National Standards Institute as T1.413, and then by
the ITU in 1999 as G.992.1. Full-rate ADSL can transmit data at speeds up to 8 megabits per second (“Mbps”)
downstream and up to 640 Kbps upstream.
In 1999, the ITU also standardized a lower speed version of ADSL, known as G.Lite or G.992.2. G.Lite can
transmit data at speeds up to 1.5 Mbps downstream and up to 512 Kbps upstream without using special filtering
equipment required by full-rate ADSL. G.Lite was intended to make the installation of ADSL faster and less
expensive for telephone companies. Notwithstanding G.Lite’s ease of installation, most ADSL service offerings
today are based on full-rate ADSL.
In 2002, the ITU consented to a new set of ADSL standards known as ADSL2 or G.992.3 and G.992.4. These
standards provide numerous improvements over previous ADSL standards, including line diagnostics, power
management, power down and power cut-back, reduced framing and on-line configuration. In February 2003, the
ITU consented to a new standard known as ADSL2+ or G.992.5. ADSL2+ builds upon the ADSL2 standard by
increasing achievable data rates to speeds of up to 24 Mbps upstream on phone lines as long as 3,000 feet (20 Mbps
out to 5,000 feet).
We license a technology package that includes a complete implementation of the ITU standards for ADSL, ADSL2
and ADSL2+. Our intellectual property offering includes chip designs, in the form of RTL, and software for
operating the chip. In January 2003, we announced that we had developed and manufactured a physical chip named
StratiPHY™ that represents our intellectual property designs. The addition of StratiPHY to Aware’s intellectual
property offering provides our customers with access to working silicon along with a complete turnkey package of
RTL and firmware. We believe the addition of a physical chip to our intellectual property offerings has the
potential of further reducing our customers’ development costs and time-to-market.
Customers can integrate our technology into their own or third party manufacturing processes to develop monolithic
chips or packaged solutions. We also license patent rights and offer engineering services to our customers.
We have complemented our core ADSL offerings with technologies aimed at enhancing the value proposition of
ADSL for telephone companies. An important innovation we have developed is our Dr. DSL® diagnostic testing
technology. Dr. DSL is designed to assist service providers with provisioning, monitoring, and maintaining their
DSL services by enabling them to collect important information about their copper loop plant and the access
network. Dr. DSL also has the potential of providing subscribers with tools they can use to assist with provisioning
and maintenance. The primary goal of Dr. DSL is to reduce the costs associated with service turn-on and
maintenance by reducing customer complaints and technician visits to subscriber locations. Specific Dr. DSL
features include loop length measurement, bridged tap measurement, crosstalk disturber detection and management,
subscriber self-installation, and in-home diagnostics.
We have also developed channelized voice technology,
named voice-enabled DSL (VeDSL™), which allows service providers to bundle new, profitable voice-over-DSL
services to their residential subscribers, enabling ADSL to evolve from a data-centric technology to a complete
residential voice and data solution.
Aware Business Model & Strategy
We have adopted an intellectual property business model under which we license our broadband technology on a
nonexclusive and worldwide basis to semiconductor companies that manufacture and sell products that incorporate
our technology. Our licensees sell integrated circuits to equipment companies that incorporate those integrated
circuits into their products.
Our business model and strategy are designed to:
(cid:131)(cid:3) offer the semiconductor industry an independent source of broadband technology;
(cid:131)(cid:3) provide multiple and flexible technology solutions for numerous silicon and equipment architectures;
(cid:131)(cid:3) offer systems-level, vertical intellectual property for specific applications that are based on worldwide
standards;
5
(cid:131)(cid:3) leverage our customers’ distribution capabilities;
(cid:131)(cid:3) contribute to industry standards by offering our expertise, which allows us to anticipate technological changes;
and
(cid:131)(cid:3) generate revenue through a combination of license fees, engineering service fees, and royalties.
Aware ADSL Hardware Products
In addition to our intellectual property licensing business, we sell ADSL-related hardware products. Our principal
hardware products include:
(cid:120)(cid:3) ADSL modules - Modules are board-level products that contain all of the components of an ADSL system.
Customers, such as ADSL test equipment companies, can integrate ADSL connectivity into their equipment-
based products using our ADSL modules;
(cid:120)(cid:3) ADSL development systems - Development systems are system-level products that are designed to help our
customers build ADSL chipsets by providing them with a means to conduct performance and interoperability
testing during product development; and
(cid:120)(cid:3) ADSL test systems - Test systems are systems-level products that are designed to help ADSL modem
manufacturers test their products during production without requiring them to purchase expensive central office
equipment.
Aware Compression Software Products
We also develop and sell image and data compression products. Since 1988, we have developed intellectual
property in the field of wavelet transform-based data compression. Our compression technology enables digital
images and certain types of data to be compressed to between 1% and 10% of their original size. Our compression
software products are sold to OEMs that integrate the software into their equipment-based solutions. Our principal
compression software products are described below.
(cid:131)(cid:3) WSQ by Aware compresses digital fingerprint data for use by law enforcement agencies such as the Federal
Bureau of Investigation.
(cid:131)(cid:3) Our electronic ID product suite includes NistPack by Aware, Sequence Check by Aware, CJIS Web by Aware,
Accuprint by Aware, and Accuscan by Aware. These products are used by law enforcement agencies to format,
edit, validate, store, and print fingerprint and facial images.
(cid:131)(cid:3) JPEG 2000 Codec by Aware provides a solution for the compression and decompression of still images using
the high-quality, wavelet-based method defined by the JPEG 2000 standard.
(cid:131)(cid:3) We also license radiology compression software, which compresses digital radiographs and other types of
medical imagery.
Research and Development
Semiconductor intellectual property markets are characterized by rapid technological changes and advances.
Accordingly, we make substantial investments in the design and development of new technologies, and for
significant improvement of existing technologies. Our research and development activities are focused on the
further development of our ADSL technology, including incorporating new industry standards that we expect will
be adopted. We have also announced that we are developing technology for diagnostics and testing (Dr. DSL),
G.SHDSL (ITU standard G.991.2), and wireless local area networking.
As of December 31, 2002, we had an engineering staff of 89 employees, representing 74% of our total employee
staff. During the years ended December 31, 2002, 2001, and 2000, research and development expenses charged to
operations were $14.0 million, $10.1 million, and $5.9 million, respectively.
In addition, because our license
agreements often call for us to provide engineering development services to our customers, a portion of our total
6
engineering costs has been allocated to cost of contract revenue. We expect that we will continue to invest
substantial funds in research and development activities.
Sales and Marketing
Our principal sales and marketing strategy is to license our ADSL intellectual property to semiconductor
manufacturers. We believe that decisions involving the selection of our technology are frequently made at senior
levels within a prospective customer’s organization. Consequently, we rely significantly on presentations by our
senior management to key employees at prospective customers. As of December 31, 2002, we had twelve people in
our broadband sales and marketing organization.
Customers who have licensed our ADSL technology include ADI, Agere Systems, Inc. (“Agere”), Infineon, Intel,
Legerity, Inc. (formerly Advanced Micro Devices’ Communication Products Division), NEC Corporation, ST
Microelectronics (“ST”), Metanoia Technologies (formerly a division of Sigmatel, Inc.), and 3COM/US Robotics.
In 2002, we derived approximately 32%, 15%, and 12% of our total revenue from ADI, Infineon, and Intel,
respectively.
In 2001, we derived approximately 52% and 14% of our total revenue from ADI and Intel,
respectively. In 2000, we derived approximately 51% of our total revenue from ADI. All revenue in 2002, 2001,
and 2000 was derived from unaffiliated customers.
We sell our software-based compression products primarily through OEMs and systems integrators. As of
December 31, 2002, there were three people in our compression software sales organization.
Competition
We compete by offering comprehensive packages of standards-based, complex, system-level, broadband
technology.
Our success as an intellectual property supplier depends on the willingness and ability of
semiconductor manufacturers to design, build and sell integrated circuits based on our intellectual property. The
semiconductor industry is intensely competitive and has been characterized by:
(cid:131)(cid:3) rapid price erosion;
(cid:131)(cid:3) rapid technological change;
(cid:131)(cid:3) short product life cycles;
(cid:131)(cid:3) cyclical market patterns; and
(cid:131)(cid:3) increasing foreign and domestic competition.
As an intellectual property supplier to the semiconductor industry, we face competition from internal development
teams within potential semiconductor customers. We must convince potential licensees to license from us rather
than develop technology internally. Furthermore, semiconductor customers, who have licensed our intellectual
property, may choose to abandon joint development projects with us and develop chipsets themselves without using
our technology. In addition to competition from internal development teams, we compete against other independent
suppliers of intellectual property for DSL and wireless local area networking.
The market for ADSL chipsets is also intensely competitive. Our success within the ADSL industry requires that
ADSL equipment manufacturers buy chipsets from our semiconductor licensees, and that telephone companies buy
ADSL equipment from those equipment manufacturers. Our customers’ chipsets compete with products from other
vendors of standards-based and ADSL chipsets, including Broadcom, Centillium, Conexant, GlobespanVirata, ST
and TI.
ADSL services compete with alternative DSL technologies that can also transport high-speed data over telephone
lines. These technologies include symmetric high speed DSL (also known as HDSL, SDSL and G.SHDSL), and
very high speed DSL, also known as VDSL. We cannot assure you that these alternative broadband technologies
7
will not be more successful than ADSL or that we will be able to participate in markets involving these alternative
broadband technologies.
ADSL services also compete with broadband technologies that use other network architectures to provide high-
speed data service. These technologies include cable modems using cable networks, and wireless solutions using
wireless networks. To date, ADSL services have been more successful than high-speed cable services outside of the
United States; however cable services serve a larger number of broadband subscribers than ADSL inside the United
States. We cannot assure you that these alternative network architectures will not be more successful than ADSL.
Many of our current and prospective ADSL licensees, as well as chipset competitors that compete with our
semiconductor licensees, including Broadcom, Conexant, GlobespanVirata, ST and TI, have significantly greater
financial, technological, manufacturing, marketing and personnel resources than we do. We cannot assure you that
we will be able to compete successfully or that competitive pressures will not seriously harm our business.
The markets for our wavelet image compression technology are competitive, and are expected to become
increasingly more competitive in the near future.
Patents and Intellectual Property
We rely on a combination of nondisclosure agreements and other contractual provisions, as well as patent,
trademark, trade secret and copyright law to protect our proprietary rights. We have an active program to protect
our proprietary technology through the filing of patents. As of December 31, 2002, we had 18 issued patents and 45
pending patent applications pertaining to telecommunications and signal processing technology. We also had 12
issued patents and 3 pending patent application pertaining to image compression, video compression, audio
compression, seismic data compression and optical applications.
Although we have patented certain aspects of our technology, we rely primarily on trade secrets to protect our
intellectual property. We attempt to protect our trade secrets and other proprietary information through agreements
with our licensees, suppliers, employees and consultants, and through security measures. Each of our employees is
required to sign a non-disclosure and non-competition agreement. Although we intend to protect our rights
vigorously, we cannot assure you that these measures will be successful. In addition, effective intellectual property
protection may be unavailable or limited in certain foreign countries.
Third parties may assert exclusive patent, copyright and other intellectual property rights to technologies that are
important to us. In the past, we have received letters from third parties suggesting that we may be obligated to
license such intellectual property rights. If we were found to have infringed any third party’s patents, we could be
subject to substantial damages and an injunction preventing us from conducting our business.
Manufacturing
Sales of hardware products constitute a relatively small portion of our total revenue. Since our primary strategic
focus is IP licensing, we do not intend to produce hardware products in any material quantity for the foreseeable
future. Consequently, we rely on third party contract manufacturers to assemble and test substantially all of our
products. Our internal manufacturing capacity is limited to final test and assembly of certain products. Other than
ADSL chipsets, which are available from ADI, we believe that other components for our equipment-based products
are available from a number of suppliers.
Employees
At December 31, 2002, we employed 120 people, including 89 in engineering, 15 in sales and marketing, 3 in
manufacturing and 13 in finance and administration. Of these employees, 118 were based in Massachusetts. None
of our employees is represented by a labor union. We consider our employee relations to be good.
8
We believe that our future success will depend in large part on the service of our technical and senior management
personnel and upon our ability to retain highly qualified technical, sales and marketing and managerial personnel.
In October 2002 we terminated approximately 22 percent of our workforce as part of an effort to reduce operating
expenses. Our workforce reduction may yield unanticipated consequences, such as attrition beyond our planned
reduction in workforce. Further, the reduction in force may reduce employee morale and may create concern among
existing employees about job security, which may lead to increased attrition or turnover. As a result of these factors,
our remaining personnel may decide to seek employment with more established companies, and we may have
difficulty attracting new personnel that we might wish to hire in the future. We cannot assure you that we will be
able to retain our key managerial and technical employees or that we will be able to attract and retain additional
highly qualified personnel in the future.
ITEM 2. PROPERTIES
We believe that our existing facilities are adequate for our current needs and that additional space sufficient to meet
our needs for the foreseeable future will be available on reasonable terms. We currently occupy:
1.
2.
72,000 square feet of office space in Bedford, Massachusetts, which serves as our headquarters. This site is
used for our research and development, sales and marketing, and administrative activities. We own this facility.
1,265 square feet of research and development space in Lafayette, California. This facility is currently leased
for a 3-year term, which expires on August 31, 2004.
ITEM 3. LEGAL PROCEEDINGS
From time to time we are involved in litigation incidental to the conduct of our business. We are not party to any
lawsuit or proceeding that, in our opinion, is likely to seriously harm our business.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders during the fourth quarter ended December 31, 2002.
9
PART II
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
Our common stock is the only class of stock we have outstanding, and it trades on the Nasdaq National Market
under the symbol AWRE. The following table sets forth the high and the low sales prices of our common stock as
reported on the Nasdaq National Market from January 1, 2001 to December 31, 2002.
2002
High..................................
Low ..................................
2001
High..................................
Low ..................................
First
Quarter
Second
Quarter
Third
Quarter
Fourth
Quarter
$9.79
5.92
$6.50
3.25
$21.00
8.50
$10.50
7.30
$3.94
1.95
$9.05
3.17
$3.05
2.01
$8.63
3.76
As of March 12, 2003, we had approximately 160 shareholders of record. This number does not include
shareholders from whom shares were held in a “nominee” or “street” name. We have never paid cash dividends on
our common stock and we anticipate that we will continue to reinvest any earnings to finance future operations.
We did not sell any equity securities that were not registered under the Securities Act of 1933 during the three
months ended December 31, 2002.
ITEM 6. SELECTED FINANCIAL DATA
In the table below, we provide you with our selected consolidated financial data. We have prepared this
information using our audited financial statements for the years ended December 31, 2002, 2001, 2000, 1999, and
1998. When you read this selected financial data, it is important that you read it along with Management’s
Discussion and Analysis of Financial Condition and Results of Operations, our historical consolidated financial
statements, and the related notes to the financial statements, which can be found in Item 8.
Year ended December 31,
2002
2001
2000
1999
1998
(in thousands, except per share data)
Statements of Operations Data
Revenue...................................................
Income (loss) from operations.................
Cumulative effect of change in
accounting principle (1).......................
Net income (loss).....................................
Net income (loss) per share – basic.........
Net income (loss) per share – diluted ......
Balance Sheet Data
Cash and short-term investments.............
Working capital .......................................
Total assets...............................................
Total liabilities.........................................
Total stockholders’ equity .......................
$13,844
(12,529)
$18,547
(4,823)
$30,667
9,490
$20,527
3,321
$11,796
(3,951)
-
-
(18,728)
($0.83)
($0.83)
(2,520)
($0.11)
($0.11)
(1,618)
13,414
$0.60
$0.56
$33,302
33,481
59,237
1,659
57,578
$57,284
59,608
78,103
1,947
76,156
$57,503
67,146
81,450
3,117
78,333
-
4,898
$0.23
$0.21
$36,265
41,348
54,482
1,514
52,968
-
(2,249)
($0.11)
($0.11)
$26,567
28,813
40,162
1,028
39,133
10
(1) Effective January 1, 2000, we adopted Securities and Exchange Commission Staff Accounting Bulletin No.
101, Revenue Recognition in Financial Statements (“SAB 101”) and recorded the impact in 2000. In 1999, the
pro forma effect of retroactive application of SAB 101 would have resulted in net income of $3.280 million and
net income per share, basic and diluted, of $0.15 and $0.14, respectively. There was no pro forma effect on
1998.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
RESULTS OF OPERATIONS
The following table sets forth, for the years indicated, certain line items from our consolidated statements of
operations stated as a percentage of total revenue:
Year ended December 31,
2001
2002
2000
Revenue:
Product sales ................................................................
Contract revenue ..........................................................
Royalties ......................................................................
Total revenue .............................................................
Costs and expenses:
Cost of product sales....................................................
Cost of contract revenue ..............................................
Research and development ..........................................
Selling and marketing ..................................................
General and administrative ..........................................
Total costs and expenses...........................................
33 %
49
18
100
7
35
101
21
26
190
Income (loss) from operations ........................................
(90)
Interest income................................................................
6
Income (loss) before benefit from (provision for)
income taxes and cumulative effect of change in
accounting principle ....................................................
Benefit from (provision for) income taxes......................
Income (loss) before cumulative effect of change in
accounting principle.....................................................
Cumulative effect of change in accounting principle .....
Net income (loss) ............................................................
(84)
(51)
(135)
-
(135) %
21 %
44
35
100
15 %
40
45
100
3
37
54
16
16
126
(26)
12
(14)
-
3
29
19
8
10
69
31
9
40
9
(14)
-
(14) %
49
(5)
44 %
Product Sales
Product sales consist primarily of revenue from the sale of hardware products and compression software. Hardware
products primarily include ADSL test and development systems, modules, and modems. Compression software
consists of standard off-the-shelf software products that are sold to OEM customers that integrate our software into
their equipment-based products.
Product sales increased 19% from $3.8 million in 2001 to $4.5 million in 2002. As a percentage of total revenue,
product sales increased from 21% in 2001 to 33% in 2002. The dollar increase was primarily due to higher unit
volume sales of modules and compression software, which was partially offset by a decrease in revenue from the
11
sale of test and development systems. Module sales were higher primarily due to sales to a customer that is using
them in ADSL test equipment. Compression software revenue increased primarily due to higher demand for our
electronic identification products. Test and development system revenue decreased primarily due to lower demand
from our semiconductor and equipment customers, which was the result of continued difficult economic conditions
in the semiconductor and telecommunications industries.
Product sales decreased 18% from $4.7 million in 2000 to $3.8 million in 2001. As a percentage of total revenue,
product sales increased from 15% in 2000 to 21% in 2001. The dollar decrease was primarily due to a decrease in
revenue from the sale of test and development systems, which was partially offset by an increase in revenue from
the sale of compression software. Test and development system revenue decreased primarily because our
semiconductor and equipment customers curtailed product development activities beginning in 2001 as a result of
difficult economic conditions in the semiconductor and telecommunications industries. Compression software
revenue was higher due to a large sale of our electronic identification products in the first quarter of 2001.
Contract Revenue
Contract revenue consists primarily of license and engineering service fees that we receive under agreements with
our customers to develop ADSL chipsets.
Contract revenue decreased 18% from $8.3 million in 2001 to $6.8 million in 2002. As a percentage of total
revenue, contract revenue increased from 44% in 2001 to 49% in 2002. Contract revenue decreased 32% from
$12.2 million in 2000 to $8.3 million in 2001. As a percentage of total revenue, contract revenue increased from
40% in 2000 to 44% in 2001.
The dollar decreases in contract revenue in 2002 and 2001 were primarily due to a difficult environment for
licensing intellectual property for communications integrated circuits. Both existing and prospective ADSL chipset
licensees were reluctant to begin new development projects given: (i) generally weak worldwide economic
conditions, (ii) a difficult and uncertain environment in the semiconductor and telecommunications industries, and
(iii) intense ADSL chipset competition and falling chipset prices. During the last two years, customers and potential
customers cautiously evaluated new chipset projects or delayed or cancelled projects in the face of such conditions.
We are uncertain when the economic and market conditions we faced in 2002 and 2001 will improve.
Royalties
Royalties consist of royalty payments that we receive under licensing agreements. We receive royalties from
customers for the right to use our technology in their chipsets or solutions.
Royalties decreased 61% from $6.5 million in 2001 to $2.5 million in 2002. As a percentage of total revenue,
royalties decreased from 35% in 2001 to 18% in 2002. The decrease in royalties was primarily due to a decrease in
ADSL chipset sales by our largest customer, ADI. We believe that ADI’s chipset sales declined primarily due to
falling ADSL chipset pricing and a potential loss of market share. Despite strong growth of worldwide ADSL
subscribers in 2002, the availability of ADSL chipsets from a number of suppliers and intense competition among
those suppliers has caused chipset prices to drop sharply over the last two years. Additionally, deployments of
ADSL service in geographic areas where chipsets based upon our technology have been sold, leveled off or
declined in 2002. We are uncertain when ADSL chipset pricing will improve, whether ADI will be able to grow its
presence or whether our other licensees will contribute meaningful royalty revenue.
Royalties decreased 53% from $13.9 million in 2000 to $6.5 million in 2001. As a percentage of total revenue,
royalties decreased from 45% in 2000 to 35% in 2001. The decrease in royalties was primarily due to a decrease in
ADSL chipset sales by ADI, our largest customer. We believe there were two principal factors behind the decline
in ADI’s chipset sales in 2001. First, while end user demand for ADSL service remains strong, particularly outside
of the United States, more ADSL chipsets were sold in 2000 than were required by new subscribers. Resulting
equipment overcapacity at telephone companies’ central offices, and excess chipset inventory at ADSL equipment
manufacturers slowed industry-wide chipset sales. Second, the glut of ADSL chipsets and central office equipment
capacity caused chipset selling prices to drop sharply.
12
Cost of Product Sales
Since the cost of compression software license sales is minimal, cost of product sales consists primarily of ADSL
equipment sales. Cost of product sales increased 52% from $0.6 million in 2001 to $1.0 million in 2002. As a
percentage of product sales, cost of product sales increased from 16% in 2001 to 21% in 2002. The increase in cost
of product sales was primarily due to a greater proportion of module sales in the sales mix. Modules have higher
cost of sales than the other products that comprise our product revenue.
Cost of product sales decreased 24% from $0.8 million in 2000 to $0.6 million in 2001. As a percentage of product
sales, cost of product sales decreased from 18% in 2000 to 16% in 2001. In terms of dollars, the decrease in cost of
product sales was primarily due to lower sales of ADSL test and development systems. The improvement in
product margins was primarily due to a greater proportion of compression software sales in the product sales
revenue mix.
Cost of Contract Revenue
Cost of contract revenue consists primarily of salaries for engineers and expenses for consultants, recruiting,
supplies, equipment, depreciation and facilities associated with customer development projects. Our total
engineering costs are allocated between cost of contract revenue and research and development expense. In a given
period, the allocation of engineering costs between cost of contract revenue and research and development is a
function of the level of effort expended on each.
Cost of contract revenue decreased 28% from $6.8 million in 2001 to $4.9 million in 2002. As a percentage of
contract revenue, cost of contract revenue decreased from 83% in 2001 to 72% in 2002. Cost of contract revenue
decreased 22% from $8.8 million in 2000 to $6.8 million in 2001. As a percentage of contract revenue, cost of
contract revenue increased from 72% in 2000 to 83% in 2001.
The dollar decrease in cost of contract revenue in 2002 and 2001 was primarily due to fewer customer contracts.
Since our cost of contract revenue is based on the level of effort we expend on customer projects and the number of
customer projects declined in 2002 and 2001, cost of contract revenue declined as well.
Research and Development Expense
Research and development expense consists primarily of salaries for engineers and expenses for consultants,
recruiting, supplies, equipment, depreciation and facilities related to engineering projects to enhance and extend our
broadband intellectual property offerings, and our compression software technology. Research and development
expense increased 38% from $10.1 million in 2001 to $14.0 million in 2002. As a percentage of total revenue,
research and development expense increased from 54% in 2001 to 101% in 2002. The dollar increase in research
and development spending was primarily due to the following factors:
(i)
spending in 2002 includes the full year effect of a number of new engineers hired in 2001. Spending in
2001 only reflects that portion of the year that these employees were employed by us;
(ii) as the number of customer projects decreased over the past year, we shifted engineers who were working
on these projects to internal research and development projects; and
(iii) we incurred additional research and development spending in 2002 to design and manufacture an
ADSL/ADSL2 chip that we have named StratiPHY.
Our research and development spending is principally focused on projects related to core ADSL technology,
including our StratiPHY chip, as well as for Dr. DSL, G.SHDSL, wireless local area network communications, and
other development projects.
In October 2002, we terminated 35 employees to reduce our operating costs. Of the 35 employees who were
terminated, 32 were engineers. The cost of severance and other employee benefits for terminated employees was
approximately $700,000. The cost was recorded in the fourth quarter of 2002, and it approximates our historical
quarterly costs for these employees as if they were active employees. Therefore, the reduction in force had a
13
minimal effect on research and development spending in 2002. As of December 31, 2002, accrued severance costs
were approximately $140,000, and are expected to be paid in the first half of 2003.
In connection with the October reduction in force, we informed remaining employees that effective January 1, 2003
their salaries would be reduced by 5% and that senior management’s salaries would be reduced by 10%. We
anticipate that the reduction in force and salary reductions will lower total 2003 engineering expenses by
approximately $3.7 million annually, and will lower total 2003 company expenses by $4.1 million annually. Total
engineering expenses include cost of contract revenue and research and development expense.
Research and development expense increased 71% from $5.9 million in 2000 to $10.1 million in 2001. As a
percentage of total revenue, research and development expense increased from 19% in 2000 to 54% in 2001. The
dollar increase was primarily due to increased spending on internal research and development projects, including
improvements to our core ADSL technology offering, projects such as VeDSL, Dr. DSL, G.SHDSL, wireless local
area network communications, powerline communications, as well as other development projects.
Selling and Marketing Expense
Selling and marketing expense consists primarily of salaries for sales and marketing personnel, travel, advertising
and promotion, recruiting, and facilities expense. Sales and marketing expense increased 2% from $2.9 million in
2001 to $3.0 million in 2002. As a percentage of total revenue, sales and marketing expense increased from 16% in
2001 to 21% in 2002. The dollar increase was primarily due to increased spending on sales staff and higher
commissions for product sales, which was partially offset by lower advertising and tradeshow expenses.
Sales and marketing expense increased 15% from $2.5 million in 2000 to $2.9 million in 2001. As a percentage of
total revenue, sales and marketing expense increased from 8% in 2000 to 16% in 2001. The dollar increase was
primarily due to the addition of sales and marketing staff during 2001.
General and Administrative Expense
General and administrative expense consists primarily of salaries for administrative personnel, facilities costs, and
public company, bad debt, legal, and audit expenses. General and administrative expense increased 24% from $2.9
million in 2001 to $3.6 million in 2002. As a percentage of total revenue, general and administrative expense
increased from 16% in 2001 to 26% in 2002. The dollar increase was primarily due to higher provisions for bad
debts. In the fourth quarter of 2002, we increased our allowance for doubtful accounts by $0.7 million for an
accounts receivable balance that we considered uncollectible.
General and administrative expense decreased 6% from $3.1 million in 2000 to $2.9 million in 2001. As a
percentage of total revenue, general and administrative expense increased from 10% in 2000 to 16% in 2001. The
dollar decrease was primarily due to lower provisions for bad debts, which was partially offset by increased
spending on salaries.
Interest Income
Interest income decreased 61% from $2.3 million in 2001 to $0.9 million in 2002. The dollar decrease was
primarily due to lower interest rates earned on our cash balances and lower cash balances.
Interest income decreased 19% from $2.8 million in 2000 to $2.3 million in 2001. The dollar decrease was
primarily due to lower interest rates earned on our cash balances.
Income Taxes
We evaluate, on a quarterly basis, the positive and negative evidence affecting the realizability of our deferred tax
assets. In 2002, we determined that due to our continuing operating losses in 2001 and 2002 as well as the
uncertainty of the timing of profitability in future periods, we should fully reserve our deferred tax assets. As a
result, we recorded a tax provision of $7.1 million in 2002 to reserve for our remaining deferred tax assets.
14
We made no provision for income taxes in 2001 because we had a net loss. In 2000, we determined that based on
our expected future profitability at that time, it was more likely than not that we would realize a portion of our tax
assets. Accordingly, we recorded a deferred tax asset of $7.1 million at December 31, 2000, which consisted of an
income statement tax benefit of $2.7 million for tax loss carryforwards and research and development credits, and
an adjustment to additional paid-in capital of $4.4 million for stock option related deductions.
At December 31, 2002, we had federal net operating loss carryforwards of approximately $48.2 million, which
begin to expire in 2007, and federal research and development credit carryforwards of approximately $7.9 million,
which begin to expire in 2003. At December 31, 2002, we also had available state net operating loss carryforwards
of approximately $48.3 million, which begin to expire in 2003, and state research and development and investment
tax credit carryforwards of approximately $4.0 million, which begin to expire in 2003.
Of the total net operating loss and research and development tax credit carryforwards for which a valuation
allowance was recorded, approximately $24.5 million is attributable to the exercise of stock options and the tax
benefit will be credited to additional paid-in capital, if realized in the future.
Cumulative Effect of Change in Accounting Principle
Effective January 1, 2000 we changed our method of revenue recognition in accordance with Securities and
Exchange Commission Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements.
Previously, we recognized contract revenue under multiple element agreements upon completion of contract
milestones or upon transfer of intellectual property. Under the accounting method we adopted retroactive to
January 1, 2000, we now recognize contract revenue under multiple element agreements by recording total license
and engineering fees for the entire contract on a straight-line basis over the estimated contract performance period,
subject to the limitation that cumulative revenue through the end of any period may not exceed cumulative contract
payments through that same period. The cumulative effect of the change on prior years resulted in a charge to
income of $1.6 million for the year ended December 31, 2000. For the years ended December 31, 2001 and 2000,
we recognized $0.9 million and $0.7 million in revenue, respectively, that was included in the cumulative effect
adjustment as of January 1, 2000.
LIQUIDITY AND CAPITAL RESOURCES
Since our inception in March 1986, we have financed our activities primarily through the sale of stock. In the years
ended December 31, 2002, 2001 and 2000, we received net proceeds from the issuance of stock under employee
stock plans of $0.2 million, $0.3 million and $7.6 million, respectively. Our operating activities used net cash of
$9.5 million in 2002. Cash used in our operating activities was primarily the result of operating losses and working
capital requirements. Operating activities provided net cash of $1.2 million and $14.5 million in the years ended
December 31, 2001 and 2000, respectively. Cash provided by operations during 2001 was primarily due to the
collection of accounts receivables, which was partially offset by a decrease in deferred revenue. Cash provided by
operations during 2000 was primarily due to our profitability in that year.
In the years ended December 31, 2002, 2001, and 2000, we made capital expenditures of $0.8 million, $1.4 million,
and $1.3 million, respectively. Capital expenditures in all three years primarily consisted of spending on computer
hardware and software, laboratory equipment, and furniture used principally in engineering activities. We have no
material commitments for capital expenditures.
At December 31, 2002, we had cash, cash equivalents, short-term investments and investments of $47.1 million.
While we can not assure you that we will not require additional financing, or that such financing will be available to
us, we believe that our cash, cash equivalents, short-term investments and investments will be sufficient to fund our
operations for at least the next twelve months.
15
CRITICAL ACCOUNTING POLICIES
We consider certain accounting policies related to revenue recognition, income taxes and the allowance for doubtful
accounts to be critical policies.
Revenue recognition. We derive our revenue from three sources (i) product revenue, which includes revenue from
the sale of ADSL equipment and compression software products, (ii) contract revenue, which includes license and
engineering service fees that we receive under customer agreements, and (iii) royalties that we receive under
customer contracts.
As prescribed by Securities and Exchange Commission Staff Accounting Bulletin No. 101, Revenue Recognition in
Financial Statements, we recognize revenue when there is persuasive evidence of an arrangement, the sales price is
fixed or determinable, collection of the related receivable is reasonably assured, and delivery has occurred or
services have been rendered. We also apply the principles set forth in AICPA Statement of Position No. 97-2,
Software Revenue Recognition, when recognizing compression software revenue. Our revenue recognition policies
are described more fully in Note 2, Summary of Significant Accounting Policies, in the Notes to our Consolidated
Financial Statements
As described below, we make significant judgments and estimates during the process of determining revenue for
any particular accounting period.
In determining revenue recognition, we assess whether fees associated with revenue transactions are fixed or
determinable and whether or not collection is reasonably assured. We make a judgment whether fees are fixed or
determinable based on the payment terms associated with that transaction. We assess collection based on a number
of factors, including past transaction history with the customer and the credit-worthiness of the customer. If we
determine that collection of a fee is not reasonably assured, we defer the fee and recognize revenue at the time
collection becomes reasonably assured, which is generally upon receipt of cash.
In addition to these general revenue recognition judgments, we make specific judgments and estimates with respect
to the recognition of contract revenue. We categorize customer contracts as either single element licensing
agreements or multiple element licensing agreements.
Contract revenue under single element licensing agreements is recognized when technology transfers have been
delivered or when engineering services have been completed in accordance with defined milestones. Revenue
recognized under single element agreements requires us to make judgments regarding the completeness of complex
technology or service deliverables. While our customer agreements generally do not contain customer acceptance
provisions, we must make judgments that our deliverables have been made in accordance with the terms of
underlying agreements.
Contract revenue under multiple element licensing agreements is recognized by recording total license and
engineering fees for the entire contract on a straight-line basis over the estimated contract performance period,
subject to the limitation that cumulative revenue through the end of any period may not exceed cumulative contract
payments through that same period. Revenue recognized under multiple element agreements requires us to make
estimates of contract performance periods. The estimate of this period is subject to revision as the product is being
developed under a contract, and a revision may result in an increase or decrease to the quarterly revenue for that
contract. Revenue recognized under multiple element agreements also involves judgments regarding the
completeness of contract milestones as described in the previous paragraph.
Income taxes. As part of the process of preparing our consolidated financial statements we are required to estimate
our actual current tax expense. We must also estimate temporary and permanent differences that result from
differing treatment of certain items for tax and accounting purposes. These differences result in deferred tax assets
and liabilities, which are included in our consolidated balance sheet. We must then assess the likelihood that our
deferred tax assets will be recovered from future taxable income and to the extent that we believe that recovery is
not likely, we must establish a valuation allowance. To the extent we establish a valuation allowance or increase
this allowance in a period, we must include an expense with the tax provision in the statement of operations.
16
Significant management judgment is required in determining our provision for income taxes, our deferred tax assets,
and any valuation allowance recorded against our net deferred tax assets. Our deferred tax assets relate to net
operating losses and research and development tax credits that we are carrying forward into future tax periods. As
of December 31, 2002, we had a total of $38.1 million of deferred tax assets for which we had recorded a full
valuation allowance.
Of the total valuation allowance, approximately $24.5 million relates to net operating loss and research and
development tax credit carryforwards that are attributable to the exercise of stock options and the tax benefit will be
credited to additional paid-in capital, if realized in the future.
Allowance for Doubtful Accounts. We make judgments as to our ability to collect outstanding receivables and
provide allowances for receivables when collection becomes doubtful. Provisions are made based upon a specific
review of all significant outstanding invoices. If the judgments we make to determine the allowance for doubtful
accounts do not reflect the future ability to collect outstanding receivables, additional provisions for doubtful
accounts may be required.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 2002, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting
Standards No. 146 (“SFAS 146”), “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS
146”). This statement addresses financial accounting and reporting for costs associated with exit or disposal
activities and supercedes EITF Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits
and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)” (“EITF 94-3”). SFAS
146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is
incurred. EITF 94-3 allowed for an exit cost liability to be recognized at the date of an entity’s commitment to an
exit plan. SFAS 146 also requires that liabilities recorded in connection with exit plans be initially measured at fair
value. The provisions of SFAS 146 are effective for exit or disposal activities that are initiated after December 31,
2002, with early adoption encouraged. We do not expect the adoption of SFAS 146 will have a material impact on
our financial position or results of operations.
In December 2002, the FASB issued SFAS 148, "Accounting for Stock-Based Compensation-Transition and
Disclosure – An Amendment of SFAS No. 123." SFAS 148 amends SFAS 123, "Accounting for Stock-Based
Compensation" to provide alternative methods of transition for those companies who voluntarily change to the fair
value based method of accounting for stock-based employee compensation. In addition, this Statement amends the
disclosure requirements of SFAS 123 to require prominent disclosures in both the annual and interim financial
statements about the method of accounting for stock-based employee compensation and the effect of the method
used on reported results. The transition and annual disclosure provisions of SFAS 148 are effective for fiscal years
ending after December 15, 2002. We have not adopted the fair value method of accounting for stock-based
compensation, and will continue to apply APB 25 for our stock-based compensation plans. We have adopted the
disclosure requirements of SFAS 148 in this Form 10-K, which is included in the "Summary of Significant
Accounting Policies" footnote of our consolidated financial statements.
In November 2002, the FASB issued FASB Interpretation No. 45 (“FIN 45”), “Guarantor’s Accounting and
Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” This
interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements
about its obligations under certain guarantees that it has issued. It also clarifies that a guarantor is required to
recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the
guarantee. This interpretation does not prescribe a specific approach for subsequently measuring the guarantor’s
recognized liability over the term of the related guarantee. This interpretation also incorporates, without change, the
guidance in FASB Interpretation No. 34, “Disclosure of Indirect Guarantees of Indebtedness of Others,” which is
being superseded. The disclosure requirements of this interpretation are effective for interim and annual periods
ending after December 15, 2002. Recognition and measurement provisions of FIN 45 become effective for
17
guarantees issued or modified on or after January 1, 2003. We are currently assessing the impact of adopting the
recognition and initial measurement provisions of this new interpretation.
In November 2002, the EITF issued No. 00-21, “Accounting for Revenue Arrangements with Multiple
Deliverables.” EITF Issue No. 00-21 addresses certain aspects of the accounting by a vendor for arrangements
under which it will perform multiple revenue-generating activities. EITF Issue No. 00-21 establishes three
principles: revenue should be recognized separately for separate units of accounting, revenue for a separate unit of
accounting should be recognized only when the arrangement consideration is reliably measurable and the earnings
process is substantially complete, and consideration should be allocated among the separate units of accounting in
an arrangement based on their relative fair values. EITF Issue No. 00-21 is effective for all revenue arrangements
entered into in fiscal periods beginning after June 15, 2003, with early adoption permitted. We are currently
determining the impact, if any, EITF Issue No. 00-21 will have on our financial position and results of operations.
FACTORS THAT MAY AFFECT FUTURE RESULTS
Some of the information in this Form 10-K contains forward-looking statements that involve substantial risks and
uncertainties. You can identify these statements by forward-looking words such as “may,” “will,” “expect,”
“anticipate,” “believe,” “estimate,” “continue” and similar words. You should read statements that contain these
words carefully because they: (1) discuss our future expectations; (2) contain projections of our future operating
results or financial condition; or (3) state other “forward-looking” information. However, we may not be able to
predict future events accurately. The risk factors listed in this section, as well as any cautionary language in this
Form 10-K, provide examples of risks, uncertainties and events that may cause our actual results to differ
materially from the expectations we describe in our forward-looking statements. You should be aware that the
occurrence of any of the events described in these risk factors and elsewhere in this Form 10-K could materially
and adversely affect our business. We assume no obligation to update any forward-looking statements.
Our Quarterly Results are Unpredictable and May Fluctuate Significantly.
Our quarterly revenue and
operating results are difficult to predict and may fluctuate significantly from quarter to quarter. Because our
revenue components fluctuate and are difficult to predict, and our expenses are largely independent of revenues in
any particular period, it is difficult for us to accurately forecast revenues and profitability. We generally recognize
contract revenues ratably over the period during which we expect to provide engineering services. While this
means that contract revenues from current licenses are generally predictable, changes can be introduced by a
reevaluation of the length of the development period, or by the termination of a contract. The initial estimate of this
period is subject to revision as the product being developed under a contract nears completion, and a revision may
result in an increase or decrease to the quarterly revenue for that contract. In addition, accurate prediction of
revenues from new licensees is difficult because the development of a business relationship with a potential licensee
is a lengthy process, frequently spanning a year or more, and the fiscal period in which a new license agreement will
be entered into, if at all, and the financial terms of such an agreement are difficult to predict. Contract revenues also
include fees for engineering services, which are dependent upon the varying level of assistance desired by licensees
and, therefore, the revenue from these services is also difficult to predict.
It is also difficult for us to make accurate forecasts of royalty revenues. Royalties are recognized in the quarter in
which we receive a report from a licensee regarding the shipment of licensed integrated circuits in the prior quarter,
and are dependent upon fluctuating sales volumes and/or prices of chips containing our technology, all of which are
beyond our ability to control or assess in advance.
Our business is subject to a variety of additional risks, which could materially adversely affect quarterly and annual
operating results, including:
(cid:131)(cid:3) market acceptance of our broadband technologies by semiconductor companies;
(cid:131)(cid:3) the extent and timing of new license transactions with semiconductor companies;
(cid:131)(cid:3) changes in our and our licensees’ development schedules and levels of expenditure on research and
development;
18
(cid:131)(cid:3) the loss of a strategic relationship with a licensee;
(cid:131)(cid:3) equipment companies' acceptance of integrated circuits produced by our licensees;
(cid:131)(cid:3) the loss by a licensee of a strategic relationship with an equipment company customer;
(cid:131)(cid:3) announcements or introductions of new technologies or products by us or our competitors;
(cid:131)(cid:3) delays or problems in the introduction or performance of enhancements or of future generations of our
technology;
(cid:131)(cid:3) delays in the adoption of new industry standards or changes in market perception of the value of new or
existing standards;
(cid:131)(cid:3) competitive pressures resulting in lower contract revenues or royalty rates;
(cid:131)(cid:3) personnel changes, particularly those involving engineering and technical personnel;
(cid:131)(cid:3) costs associated with protecting our intellectual property;
(cid:131)(cid:3) the potential that licensees could fail to make payments under their current contracts;
(cid:131)(cid:3) ADSL market-related issues, including:
o lower ADSL chipset unit demand brought on by excess channel inventory; and
o lower average selling prices for ADSL chipsets as a result of market surpluses.
(cid:131)(cid:3) regulatory developments; and
(cid:131)(cid:3) general economic trends and other factors.
As a result of these factors, we believe that period-to-period comparisons of our revenue levels and operating results
are not necessarily meaningful. You should not rely on our quarterly revenue and operating results to predict our
future performance.
We Have Experienced Net Losses. We had net losses in 2002 and 2001. We expect that we will have a net loss
during the first quarter of 2003. We may continue to experience losses in the future if:
(cid:131)(cid:3) the semiconductor and telecommunications markets do not recover from the downturn that began in 2001;
(cid:131)(cid:3) our existing customers do not increase their revenues from sales of chipsets with our technology; or
(cid:131)(cid:3) new and existing customers do not choose to license our intellectual property for new chipset products.
We Have a Unique Business Model. The success of our business model depends upon our ability to license our
technology to semiconductor and equipment companies, and our customers’ willingness and ability to sell products
that incorporate our technology so that we may receive significant royalties that are consistent with our plans and
expectations.
We face numerous risks in successfully obtaining suitable licensees on terms consistent with our business model,
including, among others:
(cid:131)(cid:3) we must typically undergo a lengthy and expensive process of building a relationship with a
potential licensee before there is any assurance of a license agreement with such party;
(cid:131)(cid:3) we must persuade semiconductor and equipment manufacturers with significant resources to rely
on us for critical technology on an ongoing basis rather than trying to develop similar technology
internally;
(cid:131)(cid:3) we must persuade potential licensees to bear development costs associated with our technology
applications and to make the necessary investment to successfully produce chipsets and products
using our technology; and
(cid:131)(cid:3) we must successfully transfer technical know-how to licensees.
19
Moreover, the success of our business model also depends on the receipt of royalties from licensees. Royalties from
our licensees are often based on the selling prices of our licensees’ chipsets and products, over which we have little
or no control. We also have little or no control over our licensees’ promotional and marketing efforts. Our
licensees are not required to pay us royalties unless they use our technology. They are not prohibited from
competing against us.
Our business could be seriously harmed if:
(cid:131)(cid:3) we cannot obtain suitable licensees;
(cid:131)(cid:3) our licensees fail to achieve significant sales of chipsets or products incorporating our technology; or
(cid:131)(cid:3) we otherwise fail to implement our business strategy successfully.
There Has Been and May Continue to be an Oversupply of ADSL Chipsets, Which Has Caused Our Royalty
Revenue to Decline. The royalties we receive are influenced by many of the risks faced by the ADSL market in
general; including reduced average selling prices (“ASPs”) for ADSL chipsets during periods of surplus. Since late
2000, the ADSL industry has experienced an oversupply of ADSL chipsets and central office equipment. Excessive
inventory levels led to soft chipset demand, which in turn led to declining ASPs. As a result of the soft demand and
declining ASPs for ADSL chipsets, our royalty revenue has decreased substantially from the levels we achieved in
2000. Price decreases for ADSL chipsets, and the corresponding decreases in per unit royalties received by us, can
be sudden and dramatic. Pricing pressures may continue during the first quarter of 2003 and beyond. Our royalty
revenue may continue to decline.
We Depend Substantially Upon a Limited Number of Licensees. There is a relatively limited number of
semiconductor and equipment companies to which we can license our broadband technology in a manner consistent
with our business model. If we fail to maintain relationships with our current licensees or fail to establish a
sufficient number of new licensee relationships, our business could be seriously harmed. We are less certain than
we have been in the past that one of our large customers, Intel, will field ADSL products based upon licensed
technology from Aware. Over the course of 2002, our confidence that Intel will be a large source of revenue for us
in the near future has diminished. In addition, our prospective customers may use their superior size and bargaining
power to demand license terms that are unfavorable to us and prospective customers may not elect to license from
us.
We Derive a Significant Amount of Revenue from One Customer. In 2001 and 2002, we derived 52% and 32%,
respectively of our total revenue from ADI. ADI was the first customer to license ADSL technology from us in
1993, and their chipsets are the most mature implementations of our technology in the market. Our royalty revenues
to date have been primarily due to sales of ADI chipsets that use our ADSL technology. Our royalty revenue in the
near term is highly dependent upon ADI’s ability to maintain its market share and pricing. The ADSL market has
experienced significant price erosion, which has adversely affected ADI’s ADSL revenue, which in turn has
adversely affected our royalty revenue. To the extent that ADI has lost market share, or loses market share in the
future, or experiences further price erosion in its ADSL chipsets, our royalty revenue could continue to decline.
Our Success Requires Acceptance of Our Technology By Equipment Companies. Due to our business strategy,
our success is dependent on our ability to generate significant royalties from our licensing arrangements with
semiconductor manufacturers. Our ability to generate significant royalties is materially affected by the willingness
of equipment companies to purchase integrated circuits that incorporate our technology from our licensees. There
are other competitive solutions available for equipment companies seeking to offer broadband communications
products. We face the risk that equipment manufacturers will choose those alternative solutions. Generally, our
ability to influence equipment companies’ decisions whether to purchase integrated circuits that incorporates our
technology is limited.
20
We also face the risk that equipment companies that elect to use integrated circuits that incorporate our technology
into their products will not compete successfully against other equipment companies. Many factors beyond our
control could influence the success or failure of a particular equipment company that uses integrated circuits based
on our technology, including:
(cid:131)(cid:3) competition from other businesses in the same industry;
(cid:131)(cid:3) market acceptance of its products;
(cid:131)(cid:3) its engineering, sales and marketing, and management capabilities;
(cid:131)(cid:3) technical challenges of developing its products unrelated to our technology; and
(cid:131)(cid:3) its financial and other resources.
Even if equipment companies incorporate our chipsets based on our intellectual property into their products, their
products may not achieve commercial acceptance or result in significant royalties to us.
Our Success Requires Telephone Companies to Install ADSL Service in Volume. The success of our ADSL
licensing business depends upon telephone companies installing ADSL service in significant volumes. Factors that
affect the volume deployment of ADSL service include:
(cid:131)(cid:3) the desire of telephone companies to install ADSL service, which is dependent on the
development of a viable business model for ADSL service, including the capability to market,
sell, install and maintain the service;
(cid:131)(cid:3) the pricing of ADSL services by telephone companies;
(cid:131)(cid:3) the quality of telephone companies’ networks;
(cid:131)(cid:3) government regulations; and
(cid:131)(cid:3) the willingness of residential telephone customers to demand ADSL service in the face of
competitive service offerings, such as cable modems.
If telephone companies do not install ADSL service in significant volumes, or if telephone companies install ADSL
service based on other technology, our business will be seriously harmed.
Our Intellectual Property is Subject to Limited Protection. Because we are a technology provider, our ability
to protect our intellectual property and to operate without infringing the intellectual property rights of others is
critical to our success. We regard our technology as proprietary, and we have a number of patents and pending
patent applications. We also rely on a combination of trade secrets, copyright and trademark law and non-
disclosure agreements to protect our unpatented intellectual property. Despite these precautions, it may be possible
for a third party to copy or otherwise obtain and use our technology without authorization.
As part of our licensing arrangements, we typically work closely with our semiconductor and equipment
manufacturer licensees, many of whom are also our potential competitors, and provide them with proprietary know-
how necessary for their development of customized chipsets based on our ADSL technology. Although our license
agreements contain non-disclosure provisions and other terms protecting our proprietary know-how and technology
rights, it is possible that, despite these precautions, some of our licensees might obtain from us proprietary
information that they could use to compete with us in the marketplace. Although we intend to defend our
intellectual property as necessary, the steps we have taken may be inadequate to prevent misappropriation.
In the future, we may choose to bring legal action to enforce our intellectual property rights. Any such litigation
could be costly and time-consuming for us, even if we were to prevail. Moreover, even if we are successful in
protecting our proprietary information, our competitors may independently develop technologies substantially
equivalent or superior to our technology. The misappropriation of our technology or the development of
competitive technology could seriously harm our business.
21
Our technology may infringe the intellectual property rights of others. A large and increasing number of
participants in the telecommunications industry have applied for or obtained patents. Some of these patent holders
have demonstrated a readiness to commence litigation based on allegations of patent and other intellectual property
infringement. Third parties may assert patent, copyright and other intellectual property rights to technologies that
are important to our business. In the past, we have received claims from other companies that our technology
infringes their patent rights. Intellectual property rights can be uncertain and can involve complex legal and factual
questions. We may infringe the proprietary rights of others, which could result in significant liability for us. If we
were found to have infringed any third party’s patents, we could be subject to substantial damages and an injunction
preventing us from conducting our business.
Our Business is Subject to Rapid Technological Change. The semiconductor and telecommunications industries,
as well as the market for high-speed network access technologies, are characterized by rapid technological change,
with new generations of products being introduced regularly and with ongoing evolutionary improvements. We
expect to depend on our ADSL technology for a substantial portion of our revenue for the foreseeable future.
Therefore, we face risks that others could introduce competing technology that renders our ADSL technology less
desirable or obsolete. Also, the announcement of new technologies could cause our licensees or their customers to
delay or defer entering into arrangements for the use of our existing technology. Either of these events could
seriously harm our business.
We expect that our business will depend to a significant extent on our ability to introduce enhancements and new
generations of our ADSL technology as well as new technologies that keep pace with changes in the
telecommunications and broadband industries and that achieve rapid market acceptance. We must continually
devote significant engineering resources to achieving technical innovations. These innovations are complex and
require long development cycles. Moreover, we may have to make substantial investments in technological
innovations before we can determine their commercial viability. We may lack sufficient financial resources to fund
future development. Also, our licensees may decide not to share certain research and development costs with us.
Revenue from technological innovations, even if successfully developed, may not be sufficient to recoup the costs
of development.
One element of our business strategy is to assume the risks of technology development failure while reducing such
risks for our licensees. In the past, we have spent significant amounts on development projects that did not produce
any marketable technologies or products, and we cannot assure you that it will not occur again.
We Face Intense Competition From a Wide Range of Competitors. Our success as an intellectual property
supplier depends on the willingness and ability of semiconductor manufacturers to design, build and sell integrated
circuits based on our intellectual property. The semiconductor industry is intensely competitive and has been
characterized by price erosion, rapid technological change, short product life cycles, cyclical market patterns and
increasing foreign and domestic competition.
As an intellectual property supplier to the semiconductor industry, we face intense competition from internal
development teams within potential semiconductor customers. We must convince potential licensees to license
from us rather than develop technology internally. Furthermore, semiconductor customers, who have licensed our
intellectual property, may choose to abandon joint development projects with us and develop chipsets themselves
without using our technology. In addition to competition from internal development teams, we compete against
other independent suppliers of intellectual property. We anticipate intense competition from suppliers of
intellectual property for ADSL and wireless local area networking.
The market for ADSL chipsets is also intensely competitive. Our success within the ADSL industry requires that
ADSL equipment manufacturers buy chipsets from our semiconductor licensees, and that telephone companies buy
ADSL equipment from those equipment manufacturers. Our customers’ chipsets compete with products from other
vendors of standards-based and ADSL chipsets, including Broadcom, Centillium, Conexant, GlobespanVirata, ST,
and TI.
ADSL services offered over copper telephone networks also compete with alternative broadband transmission
technologies that use the telephone network as well as other network architectures. Alternative technologies for the
22
telephone network include symmetric high speed DSL (also known as HDSL, SDSL and G.SHDSL), and very high
speed DSL, also known as VDSL. These DSL technologies are based on techniques other than those used by
ADSL to transport high-speed data over telephone lines.
Alternative technologies that use other network
architectures to provide high-speed data service include cable modems using cable networks, and wireless solutions
using wireless networks. These alternative broadband technologies may be more successful than ADSL and we
may not be able to participate in the markets involving these alternative technologies.
Many of our current and prospective ADSL licensees, as well as chipset competitors that compete with our
semiconductor licensees, including Broadcom, Conexant, GlobespanVirata, ST, and TI have significantly greater
financial, technological, manufacturing, marketing and personnel resources than we do. We may be unable to
compete successfully, and competitive pressures could seriously harm our business.
Our Recent Reduction in Workforce May Adversely Affect the Morale and Performance of Our Personnel,
In October 2002, as part of an effort to reduce
Our Ability to Hire New Personnel and Our Operations.
operating expenses, we terminated 35 employees, which constituted approximately 22 percent of our workforce. As
a result of that workforce reduction, we have incurred costs related to severance and other employee-related costs.
Our workforce reduction may also subject us to litigation risks and expenses. In addition, our restructuring plan
may yield unanticipated consequences, such as attrition beyond our planned reduction in workforce. As a result of
these reductions, our ability to respond to unexpected challenges may be impaired, and we may be unable to take
advantage of new opportunities. Further, the reduction in force may reduce employee morale and may create
concern among existing employees about job security, which may lead to increased attrition or turnover. As a result
of these factors, our remaining personnel may decide to seek employment with more established companies, and we
may have difficulty attracting new personnel that we might wish to hire in the future.
Our Stock Price May Be Extremely Volatile. Volatility in our stock price may negatively affect the price you
may receive for your shares of common stock and increases the risk that we could be the subject of costly securities
litigation. The market price of our common stock has fluctuated substantially and could continue to fluctuate based
on a variety of factors, including:
(cid:131)(cid:3) quarterly fluctuations in our operating results;
(cid:131)(cid:3) changes in future financial guidance that we may provide to investors and public market analysts;
(cid:131)(cid:3) changes in our relationships with our licensees;
(cid:131)(cid:3) announcements of technological innovations or new products by us, our licensees or our
competitors;
(cid:131)(cid:3) changes in ADSL market growth rates as well as investor perceptions regarding the investment opportunity
that companies participating in the ADSL industry afford them;
(cid:131)(cid:3) changes in earnings estimates by public market analysts;
(cid:131)(cid:3) key personnel losses;
(cid:131)(cid:3) sales of common stock; and
(cid:131)(cid:3) developments or announcements with respect to industry standards, patents or proprietary rights.
In addition, the equity markets have experienced volatility that has particularly affected the market prices of equity
securities of many high technology companies and that often has been unrelated or disproportionate to the operating
performance of such companies. These broad market fluctuations may adversely affect the market price of our
common stock.
Our Business May Be Affected by Government Regulations.
the
the Federal
telecommunications
Communications Commission, and various state public utility and service commissions, could affect us through the
effects of such regulation on our licensees and their customers. In addition, our business may also be affected by
the imposition of certain tariffs, duties and other import restrictions on components that our customers obtain from
industry by federal, state and foreign regulatory agencies,
The extensive regulation of
including
23
non-domestic suppliers or by the imposition of export restrictions on products sold internationally and incorporating
our technology. Changes in current or future laws or regulations, in the United States or elsewhere, could seriously
harm affect our business.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our exposure to market risk relates primarily to our investment portfolio, and the effect that changes in interest rates
would have on that portfolio. Our investment portfolio includes:
(cid:131)(cid:3) Cash and cash equivalents, which consist of financial instruments with original maturities of three months
or less; and
(cid:131)(cid:3) Investments, which consist of financial instruments that meet the high quality standards specified in our
investment policy. This policy dictates that all instruments mature in 3 years or less, and limits the amount
of credit exposure to any one issue, issuer, and type of instrument.
We do not use derivative financial instruments for speculative or trading purposes. As of December 31, 2002, we
had invested $33.3 million in cash, cash equivalents and short-term investments that matured in twelve months or
less. Due to the short duration of these financial instruments, we do not expect that an increase in interest rates
would result in any material loss to our investment portfolio.
As of December 31, 2002, we had invested $13.8 million in long-term investments that matured in one to three
years. These long-term securities are invested in high quality corporate securities and U.S. government securities.
Despite the high quality of these securities, they may be subject to interest rate risk. This means that if interest rates
increase, the principal amount of our investment would probably decline. A large increase in interest rates may
cause a material loss to our long-term investments. The following table (dollars in thousands) presents hypothetical
changes in the fair value of our long-term investments at December 31, 2002. The modeling technique measures the
change in fair value arising from selected potential changes in interest rates. Movements in interest rates of plus or
minus 50 basis points (BP) and 100 BP reflect immediate hypothetical shifts in the fair value of these investments.
Type of security
Long-term investments with
maturities of one to three years ...
Valuation of securities
given an interest rate
decrease of
(100BP)
(50 BP)
No change
in interest
rates
Valuation of securities
given an interest rate
increase of
100 BP
50 BP
$14,037
$13,926
$13,816
$13,599
$13,707
24
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Index to Consolidated Financial Statements
The following consolidated financial statements of Aware, Inc. are filed as part of this Report on Form 10-K:
Consolidated Financial Statements:
Report of Independent Accountants .................................................................................
Consolidated Balance Sheets as of December 31, 2002 and 2001 ...................................
Consolidated Statements of Operations for each of the three
years in the period ended December 31, 2002..............................................................
Consolidated Statements of Cash Flows for each of the
three years in the period ended December 31, 2002.....................................................
Consolidated Statements of Stockholders’ Equity for each of
the three years in the period ended December 31, 2002..............................................
Notes to Consolidated Financial Statements ....................................................................
Financial Statement Schedule:
Schedule II - Valuation and Qualifying Accounts............................................................
Page
26
27
28
29
30
31
Page
42
25
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Shareholders of Aware, Inc.:
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material
respects, the financial position of Aware, Inc. and its subsidiary at December 31, 2002 and 2001, and the results of
their operations and their cash flows for each of the three years in the period ended December 31, 2002 in
conformity with accounting principles generally accepted in the United States of America. In addition, in our
opinion, the financial statement schedule listed in the accompanying index presents fairly, in all material respects,
the information set forth therein when read in conjunction with the related consolidated financial statements.
These financial statements and financial statement schedule are the responsibility of the Company's management;
our responsibility is to express an opinion on these financial statements and financial statement schedule based on
our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted
in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance
about whether the financial statements are free of material misstatement. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting
principles used and significant estimates made by management, and evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our opinion.
As discussed in Note 2 to the consolidated financial statements, effective January 1, 2000, the Company changed
its method of recognizing revenue.
PricewaterhouseCoopers LLP
Boston, Massachusetts
February 4, 2003, except for the
information described in the last
paragraph of Note 6, for which
the date is March 3, 2003
26
AWARE, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share data)
ASSETS
Current assets:
Cash and cash equivalents .......................................................................
Short-term investments ............................................................................
Accounts receivable (less allowance for doubtful ...................................
accounts of $1,077 in 2002 and $380 in 2001)
Inventories ...............................................................................................
Deferred tax assets...................................................................................
Prepaid expenses and other current assets ...............................................
Total current assets ............................................................................
Property and equipment, net .........................................................................
Deferred tax assets........................................................................................
Investments...................................................................................................
Other assets, net............................................................................................
Total assets ........................................................................................
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable.....................................................................................
Accrued expenses ....................................................................................
Accrued compensation.............................................................................
Accrued professional ...............................................................................
Deferred revenue .....................................................................................
Total current liabilities.....................................................................
Commitments and contingent liabilities (Note 7)
Stockholders’ equity:
Preferred stock, $1.00 par value; 1,000,000 shares authorized,
none outstanding ................................................................................
Common stock, $.01 par value; shares authorized,
70,000,000 in 2002 and 30,000,000 in 2001; issued
and outstanding, 22,698,171 in 2002 and 22,657,741 in 2001........
Additional paid-in capital .......................................................................
Retained earnings (accumulated deficit).................................................
Total stockholders’ equity ...............................................................
Total liabilities and stockholders’ equity.........................................
December 31,
2002
2001
$25,268
8,034
1,258
50
-
530
35,140
10,038
-
13,816
243
$59,237
$274
213
965
65
142
1,659
$36,056
21,228
1,383
282
1,811
795
61,555
10,937
5,282
-
329
$78,103
$353
521
948
125
-
1,947
-
-
227
77,301
(19,950)
57,578
$59,237
227
77,151
(1,222)
76,156
$78,103
The accompanying notes are an integral part of the financial statements.
27
AWARE, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
Years ended December 31,
2001
2000
2002
Revenue:
Product sales ...............................................................
Contract revenue .........................................................
Royalties .....................................................................
Total revenue ..........................................................
Costs and expenses:
Cost of product sales...................................................
Cost of contract revenue .............................................
Research and development..........................................
Selling and marketing .................................................
General and administrative .........................................
Total costs and expenses ........................................
Income (loss) from operations ........................................
Interest income................................................................
Income (loss) before benefit from (provision for) income
taxes and cumulative effect of change in accounting
principle .......................................................................
Benefit from (provision for) income taxes......................
Income (loss) before cumulative effect of change in
accounting principle.....................................................
Cumulative effect of change in accounting
principle (Note 2).........................................................
$4,530
6,797
2,517
13,844
955
4,889
13,956
2,966
3,607
26,373
(12,529)
894
$3,817
8,253
6,477
18,547
629
6,822
10,104
2,916
2,899
23,370
(4,823)
2,303
$4,655
12,152
13,860
30,667
831
8,800
5,915
2,533
3,098
21,177
9,490
2,826
(11,635)
(7,093)
(2,520)
-
12,316
2,716
(18,728)
(2,520)
15,032
-
-
(1,618)
Net income (loss) ............................................................
($18,728)
($2,520)
$13,414
Basic net income (loss) per share:
Income (loss) before cumulative effect of change in
accounting principle.................................................
Cumulative effect of change in accounting principle ..
Net income (loss) per share..........................................
Diluted net income (loss) per share:
Income (loss) before cumulative effect of change in
accounting principle.................................................
Cumulative effect of change in accounting principle...
Net income (loss) per share..........................................
($0.83)
-
($0.83)
($0.83)
-
($0.83)
($0.11)
-
($0.11)
$0.67
($0.07)
$0.60
($0.11)
-
($0.11)
$0.63
($0.07)
$0.56
Weighted average shares – basic ....................................
Weighted average shares – diluted..................................
22,679
22,679
22,631
22,631
22,454
23,807
The accompanying notes are an integral part of the financial statements.
28
AWARE, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
1,738
325
181
(45)
(2,716)
(31)
(305)
439
1,469
14,469
(1,305)
500
(4,824)
-
(5,629)
7,574
7,574
16,414
35,248
Years ended December 31,
2001
2000
2002
($18,728)
($2,520)
$13,414
Cash flows from operating activities:
Net income (loss)..................................................................
Adjustments to reconcile net income (loss) to net cash
provided by operating activities:
Depreciation and amortization ..........................................
Provision for doubtful accounts .......................................
Increase (decrease) from changes in assets and liabilities:
Accounts receivable .......................................................
Inventories ......................................................................
Deferred tax assets..........................................................
Prepaid expenses and other current assets......................
Accounts payable ...........................................................
Accrued expenses ...........................................................
Deferred revenue ............................................................
Net cash provided by (used in) operating activities .....
Cash flows from investing activities:
Purchases of property and equipment..................................
Other assets .........................................................................
Net sales (purchases) of short-term investments .................
Net purchases of investments ..............................................
Net cash used in investing activities.............................
1,844
707
(582)
232
7,093
265
(79)
(351)
142
(9,457)
(807)
(52)
13,194
(13,816)
(1,481)
1,720
25
3,792
(115)
-
(495)
(130)
429
(1,469)
1,237
(1,424)
(375)
(15,387)
-
(17,186)
Cash flows from financing activities:
Proceeds from issuance of common stock ..........................
Net cash provided by financing activities ....................
150
150
343
343
Increase (decrease) in cash and cash equivalents ....................
Cash and cash equivalents, beginning of year.........................
(10,788)
36,056
(15,606)
51,662
Cash and cash equivalents, end of year ..................................
$25,268
$36,056
$51,662
The accompanying notes are an integral part of the financial statements.
29
AWARE, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(in thousands)
Common Stock
Shares
Amount
Additional
Paid-In
Capital
Retained
Earnings
(Accumulated
Deficit)
Total
Stockholders’
Equity
Balance at December 31, 1999 ........................
21,918
$219
$64,865
($12,116)
$52,968
Exercise of common stock options .............
Issuance of common stock under
employee stock purchase plan ..................
Tax benefit of stock option exercises...........
Net income...................................................
680
8
7
-
7,405
162
4,377
7,412
162
4,377
13,414
13,414
Balance at December 31, 2000 ........................
22,606
226
76,809
1,298
78,333
Exercise of common stock options .............
Issuance of common stock under
employee stock purchase plan ..................
Net loss ........................................................
24
28
-
1
180
162
180
163
(2,520)
(2,520)
Balance at December 31, 2001 ........................
22,658
227
77,151
(1,222)
76,156
Exercise of common stock options .............
Issuance of common stock under
employee stock purchase plan ..................
Net loss ........................................................
10
30
-
-
63
87
63
87
(18,728)
(18,728)
Balance at December 31, 2002 ........................
22,698
$227
$77,301
($19,950)
$57,578
The accompanying notes are an integral part of the financial statements.
30
AWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1.
NATURE OF BUSINESS
We are a leader in the development and marketing of intellectual property for broadband communications.
Our principal offering to date has been Asymmetric Digital Subscriber Line (“ADSL”) technology for the
telecommunications industry. ADSL enables telephone companies to use their existing copper telephone lines
to offer broadband services. We have adopted an intellectual property business model in which we neither
manufacture nor sell integrated circuits incorporating our technology. We license our broadband technology
on a nonexclusive and worldwide basis to semiconductor companies that manufacture and sell products that
incorporate our technology. Our licensees sell integrated circuits to equipment companies who incorporate
those integrated circuits into their products. We also offer ADSL hardware products and image compression
software products.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation - The consolidated financial statements include the accounts of Aware, Inc. and its
subsidiary. All significant intercompany transactions have been eliminated.
Cash and Cash Equivalents – Cash and cash equivalents consist primarily of demand deposits, money market
funds, commercial paper, and discount notes in highly liquid short-term instruments with original maturities
of three months or less from the date of purchase and are stated at cost, which approximates market.
Investments - At December 31, 2002 and 2001, we categorized all securities as “available-for-sale,” since we
may liquidate these investments currently. In calculating realized gains and losses, cost is determined using
specific identification. Unrealized gains and losses on available-for-sale securities are excluded from earnings
and reported in a separate component of stockholders’ equity. At December 31, 2002 and 2001, unrealized
gains and losses were not material.
The amortized cost of securities, which approximates fair value, consists of the following at December 31,
2002 and 2001 (in thousands):
Short-term investments
Corporate debt securities................
U.S. agency securities ....................
Total .............................................
2002
$ 3,185
4,849
$8,034
Investments
Corporate debt securities................
U.S. agency securities ....................
Total .............................................
2002
$1,030
12,786
$13,816
2001
$ 6,869
14,359
$21,228
2001
-
-
-
Allowance for Doubtful Accounts – Accounts are charged to the allowance for doubtful accounts as they are
deemed uncollectible based on a periodic review of the accounts. Bad debt expense was $707,000, $25,000,
and $325,000 for 2002, 2001, and 2000, respectively.
Inventories – Inventories are stated at the lower of cost or market with cost being determined by the first-in,
first-out (“FIFO”) method.
31
AWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Property and Equipment – Property and equipment are stated at cost. Depreciation and amortization of
property and equipment is provided using the straight-line method over the estimated useful lives of the assets.
Upon retirement or sale, the costs of the assets disposed of and the related accumulated depreciation are
removed from the accounts and any resulting gain or loss is included in the determination of income or loss.
The estimated useful lives of assets used by us are:
Building and improvements .................................................
Furniture and fixtures and office equipment........................
Computer & manufacturing equipment ...............................
Purchased software ..............................................................
30 years
5 years
3 years
3 years
Impairment of Long-Lived Assets – We review long-lived assets for impairment whenever events or changes
in business circumstances indicate that the carrying amount of the assets may not be fully recoverable or that
the useful lives of these assets are no longer appropriate. Each impairment test is based on a comparison of
the undiscounted cash flows to the recorded value of the asset.
If an impairment is indicated, the asset is
written down to its estimated fair value on a discounted cash flow basis. The cash flow estimates used to
determine the impairment, if any, reflect our best estimates using appropriate assumptions and projections at
that time. We believe that no significant impairment of our long-lived assets has occurred as of December 31,
2002.
Revenue recognition. Effective January 1, 2000, we adopted Securities and Exchange Commission Staff
Accounting Bulletin No. 101, Revenue Recognition in Financial Statements (“SAB 101”). Accordingly, our
general revenue recognition policy is to recognize revenue when there is persuasive evidence of an
arrangement, the sales price is fixed or determinable, collection of the related receivable is reasonably assured,
and delivery has occurred or services have been rendered.
We derive our revenue from three sources (i) product revenue, which includes revenue from the sale of ADSL
equipment products and compression software products, (ii) contract revenue, which includes license and
engineering service fees that we receive under customer agreements, and (iii) royalties that we receive under
customer contracts. In addition to the general revenue recognition principles prescribed by SAB 101, our
specific revenue recognition policies for each revenue source are more fully described below.
Product sales. Product sales consist primarily of revenue from the sale of: (i) hardware products, and (ii)
compression software.
(cid:120)(cid:3) Hardware products, including ADSL transceiver modules and test and development systems are
standalone products that are sold independently of our technology licensing business. The terms of
sales generally do not contain provisions that obligate us to provide additional products or services
after shipment. Additionally, we do not grant return rights other than normal warranty rights of return.
We recognize revenue: (i) upon shipment when products are shipped FOB shipping point, and (ii)
upon delivery at the customer’s location when products are shipped FOB destination.
(cid:120)(cid:3) Compression software consists of standard off-the-shelf software products that are sold to OEM
customers that integrate our software into their equipment-based products. The terms of sale generally
do not contain provisions that obligate us to provide additional products or services after shipment,
other than technical telephone support for a brief period of time post sale. The cost of providing
technical support is inconsequential because of the limited scope of the support. Additionally, we do
not grant return rights other than normal warranty rights of return, and we generally do not customize
software for customers. Occasionally, we sell maintenance contracts that entitle customers to product
updates.
We recognize compression software revenue by applying the principles set forth in SAB 101 and
American Institute of Certified Public Accountants (“AICPA”) Statement of Position No. 97-2,
Software Revenue Recognition. Accordingly, we recognize revenue for software licenses: (i) upon
shipment when products are shipped FOB shipping point, and (ii) upon delivery at the customer’s
32
AWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
location when products are shipped FOB destination. We recognize revenue for maintenance
contracts ratably over the related contract period.
Contract revenue. We enter into nonexclusive technology licensing agreements with semiconductor licensees
that contain terms and conditions that have historically varied by licensee. Such agreements generally require
us to provide: (i) intellectual property, which consists primarily of integrated circuit designs; (ii) engineering
services; and (iii) the right to incorporate our intellectual property components and patented technology into
our customers’ products. Generally our licensing agreements include one or more of the following elements
of financial consideration to us: (i) technology license fees; (ii) engineering service fees, and (iii) royalty
payments. We classify license and engineering service fees received under licensing agreements as contract
revenue.
Technology license fees and engineering service fees are paid during product development and royalties are
paid once customers begin shipping products that incorporate our technology. License fees are typically
payable on an upfront basis or in lump sums at various points during a development project. Engineering
services fees are typically paid on a more uniform basis throughout the project to reflect the level of
engineering services being performed. In addition, customers may engage us to provide on-going engineering
services or support after a project has been completed.
Revenue recognition for contract revenue is based on whether a licensing agreement contains a single element
of either license fees or engineering service fees, or whether a licensing agreement contains multiple elements
of both license fees and engineering service fees. Our revenue recognition policy for each type of licensing
agreement is described as follows:
Single element licensing agreements. To the extent that the single element contained in a licensing
agreement is for technology only, then technology license fees are recognized as revenue when technology
transfers have been effected and no contingent factors are present. To the extent that the single element
contained in a licensing agreement is for engineering services only, then engineering services are
recognized as revenue when the defined milestones are completed. Engineering milestones have
historically been formulated to correlate with the estimated level of effort and related costs.
Multiple element licensing agreements. Contract revenue under multiple element agreements is recognized
by recording total license and engineering fees for the entire contract on a straight-line basis over the
estimated contract performance period, subject to the limitation that cumulative revenue through the end of
any period may not exceed cumulative contract payments through that same period. Based on our multiple
element licensing agreements, we believe that the straight-line method represents the appropriate
systematic method for revenue recognition.
Royalty revenue. Royalty revenue is generally recognized in the quarter in which a report is received from a
licensee detailing the shipments of products incorporating our intellectual property components (i.e., in the
quarter following the sales of the licensed product by the licensee). The terms of our licensing agreements
generally require licensees to give notification to us and to pay royalties within 45 to 60 days of the end of the
quarter during which sales of licensed products take place.
Change in Accounting Principle – Effective January 1, 2000 we changed our method of revenue recognition
in accordance with Securities and Exchange Commission Staff Accounting Bulletin No. 101, Revenue
Recognition in Financial Statements. Previously, we recognized contract revenue under multiple element
agreements upon completion of contract milestones or upon transfer of intellectual property. Under the
accounting method we adopted retroactive to January 1, 2000, we now recognize contract revenue under
multiple element agreements by recording total license and engineering fees for the entire contract on a
straight-line basis over the estimated contract performance period, subject to the limitation that cumulative
revenue through the end of any period may not exceed cumulative contract payments through that same
period. The cumulative effect of the change on prior years resulted in a charge to income of $1.6 million for
the year ended December 31, 2000. For the years ended December 31, 2001 and 2000, we recognized $0.9
million and $0.7 million in revenue, respectively, that was included in the cumulative effect adjustment as of
January 1, 2000.
33
AWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Income Taxes – We compute deferred income taxes based on the differences between the financial statement
and tax basis of assets and liabilities using enacted rates in effect in the years in which the differences are
expected to reverse. We must establish a valuation allowance to offset temporary deductible differences, net
operating loss carryforwards and tax credits when it is more likely than not that the deferred tax assets will not
be realized.
Capitalization of Software Costs – We capitalize certain internally generated software development costs
after technological feasibility of the product has been established. No software costs were capitalized for the
years ended December 31, 2002, 2001 and 2000, because such costs incurred subsequent to the establishment
of technological feasibility, but prior to commercial availability, were immaterial.
Concentration of Credit Risk – At December 31, 2002 and 2001, we had cash and investments, in excess of
federally insured deposit limits of approximately $47.0 million and $57.2 million, respectively.
Concentration of credit risk with respect to net accounts receivable consists of $0.6 million, $0.4 million, and
$0.2 million with three customers at December 31, 2002 and $0.7 million, $0.3 million, $0.2 million, and $0.1
million with four customers at December 31, 2001.
Stock-Based Compensation – We grant stock options to our employees and directors. Such grants are for a
fixed number of shares with an exercise price equal to the fair value of the shares at the date of grant. As
permitted by SFAS No. 123, “Accounting for Stock-Based Compensation”, we account for stock option
grants in accordance with Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock
Issued to Employees” and FASB Interpretation No. 44 (“FIN 44”), “Accounting for Certain Transactions
Involving Stock Compensation.” Accordingly, we have adopted the provisions of SFAS No. 123 through
disclosure only.
At December 31, 2002, we have four stock-based employee compensation plans, which are described more
fully in Note 6. No stock-based employee compensation cost is reflected in net income, as all options granted
under those plans had an exercise price equal to the fair market value of the underlying common stock on the
date of grant. The following table illustrates the pro forma effect on net income (loss) and earnings per share
if we had applied the fair value recognition provisions of SFAS No. 123 and SFAS No. 148 to stock-based
employee compensation (in thousands, except per share data):
Net income (loss) - as reported.......................................
Deduct: Total stock-based employee compensation
expense determined under fair value based method
for all awards ................................................................
Net loss - pro forma ........................................................
Basic earnings (loss) per share – as reported..................
Basic earnings (loss) per share – pro forma....................
Diluted earnings (loss) per share – as reported...............
Diluted earnings (loss) per share – pro forma ................
Year ended December 31,
2001
2002
2000
($18,728)
($2,520)
$13,414
21,207
($39,935)
25,253
($27,773)
($0.83)
($1.76)
($0.83)
($1.76)
($0.11)
($1.23)
($0.11)
($1.23)
17,247
($3,833)
$0.60
($0.17)
$0.56
($0.17)
The fair value of options on their grant date was measured using the Black-Scholes option pricing model.
Key assumptions used to apply this pricing model are as follows:
2002
Year ended December 31,
2001
2000
Average risk-free interest rate ......................
Expected life of option grants.......................
Expected volatility of underlying stock ........
Expected dividend yield ...............................
3.82%
5 years
99%
-
4.55%
5 years
104%
-
6.15%
5 years
106%
-
34
AWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Computation of Earnings per Share – Basic earnings per share is computed by dividing income available to
common shareholders by the weighted average number of common shares outstanding. Diluted earnings per
share is computed by dividing income available to common shareholders by the weighted average number of
common shares outstanding plus additional common shares that would have been outstanding if dilutive
potential common shares had been issued. For the purposes of this calculation, stock options are considered
common stock equivalents in periods in which they have a dilutive effect. Stock options that are antidilutive
are excluded from the calculation.
Use of Estimates – The preparation of our financial statements in conformity with generally accepted
accounting principles requires us to make estimates and assumptions that affect the reported amounts of assets
and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the
reported amount of revenues and expenses during the reporting period. Significant estimates include revenue
recognition, reserves for doubtful accounts, reserves for excess and obsolete inventory, useful lives of fixed
assets, valuation allowance for deferred income tax assets, and accrued liabilities. Actual results could differ
from those estimates.
Fair Value of Financial Instruments – The carrying amounts of cash and cash equivalents, short-term
investments, accounts receivable, accounts payable and accrued expenses approximate fair value because of
their short-term nature.
Comprehensive Income (Loss) - Comprehensive income (loss) is defined as the change in equity of a business
enterprise during a period from transactions and other events and circumstances from non-owner sources,
including foreign currency translation adjustments and unrealized gains and losses on marketable securities.
For the years ended December 31, 2002, 2001 and 2000, comprehensive income (loss) was not materially
different from net income (loss).
Recent Accounting Pronouncements – In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs
Associated with Exit or Disposal Activities” (“SFAS 146”). This statement addresses financial accounting
and reporting for costs associated with exit or disposal activities and supercedes EITF Issue No. 94-3,
“Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity
(including Certain Costs Incurred in a Restructuring)” (“EITF 94-3”). SFAS 146 requires that a liability for a
cost associated with an exit or disposal activity be recognized when the liability is incurred. EITF 94-3
allowed for an exit cost liability to be recognized at the date of an entity’s commitment to an exit plan. SFAS
146 also requires that liabilities recorded in connection with exit plans be initially measured at fair value. The
provisions of SFAS 146 are effective for exit or disposal activities that are initiated after December 31, 2002,
with early adoption encouraged. We do not expect the adoption of SFAS 146 will have a material impact on
our financial position or results of operations.
In December 2002, the FASB issued SFAS 148, "Accounting for Stock-Based Compensation-Transition and
Disclosure – An Amendment of SFAS No. 123." SFAS 148 amends SFAS 123, "Accounting for Stock-Based
Compensation" to provide alternative methods of transition for those companies who voluntarily change to the
fair value based method of accounting for stock-based employee compensation. In addition, this Statement
amends the disclosure requirements of SFAS 123 to require prominent disclosures in both the annual and
interim financial statements about the method of accounting for stock-based employee compensation and the
effect of the method used on reported results. The transition and annual disclosure provisions of SFAS 148
are effective for fiscal years ending after December 15, 2002. We have not adopted the fair value method of
accounting for stock-based compensation, and will continue to apply APB 25 for our stock-based
compensation plans. We have adopted the disclosure requirements of SFAS 148 in this Form 10-K, which is
included in the "Summary of Significant Accounting Policies" footnote of our consolidated financial
statements.
In November 2002, the FASB issued FASB Interpretation No. 45 (“FIN 45”), “Guarantor’s Accounting and
Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” This
interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial
statements about its obligations under certain guarantees that it has issued. It also clarifies that a guarantor is
required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken
35
AWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
in issuing the guarantee. This interpretation does not prescribe a specific approach for subsequently measuring
the guarantor’s recognized liability over the term of the related guarantee. This interpretation also
incorporates, without change, the guidance in FASB Interpretation No. 34, “Disclosure of Indirect Guarantees
of Indebtedness of Others,” which is being superseded. The disclosure requirements of this interpretation are
effective for interim and annual periods ending after December 15, 2002. Recognition and measurement
provisions of FIN 45 become effective for guarantees issued or modified on or after January 1, 2003. We are
currently assessing the impact of adopting the recognition and initial measurement provisions of this new
interpretation.
In November 2002, the EITF issued No. 00-21, “Accounting for Revenue Arrangements with Multiple
Deliverables.” EITF Issue No. 00-21 addresses certain aspects of the accounting by a vendor for arrangements
under which it will perform multiple revenue-generating activities. EITF Issue No. 00-21 establishes three
principles: revenue should be recognized separately for separate units of accounting, revenue for a separate
unit of accounting should be recognized only when the arrangement consideration is reliably measurable and
the earnings process is substantially complete, and consideration should be allocated among the separate units
of accounting in an arrangement based on their relative fair values. EITF Issue No. 00-21 is effective for all
revenue arrangements entered into in fiscal periods beginning after June 15, 2003, with early adoption
permitted. We are currently determining the impact, if any, EITF Issue No. 00-21 will have on our financial
position and results of operations.
Segments – We organize ourselves as one segment reporting to the chief operating decision-maker. We have
sales outside of the United States, which are described in Note 8. All long-lived assets are maintained in the
United States.
3. INVENTORIES
Inventories consisted of the following at December 31 (in thousands):
Raw materials...............................................
Finished goods .............................................
Total .........................................................
$46
4
$50
$146
136
$282
2002
2001
4. PROPERTY AND EQUIPMENT
Property and equipment consisted of the following at December 31 (in thousands):
Land .....................................................................................
Building and improvements .................................................
Computer equipment............................................................
Purchased software ..............................................................
Furniture and fixtures...........................................................
Office equipment .................................................................
Manufacturing equipment....................................................
Total..................................................................................
Less accumulated depreciation and amortization ................
Property and equipment, net .............................................
2002
$1,080
8,784
5,568
2,818
928
346
268
19,792
(9,754)
$10,038
2001
$1,080
8,757
5,272
2,343
923
342
268
18,985
(8,048)
$10,937
Depreciation expense amounted to $1.7 million in each of the years ended December 31, 2002, 2001, and
2000, respectively.
36
AWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
5.
INCOME TAXES
Deferred tax assets are attributable to the following at December 31 (in thousands):
Federal net operating loss carryforwards .......................................
Research and development and other tax credit carryforwards......
State net operating loss carryforwards ...........................................
Capitalized research and development costs ..................................
Other ..............................................................................................
Total ............................................................................................
Less valuation allowance................................................................
Deferred tax assets, net................................................................
2002
$16,370
10,533
3,042
6,932
1,228
38,105
(38,105)
$ -
2001
$19,073
10,575
3,385
-
791
33,824
(26,731)
$ 7,093
A reconciliation of the U.S. federal statutory rate to the effective tax rate is as follows:
Federal statutory rate .............................................................
State rate, net of federal benefit.............................................
Tax credits .............................................................................
Change in valuation allowance..............................................
Other......................................................................................
Effective tax rate ................................................................
Year ended December 31,
2001
(34%)
(6)
(60)
100
-
-%
2002
(34%)
(6)
(14)
111
4
61%
2000
34%
6
(9)
(58)
5
(22)%
We have evaluated the positive and negative evidence affecting the realizability of our deferred tax assets. As
of December 31, 2002, based on the weight of the available evidence, we determined that it is more likely
than not that all of our deferred tax assets will not be realized, and fully reserved our deferred tax assets. We
will continue to evaluate, on a quarterly basis, the positive and negative evidence affecting the realizability of
our deferred tax assets.
At December 31, 2002, we had federal net operating loss carryforwards of approximately $48.2 million,
which begin to expire in 2007, and federal research and development credit carryforwards of approximately
$7.9 million, which begin to expire in 2003. At December 31, 2002, we also had available state net operating
loss carryforwards of approximately $48.3 million, which begin to expire in 2003, and state research and
development and investment tax credit carryforwards of approximately $4.0 million, which begin to expire in
2003.
Of the total net operating loss and research and development tax credit carryforwards for which a valuation
allowance was recorded, approximately $24.5 million is attributable to the exercise of stock options and the
tax benefit will be credited to additional paid-in capital, if realized in the future.
6. EQUITY AND STOCK COMPENSATION PLANS
At December 31, 2002, we have four stock-based compensation plans, which are described below.
Fixed Stock Option Plans – We have three fixed option plans. Under the 1990 Incentive and Nonstatutory
Stock Option Plan (“1990 Plan”), we may grant incentive stock options or nonqualified stock options to our
employees and directors for up to 2,873,002 shares of common stock. Under the 1996 Stock Option Plan
(“1996 Plan”), we may grant incentive stock options or nonqualified stock options to our employees and
directors for up to 6,100,000 shares of common stock. Under the 2001 Nonqualified Stock Plan (“2001
Plan”), we may grant nonqualified stock options to our employees and directors for up to 8,000,000 shares of
37
AWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
common stock. Under all three plans, options are granted at an exercise price as determined by the Board of
Directors; have a maximum term of ten years; and generally vest over three to five years. As of December 31,
2002, there were 4,573,925 shares available for grant under the 2001 Plan, 678,740 shares available for grant
under the 1996 Plan, and no shares available under the 1990 Plan.
A summary of the transactions of our three fixed stock option plans for the years ended December 31, 2002,
2001, and 2000 are presented below:
2002
2001
2000
Weighted
Average
Exercise
Price
$20.63
3.50
6.48
16.00
$17.47
Weighted
Average
Exercise
Price
$29.52
6.42
7.60
32.73
$20.63
Weighted
Average
Exercise
Price
$22.05
37.86
10.89
29.10
$29.52
Shares
3,538,687
1,631,350
(680,413)
(405,941)
4,083,683
Shares
4,083,683
2,407,423
(23,731)
(199,167)
6,268,208
Shares
6,268,208
1,521,100
(9,736)
(937,026)
6,842,546
Outstanding at beginning of year...
Granted ..........................................
Exercised........................................
Forfeited or cancelled ....................
Outstanding at end of year .............
Options exercisable at year end .....
4,265,956
$21.01
3,358,403
$21.28
1,711,351
$23.79
The weighted average grant date fair values of options granted during the years ended December 31, 2002,
2001 and 2000 were $2.65, $5.01 and $30.30, respectively.
The following table summarizes information about stock options outstanding at December 31, 2002:
Range of
Exercise Prices
$0 to 10 ................
10 to 20 ................
20 to 30 ................
30 to 40 ................
40 to 50 ................
50 to 70 ................
Number
Outstanding at
12/31/02
3,714,944
737,432
609,730
512,350
1,258,090
10,000
6,842,546
Options Outstanding
Weighted-Avg.
Remaining
Contractual Life
8.6 years
4.9
6.7
7.0
6.9
6.8
7.6
Weighted-Avg.
Exercise Price
$5.26
$11.81
$23.73
$31.97
$47.55
$58.06
$17.47
Options Exercisable
Number
Exercisable
At 12/31/02
1,687,331
725,941
503,955
393,631
946,348
8,750
4,265,956
Weighted-Avg.
Exercise Price
$6.48
$11.82
$24.43
$31.96
$47.26
$57.36
$21.01
Employee Stock Purchase Plan - In June 1996, we adopted an Employee Stock Purchase Plan (the “ESPP
Plan”) under which eligible employees may purchase common stock at a price equal to 85% of the lower of
the fair market value of the common stock at the beginning or end of each six-month offering period.
Participation in the ESPP Plan is limited to 6% of an employee’s compensation, may be terminated at any time
by the employee and automatically ends on termination of employment. A total of 100,000 shares of common
stock have been reserved for issuance. As of December 31, 2002 there were 20,303 shares available for
future issuance under the ESPP Plan. We issued 30,694, 27,733 and 7,808 common shares under the ESPP
Plan in 2002, 2001 and 2000, respectively.
Stockholder Rights Plan - In October 2001, our board of directors adopted a stockholder rights plan and
declared a dividend distribution of one share purchase right (a "Right") for each outstanding share of our
common stock to stockholders of record at the close of business on October 15, 2001. Each share of common
stock issued after that date also will carry with it one Right, subject to certain exceptions. Each Right, when it
38
AWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
becomes exercisable, will entitle the record holder to purchase from us one ten-thousandth of a share of series
A preferred stock at an exercise price of $40.00 subject to adjustment.
The Rights become exercisable upon the earliest of the following dates: (i) the date on which we first publicly
announce that a person or group has become an acquiring person, or (ii) the date, if any, that our board of
directors may designate following the commencement of, or first public disclosure of an intent to commence,
a tender or exchange offer which could result in the potential buyer becoming a beneficial owner of 15% or
more of our outstanding common stock. Under these circumstances, holders of Rights will be entitled to
purchase, for the exercise price, the preferred stock equivalent of common stock having a market value of two
times the exercise price. The Rights expire on October 2, 2011, and may be redeemed by us for $.001 per
Right.
Employee Stock Option Exchange Program - On March 3, 2003, we commenced an offer to exchange
outstanding stock options with eligible employees. Under the terms of the program, eligible employees have
the right to tender for cancellation all stock options that they hold with an exercise price above $3.00 per
share. Employees electing to participate must tender all such outstanding stock options held by them by the
end of the day on April 1, 2003. In return, employees will receive replacement stock options that will be
granted between October 2, 2003 and November 13, 2003. Employees will receive replacement options based
on a formula that allows them to purchase one share of common stock for every two option shares surrendered
by them. Replacement grants will be priced at the current market value of our stock on the replacement grant
date.
7.
COMMITMENTS AND CONTINGENT LIABILITIES
Lease Commitments – We own our principal office and research facility in Bedford, Massachusetts, which we
have occupied since November 1997. We conduct a portion of our activities in leased facilities in Lafayette,
California under a non-cancellable operating lease that expires in 2004. The following is a schedule of future
minimum rental payments (in thousands):
Year ended December 31,
2003.........................................................
2004.........................................................
Total minimum lease payments ............
44
30
$74
Rental expense was approximately $44,000, $36,000 and $105,000 in 2002, 2001 and 2000, respectively.
Litigation - There are no material pending legal proceedings to which we are a party or to which any of our
properties are subject which, either individually or in the aggregate, are expected to have a material adverse
effect on our business, financial position or results of operations.
Guarantees and Indemnification Obligations – We enter into licensing agreements in the ordinary course of
business that require us: i) to perform under the terms of the contracts, ii) to protect the confidentiality of our
customers’ intellectual property, and iii) to indemnify customers, including indemnification against third party
claims alleging infringement of intellectual property rights. We also have agreements with each of our
directors and executive officers to indemnify such directors or executive officers, to the extent legally
permissible, against all liabilities reasonably incurred in connection with any action in which such individual
may be involved by reason of such individual being or having been a director or officer of Aware.
Given the nature of the above obligations and agreements, we are unable to make a reasonable estimate of the
maximum potential amount that we could be required to pay. Historically, we have not made any significant
payments on the above guarantees and indemnifications and no amount has been accrued in the accompanying
consolidated financial statements with respect to these guarantees and indemnifications.
39
AWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
8.
BUSINESS SEGMENTS AND MAJOR CUSTOMERS
We organize ourselves as one segment and conduct our operations in the United States.
We sell our products and technology to domestic and international customers. Revenues were generated from
the following geographic regions (in thousands):
United States.......................................................
Europe ................................................................
Asia/Pacific ........................................................
Rest of world ......................................................
Year ended December 31,
2001
$17,092
717
627
111
$18,547
2002
$11,045
2,438
225
136
$13,844
2000
$26,606
2,231
1,567
263
$30,667
The portion of total revenue that was derived from major customers was as follows:
Customer A.....................................................
Customer B .....................................................
Customer C .....................................................
32%
15%
12%
52%
14%
2%
51%
9%
7%
Year ended December 31,
2001
2000
2002
9.
EMPLOYEE BENEFIT PLAN
In 1994, we established a qualified 401(k) Retirement Plan (the “Plan”) under which employees are allowed
to contribute certain percentages of their pay, up to the maximum allowed under Section 401(k) of the Internal
Revenue Code. Our contributions to the Plan are at the discretion of the Board of Directors. Our
contributions were $340,000, $313,000 and $166,000 in 2002, 2001 and 2000, respectively.
10. NET INCOME (LOSS) PER SHARE
Net income (loss) per share is calculated as follows (in thousands, except per share data):
Year ended December 31,
2002
Net income (loss).......................................................
($18,728)
Weighted average common shares outstanding........
Additional dilutive common stock equivalents .........
Diluted shares outstanding .......................................
Net income (loss) per share – basic ..........................
Net income (loss) per share – diluted .......................
22,679
-
22,679
($0.83)
($0.83)
2001
($2,520)
22,631
-
22,631
($0.11)
($0.11)
2000
$13,414
22,454
1,353
23,807
$0.60
$0.56
For the year ended December 31, 2002 and 2001, potential common stock equivalents of 226,303 and
285,427, respectively, were not included in the per share calculation for diluted EPS, because we had a net
loss and the effect of their inclusion would be anti-dilutive. For the years ended December 31, 2002, 2001
and 2000, options to purchase 4,770,052, 3,488,215 and 1,508,194 shares of common stock at average
weighted prices of $23.54, $31.95 and $47.53 per share, respectively, were outstanding, but were not
40
AWARE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
included in the computation of diluted EPS because the options’ exercise prices were greater than the average
market price of the common shares and thus would be anti-dilutive.
11. QUARTERLY RESULTS OF OPERATIONS - UNAUDITED
The following table presents unaudited quarterly operating results for each of our quarters in the two-year
period ended December 31, 2002 (in thousands, except per share data):
March 31
June 30
September 30 December 31
2002 Quarters Ended
Revenue ................................................
Loss from operations ............................
Net loss .................................................
$3,576
(2,815)
(2,576)
$4,012
(2,362)
(2,130)
$3,953
(2,812)
(9,681)
$2,303
(4,540)
(4,341)
Net loss per share – basic .....................
Net loss per share – diluted .................
($0.11)
($0.11)
($0.09)
($0.09)
($0.43)
($0.43)
($0.19)
($0.19)
March 31
June 30
September 30 December 31
2001 Quarters Ended
Revenue ................................................
Income (loss) from operations..............
Net income (loss)..................................
$8,218
2,633
2,056
$4,017
(1,655)
40
$3,108
(2,874)
(2,039)
$3,204
(2,927)
(2,577)
Net income (loss) per share – basic ......
Net income (loss) per share – diluted ...
$0.09
$0.09
$0.00
$0.00
($0.09)
($0.09)
($0.11)
($0.11)
41
FINANCIAL STATEMENT SCHEDULE
Schedule II - Valuation and Qualifying Accounts – Years ended December 31, 2002, 2001, and 2000
(in thousands)
Col. A
Col. B
Col. C (1)
Col. C (2)
Col. D
Col. E
Additions
Balance at
Beginning
of Period
Charged to
Costs and
Expenses
Charged
to Other
Accounts
Deductions
Charged to
Reserves
Balance
At End
of Period
Allowance for doubtful
accounts receivable:
2002 ..........................
2001 ..........................
2000 ..........................
Allowance for sales
returns and allowances:
2002 ..........................
2001 ..........................
2000 ..........................
Inventory reserves:
2002 ..........................
2001 ..........................
2000 ..........................
$380
$402
$175
-
$125
$35
$284
$209
$159
-
-
-
-
($125)
$90
-
-
-
$10
$47
$98
-
-
-
-
-
-
$1,077
$380
$402
-
-
$125
$284
$284
$209
$707
$25
$325
-
-
-
-
$75
$50
42
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
Not applicable.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Our executive officers and directors, and their ages as of March 12, 2003 are as follows:
Name
Michael A. Tzannes.............................
Edmund C. Reiter ................................
Richard P. Moberg ..............................
Richard W. Gross ................................
John K. Kerr .......................................
David Ehreth ......................................
G. David Forney, Jr. ...........................
Frederick D. D’Alessio........................
Age
41
39
48
45
65
53
62
54
Position
Chief Executive Officer and Director
President and Director
Chief Financial Officer and Treasurer
Senior Vice President – Engineering
Chairman of the Board of Directors
Director
Director
Director
Michael A. Tzannes has been Aware’s chief executive officer since April 1998 and has served as a director of
Aware since March 1998. Mr. Tzannes served as Aware’s president from April 1998 to March 2001. From
September 1997 to April 1998, he served as Aware’s chief technology officer and general manager of
telecommunications. Mr. Tzannes served as Aware’s senior vice president, telecommunications from April 1996 to
September 1997, as Aware’s vice president, telecommunications from December 1992 to April 1996, as a senior
member of Aware’s technical staff from January 1991 to November 1992, and as a consultant to Aware from
October 1990 to December 1990. From 1986 to 1990, he was a staff engineer at Signatron, Inc., a
telecommunications technology and systems developer. Mr. Tzannes received a Ph.D. in electrical engineering
from Tufts University, an M.S. from the University of Michigan at Ann Arbor, and a B.S. from the University of
Patras, Greece.
Edmund C. Reiter has served as Aware’s president since March 2001 and as a director of Aware since December
1999. Mr. Reiter served as a senior vice president from May 1998 to March 2001, as Aware’s vice president,
advanced products from August 1995 to May 1998, as Aware’s manager of product development for still image
compression products from June 1994 to August 1995, as a senior member of Aware’s technical staff from
November 1993 to June 1994, and as a member of Aware’s technical staff from December 1992 to November 1993.
Mr. Reiter served as senior scientist at New England Research, Inc. from January 1991 to November 1992. Mr.
Reiter received a Ph.D. from the Massachusetts Institute of Technology and a B.S. from Boston College.
Richard P. Moberg joined Aware in June 1996 as chief financial officer and treasurer. From December 1990 to
June 1996, Mr. Moberg held a number of positions at Lotus Development Corporation, a computer software
developer, including corporate controller from June 1995 to June 1996, assistant corporate controller from May
1993 to June 1995, and director of financial services from December 1990 to May 1993. Mr. Moberg received an
M.B.A. from Bentley College and a B.B.A. in accounting from the University of Massachusetts at Amherst.
Richard W. Gross was appointed senior vice president - engineering in July 1999. Mr. Gross served as vice
president - strategic development from July 1998 to July 1999. Prior to the vice president position, he held various
senior level engineering positions from the time he joined Aware in September 1993 until July 1998. Prior to
joining Aware, Mr. Gross was a senior technical staff member at GTE Laboratories from 1987 to 1993; a technical
staff member at the Heinrich Hertz Institute from 1984 to 1987; and a programmer for IBM, Federal Systems
Division from 1980 to 1984. Mr. Gross received a Ph.D. and M.S. in electrical engineering from the University of
Rhode Island and a B.A. in physics from Holy Cross College.
43
John K. Kerr has been a director of Aware since 1990 and chairman of the board of directors since March 1999.
Mr. Kerr previously served as a director of Aware from 1988 to 1989 and as chairman of the board of directors from
November 1992 to March 1994. Mr. Kerr has been general partner of Grove Investment Partners, a private
investment partnership, since 1990. Mr. Kerr received an M.A. and a B.A. from Baylor University.
David Ehreth has served as a director of Aware since November 1997. Since April 1998, Mr. Ehreth has served as
chairman of Westwave Communications, Inc., a telecommunications software company. From April 1998 to July
2002, Mr. Ehreth also served as president and chief executive officer of Westwave. From June 1992 to August
1998, Mr. Ehreth served as division vice president of the access division of DSC Communications Corporation, a
manufacturer of digital switching, access, transport and private network system products for the telecommunications
industry. From 1987 to June 1992, Mr. Ehreth served as vice president of engineering of Optilink, Inc., a
manufacturer of access systems for the telecommunications industry. Optilink, Inc. was acquired by DSC
Communications Corporation in 1990. From 1977 to 1987, Mr. Ehreth held numerous positions in the Digital
Telephone Systems division of Harris Corporation. Mr. Ehreth received a degree in electrical engineering from
College of Marin.
G. David Forney, Jr. has served as a director of Aware since May 1999. Mr. Forney was a vice president of
Motorola, Inc. from 1977 until his retirement in January 1999. Mr. Forney was previously a vice president of
research and development, and a director of Codex Corporation prior to its acquisition by Motorola in 1977. Mr.
Forney is currently Bernard M. Gordon Adjunct Professor in the Department of Electrical Engineering and
Computer Sciences at the Massachusetts Institute of Technology. Mr. Forney received an Sc.D. in electrical
engineering from Massachusetts Institute of Technology and a B.S.E. in electrical engineering from Princeton
University.
Frederick D. D'Alessio has served as a director of Aware since December 2002. Mr. D'Alessio is currently a
general partner at Capitol Management Partners, a business advisory partnership. Mr. D'Alessio served as president
for the Advanced Services Group for Verizon Communications from July 2000 to November 2001. The Advanced
Services Group included Verizon's Long Distance, DSL and Internet Service Provider Businesses. From December
1998 to June 2000, Mr. D'Alessio served as group president consumer services for Bell Atlantic Communications,
responsible for all aspects of Residential Services. From April 1995 to November 1998 Mr. D'Alessio served as
president-consumer sales and services for Bell Atlantic. Mr. D'Alessio received a B.S.E.E. and M.S. degree from
New Jersey Institute of Technology and a Masters of Business Administration from Rutgers University.
ITEM 11. EXECUTIVE COMPENSATION
The information required by Item 11 of Form 10-K is incorporated by reference from the information contained in
the section captioned “Compensation of Directors and Executive Officers” in the Proxy Statement that will be
delivered to our shareholders in connection with our May 29, 2003 Annual Meeting of Shareholders.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
The information required by Item 12 of Form 10-K is incorporated by reference from the information contained in
the section captioned “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder
Matters” in the Proxy Statement that will be delivered to our shareholders in connection with our May 29, 2003
Annual Meeting of Shareholders.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Not applicable.
44
ITEM 14. CONTROLS AND PROCEDURES
(a) Disclosure controls and procedures. Within 90 days before filing this report, we evaluated the effectiveness of
the design and operation of our disclosure controls and procedures. Our disclosure controls and procedures are the
controls and other procedures that we designed to ensure that we record, process, summarize and report in a timely
manner the information we must disclose in reports that we file with or submit to the SEC. Our disclosure controls
and procedures include a significant portion of our internal controls. Michael A. Tzannes, our Chief Executive
Officer, and Richard P. Moberg, our Vice President and Chief Financial Officer, supervised and participated in this
evaluation. Based on this evaluation, Mr. Tzannes and Mr. Moberg concluded that, as of the date of their
evaluation, our disclosure controls and procedures were effective.
(b) Internal controls. Since the date of the evaluation described above, there have not been any significant changes
in our internal controls or in other factors that could significantly affect those controls.
45
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(A) See Item 8 for an index to the consolidated financial statements, supplementary financial information, and
financial statement schedule.
Our chief executive officer and chief financial officer have furnished to the SEC the certification with respect to
this Report that is required by Section 906 of the Sarbanes-Oxley Act of 2002.
(B) There were no reports on Form 8-K filed during the fourth quarter ended December 31, 2002.
(C) INDEX TO EXHIBITS
Exhibits have been filed separately with the United States Securities and Exchange Commission in
connection with this Annual Report on Form 10-K or have been incorporated into this Report by
reference. Copies of such exhibits may be obtained from us upon request.
Exhibit No.
3.1
3.2
3.3
4.1
4.2
4.3
10.1
10.2
10.3
10.4
10.5
21.1
23.1
99.1
99.2
Description of Exhibit
Amended and Restated Articles of Organization (filed as Exhibit 3.2 to the Company’s
Registration Statement on Form S-1, File No. 333-6807 and incorporated herein by
reference).
Articles of Amendment to the Articles of Organization (filed as Exhibit 3.3 to the
Company’s Form 10-Q for the quarter ended September 30, 2002 and incorporated
herein by reference).
Amended and Restated By-Laws (filed as Exhibit 3.3 to the Company’s Form 10-Q for
the quarter ended June 30, 1996 and incorporated herein by reference).
Rights Agreement dated as of October 2, 2001 between Aware, Inc. and Equiserve
Trust Company, N.A., as Rights Agent (filed as Exhibit 4(a) to the Company’s Form 8-
K filed with the Securities and Exchange Commission on October 3, 2001 and
incorporated herein by reference).
Terms of Series A Participating Cumulative Preferred Stock of Aware, Inc. (attached
as Exhibit A to the Rights Agreement filed as Exhibit 4.1 hereto).
Form of Right Certificate (attached as Exhibit B to the Rights Agreement filed as
Exhibit 4.1 hereto).
1990 Incentive and Non-Statutory Stock Option Plan (filed as Exhibit 10.2 to the
Company’s Registration Statement on Form S-1, File No. 333-6807 and incorporated
herein by reference).
1996 Stock Option Plan, as amended and restated (filed as Annex A to the Company’s
Definitive Proxy Statement filed with the Securities and Exchange Commission on
April 11, 2000 and incorporated herein by reference).
1996 Employee Stock Purchase Plan (filed as Exhibit 10.4 to the Company’s
Registration Statement on Form S-1, File No. 333-6807 and incorporated herein by
reference).
Form of Director and Officer Indemnification Agreement.
2001 Nonqualified Stock Plan (filed as Exhibit 99(d)(4) to the Company’s Schedule
TO filed with the Securities and Exchange Commission on March 3, 2003 and
incorporated herein by reference).
Subsidiaries of Registrant.
Consent of PricewaterhouseCoopers LLP.
Certification of Chief Executive Officer pursuant to 18 U.S.C. 1350
Certification of Chief Financial Officer pursuant to 18 U.S.C. 1350
46
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly
caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
SIGNATURES
AWARE, INC.
By: /s/ Michael A. Tzannes
Michael A. Tzannes, Chief Executive Officer
Date: March 26, 2003
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the
following persons on behalf of the registrant and in the capacities indicated on the 26th day of March 2003.
Signature
/s/ Michael A. Tzannes
Michael A. Tzannes
/s/ Edmund C. Reiter
Edmund C. Reiter
/s/ Richard P. Moberg
Richard P. Moberg
/s/ John K. Kerr
John K. Kerr
/s/ David Ehreth
David Ehreth
/s/ G. David Forney, Jr.
G. David Forney, Jr
/s/ Frederick D. D’Alessio
Frederick D. D’Alessio
Title
Chief Executive Officer and Director
(Principal Executive Officer)
President and Director
Chief Financial Officer, Treasurer
(Principal Financial and Accounting Officer)
Chairman of the Board of Directors
Director
Director
Director
47
CERTIFICATIONS
Exhibit 99.1
I, Michael A. Tzannes, Chief Executive Officer of Aware, Inc., certify that:
1.
I have reviewed this annual report on Form 10-K of Aware, Inc.;
2.
Based on my knowledge, this annual report does not contain any untrue statement of a material
fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which
such statements were made, not misleading with respect to the period covered by this annual report;
3.
Based on my knowledge, the financial statements, and other financial information included in this
annual report, fairly present in all material respects the financial condition, results of operations and cash flows of
the registrant as of, and for, the periods presented in this annual report;
4.
The registrant’s other certifying officers and I are responsible for establishing and maintaining
disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we
have:
a)
designed such disclosure controls and procedures to ensure that material information
relating to the registrant, including its consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this annual report is being prepared;
b)
evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a
date within 90 days prior to the filing date of this annual report (the “Evaluation Date”); and
c)
presented in this annual report our conclusions about the effectiveness of the disclosure
controls and procedures based on our evaluation as of the Evaluation Date;
5.
The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation,
to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the
equivalent function):
a)
all significant deficiencies in the design or operation of internal controls which could
adversely affect the registrant’s ability to record, process, summarize and report financial data and have
identified for the registrant’s auditors any material weaknesses in internal controls; and
b)
any fraud, whether or not material, that involves management or other employees who
have a significant role in the registrant’s internal controls; and
6.
The registrant’s other certifying officer and I have indicated in this annual report whether or not
there were significant changes in internal controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant
deficiencies and material weaknesses.
Date: March 26, 2003
/s/ Michael A. Tzannes
Michael A. Tzannes
Chief Executive Officer
Exhibit 99.2
I, Richard P. Moberg, Vice President and Chief Financial Officer of Aware, Inc., certify that:
1.
I have reviewed this annual report on Form 10-K of Aware, Inc.;
2.
Based on my knowledge, this annual report does not contain any untrue statement of a material
fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which
such statements were made, not misleading with respect to the period covered by this annual report;
3.
Based on my knowledge, the financial statements, and other financial information included in this
annual report, fairly present in all material respects the financial condition, results of operations and cash flows of
the registrant as of, and for, the periods presented in this annual report;
4.
The registrant’s other certifying officers and I are responsible for establishing and maintaining
disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we
have:
a)
designed such disclosure controls and procedures to ensure that material information
relating to the registrant, including its consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this annual report is being prepared;
b)
evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a
date within 90 days prior to the filing date of this annual report (the “Evaluation Date”); and
c)
presented in this annual report our conclusions about the effectiveness of the disclosure
controls and procedures based on our evaluation as of the Evaluation Date;
5.
The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation,
to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the
equivalent function):
a)
all significant deficiencies in the design or operation of internal controls which could
adversely affect the registrant’s ability to record, process, summarize and report financial data and have
identified for the registrant’s auditors any material weaknesses in internal controls; and
b)
any fraud, whether or not material, that involves management or other employees who
have a significant role in the registrant’s internal controls; and
6.
The registrant’s other certifying officer and I have indicated in this annual report whether or not
there were significant changes in internal controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant
deficiencies and material weaknesses.
Date: March 26, 2003
/s/ Richard P. Moberg
Richard P. Moberg
Vice President and Chief Financial Officer
CORPORATE INFORMATION
BOARD OF DIRECTORS
LEGAL COUNSEL
John K. Kerr
Chairman of the Board
Aware, Inc.
Michael A. Tzannes, Ph.D.
Chief Executive Offi cer
Aware, Inc.
Edmund C. Reiter, Ph.D.
President
Aware, Inc.
Frederick D. D’Alessio
General Partner
Capitol Management Partners
David Ehreth
Chairman of the Board
Westwave Communications, Inc.
G. David Forney, Jr., Sc.D.
Adjunct Professor, MIT
Vice President (retired),
Motorola, Inc.
OFFICERS
Michael A. Tzannes, Ph.D.
Chief Executive Offi cer
Edmund C. Reiter, Ph.D.
President
Richard P. Moberg
Chief Financial Offi cer
and Treasurer
Richard W. Gross, Ph.D.
Senior Vice President
Engineering
Foley Hoag LLP
Boston, MA
INDEPENDENT ACCOUNTANTS
PricewaterhouseCoopers LLP
Boston, MA
TRANSFER AGENT
EquiServe Trust Company, NA
PO Box 43023
Providence, RI 02940
www.equiserve.com
ANNUAL MEETING
Thursday, 10:00 a.m.
May 29, 2003
Bedford Renaissance Hotel
Bedford, MA
STOCK LISTING
NASDAQ: AWRE
CORPORATE HEADQUARTERS
40 Middlesex Turnpike
Bedford, MA 01730
(781) 276-4000
WEST COAST LOCATION
3685 Mt. Diablo Boulevard
Lafayette, CA 94549
CONTACT INFORMATION
Investor Relations
Aware, Inc.
40 Middlesex Turnpike
Bedford, MA 01730
(781) 276-4000
www.aware.com
AWARE, INC.
2002 ANNUAL REPORT
40 Middlesex Turnpike, Bedford, MA 01730 USA
T (781) 276-4000 F (781) 276-4001
www.aware.com