ITEM 1. BUSINESS.
GENERAL
The Company was incorporated in Delaware in November 1994 as Neurotec International Corp., a wholly owned subsidiary of Neurotec Hochtechnologie GmbH ("Neurotec GmbH"), a German multimedia and Internet solutions company owned by Eberhard Schoneburg, Artificial Life's President, Chief Executive Officer and Chairman, and two corporate investors: a major German retailer and an industrial conglomerate. In July 1997, Mr. Schoneburg sold all of his shares of Neurotec GmbH to the two remaining stockholders and contemporaneously purchased 100% of the shares of Neurotec International Corp. from Neurotec GmbH (the "Management Buyout"). In August 1997, the Company's name was changed to Artificial Life, Inc.
Artificial Life, Inc. ("Artificial Life" or the "Company") develops, markets and supports "intelligent" software robots ("bots"). The Company's bots, known as "SmartBots," are software programs that the Company is developing to automate and simplify time-consuming and complex business-related Internet functions such as Web navigation, direct marketing, e-mail automation, user profiling, knowledge management, sales response and call center automation. The Company is also developing products for applications in data mining, statistical analysis and customer service to support the functionality of the SmartBot products. While each Artificial Life SmartBot will function independently and will be programmed for a particular application, customers will be able to combine the SmartBots to create what the Company believes will be the industry's first integrated commercial, robot-based electronic commerce ("e-commerce") solution. In addition, the Company provides software consulting services to corporations and other entities seeking software solutions, particularly in the field of "intelligent" software programs.
INDUSTRY BACKGROUND
Computer users and businesses have rapidly adopted the Internet as a means to gather information, communicate, transact business, interact and be entertained, making it an important new mass medium. International Data Corporation ("IDC"), a market research firm, estimates that the number of Internet users exceeded 69 million in 1997, and will grow to over 320 million by 2002. The Internet enables advertisers to target advertising campaigns utilizing sophisticated databases of information about the users of various sites and to directly generate revenues from these users through online transactions. As a result, the Internet has become a compelling means to advertise and market products and services. IDC estimates that the total value of goods and services purchased over the Internet will grow from $12 billion in 1997 to approximately $425 billion per year by the end of 2002.
Consequently, the amount of information available on the Internet has grown dramatically. Web sites have proliferated along with the data available on such sites, making it more difficult and time consuming for users to find the information they want. Users are spending a substantial portion of their on-line time searching for the specific information, products or services they desire. Furthermore, once an Internet user locates a desired site or sites, the user often finds it difficult to navigate such sites. As Web technology has improved, many Web sites have become more complex by adding new features, products, services, chat rooms, games, and other services. It is not uncommon for one Web site to have dozens of different options and links to other associated sites. While it is generally true that this increase in information and choices benefits Web users, more effective tools are needed to find information, products and services efficiently.
For corporations offering products and services on the Internet, the rapidly increasing number of Internet users offers benefits but also presents challenges. For example, a company may place a description of a new product on its Web site and then find that within a few hours, thousands of Internet users have sent e-mail messages to learn more about the product. While the volume of inquiries suggests that the company might ultimately generate significant revenues from selling its new product online, responding to each of these inquiries in a timely manner can require an expensive customer service force. A second problem facing e-commerce companies is the dramatic increase in competition among e-commerce sites. Numerous e-commerce sites are launched worldwide on the Internet daily. Accordingly, e-commerce retailers must find increasingly efficient and cost-effective ways to market their products and services to new customers and maintain or enhance existing customer relationships.
THE ARTIFICIAL LIFE SOLUTION
Artificial Life is continuing the development of its ALife suite of SmartBot products to assist in solving problems relating to information retrieval, Web navigation, sales and service support and direct marketing on the Internet. These software robots are designed to communicate in natural language and to respond "intelligently" to the user's command or inquiry, and in some cases, to act autonomously.
All of the Company's SmartBot products are based on the Company's ALife- SmartEngine technology. The ALife-SmartEngine is the core component that gives the Company's products the ability to converse with its users in natural language to process and respond to natural language commands or questions. The ALife-SmartEngine contains several "intelligent" modules that process and interpret manual input. These modules work together to break down the essential components of human conversation -- detailed knowledge of certain topics, casual talk about topics of interest ("small talk"), short and long term memory of previously discussed topics, and some emotional content and intentions that drive the conversation -- and use these components to "understand" and respond to the user in a manner that is more human-like and less machine-like than current "query-based" software. The Company believes that its products will allow people to interact with computers in a more natural way -- similar to a conversation with a human being.
Historically, general natural language understanding and processing software programs (often classified under the category "artificial intelligence") have focused on understanding the meaning of a sentence in the same way as a human would, so that the software program can react appropriately to a spoken sentence or a sentence typed in at the keyboard. These programs have had only limited success. The ALife-SmartEngine instead attempts to mimic comprehension of a sentence by using complex pattern matching techniques to determine the actual goals and intentions of the user. By "understanding" the user's goals and intentions, ALife-SmartEngine-based products are being designed to possess the ability to actively drive and maintain a conversation about certain topics, and not merely react to the user.
The ALife-SmartEngine stores information in "Knowledge Bases," databases which can be combined or exchanged to give the derived products differing sets of expertise. Customers can add information to a Knowledge Base using a special "Knowledge Capture Editor." The ALife-SmartEngine has several linked stages that read text-based input and produce spoken or text-based output. When a user types in text or speaks to the ALife-SmartEngine via standard voice recognition software packages, the pre-processed speech input is routed to a parser. The parser then converts the input from a stream of text to a series of words and phrases. An analysis module draws on the topic information in the memory section of the ALife-SmartEngine as well as the syntactic structure of the sentence derived from the Knowledge Base. The major control module of the ALife- SmartEngine is a meta-control module (the "Meta Controller") that is essential for switching between the different speech processing modules to process the input and prepare the appropriate response corresponding to a given input. The Meta Controller picks a reply appropriate to the perceived intention of the user by applying a set of rules that define the conversational strategy of the bot. All modules communicate through the Meta Controller, which also coordinates and balances the weighting of each of the separate modules as the bot prepares its composite action.
Most of the Company's SmartBots communicate with the user through a life-like three-dimensional graphical interface known as an "Avatar." Most products come with a standard human-like Avatar. However, the Avatar may be customized by the customer, including using pre-existing branded icons or displays. For instance, an e-commerce retailer of computer equipment might customize its Avatar so that visitors to its Web site converse with a talking computer. The Company believes that the use of an animated "talking partner" allows people to interact with computers in a more natural and personal manner, and that the ability of the Company's customers to customize the Avatars allows them to develop or maintain brand or name recognition among visitors to a customer's Web site.
PRODUCTS
The Company is currently developing seven basic software robots for use individually or in various combinations.
ALIFE-WEBGUIDE: The Company released the Personal Version 1.0 of this SmartBot in September 1998.; the Professional Version 1.0 in November 1998 and the Enterprise Version in April 1999. These versions are designed to reside on a Web site and help users navigate the site by accepting and processing questions, such as search queries, from users in natural language and responding to users in natural language. These SmartBot versions engage the user in a "conversation" through questions and answers and, upon learning of the user's interests, are designed to display Web pages that match the content of the "conversation" or to suggest links to other locations on the Web site. In an e-commerce application, the ALife-WebGuide can be designed by the Web site host to function like a human sales associate at a retail store, greeting customers coming through the door of the virtual store and assisting them with advice and background information about products and prices. This bot allows the use of a customizable animated Avatar interface.
ALife-WebGuide versions run on both Netscape Navigator or Communicator 3.0 or higher and Microsoft Internet Explorer 3.0 or higher. The Enterprise Version of the ALife-WebGuide is designed with a client/server architecture, requiring a Java virtual machine 1.02 or higher. The Knowledge Capture Tool of the ALife- WebGuide Enterprise Version is designed to run on Microsoft Windows 95, 98 or NT. The Company believes that the potential market for this product includes Internet Web sites which need or desire a more user-friendly natural language interface.
ALIFE-SALESREP: The ALife-SalesRep is being designed for e-commerce retailers to use for one-to-one marketing on the Internet. Retailers will be able to collect user profile information and to add product information into this SmartBot's Knowledge Bases to deliver customer-specific targeted sales information on the Internet via e-mail. For example, the ALife-SalesRep can be configured by a corporate user to utilize customer profile information to deliver information about a specific sale or promotion to an existing or potential customer. In this type of application, called BOTME by the Company, the user will typically have the option of downloading the ALife-SalesRep Avatar to his or her computer. Once the Avatar is resident on the user's computer, the user can access the e- commerce retailer's Web site simply by clicking on the Avatar, which will appear as an icon on the user's computer screen. In many cases, such as its current use in the net-tissimo.com web site, it will maintain a link to the host Web site.
The Company is also designing ALife-SalesRep to engage in autonomous action. For example, a user will download an Avatar, and the Avatar will continue to appear on the user's start-up screen. Each time the user turns on his computer, the Avatar, through its link to the host Web site, will automatically download new information that the program has determined may be of interest to the user, based upon the information in its Knowledge Bases. For example, the user could learn from the Avatar resident on the computer that the host company is having a sale on modems which run at faster speeds than the one the user currently owns. The host company will have determined which modem the user currently owns because the user had a "conversation" with the ALife-SalesRep about the user's computer hardware. Later, the user might be offered discounted tickets by the Avatar to an upcoming computer industry trade show in the user's hometown at which the host will be exhibiting its products.
ALife-SalesRep is first being designed to run on personal computers with Microsoft Windows 98 or NT. The Company intends to release the Version of ALife- SalesRep in 2000. The initial target market for this product consists of advertising companies, companies with direct Internet marketing activities and more generally all companies with extensive Internet sales and marketing strategies and activities.
ALIFE-MESSENGER: The ALife-Messenger serves as a natural language-based automated e-mail reply and answering service. By customizing the Knowledge Bases of the ALife-Messenger, a company can automate replies to incoming e-mail queries and customer requests. The ALife-Messenger is designed to work like an off-line ALife-WebGuide by selecting appropriate answers to input queries in an "intelligent" way. However, instead of displaying Web pages, the ALife-Messenger is designed to automatically scan an incoming e-mail for certain keywords and phrases, prepare a reply e-mail and attach, as appropriate, additional information that matches what this SmartBot determines might be useful to the user, such as relevant documents, price-lists, and links to other Web sites. For an individual who purchases ALife-Messenger for his Web page, it could be used as a customized e-mail "answering machine" on the Internet. It is intended that, for a corporate purchaser using ALife-SalesRep, ALife-Messenger could subsequently be configured to select the appropriate ALife-SalesRep to be attached to the reply e-mails, with the goal of improving and supporting the direct marketing channel.
The ALife-Messenger supports standard e-mail systems. The Company released the 1.0 Version of the ALife-Messenger in April 1999. The Company markets this product to companies and institutions which need to extensively interact with clients via e-mail or which have extensive customer/client service programs using the Internet.
ALIFE-PORTFOLIO-MANAGER: The ALife-Portfolio-Manager is continuing to be developed to monitor an individual's investment portfolio. Once the user's portfolio guidelines are established, the ALife-Portfolio-Manager can monitor the portfolio 24 hours per day and autonomously notify the user when the user's price or ratio guidelines are not being met through one of a variety of predefined media such as e-mail, telephone or pager. In addition to monitoring existing investment portfolios, the Alife-Portfolio-Manager is continuing to be designed to find other potential investments fitting the user's specified criteria and notify the investor about any such investment opportunities once found.
The ALife-Portfolio-Manager is designed to run on personal computers with Microsoft Windows 98 or NT. The Company released the 1.0 Version of the ALife-Portfolio-Manager in November of 1999 on a project application basis only. The Company anticipates that the ALife-Portfolio-Manager will first be released for general distribution in March of 2000. The Company believes that the market for this product will consist of individuals and companies in the financial services industry, including Internet brokers, as well as individual investors.
ALIFE-CALL-CENTER-AGENT: The ALife-Call-Center-Agent is being designed to link conversations with a Company's WebGuide and eCRM solution to a human or live chat call center agent. The Alife Call-Center-Agent adds a module for problem solving to the Alife WebGuide. If the Alife Call-Center-Agent cannot solve a customer's problem by itself, it is intended to link the customer directly to a human call center agent.
The ALife-Call-Center-Agent will require an operating platform with a Java virtual machine. Additional software and hardware enhancements may be necessary depending on the specific interfaces to call center operating systems. The Company plans to release the 1.0 version of ALife-Call-Center-Agent by June of 2000. The Company intends to market this product to customers with call centers and to call center software vendors.
ALIFE-KNOWLEDGE-MANAGER: This SmartBot is being designed to extract information contained in a company's Intranet documents, organize it and make it more easily accessible for retrieval to enable companies to more efficiently and intelligently manage the large amount of data and documents that companies are making available on their Intranets. ALife-Knowledge-Manager can be configured to allow each Intranet user to describe his own profile, background and interests in addition to other information contained on the Intranet. Once so configured, users can make natural language search queries about topics of interest through the ALife-Knowledge-Manager, and the program will respond by providing relevant information contained on the company's Intranet.
The ALife-Knowledge-Manager is being designed to run on standard OS platforms and to provide for interfaces to standard databases and third party document retrieval and management systems. The Company intends to use the product in its Web Services to be launched by the Company in 2000.
ALIFE-PERSONAL-TUTOR: The Company is developing this SmartBot to address certain limitations of traditional Computer-based Training ("CBT") and Internet-based Training ("IBT") products that are currently available. Whereas conventional CBT and IBT programs follow a pre-defined path of learning, the ALife-Personal-Tutor is being designed to use student profile information extracted from natural language conversation between the SmartBot and the student user to automatically adapt the difficulty and content of the lessons to the skill level of the student. Using the natural language capabilities of the ALife-SmartEngine, students will be able to ask numerous questions about any topic at any time in plain English. In addition, the ALife-Personal-Tutor is being designed to respond to questions with additional explanatory multimedia data (video and audio) depending on the context of the ongoing lecture between the student and the ALife-Personal-Tutor. It will also formulate questions and tests depending on the flow of the conversation and lesson.
The ALife-Personal-Tutor is being designed to run on Windows 98 and NT or on standard Internet browsers for on-line applications. The Company released the first tutorial in July 1999 as a German language demonstration product focusing on the life of Albert Einstein called Einstein ALife, and presently the generic version is planned for release during the second quarter 2000. The Company's target market for this product is expected to be the CBT and IBT market, corporate intranets and extranets and the general education market.
CONSULTING AND PRODUCT SERVICES
The Company expects to provide consulting, maintenance, technical hotline and support services for most or all of its products. The Company anticipates that customers will require support for, and customized versions of, the Company's SmartBot products or additional developments in order to tailor the product to the customers' needs. In addition, the Company plans to provide support for the creation and maintenance of the Knowledge Bases of its bots and customer specific back-office tools for analyzing client profiles gathered by its bots.
Historically, the Company has derived substantially all of its revenues from software consulting services provided to a small number of customers with the exception of the year-ended December 31, 1999. During the year ended December 31, 1999, approximately 25% of the Company's revenue was derived from license sales. During the year ended December 31, 1998 substantially all of the Company's revenue was derived from the completion of its existing obligations for the Company's sole remaining consulting contract for 1998 and the resulting license sale thereto. During the year ended December 31, 1997, consulting services provided to the Company's two largest customers, Neurotec Hochtechnologie GmbH (its former parent company) and Passkey Systems, Inc., accounted for approximately 60% and 40% of the Company's total revenues, respectively. All revenues derived from software consulting services to the Company's former parent ceased shortly after the Management Buyout. Although the Company has shifted its primary business focus from software consulting to product development, marketing and support, the Company anticipates that it will continue to derive a portion of its revenues from software consulting projects. In particular, the Company expects that it will provide software solutions for companies and other entities seeking consulting expertise with agent-based software programs. In the near term, the Company believes that a significant percentage of its revenues may be derived from software consulting services. See "-- Strategic Alliances and Joint Ventures".
BUSINESS STRATEGY
In its first year as a publicly traded company, Artificial Life focused on developing its international presence, its sales and support infrastructure and completing the development of several products and continuing the development of others. From its St. Petersburg, Russia development facility, to sales and support offices in Switzerland, Germany and the United States, the Company feels it has achieved these primary goals. With these achievements noted and the first clients in place, the Company will now focus its attention on global sales and marketing, continued product development and Web Services.
The Company's objective is to become a worldwide leader in the development and implementation of commercial software robot-based solutions to solve various issues confronting today's Internet use. To achieve this objective, the Company's strategy includes the following key elements:
BUILD BRAND NAME RECOGNITION. The Company is seeking to achieve rapid and broad adoption of its products and strong brand recognition. The Company intends to embark on a promotional campaign to increase awareness of the Artificial Life brand and the ALife family of products in the year 2000. The promotional campaign is expected to involve traditional media (i.e., radio, television, print and trade shows) together with an emphasis on Internet channels. The initial campaign in print, online and television media began in November 1999. Further, the Company has also begun presenting at targeted industry trade shows and events.
CREATE MULTIPLE REVENUE STREAMS. The Company believes that its growing product line, corporate customization, product Web sites and its future installed user base will present a significant opportunity to develop and maintain multiple revenue streams resulting from product sales and maintenance, customization and consulting, licensing fees and potentially in the future, advertising and subscription revenues. As these different revenue streams mature, decisions will be made as to the expansion and contraction of existing programs based on their success as well as the introduction of new programs.
ESTABLISH STRATEGIC ALLIANCES. The Company intends to aggressively pursue strategic alliances to gain access to complementary technologies and distribution channels. The Company continually evaluates relationships with companies and other entities that offer technologies complementary to the Company's SmartBot products (such as speech integration and high-end graphics providers). The Company intends to use alliances wherever possible to gain economies of scale and to allow it to focus on its core strengths while using those of its partners to add the complementary functionality necessary to increase value to users. In 1999, the Company signed a cooperation agreement with PriceWaterhouse Coopers GmbH Germany (PwC) for joint sales and development activities that are intended to leverage the existing client base and consulting services of PwC to allow for the sale and integration of the Company's products within the PwC consulting group client base.
EXPAND GLOBALLY. The Company believes that significant opportunities exist to capitalize on the growth of the Internet internationally. Because the Company was once a subsidiary of a large and well-known German multimedia and Internet solutions company, it already has significant contacts with a number of European businesses. The Company believes that its products can be used worldwide, and accordingly the Company intends to initiate an international program of partnering and strategic investment to exploit cross-marketing, co-branding and promotional opportunities. In the fourth quarter of 1998, the Company established wholly owned European subsidiaries in Switzerland and Russia. In October 1998, the Company formed Artificial Life Europe AG ("Artificial Life Europe"). Artificial Life Europe, the headquarters of the Company's European activities will focus on strategic investments in Switzerland, joint ventures and product related consulting and development activities in the areas of e- commerce and Internet banking and act as a holding company for Artificial Life Solutions AG, the Swiss operating company, and Artificial Life RUS, the Russian research and development arm of the Company. In November 1998, Artificial Life Europe AG formed the wholly-owned subsidiary Artificial Life Rus Ltd ("Artificial Life Rus") which is based in St. Petersburg, Russia. The primary focus of Artificial Life Rus is product development, quality assurance and research. In the second quarter of 1999, the Company established its German subsidiary Artificial Life Deutschland AG ("Artificial Life Deutschland"), situated in Frankfurt, Germany. Artificial Life Deutschland will focus on strategic investments, product development, product customization, product- related marketing and sales activities and general support to German customers. Also in the second quarter 1999, the Company established Artificial Life Solutions AG. Headquartered in Switzerland, Artificial Life Solutions will focus on strategic investments, product development, product customization, product- related marketing and sales activities and general support to Swiss customers.
EXPAND AND ENHANCE PRODUCT BASE AND TECHNOLOGY. The Company believes that it must regularly provide new products and technologies and improve existing ones to be successful. The Company's products utilize proprietary technologies, including the ALife-SmartEngine. The Company's strategy is to continue to enhance its existing technologies and develop new technologies that it can incorporate into future product offerings. Because the Company's product lines are being centered around core concepts and technology, the Company believes many complementary products will be able to be developed by leveraging the Company's existing competencies and experience into new ideas. Furthermore, the Company believes that its overall strategy will allow it to address issues regarding products and services in a dynamic, almost real-time basis, thereby allowing rapid response to market feedback and developments.
MARKETING AND SALES
It is the Company's belief that its products will ultimately serve the World Wide Web in a horizontal capacity but until significant branding is achieved, targeted vertical markets will be its most effective method in achieving installation success and product acceptance. The Company plans to sell and market its products through a variety of methods and channels, including but not limited to direct sales, distribution and channel agreements, strategic relationships and third party providers. The Company believes joint ventures and strategic relationships can be most effective in entering targeted vertical markets while targeted direct sales can be most effective for large, must-have clients. It is the Company's belief that this strategy will provide a cost effective means of achieving maximum exposure for its products and services.
In the first quarter of 1999, the Company began selling the ALife-WebGuide via the Company's Web site and through additional distribution partners. Also, the Company began distribution of its ALife-WebGuide `intelligent' software robot for the Benelux market under a non-exclusive distributor arrangement with MBE Consultants of Belgium. Based in Brussels, MBE Consultants is marketing and selling the Enterprise version of the ALife-WebGuide, and other products as they are released, and providing consulting services and training in the application and use of Artifical Life's software products. In September 1999, the Company signed a German market exclusive cooperation agreement with PriceWaterhouse Coopers mbH Germany (PwC) for joint sales and development activities. These efforts are intended to leverage the existing client base and consulting services of PwC that will allow for the sale and integration of the Company's products within PwC consulting group client base.
The Company is discussing a strategic relationship with an international entity already established in the call center market to market and sell the ALife-Call- Center-Agent. Due to the highly competitive nature of the call-center market, the Company believes this joint approach has the greater probability of success.
The ALife-Personal-Tutor and the ALife-Knowledge-Manager target the IBT/CBT market and the Intranet and corporate market. Accordingly, the Company intends to enhance its direct marketing efforts by partnering with other selected vertical market specific entities.
In addition to its prior marketing efforts for the individual products in the ALife product suite, the Company began, in the second half of 1999 to initiate marketing campaigns to establish recognition of the Artificial Life brand. These marketing activities are expected to eventually involve traditional media together with an emphasis on the Internet channels. The Company will generate marketing material using its in-house capabilities and multi-media know-how to produce video spots and innovative interactive advertisement techniques for the Internet. Additionally, the Company will use its own products, ALife-Messenger and the ALife-WebGuide, to further promote its products and services.
STRATEGIC ALLIANCES AND JOINT VENTURES
In March 1999, the Company agreed to enter into a joint venture with the Bon Appetit group of Switzerland in which Artificial Life's technology is being used to offer a software robot based ecommerce solution. The main focus of this joint venture is to develop a high traffic, high volume, low cost e- commerce site on the Internet. The Company licensed its SmartBot products to the joint venture. Pursuant to a separate development agreement with the joint venture, the Company will also provide products and software development and consulting services to the venture and receive payments therefor. The joint venture partner will use its purchasing relationships to obtain certain of the consumer products that will be sold on the joint venture's e-commerce Website.
In addition, the Company completed a contract for the first phase of a development and consulting project with a European based global trust. The project goal was to define and design the trust's future Internet-based financial services. The successful completion of this phase led to a larger scale implementation of this development project. As part of the transaction, the Company is providing, for fees, licensed products and software consulting services to the trust.
In September 1999 the Company signed a German market joint cooperation agreement for the development and introduction of new technology for e-business with PriceWaterhouse Coopers GmbH (Germany). Cooperatively, Pricewaterhouse Coopers and Artificial Life will invest in the development of both sector-specific and multifunctional products.
In February and March 2000 the Company signed cooperation agreements with CyberOffice Communications AG and echtzeit AG, respectively. CyberOffice Communications AG, a leading supplier of unified communications services intends to develop new products and services by integrating ALife SmartBot(TM) functionality into the existing communications and messaging services of the Indepensis communications portal. The cooperation with echtzeit AG, one of Europe's leading suppliers of virtual reality, 3D simulation, 3D telecom, and information technology applications and services, is designed to benefit both partners with business referrals, innovative Web services, and contract work.
Furthermore, the Company is constantly evaluating strategic alliances with companies in the United States and Europe for marketing and selling products as well as for collaborations in product development.
PRODUCT DEVELOPMENT
The Company believes that strong development capabilities are essential to its future performance and the maintenance of its competitive position. Since its formation, the Company has primarily developed its technology and products internally. The Company is exploring the opportunity to extend the functionality of its ALife-SmartEngine-derived products through the inclusion of third party software and applications in the development of such products.
The Company's development organization is arranged in five groups: the Core Technology Group, which does research and designs and develops the technologies; the Production Group, which specifies, produces and maintains product releases; the Quality Assurance Group, which verifies that products meet their specifications and the Company's quality standards; and, the Competence Group, which focuses on rapid prototyping of new ideas, consulting and adapting customer specific versions of the product and a research group. The Company allocates responsibilities among the groups to optimize the time, cost and quality control issues associated with product development.
As of December 31, 1999, there were 179 employees on the Company's development staff. The total product development expenses for its ALife-SmartEngine product suite increased significantly through 1999. The Company expects to allocate substantial resources to future research and development activities. Through December 31, 1999, the Company has incurred capitalized software development costs from its development efforts in the amount of $1,366,093.
To the extent one or more of the Company's competitors introduce products that more fully address customer requirements, the Company's business could be materially adversely affected. There can be no assurance that the Company will be successful in developing and marketing enhancements to its existing products or new products, incorporating new technology on a timely basis, or that its new products will adequately address the changing needs of the marketplace. If the Company is unable to develop and introduce new products or enhancements to existing products in a timely manner in response to changing market conditions or customer requirements, the Company's business, prospects, financial condition and results of operations will be materially adversely affected.
COMPETITION
The market for the Company's products and services is new, evolving and growing rapidly. Competition can be expected to intensify significantly as the market matures and the more established software companies, such as Microsoft Corporation, become increasingly involved. Barriers to entry are relatively insubstantial. The Company believes that the principal competitive factors for companies seeking to become involved in the software robot industry are core technology, delivery methods, brand recognition, ease of use and interfaces.
The Company uses its core technology, the ALife-SmartEngine, in a wide variety of business areas. Although the Company has not yet identified any competitors in exactly the same areas in which it is active, there are companies that have overlapping activities and therefore could be regarded as competition to Artificial Life. Such firms include, among others: Ask Jeeves; Autonomy, Inc.; Big Science Company; Brightware, Inc.; Broadvision, Inc.; Digital Marketing Concepts, Inc.; eGain, Inc.; Extempo, Inc.; General Magic, Inc.; GK Intelligent Systems, Inc.; Haptek, Inc.; Intellix A/S; Kinetoscope, Inc.; Microsoft Corporation; Netsage Corp.; Neuromedia, Inc.; Nuance, Inc.; SRA International, Inc. and Virtual Personalities, Inc. This list may not be complete and may change and substantially increase over time.
Some of the Company's existing and potential competitors have longer operating histories, greater name recognition, larger customer bases and significantly greater financial, technical and marketing resources than the Company. Such competitors are able to commit operating resources to product development and enhancement, engage in more thorough marketing campaigns for their products and services, be more aggressive from a pricing standpoint and make more attractive offers to potential employees and partners.
INTELLECTUAL PROPERTY AND OTHER PROPRIETARY RIGHTS
The Company relies upon trade secrets, know-how, copyrights and continuing technological innovations to develop and maintain its competitive position. The Company seeks to protect such information, in part, by confidentiality agreements with its corporate partners, collaborators, employees and consultants. These agreements provide that all confidential information developed or made known during the course of the individual's or entity's relationship with the Company is to be kept confidential and not be disclosed to third parties except in specific circumstances. The Company has endeavored to cause its employees to execute forms of Confidentiality and Inventions Agreements which provide that, to the extent permitted by applicable law, all inventions conceived by an individual during the individual's employment will remain the exclusive property of the Company. There can be no assurance that these agreements will not be breached, that the Company would have adequate remedies for any breach, or that the Company's trade secrets will not otherwise become known or be independently discovered by competitors. Further, there can be no assurance that the Company will be able to protect its copyrights, trade secrets or that others will not independently develop substantially equivalent proprietary information and techniques.
The Company has no patents or patent applications pending, nor does it have any registered copyrights. There can be no assurance that the existing or future patents of third parties will not have an adverse effect on the ability of the Company to continue to commercialize its products. Furthermore, there can be no assurance that other companies will not independently develop similar products or duplicate any of the Company's planned products or obtain patents that will require the Company to alter its products or processes, pay licensing fees or cease development of its planned products.
EMPLOYEES
As of December 31, 1999, the Company had 220 full-time employees. Of the Company's 220 full-time employees, 41 are involved in sales, marketing and administrative functions and 179 are involved in engineering, research and development. The Company will need to hire additional staff to accomplish its business development goals. There can be no assurance that the Company will be able to find, attract or retain such additional staff.
The Company's employees are not represented by any labor unions. The Company considers its relations with its employees to be good.
SUB-CONTRACTORS AND EXTERNAL HUMAN RESOURCES
To fulfill timely delivery of products, the Company is currently using external human resources and sub-contractors to develop its products. There can be no assurance that these external resources and sub-contractors will be available in the future, or that the current conditions and agreements with these contractors or resources will remain reasonable.
ITEM 2.
ITEM 2. PROPERTIES.
The Company rents 7,334 square feet of office space at Four Copley Place, Suite 102, Boston, Massachusetts. The 36 month lease commenced February 1, 1998, at an annual rental of $205,332. Additionally, the Company leases approximately 15,000 square feet of office space in Saint Petersburg, Russia. The 60 month lease commenced December 1, 1998 at an annual rental of $35,000. The Company also leased approximately 2,500 and 9,000 square feet of space in Switzerland and Germany, at an approximate annual rent of $60,000 and $330,000, respectively, for its European operations. Due to the planned expansion of the Company, management is currently negotiating the terms for the lease of additional office space in Greater Boston, Massachusetts. Also in July of 1999, the Company began renting on a short term basis, office space in New York, New York for the marketing and sale of its products.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
There are no material legal proceedings pending or, to the Company's knowledge, threatened against the Company.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
The Company's Common Stock commenced trading on the Nasdaq SmallCap Market on December 18, 1998 under the symbol "ALIF," and is listed on the Nasdaq SmallCap Market. Prior to that date, there was no established trading market for the Common Stock. The following table sets forth for the periods indicated, the range of the high and low bid quotations for the Company's Common Stock. Such quotations reflect inter-dealer prices, without retail mark-up, mark-down or commissions and may not represent actual transactions.
HIGH LOW ------ ----- First Quarter $17.50 $ 9.50 Second Quarter 23.00 12.875 Third Quarter 15.00 9.00 Fourth Quarter 19.75 12.875 First Quarter (through March 17, 2000) 38.938 15.875
On March 17, 2000, the last reported sale price of the Common Stock was $30.00 per share. As of March 17, 2000, there were approximately 32 holders of record of the Company's Common Stock. To date, the Company has neither declared nor paid any cash dividends on shares of its Common Stock and does not anticipate doing so for the foreseeable future.
A Registration Statement on Form S-1 (File No. 333-64619) registering 1,600,000 shares of the Company's Common Stock, $.01 par value per share, filed in connection with the Company's initial public offering ("IPO"), was declared effective by the Securities and Exchange Commission on December 17, 1998. The primary offering of 1,400,000 shares by the Company and 200,000 shares by the Selling Stockholder closed on December 22, 1998. On December 23, 1998, the underwriters exercised an overallotment option to purchase 150,000 shares from the Selling Stockholder and, on January 19, 1999, exercised an overallotment option to purchase 50,000 shares from the Selling Stockholder and 40,000 shares from the Company, exercising a 240,000 share overallotment in full. The aggregate offering price to the public was $13,600,000 before underwriter discounts and the costs of the offerings. The underwriters of the IPO were New York Broker, Inc. and New York Broker Deutschland AG. The following is a summary of the gross proceeds, underwriter's discounts and expenses, other expenses and net proceeds in connection with the IPO.
None of the above expenses was paid either directly or indirectly to directors, officers, general partners of the Company or its associates, or to persons owning more than 10% of any class of equity security of the Company or to affiliates of the Company.
In December 1999, New York Broker, Inc. exercised a portion of its warrant for 140,000 shares, utilizing the net exercise feature of its warrant.
Through December 31, 1999, the Company had temporarily invested excess net proceeds of the IPO in savings and money market accounts with three major financial institutions. The Company allocated up to $2,500,000 of such proceeds to fund certain strategic alliances but used approximately $1,000,000 for such alliances. The balance of the proceeds were used as general working capital to fund internal developmental activities and expanded operations. See "Management's Discussion and Analysis of Financial Condition and Results of Operation - Liquidity and Capital Resources."
In February 2000, the Company concluded two private placements of Common shares. Both transactions occurred at purchase prices that were at a premium to the average closing price for five days prior to the transaction date. The first transaction netted $2,562,500 to the Company in exchange for 102,500 common shares; the second transaction netted $1,550,000 to the Company in exchange for 50,000 common shares. Costs related to these transactions were immaterial.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following table presents summary selected historical financial data of the Company as of and for each of the two years in the period ended December 31, 1996, the periods ended July 3, 1997 and December 31, 1997, and the years ended December 31, 1998 and 1999 and should be read in conjunction with "Management's Discussion and Analyses of Financial Conditions and Results of Operations" and the Financial Statements and the notes thereto included in this Form 10-K.
SELECTED FINANCIAL DATA(1) (IN THOUSANDS, EXCEPT PER SHARE DATA)
(1) In connection with the Management Buyout on July 4, 1997, the Company has presented its assets at fair value as of such date of the change in control and has presented separately operations prior to the Management Buyout (Predecessor) and subsequent to the Management Buyout (Successor). See Note 1 of Notes to Financial Statements. (2) Net income (loss) per share is determined by dividing the net income (loss) attributable to common stockholders by the weighted average number of Common Stock and Common Stock equivalents outstanding during the period. See Note 2 of Notes to Financial Statements.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION.
OVERVIEW
The Company was incorporated in Delaware in November 1994 as Neurotec International Corp., a wholly-owned subsidiary of Neurotec GmbH, a German multimedia and Internet solutions company owned by Eberhard Schoneburg, Artificial Life's President, Chief Executive Officer and Chairman, and two corporate investors: a major German retailer and an industrial conglomerate. In July 1997, Mr. Schoneburg sold all of his shares of Neurotec GmbH to the two remaining stockholders and contemporaneously purchased 100% of the shares of Neurotec International Corp. (the "Management Buyout"). In August 1997, the Company changed its name to Artificial Life, Inc.
As a result of a change in control of the Company in connection with the Management Buyout, the Company has presented its assets and liabilities subsequent to July 3, 1997 to reflect the purchase price paid for the stock of the Company. This treatment is consistent with "push down" accounting as promulgated by the Securities and Exchange Commission ("SEC"). The results of operations for the Company for 1997 have been separately presented to reflect the results of operations prior to the Management Buyout, as Predecessor operations, and for the period subsequent to the Management Buyout, as Successor operations. In Management's opinion, the purchase price of the Company's stock in the Management Buyout reflected the fair value of the Company at such time.
The difference between the Company's net book value at July 4, 1997 and the fair value has been recorded as a reduction of the Company's net deferred tax asset and long-term assets, resulting in a new depreciation basis for financial statement purposes for such assets. As of July 4, 1997, the stockholder's equity section reflects cumulative earnings prior to the Management Buyout as paid-in capital. As a result, accumulated deficit at December 31, 1999 reflects the results of operations of the Company only from the date of the Management Buyout.
The only difference in accounting policies utilized in the presentation of the Successor and Predecessor financial statements is the estimated useful lives utilized in the depreciation of property and equipment, as described in Note 2 of Notes to Consolidated Financial Statements.
Following the Management Buyout, the Company's management made the strategic decision to shift the Company's primary business focus from providing software consulting services to the development, marketing and support of its ALife suite of SmartBot software products. Management's decision to shift the primary business focus of the Company has had and will likely continue to have an adverse effect on the Company's results of operations in the near term. The Company expects that an increasing percentage of its future revenues will be derived from sales and services associated with its SmartBot software products and that revenues from its consulting business, as a percentage of gross revenues, will significantly decrease over time. Through 1998, the Company's major source of revenue has been its software consulting services, and it generated minimal revenue from the sale of its SmartBot software products. However, in 1999 the Company realized its first significant software license revenue. The Company continues to expand its research and development, production and marketing capabilities associated with the anticipated sale of its SmartBot products, and as a result, operating expenses are expected to increase significantly going forward. The Company expects to continue to incur increasing losses and generate negative cash flow from operations until at least the year 2000. To the extent that the Company's product development, marketing and sales efforts do not result in commercially successful products that generate significant net revenues, the Company will be materially adversely affected. There can be no assurance that the Company will ever generate sufficient revenues from the sale of the Company's products or associated services to achieve or maintain profitability.
In addition, as a result of the Company's transition in its primary business focus from software consulting to product development, marketing and support, the Company's research and development expenditures, excluding amounts included in capitalized software development costs, increased from zero in 1997 to $446,317 in 1998 and $666,046 in 1999. This increase is due to the fact that prior to 1998, all research and development expenditures were related to consulting services for which the Company was reimbursed by its customers and thus, such expenditures are included in engineering expenses in the Company's financial statements through December 31, 1997. Conversely, during 1999, due to the Company's shift in business focus, the Company had the majority of its employees engaged in the research and development of its SmartBot products.
Because the Company has shifted its primary business focus from software consulting to product development, marketing and support, results of operations to date are not reflective of the Company's business prospects going forward. Moreover, the Company expects to experience significant fluctuations in its future operating results due to a variety of factors. Factors that may affect the Company's operating results include the success of product development, the amount of software consulting undertaken in the future, market acceptance of the Company's products, frequency and timeliness of new product releases, success of strategic alliances, the mix of product and service sales, the Company's response to competitive pressure and its ability to attract and retain qualified personnel. Gross profit margins will vary from product to product and between products and services and although the Company may have some ability to affect its products and services mix, the Company's sales mix may vary from period to period and its gross margins will fluctuate accordingly.
RESULTS OF OPERATIONS
Fiscal 1999 realized the first significant software license revenues in Company history. This is consistent with the Company's business strategy as changed to reflect its focus on product development and license sales.
The Company's principal source of revenue from inception through May 1998 was from the provision of software consulting services. From inception through July 3, 1997, the preponderance of those revenues were generated by subcontracts issued from Artificial Life's former parent company and affiliates thereof, all of which revenues ceased shortly after the Management Buyout. Of the non-related party revenues, most were derived from the Company's long-term consulting contract with its major domestic client. This consulting contract started in late 1996 and concluded in May 1998.
During the fourth quarter of 1997, the Company began evaluating the addition of software product development to its core business of providing software consulting services. The Company commenced software development plans while it continued to provide software consulting services under its existing contracts and to seek new consulting contracts. In the first quarter of 1998, the Company began software development activities while continuing to service its one existing consulting contract. During this time the Company limited its efforts in seeking new consulting contracts as it began to shift its primary business focus to software development. During the second quarter of 1998, when the Company's major domestic consulting contract ended, the Company focused a substantial portion of its available resources on product development. This change in focus resulted in the Company, in fiscal 1999, realizing its first significant software license revenue.
YEAR ENDED DECEMBER 31, 1999 COMPARED TO YEAR ENDED DECEMBER 31, 1998
Revenues: Revenues for the year ended December 31, 1999 were $3,909,076 as compared to $450,768 for the year ended December 31, 1998. The increase of $3,458,308 or 767.20% is primarily due to a contract for licenses and support entered into with a European trust.
Engineering and Cost of Sales: Engineering expenses generally consist of salary and payroll tax expenses, training, consulting, subcontracting, and other expenses incurred to develop and fulfill the engineering design specifications of the products and service's from which the company derives its revenue. Engineering expenses for the year ended December 31, 1999 were $3,566,192 as compared to $640,237 for the year ended December 31, 1998. The increase of $2,925,955 or 457.01% was due to support activities related to the Company's product installations and related consulting thereof. The significant increases in 1999 included salaries and benefits of $1,312,000, consulting expenses of $515,000, travel of $190,000, recruitment fees of $158,000, amortization of capitalized software development costs of $250,000 and depreciation expense of $191,000.
Research & Development Expenses: Research and Development expenses are similar in nature to engineering expenses with the exception being that they relate to products in their initial stage and will generate revenue at a later date. Research and Development expenses for the year ended December 31, 1999 were $666,046 compared to $446,317 in the year ended December 31, 1998. The increase of $219,729 or 49.23% is primarily due to costs associated with continued product research and development related to the Company's product line. As a result the entire research and development increase related to an increase in salaries and benefits. The research and development expenses in 1999, like, 1998 are net of capitalized software development costs.
General and Administrative Expenses: General and Administrative Expenses consist of salary and payroll tax expenses of administrative personnel, rent, and professional fees and costs associated with employee benefits, supplies, communications, and travel. General and Administrative expenses for the year ended December 31, 1999 were $4,055,881 as compared to $1,310,875 for the year ended December 31, 1998. The increase of $2,745,006 or 209.40% was due to approximate increases in the following: professional fees, $1,000,000; salaries and benefits of $840,000; travel, $200,000; with the balance mainly due to costs associated with the Company's worldwide infrastructure buildup.
Marketing Expenses: Marketing expenses consists of salary, and payroll tax expenses of marketing personnel, and costs relating to marketing materials, promotional videos, advertising, trade show related expense, and public relation activities. Marketing expenses for the year ended December 31, 1999 were $1,982,694 compared to $179,286 for the year ended December 31, 1998. The increase of $1,803,403 or 1005.88% was due to approximate increases in the following: $500,000 for the addition of sales personnel, $200,000 for promotional material and packaging of products; $800,000 was related to a media marketing campaign and costs associated with trade shows and $200,000 for the outside consultants to help market the Company.
Net Loss: Net Loss for the year ended December 31, 1999 was $6,758,214 as compared to $2,191,206 for the year ended December 31, 1998. This increase of 4,567,008 or 208.42% was due to the following. The expansion in Europe, including the Company's equity and net loss of the joint venture of $509,000, accounted for approximately one half of this increase. The increased marketing effort represented approximately another $1,000,000.
YEAR ENDED DECEMBER 31, 1998 COMPARED TO PERIOD FROM JULY 4, 1997 TO DECEMBER 31, 1997
Note: The December 31, 1997 period only includes activity from July 4, 1997, approximately 6 months, as a result of the Management Buyout (see above).
Revenues: Revenues for the year ended December 31, 1998 were $450,768 as compared to $537,008 for the period from July 4, 1997 to December 31, 1997. The decrease of $86,240 or 16.1% is primarily attributable to the Company's decision to shift its revenue focus from consulting to product based sales.
Engineering and Cost of Sales: Engineering expenses generally consist of salary and payroll tax expenses, training, consulting, subcontracting and other expenses incurred to develope and fulfill the engineering requirements of the products and services from which the Company derives its revenues. Engineering expenses for the year ended December 31, 1998 were $640,237 as compared to $220,091 for the period from July 4, 1997 to December 31, 1997. The increase of $420,146 is primarily attributable to the difference in the length of the reporting periods and the increased activity with the Company's primary domestic client in 1998.
Research and Development Expenses: Research and development expenses consist of expenses similar in nature to engineering expenses except that such expenses typically relate to new products and activities that will generate revenue at some future date. Research and development expenses for the year ended December 31, 1998 were $446,317 as compared to $0 for the period from July 4, 1997 to December 31, 1997. This increase is directly related to the substantial increase in research and development activity by the Company in 1998. All research and development expenses for periods prior to 1998 were related to contractual software consulting services for which the Company was reimbursed and were included in engineering expenses. The research and development expenses in 1998 are net of costs capitalized for software development.
General and Administrative Expenses: General and administrative expenses consist of salary and payroll tax expenses of administrative personnel, rent, legal and accounting fees and costs associated with employee benefits, supplies, communications and travel. General and administrative expenses for the year ended December 31, 1998 were $1,310,875 as compared to $437,216 for the period from July 4, 1997 to December 31, 1997. The increase of $873,659 was primarily attributable to the difference in the length of the reporting periods and increased costs in 1998 including professional fees ($63,568), travel and entertainment ($43,326), franchise and excise taxes ($43,064), and employment recruiting ($26,384). In addition general and administrative expenses for the newly established European operations amounted to $131,042 in 1998.
Marketing Expenses: Marketing expenses consist of salary, and payroll taxes expenses of marketing personnel, and costs relating to marketing materials such as promotional videos, advertising, trade show related expenses and public relation activities. Marketing expenses for the year ended 1998 were $179,286 as compared to $7,900 in for the period from July 4, 1997 to December 31, 1997. The increase of $171,386 was mainly due to the addition of a marketing personnel ($62,000) and Public Relations expense of ($110,000).
Net Loss: Net loss for the year ended December 31, 1998 was $2,191,206 as compared to net income of $43,940 for the period from July 4, 1997 to December 31, 1997. This increase of $2,235,146 was directly related to the decrease in software consulting revenues related to the Company's transition of its primary business focus to product development, marketing and support.
PERIOD FROM JULY 4, 1997 THROUGH DECEMBER 31, 1997 COMPARED TO PERIOD FROM JANUARY 1, 1997 THROUGH JULY 3, 1997
Revenues: Revenues for the period from July 4, 1997 through December 31, 1997 were $537,008 as compared to $1,043,414 for the period from January 1, 1997 through July 3, 1997. The decrease of $506,406 or 48.5% is directly attributable to the Company's discontinuing software consulting work for its former parent after the Management Buyout.
Engineering and Cost of Sales: Engineering expenses for the period from July 4, 1997 through December 31, 1997 were $220,091 as compared to $293,104 for the period from January 1, 1997 through July 3, 1997. The decrease of $73,013 or 24.91% resulted primarily from the Company's discontinuing software consulting work for its former parent after the Management Buyout.
Research and Development Expenses: Research and development expenses for the period from July 4, 1997 through December 31, 1997 and the period from January 1, 1997 through July 3, 1997 were related to contractual software consulting services for which the Company was reimbursed and were included in engineering expenses.
General and Administrative Expenses:, General and administrative expenses for the period from July 4, 1997 through December 31, 1997 were $437,216 as compared to $662,474 for the period from January 1, 1997 through July 3, 1997. The decrease of $225,258 or 34.00% is attributable to reduced overhead associated with the Company's reduction in contractual consulting services after the Management Buyout.
Marketing Expenses: Marketing Expenses for the period for July 4, 1997 through December 31, 1997 were $7,900 as compared to $30,645 for January 1, 1997 through July 3, 1997. The decrease of $22,745 or 74.0% is attributable to reduced overhead after the Management Buyout
Net Income: Net income for the period ended December 31, 1997 was $43,940 as compared to $12,669 for the period from January 1, 1997 through July 3, 1997. The increase of $31,271 or 246.8% is attributable to the settlement income received from the former parent and a reduction in depreciation expense as a result of reflecting long-term assets at fair value subsequent to the Management Buyout, offset by the reduction in consulting services revenue from the former parent.
LIQUIDITY AND CAPITAL RESOURCES
From inception through July 3, 1997, the Company funded its operations primarily through initial equity investments in 1994 and 1995 totaling $500,000 and net income from operations. Subsequent to July 3, 1997, the Company incurred operating losses in connection with its transition from software consulting to product development, marketing and sales. These losses are expected to increase and have been funded to date by a long-term stockholder loan of $500,000, a private placement of Non-Voting Common Stock of $181,367, the net proceeds of which the Company received in June 1998 and a private placement of $824,000 shares of Common Stock which raised $3,946,481 in net proceeds. In December 1998, the Company received $9,302,773 net proceeds from its IPO. During 1999, optionholders of the Company exercised options netting the Company approximately $1,300,000, which was received in 1999 and the first quarter of 2000. In February 2000, the Company concluded two private placements of Common Stock. Both transactions occurred at purchase prices that were at a premium to the average closing price for five days prior to the transaction date. The first transaction netted $2,562,500 to the Company in exchange for 102,500 common shares; the second transaction netted $1,550,000 to the Company in exchange for 50,000 common shares. Costs related to either of these transactions were immaterial. The Company's requirements for additional capital will depend on many factors, including but not limited to the progress and costs associated with its research and development activities, production costs and sales, marketing and promotional programs, establishment of foreign operations and the levels of revenues achieved through the sale of its SmartBot suite of products. The Company has currently placed excess funds in interest bearing vehicles such as money market accounts and savings accounts.
Effective October 10, 1995, the Company entered into a consortium agreement (the "MIT Agreement") with the Massachusetts Institute of Technology ("MIT"). Under the MIT Agreement, MIT will conduct research projects for the "Things That Think Consortium." The term of the agreement is for five years through October 9, 2000 but provides for early termination, with one year written notice, as well as renewal options. The Company is obligated to pay an annual membership fee of $125,000 under the MIT Agreement.
The Company leases office and other space and certain office equipment under various noncancelable leases. Minimum annual lease payments, exclusive of additional operating costs, for the years ended December 31, 2000, 2001, 2002 and 2003 are approximately $700,000, $450,000, $430,000 and $430,000 respectively.
The Company has an employment agreement its Chief Executive Officer. The agreement is three years in length and provides for a minimum base salary. The agreement includes severance payments under certain conditions of approximately 300% of annual compensation. In addition the President, Chief Executive Officer and Chairman of the Company is entitled to receive an annual incentive bonus of 3% of the Company's profits from operations.
The Company entered into a joint venture with an international retailer in the field of e-commerce. The main focus of this joint venture is to sell consumer goods over the Internet using deep discounts and high volume, both in terms of transactions and web visits. As part of the transaction, the Company licensed its SmartBot technology to the joint venture. In addition, the Company provided products and software development and consulting services to the joint venture and receive payments therefor. The partner in the joint venture will be responsible for using its purchasing relationships to obtain certain consumer products which will be sold on the joint venture's e-commerce Website. The Company allocated up to $2,150,000 of the proceeds from its IPO to purchase its 50% interest in this joint venture and to meet its obligations to contribute additional capital to the joint venture.
In addition, the Company completed a contract for the first phase of a development and consulting project with a European based global trust. The project goal was to define and design the trust's future Internet-based financial services. The successful completion of this phase led to a larger scale implementation of this development project. As part of the transaction, the Company is providing licensed products and software consulting services to the trust.
The Company believes that the net proceeds of the IPO and private placements, together with its current cash and cash equivalents, and other cash generated from operations will enable the Company to maintain its current and planned operations at least through January 2001, although there can be no assurance that the Company will not have additional capital needs prior to such time. If cash generated from operations is insufficient to satisfy the Company's liquidity requirements after that time, the Company may seek to sell additional equity or debt securities or obtain a credit facility. The sale of additional equity or convertible debt securities could result in additional dilution to the Company's stockholders. There can be no assurance that financing will be available in amounts or on terms acceptable to the Company, if at all.
The Company has incurred losses for income tax purposes for fiscal years 1998 and 1999. These losses will be available to carry forward and reduce income taxes, if any, in future periods.
THE YEAR 2000 ISSUE The Year 2000 issue is the result of computer programs using a two-digit format, as opposed to four digits, to indicate the year. The Company is not aware of any problems that have arisen from the Year 2000 issue and as a result does not believe its operations have been affected in any material way. All costs associated with internal and product specific reviews of Year 2000 compliance that were completed in 1999 were immaterial to the Company's 1999 operating results.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
The Company maintains its cash and cash equivalents in checking, savings, and money market accounts. Approximately 60% of these deposits are denominated in U.S. dollars. Approximately 35% of these deposits are denominated in Euros and the remainder is demoninated in Swiss Franc. Deposits in both fixed rate and floating rate interest accounts carry a degree of interest rate risks. Fixed rate deposits may be adversely impacted due to a rise in interest rates, while floating rate deposits may produce less income than expected if interest rates fall. Due in part to these factors, the Company's future interest income may fall short of expectations due to changes in interest rates. The cash denominated in non-U.S. currency units is subject to exchange risks as well as interest rate risks. The Company believes that a hypothetical 10% increase or decrease in either interest or exchange rates, however, would not have a material adverse effect on the Company's financial condition.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
Consolidated Financial Statements and supplementary data appear at pages through of this report on Form 10-K.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES.
Not applicable.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
DIRECTORS. The following table sets forth certain information regarding the directors of the Company as of December 31, 1999:
Eberhard Schoneburg has been President and a member of the Board of Directors of the Company since November 1994. He was Chief Executive Officer from November 1994 to May 1996 and from October 1997 to the present. Mr. Schoneburg has been the Chairman of the Board of Directors of the Company since the founding of the Company. The Company was founded in November 1994 as Neurotec International Corp., a wholly owned subsidiary of Neurotec GmbH, a German multimedia and Internet solutions company owned by Mr. Schoneburg and two corporate investors: a major
German retailer and an industrial conglomerate. Neurotec GmbH was part of the Neurotec Group, a group of high tech companies founded in Germany by Mr. Schoneburg in 1993. In 1997 he sold all of his shares in Neurotec GmbH to the remaining stockholders and contemporaneously purchased 100% of the shares of the Company from Neurotec GmbH. From 1989 to 1994 Mr. Schoneburg was a professor for industrial applications of artificial intelligence at Fachhochschule Furtwangen, Germany. From 1988 to 1993, he was the Chairman of the BIT Group, a group of five German high tech companies which he founded in 1988.
Mr. Schoneburg was awarded the First Prize of the Berlin Innovation Award in 1990 for the development of the First European Neural Compiler and again in 1992 for the development of an expert system for detecting chemical hazards for Procter and Gamble. He has published five course books on a wide variety of topics such as computer viruses, neural networks, evolution strategies and genetic programming and over 60 research papers on related topics. He is also a member of the jury of the Golden Award of Montreux.
Bruno Gabriel joined the Company's Board of Directors in September 1998. In January 1999 he became Chief Executive Officer of Artificial Life Europe AG. Since 1989, Mr. Gabriel has been a management consultant to several European companies. From 1984 to 1989, he was the Chief Executive Officer and President of the ALSO Group, a European distributor of personal computers and computer equipment which he founded in 1984. From 1978 to 1984, Mr. Gabriel was the Chief Executive Officer of ADV/ORGA Switzerland, a software and consulting company. From 1976 until 1978, he was manager for new media at Tagesanzeiger Zurich, a Swiss newspaper company. Mr. Gabriel began his career in 1971 as a manager for software development at Telekurs AG, a Swiss telecommunications company.
Elmar Wohlgensinger joined the Company's Board of Directors in September 1998. He has worked for the IHA Institute, a Swiss market research company, since 1961 where he has been a member of the board since 1970 and President since 1980. Mr. Wohlgensinger is a Vice President of ATAG Holding, an accounting firm, and has been a member of ATAG Ernst & Young management, an accounting firm, since 1991. Mr. Wohlgensinger also serves on the boards of German GFK, EKN Bank Nidwalden, Schweizerische Gesellschaft Fuer Marketing and the Chamber of Commerce of Central Switzerland.
Hartmut Bergmann joined the Board of Directors in December 1998, upon completion of the Company's IPO, pursuant to an agreement between the Company and the underwriters New York Broker, Inc. and New York Broker Deutschland AG. Mr. Bergmann has been Chairman of the Management Board of New York Broker Deutschland AG since 1990. Mr. Bergmann resigned his position in February, 2000.
Felix Widmer was appointed by the Board of Directors in March 2000 to fill the vacancy created by Mr. Bergmann's resignation in February 2000. He has worked for Widmer Management, a consulting firm he founded in Switzerland, since 1997. Prior to that he worked at Guebelin Ltd/Guebelin Inc. of Lucerne, Switzerland and New York, NY from 1972 to 1996 in a variety of capacities, including Executive Vice President, Vice President and Director of Finance and Administration. Previously he worked for the Federal Tax Authority of Switzerland.
EXECUTIVE OFFICERS. The following table sets forth certain information regarding the executive officers of the Company as of December 31, 1999:
Daniel Sapir, the Company's Chief Operating Officer, joined the Company in August 1999. From 1998 until that time, he was CEO of iCentric Solutions, Inc., an internet application software company. From 1989 to 1997 he worked at Data General Corporation as the Vice President of the Enterprise Solutions Business Unit. From 1987 to 1989 he worked at McDonnell Information Systems as the Director of Sales for Enterprise Applications and prior to that Mr. Sapir was at Allerion Corporation as the Director of Channel Sales-Western Operations.
Robert Pantano, the Company's Chief Financial Officer, joined the Company in April 1995 as an accountant, was appointed Controller and Director of Human Resources in 1996 and was promoted to his present position in September 1997. From 1993 until joining the Company, Mr. Pantano worked as the Controller and General Manager of Intertech International Corp., an international engineering firm. From 1990 to 1993, he was a Principal with Global Vision International, an international export trade consulting firm specializing in central and eastern Europe. Mr. Pantano holds a B.S. in Accountancy from Bentley College.
Klaus Kater joined the Company as Chief Technology Officer in May 1998. From December 1997 through April 1998, Mr. Kater provided consulting services to the Company. Prior to that time, from June 1997 to December 1997, he was Managing Director for the MediaCenter Research Institute GmbH, a German multimedia research center and a subsidiary of Neurotec GmbH. From March 1996 to July 1997, Mr. Kater worked as a freelance consultant, coordinating the activities of the Wirtschaftsforderungsgesellschaft Business Development Institute in the context of multimedia initiatives, and concurrently from 1993 to 1996, he worked for Neurotec GmbH, where he served as project manager for chemical expert
systems. From 1992 to 1993, Mr. Kater was a project manager at Expert Informatik GmbH, where he managed a team that developed an expert system for Procter & Gamble. From 1990 to 1992, he ran his own company Kater & Stirm Softwareentwicklung GbR which produced and sold software for the hotel management market. Mr. Kater holds a degree in computer science and artificial intelligence from Fachhochschule of Furtwangen in Germany.
SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE. The Company's executive officers and directors are required under Section 16(a) of the Exchange Act to file reports of ownership of Company securities and changes in ownership with the Securities and Exchange Commission. Copies of those reports must also be furnished to the Company. Based solely on a review of the copies of reports furnished to the Company and written representations that no other reports were required, the Company believes that during 1999 the executive officers and directors of the Company complied with all applicable Section 16(a) filing requirements.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
SUMMARY COMPENSATION. The following tables set forth certain information with respect to compensation paid or accrued for services rendered to the Company in all capacities for the fiscal year ended December 31, 1999 by its Chief Executive Officers and the one other most highly compensated executive officer of the Company whose salary and bonus exceeded $100,000 (the "Named Executive Officers"). No other executive officer of the Company earned greater than $100,000 in the fiscal year ended December 31, 1999.
SUMMARY COMPENSATION TABLE
(1) Klaus Kater became the Company's Chief Technology Officer in September 1997, but did not have a total compensation which exceeded $100,000 in the fiscal years ended December 31, 1997 and 1998. (2) Mr. Schoneburg assumed the position of Chief Executive Officer in October 1997. (3) Consists of rent paid by the Company for an apartment occupied by Mr. Schoneburg. (4) Daniel Sapir became the Company's Chief Operating Officer in August 1999, but did not have a total compensation which exceeded $100,000 in the fiscal year ended December 31, 1999. However, Mr. Sapir currently has an annual base salary of $130,000. (5) In 1998 Bruno Gabriel provided services to the Company as an independent consultant. Total compensation in 1998 amounted to $173,537; In addition, on June 30, 1998, he was granted options to purchase 184,426 shares of Common Stock at an exercise price of $3.66 per share, exercisable immediately.
OPTION GRANTS. The following table sets forth certain information regarding options granted during the fiscal year ended December 31, 1999 by the Company to the Named Executive Officers.
OPTION GRANTS IN LAST FISCAL YEAR
OPTION EXERCISES.
AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAR-END OPTION VALUES
- -------------------- (1) Bruno Gabriel exercised an option to purchase 184,426 shares of Common Stock, utilizing a net exercise feature, resulting in the issuance of 139,426 shares of Common Stock.
DIRECTOR COMPENSATION. Directors who are not employees of the Company receive $3,000 for each meeting of the board of directors attended and reimbursed for reasonable out-of-pocket expenses incurred in attending such meetings. Non- employee directors are also eligible for participation in the Company's 1998 Equity Incentive Plan, and the Company may, in the future grant non-qualified stock options to non-employee directors as an incentive to join or remain on the Board of Directors.
EMPLOYMENT AGREEMENTS. Under an Executive Employment Agreement dated July 1, 1998, and amended and restated as of September 1, 1998, the Company has agreed to employ Eberhard Schoneburg as President, Chief Executive Officer and Chairman of the Board of Directors for a period of three years at an initial annual base salary of $240,000 plus an incentive bonus equal to 3% of the Company's income from operations. The Agreement also provides that the annual base salary will increase as determined by the Board but at not less than 10% per year. If Mr. Schoneburg is terminated without cause (including a failure to renew the agreement) or if he terminates his employment for "good reason" (as defined in the agreement), he will be entitled to receive a lump sum payment of one to three times (depending upon whether such termination occurs before or after a change of control of the Company) the sum of (i) his base salary plus (ii) the greater of the average of his two most recent annual bonuses or his annual bonus payable in the year of termination. The agreement also contains a non-compete and non-solicitation provision which covers the longer of the term of his employment or any time period during which he serves as a director of the Company, plus a period of one year thereafter.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION. Messrs. Wohlgeninger and Bergmann, both non-employee directors, constitute the Company's Compensation Committee. Subsequent to Year-End, Mr. Bergmann resigned as a director. Mr. Widner was selected by the remaining directors to succeed him as a director and on this Committee.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The following table sets forth certain information regarding the beneficial ownership of the Company's Common Stock as of March 17, 2000 by (i) each person known by the Company to own beneficially 5% or more of the Common Stock; (ii) each Named Executive Officer; (iii) each director of the Company and (iv) all current directors and executive officers of the Company as a group:
* Less than 1%
(1) Shares of Common Stock that an individual or group has the right to acquire within 60 days of March 17, 2000, pursuant to the exercise of options or warrants are deemed to be outstanding for the purposes of computing the percentage ownership of such individual or group, but are not deemed to be outstanding for the purpose of computing the percentage ownership of any other person shown in the table. Except as indicated in footnotes to this table, the Company believes that the beneficial owners named in this table have sole voting and investment power with respect to all shares of Common Stock shown to be beneficially owned by them based on information provided to the Company by such beneficial owners.
(2) The address of all persons who are executive officers or directors of the Company is: c/o Artificial Life, Inc., Four Copley Place, Suite 102, Boston, Massachusetts, 02116.
(3) Percentage of ownership is based on shares of Common Stock outstanding as of March 17, 2000.
(4) Consists solely of shares subject to stock options which are currently exercisable.
(5) Includes 125,660 shares subject to stock options which are currently exercisable.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The Company was founded in November 1994 as Neurotec International Corp., a wholly-owned subsidiary of Neurotec GmbH, a German multimedia and Internet solutions company owned by Eberhard Schoneburg, Artificial Life's President, Chief Executive Officer and Chairman, and two corporate investors: a major German retailer and an industrial conglomerate. In July 1997, Mr. Schoneburg sold all of his shares of Neurotec GmbH to the remaining two stockholders for approximately $1,027,000 and contemporaneously purchased 100% of the shares of the Company (Neurotec International Corp.) from Neurotec GmbH. for approximately $500,000. See "Note 1 of Notes to Financial Statements."
On June 29, 1998, Mr. Schoneburg loaned the company $500,000 at an annual interest rate of 10%. The full amount of the loan, including principal and all accumulated interest thereon, was originally due and payable on January 1, 2000. Subsequent to year end the due date of the note was extended to April 30, 2000.
Prior to the date of the Management Buyout, Mr. Schoneburg received fixed compensation payments of $5,000 each month with additional compensation, if any, determined by the former parent based on the level of activities dedicated by Mr. Schoneburg to the Company versus other subsidiaries of the former parent.
Beginning January 1, 1998, Mr. Schoneburg's salary was deferred. During the time that his salary was deferred, the Company made net advances to Mr. Schoneburg of approximately $273,000 for living and personal expenses. On September 25, 1998 the Company paid Mr. Schoneburg a total of $175,385 representing 38 weeks of deferred salary. Mr. Schoneburg used the after tax proceeds of this payment to repay a portion of the advances made to him during the deferral period. During the period from September 26, 1998 to December 31, 1999, the Company advanced Mr. Shoneburg approximately $547,525 for living and personal expenses. Mr. Shoneburg repaid or applied against amounts owed him a total of $626,893. The balance due the Company as of December 31, 1999 was $43,479.
Prior to the time that they became directors of the Company in September 1998, Bruno Gabriel and Elmar Wohlgensinger provided consulting services to the Company. During that time, Messrs. Gabriel and Wohlgensinger advised the Company on strategic and logistical issues regarding the establishment of business opportunities outside the United States. In consideration for such services, in 1998, Mr. Gabriel was paid or had accrued an aggregate of $173,537 by the Company and on June 30, 1998, Messrs. Gabriel and Wohlgensinger were granted options to purchase 184,426 and 163,934 shares of Common Stock, respectively. These options are exercisable immediately for a period of one year at an exercise price of $3.66 per share.
In June 1999, the Company acquired 51% of the outstanding stock of Cybermind Ventures, Inc. ("Cybermind") for $75,000 from two of the Company's stockholders, Eberhard Schoneburg and Cybermind Interactive AG. Cybermind was inactive with a net loss in 1999 through the date of acquisition of $5,520. At the time of the acquisition, Cybermind's name was changed to Artificial Life Ventures, Inc. In November 1999, the Company acquired the remaining 49% of the outstanding stock of Artificial Life Ventures, Inc. from Cybermind Interactive AG. The Company acquired this stock for $75,000 cash and the issuance of 5,000 stock options at an exercise price of $14.50 per share. The options are valued at $25,000 and have a three year life and vest in equal amounts on the first, second and third anniversary of the grant date. Goodwill recognized in connection with this acquisition amounted to approximately $86,000, and is being amortized over five years.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
a. Documents filed as part of this Report:
1. Financial Statements
See "Index to Financial Statements" at Item 8 to this Annual Report on Form 10-K.
2. Financial Statement Schedules
b. Reports on Form 8-K
No reports on Form 8-K were filed during the fourth quarter of 1998.
c. Exhibits
The following is a list of exhibits filed as part of this Annual Report on Form 10-K.
EXHIBIT NO. DESCRIPTION - ----------- -----------
*3.1 Amended and Restated Certificate of Incorporation of the Company. Filed as Exhibit 3.1 to the Company's Registration Statement on Form S-1 (File No. 333-64619) and incorporated herein by reference.
*3.2 Restated Bylaws of the Company. Filed as Exhibit 3.2 to the Company's Registration Statement on Form S-1 (File No. 333-64619) and incorporated herein by reference.
*4.1 Specimen Common Stock Certificate for share of Common Stock of the Company. Filed as Exhibit 4.1 to the Company's Registration Statement on Form S-1 (File No. 333-64619) and incorporated herein by reference.
*4.2 Form of Representatives' Warrant issued by the Company to underwriters New York Broker, Inc. and New York Broker Deutschland AG. upon consummation of the Company's IPO. Filed as Exhibit 4.2 to the Company's Registration Statement on Form S-1 (File No. 333-64619) and incorporated herein by reference.
*10.1 Form of the Company's Employee Confidentiality and Inventions Agreement. Filed as Exhibit 10.1 to the Company's Registration Statement on Form S-1 (File No. 333-64619) and incorporated herein by reference.
*10.2 Form of Company's Advisory Board Confidentiality and Inventions Agreement. Filed as Exhibit 10.2 to the Company's Registration Statement on Form S-1 (File No. 333-64619) and incorporated herein by reference.
*10.3 Amended and Restated Executive Employment Agreement between the Company and Eberhard Schoneburg, dated as of September 1, 1998. Filed as Exhibit 10.3.1 to the Company's Registration Statement on Form S-1 (File No. 333-64619) and incorporated herein by reference.
*10.4 Employment Agreement between the Company and Robert Pantano, dated as of May 1, 1998. Filed as Exhibit 10.4 to the Company's Registration Statement on Form S-1 (File No. 333-64619) and incorporated herein by reference.
EXHIBIT NO. DESCRIPTION - ----------- -----------
*10.5 Employment Agreement between the Company and Klaus Kater, dated as of May 1, 1998. Filed as Exhibit 10.5 to the Company's Registration Statement on Form S-1 (File No. 333-64619) and incorporated herein by reference.
*10.6 Lease Agreement, dated February 6, 1995, between the Company and Copley Place Associates Nominee Corporation. Filed as Exhibit 10.6 to the Company's Registration Statement on Form S-1 (File No. 333-64619) and incorporated herein by reference.
*10.7 Lease Amendment No. 1, dated July 27, 1995, between the Company and Copley Place Associates Nominee Corporation. Filed as Exhibit 10.7 to the Company's Registration Statement on Form S-1 (File No. 333-64619) and incorporated herein by reference.
*10.8 Lease Amendment No. 2, dated February 27, 1997, between the Company and Copley Place Associates Nominee Corporation. Filed as Exhibit 10.8 to the Company's Registration Statement on Form S-1 (File No. 333-64619) and incorporated herein by reference.
*10.9 Consortium Agreement, dated October 10, 1995, between the Company and Massachusetts Institute of Technology. Filed as Exhibit 10.9 to the Company's Registration Statement on Form S-1 (File No. 333-64619) and incorporated herein by reference.
*10.10 1998 Equity Incentive Plan. Filed as Exhibit 10.10 to the Company's Registration Statement on Form S-1 (File No. 333-64619) and incorporated herein by reference.
*10.11 Form of Subscription Agreement, dated June 1998, between the Company, Eberhard Schoneburg and the purchaser of 1,000,000 shares of Common Stock and the purchasers of an aggregate of 130,000 shares of Non-Voting Common Stock. Filed as Exhibit 10.11 to the Company's Registration Statement on Form S-1 (File No. 333-64619) and incorporated herein by reference.
*10.12 Form of Subscription Agreement dated September 23, 1998 between the Company and the purchasers of 824,000 shares of Common Stock. Filed as Exhibit 10.12 to the Company's Registration Statement on Form S-1 (File No. 333-64619) and incorporated herein by reference.
*10.13 Form of Amendment and Confidential Offering Supplement, dated September 23, 1998. Filed as Exhibit 10.13 to the Company's Registration Statement on Form S-1 (File No. 333-64619) and incorporated herein by reference.
10.12 Lease Agreement dated March 30, 1999 between the company (Artificial Life Deutschland A.G.) and Internationales Immobilien.
10.13 Lease Agreement dated December 31, 1999 between the company (Artificial Life Rus) and the Association of Concert Performers in the Russian Federation (ARENDODATEL).
10.14 Lease Agreement dated October 1, 1999 between the company (Artificial Life Solutions) and Vierwaldstatter Bereiligungen AG.
10.15 Lease Agreement dated July 1, 1999 between the company (Artificial Life Solutions) and Vierwaldstatter Bereiligungen AG.
EXHIBIT NO. DESCRIPTION - ----------- -----------
10.16 Lease Agreement dated August 1, 1999 between the company (Artificial Life Solutions) and Charles Barrier Immobilien.
10.17 A June 1999 Stock Purchase Agreement between the Company and Eberhard Schoneburg for the Purchase of 490,000 Shares of Cybermind Ventures, Inc.
10.18 A June 1999 Stock Purchase Agreement between the Company and Cybermind Interactive AG for the Purchase of 20,000 Shares of Cybermind Ventures, Inc.
10.19 A Member 1999 Stock Purchase Agreement between the Company and Cybermind Interactive AG for the Purchase of 490,000 Shares of Cybermind Ventures, Inc.
21 Subsidiaries of the Company
27.1 Financial Data Schedule
99.1 Important Factors Regarding Forward-Looking Statements
*Previously filed.
SIGNATURES
Pursuant to the requirements of Section 31 or 15(d) of the Securities Exchange Act of 1934, the Registrant certifies that it has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Boston, Commonwealth of Massachusetts, on March 29, 2000.
ARTIFICIAL LIFE, INC.
By: /s/ Eberhard Schoneburg --------------------------------------- Eberhard Schoneburg President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report on Form 10-K has been signed by the following persons in the capacities and on the dates indicated.
- ------------------------ Felix Widmer Director [ ]
INDEPENDENT AUDITORS' REPORT
The Board of Directors Artificial Life, Inc, Boston, Massachusetts
We have audited the accompanying consolidated balance sheets of Artificial Life, Inc. (formerly Neurotec International Corp.) as of December 31, 1998 and 1999 (Successor), and the related consolidated statements of operations, changes in stockholders' equity and cash flows for the periods ended July 3, 1997 (Predecessor) and December 31, 1997 and the years ended December 31, 1998 and 1999 (Successor). These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Artificial Life, Inc. as of December 31, 1998 and 1999, and the consolidated results of its operations and its cash flows for the periods ended July 3, 1997 and December 31, 1997, and the years ended December 31, 1998 and 1999, in conformity with generally accepted accounting principles.
WOLF & COMPANY, P.C.
Boston, Massachusetts March 14, 2000
ARTIFICIAL LIFE, INC. (formerly Neurotec International Corp.)
CONSOLIDATED BALANCE SHEETS
See accompanying notes to consolidated financial statements.
ARTIFICIAL LIFE, INC. (formerly Neurotec International Corp.)
CONSOLIDATED STATEMENTS OF OPERATIONS
See accompanying notes to consolidated financial statements.
ARTIFICIAL LIFE, INC. (formerly Neurotec International Corp.)
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
See accompanying notes to consolidated financial statements.
ARTIFICIAL LIFE, INC. (formerly Neurotec International Corp.)
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes to consolidated financial statements.
ARTIFICIAL LIFE, INC. (Formerly Neurotec International Corp.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Periods January 1, 1997 to July 3, 1997 and July 4, 1997 to December 31, 1997 and the Years Ended December 31, 1998 and 1999
1. Organization, Risks and Uncertainties
Nature of Operations and Basis of Presentation
Artificial Life, Inc. ("Artificial Life" or the "Company") develops, markets and supports "intelligent" software robots ("bots"). The Company's bots, known as "SmartBots," are software programs that the Company designs to automate and simplify time-consuming and complex business-related Internet functions such as Web navigation, direct marketing, user profiling, information gathering, messaging, knowledge management, sales response and call center automation. In 1998, the Company changed its primary business focus from software consulting to the development, marketing and support of it's ALife suite of SmartBot software products. As a consequence of the Company's recent change in its primary business focus, the Company expects that an increasing percentage of its future revenues will be derived from sales and services associated with its software robot products and that revenues from its consulting business will, as a percent of gross revenues, significantly decrease over time.
In addition, because the Company's emerging online agent-based software products business will require significant infusions of additional capital, results of operations to date are not reflective of the Company's future results of operations. The Company's decision to become a provider of software robot products is predicated on the assumption that the demand for such products will be large enough to permit the Company to operate profitably. There can be no assurance that the Company's assumption will be correct or that the Company will be able to successfully compete as a provider of such products. If the Company's assumption is not accurate, or if the Company is unable to compete as a provider of online agent-based software products, the Company's business, prospects, financial condition and results of operations will be materially adversely affected.
The Company's management has recently obtained funds to support its operations through a combination of sources including a long-term loan from a stockholder, private placements of Common Stock and an initial public offering.
In 1997, the Company was a wholly-owned subsidiary of Neurotec Hochtechnologie GmbH, a German corporation. Neurotec Hochtechnologie GmbH has two other wholly-owned subsidiaries other than the Company and conducts operations in Germany.
On July 4, 1997, Eberhard Schoneburg, the Company's President, Chief Executive Officer and Chairman and a minority stockholder of the Company's former parent company, entered into an agreement with the former parent company, to sell his 10% interest in the former parent company for DM 1,800,000, approximately $1,027,000, in cash to the two remaining equal stockholders and contemporaneously purchase all of the outstanding shares of Neurotec International Corp. for DM 850,000, approximately $485,000, in cash (the "Management Buyout").
The Company was founded in November 1994, by the former parent company with a total capital investment of $500,000 in cash. Net book value of the Company at the date of the Management Buyout, including cumulative earnings since inception of $138,084, amounted to $638,084.
As a result of a change in control of the Company in connection with the Management Buyout, the Company has presented its assets and liabilities subsequent to July 3, 1997 to reflect the purchase price paid for the stock of the Company. This treatment is consistent with "push down" accounting as promulgated by the SEC.
ARTIFICIAL LIFE, INC. (Formerly Neurotec International Corp.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) Periods January 1, 1997 to July 3, 1997 and July 4, 1997 to December 31, 1997 and the Years Ended December 31, 1998 and 1999
The results of operations for the Company for 1997 have been separately presented to reflect the results of operations prior to the Management Buyout, as Predecessor operations, and for the period subsequent to the Management Buyout, as Successor operations. In Management's opinion, the purchase price of the Company's stock in the Management Buyout reflected the fair value of the Company at that time.
The difference between the Company's net book value at July 4, 1997 and the purchase price has been recorded as a reduction of the Company's net deferred tax asset and long-term assets, resulting in a new depreciation basis for financial statement purposes for such assets. As of July 4, 1997, the stockholder's equity section reflects cumulative earnings prior to the Management Buyout as paid-in capital. As a result, retained earnings at December 31, 1997 and subsequently, reflect the results of operations of the Company only from the date of the Management Buyout.
The only difference in accounting policies utilized in the presentation of the Successor and Predecessor financial statements is the estimated useful lives utilized in the depreciation of property and equipment, as described in Note 2.
In connection with the Management Buyout, the Company agreed not to compete in any manner with the former parent company in Europe through the period ended December 31, 1998. Subsequent to the Management Buyout, the Company changed its name to Artificial Life, Inc.
During the periods January 1, 1997 to July 3, 1997 and July 4, 1997 to December 31, 1997, approximately 64% and 37%, respectively, of the Company's revenue was derived from various contracts with the Company's former parent company and its affiliates. As a result of the Management Buyout and the Company's changing its primary business focus from software consulting to the development, marketing and sale of its ALife suite of SmartBot software products, the Company is not anticipating any future revenue to be derived from its former parent.
In October 1998, the Company formed Artificial Life Europe AG ("Artificial Life Europe") as a wholly-owned subsidiary. Artificial Life Europe is located in Stansstad, Switzerland and was established as the Company's European headquarters.
In November 1998, Artificial Life Europe formed Artificial Life Rus Limited ("Artificial Life Rus") as a wholly owned subsidiary. Artificial Life Rus is located in St. Petersburg, Russian Federation and was formed to perform software development.
In March 1999, the Company formed a wholly-owned subsidiary Artificial Life Deutschland AG, ("Artificial Life Germany") located in Frankfurt, Germany. The subsidiary was formed to serve European markets and combine the Company's European sales and marketing initiatives. The subsidiary commenced operations in June 1999 and concentrates on the development of Internet applications for banks and financial service organizations.
In June, 1999, Artificial Life Europe formed a wholly-owned subsidiary Artificial Life Solutions, AG located in Stansstad, Switzerland. The subsidiary was formed principally to provide software development and product support for customers in the Switzerland area.
Also in, June 1999, the Company acquired 51% of the outstanding stock of Cybermind Ventures, Inc. ("Cybermind") for $75,000 from two of the Company's stockholders. Cybermind was inactive with a net loss in 1999 through the date of acquisition of $5,520. At the time of the acquisition, Cybermind's name was changed to Artificial Life Ventures, Inc. ("Artificial Life Ventures"). In November 1999, the Company acquired the remaining 49% of the outstanding stock of Artificial Life Ventures from a stockholder of the Company. The Company acquired this stock for $75,000 in cash and the issuance of 5,000 stock options at an exercise price of $14.50 per share. The options are valued at $25,000, have a three year life and vest in equal amounts on the first, second and third anniversary of the grant date. Goodwill recognized in connection with this acquisition amounted to approximately $86,000, and is being amortized over five years.
ARTIFICIAL LIFE, INC. (Formerly Neurotec International Corp.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) Periods January 1, 1997 to July 3, 1997 and July 4, 1997 to December 31, 1997 and the Years Ended December 31, 1998 and 1999
In October 1999, Artificial Life Europe acquired all the outstanding common stock of IT Partners AG ("IT") for 120,000 Swiss Francs (approximately $80,000). IT is a Swiss company organized in June 1999 as a dealer of computer and other equipment and to provide related consulting services. IT was inactive through the date of acquisition. Goodwill recognized in connection with this acquisition amounted to approximately $19,000, and is being amortized over five years.
Concentration of Credit Risk
Financial instruments which potentially subject the Company to a concentration of credit risk principally consist of cash and cash equivalents and accounts receivable.
The Company maintains its cash and cash equivalents in checking, savings and money market accounts. The majority of the Company's cash and cash equivalents were on deposit in three major financial institutions in 1998 and two major financial institutions in 1999.
During the periods January 1, 1997 to July 3, 1997 and July 4, 1997 to December 31, 1997, the Company recognized revenue from one customer amounting to approximately $377,000 and $333,000, respectively, representing 36% and 62%, respectively, of its total revenues. During the year ended December 31, 1998, the substantial majority of the Company's revenue was derived from this same customer. Accounts receivable, trade were due entirely from this customer at July 3, 1997 and December 31, 1997.
In 1999, the Company recognized revenues from one customer in the amount of $2,483,467, representing 63.5% of its total revenues. At December 31, 1999, 83% of accounts receivable, trade was due from this customer. Also in 1999, the Company recognized revenues, after elimination of unrealized intercompany profit, from license and application services sales to a joint venture of the Company in the amount of $681,773, representing 17.4% of its total revenues. At December 31, 1999 the entire accounts receivable, affiliate was due from the joint venture.
ARTIFICIAL LIFE, INC. (Formerly Neurotec International Corp.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) Periods January 1, 1997 to July 3, 1997 and July 4, 1997 to December 31, 1997 and the Years Ended December 31, 1998 and 1999
Management Estimates
The process of preparing financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. These estimates and assumptions involve the areas of collection of receivables, contract costs, depreciation and amortization and certain accruals, among others. Actual results could differ from those estimates.
2. Summary of Significant Accounting Policies
Basis of Consolidation
The consolidated financial statements include the accounts of Artificial Life, Inc., Artificial Life Europe, Artificial Life Rus, Artificial Life Solutions, Artificial Life Germany, Artificial Life Ventures and IT. All significant intercompany balances and transactions have been eliminated.
All assets and liabilities of Artificial Life Europe, including its subsidiaries Artifical Life Solutions and IT, which has the Swiss Franc as its functional currency, Artificial Life Rus which has the Russian Rouble as its functional currency, and Artificial Life Germany, which has the Euro as its functional currency, are translated at the year end exchange rate. The operations of these companies included in the consolidated statement of operations are translated using the weighted average exchange rate during the period. Translation gains and losses are not included in determining net income but are accumulated as a separate component of stockholder's equity. Foreign currency transaction gains and losses are included in determining net income.
Cash Equivalents
Cash equivalents consist of short-term investments with original maturities of three months or less when purchased.
Property and Equipment
Property and equipment is stated at cost. Depreciation and amortization of property and equipment is calculated using the straight-line method over the following useful lives.
Estimated Useful Lives ------------------------ Classification Predecessor Successor -------------- ------------ ---------- Computer equipment....................... 3-5 years 3 years Furniture and fixtures................... 7 years 5 years Leasehold improvements................... Lease term Lease term Office equipment......................... 5 years 4 years
Expenditures for maintenance, repairs and minor renewals are charged to expense as incurred. Betterments and major renewals are capitalized.
Computer Software Costs
Costs of developing software which are incurred beyond the point of demonstrated technological feasibility are capitalized and, after the product is available for general release to customers, such costs are amortized based on the greater of the charge resulting from the straight-line method over a two-year period or the proportion of current sales to estimated future revenues of the product.
ARTIFICIAL LIFE, INC. (Formerly Neurotec International Corp.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) Periods January 1, 1997 to July 3, 1997 and July 4, 1997 to December 31, 1997 and the Years Ended December 31, 1998 and 1999
Revenue Recognition
The Company recognizes revenues from marketing computer software programs as follows:
Revenues from the sale of initial "software license agreements" for computer programs and related services are recognized upon the delivery of the software.
Development and application services contract revenues and related costs are recognized upon the completion of the contract or certain phases as defined in each agreement.
Revenues from the sale of software products are recognized upon delivery of the software.
There are no significant future costs associated with any of the Company's revenue transactions. Development costs which are not required to be capitalized, marketing and installation costs are charged to earnings as incurred.
Advertising Expense
Advertising costs are charged to expense when incurred. Advertising costs amounted to $660,090 in 1999. There were no advertising costs prior to 1999.
Comprehensive Income
The Company has adopted Statement of Financial Accounting Standards ("SFAS") No. 130, "Reporting Comprehensive Income," as of January 1, 1998. Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as foreign currency translation adjustments, are reported as a separate component of the equity section of the balance sheet, such items, along with net income, are components of comprehensive income. The adoption of SFAS No. 130 had no effect on the Company's net income or stockholders' equity.
Computation of Net Income (Loss) Per Share
The Company adopted SFAS No. 128, "Computation of Earnings Per Share," during 1997. The provision and disclosure requirements for SFAS No. 128 were required to be adopted for interim and annual periods ending after December 15, 1997, with restatement of earnings per share for prior periods. In accordance with SFAS No. 128, basic earnings per share is computed using the weighted average number of common shares outstanding during the period. Diluted earnings per share is computed using the weighted average number of common shares outstanding during the period and the weighted average dilutive common equivalent shares outstanding during the period. Common equivalent shares consist of the incremental common shares issuable upon the exercise of stock options and warrants (using the Treasury Stock method); common equivalent shares are excluded from the calculation if their effect is anti-dilutive. All common equivalent shares of the Company are not dilutive. Therefore, diluted earnings per share is the same as basic earnings per share. Pursuant to SEC Staff Accounting Bulletin No. 98, common stock issued for nominal consideration, prior to the anticipated effective date of an IPO, are required to be included in the calculation of basic and diluted net loss per share, as if they are outstanding for all periods presented. To date, the Company has not had any stock issuances for nominal consideration.
Stock-Based Compensation
The Company has adopted the disclosure provisions of SFAS No. 123, "Accounting for Stock-Based Compensation." As allowed under the provisions of SFAS No. 123, the Company applies Accounting Principles Board Opinion No. 25 and related interpretations in accounting for its employee stock options plans. There are no effects on reported net income (loss) and earnings per share based on the fair value of options and shares as prescribed by SFAS No. 123.
ARTIFICIAL LIFE, INC. (Formerly Neurotec International Corp.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) Periods January 1, 1997 to July 3, 1997 and July 4, 1997 to December 31, 1997 and the Years Ended December 31, 1998 and 1999
Stock Dividend, Reverse Stock Split and Changes in Authorized Stock
On June 10, 1998, the Company declared a dividend of 339 shares of common stock for each share of common stock held to stockholders of record on June 10, 1998. On September 22, 1998 the Company effected a 1-for-2.44 reverse stock split and amended the total authorized shares of Voting Common Stock to 19,000,000 shares and Non-Voting Common Stock to 1,000,000 shares. Effective with the consummation of the IPO on December 17, 1998, the Company amended its articles of organization to amend the total authorized shares of common stock to 30,000,000 shares, all voting, and to authorize 5,000,000 shares of preferred stock. All references in the financial statements to shares, share prices, per share amounts, stock options and authorized shares have been retroactively adjusted for the stock dividend, reverse stock split and change in authorized stock.
Income Taxes
Deferred tax assets and liabilities are recorded for temporary differences between the financial statement and tax basis of assets and liabilities. Deferred tax assets and liabilities are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. A deferred tax asset is recorded for any net operating loss, capital loss and tax credit carryforward for income tax purposes, to the extent their realization is more likely than not. As changes in tax laws or rates are enacted, deferred tax assets and liabilities will be adjusted through the provision for income taxes.
Fair Value of Financial Instruments
Carrying amounts of certain of the Company's financial instruments, including cash and cash equivalents, accounts receivable, accounts payable, accrued expenses and other liabilities approximate fair value due to their short maturities. Based upon rates currently available for loans with similar terms, the carrying value of notes receivable approximates fair value.
Reclassification
Certain items previously reported in specific financial statement captions have been reclassified to conform with the 1999 presentation.
3. Related Party Transactions
The Company had transactions with its former parent company and wholly-owned subsidiaries of the former parent company, MediaCenter GmbH ("MediaCenter") and IST Intelligent Safety Technologies GmbH ("IST"), and a stockholder of the former parent company as follows:
(a) The Company provided contract services to the former parent company, IST and to a stockholder of the former parent company on which it recorded applications revenue of $666,229 and $197,948 for the periods January 1, 1997 to July 3, 1997 and July 4, 1997 to December 31, 1997, respectively. Certain contracts for services are denominated in Deutsche Marks ("DM").
(b) The Company received advances from the former parent company in the amount of DM 120,000. The advances were due on September 30, 1997 with interest at 8.5%. Interest expense on these advances amount to $3,399 and $1,848 for the periods from January 1, 1997 to July 3, 1997 and July 4, 1997 to December 31, 1997, respectively. The advances were repaid in 1997 (see below).
(c) The former parent charged the Company for engineering services rendered. These costs amounted to $39,168 for the period from January 1,
ARTIFICIAL LIFE, INC. (Formerly Neurotec International Corp.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) Periods January 1, 1997 to July 3, 1997 and July 4, 1997 to December 31, 1997 and the Years Ended December 31, 1998 and 1999
1997 to July 3, 1997. No services were rendered by the former parent after the Management Buyout.
(d) Through July 3, 1997, the Company charged the former parent company for various expenses paid by the Company on its behalf as follows:
In 1997, subsequent to the Management Buyout, and as a result of unresolved disputes between the Company and its former parent in connection with existing contractual obligations of the former parent, the Company discontinued performing services for its former parent company and its affiliates. At that time, the Company had in process several contracts for services to be provided to the former parent company and outstanding accounts receivable from the former parent of $160,000. In addition, the Company owed the former parent $119,938 in notes payable, accounts payable and accrued expenses. In December of 1997, the Company and the former parent negotiated a settlement agreement whereby the former parent agreed to forgive all outstanding liabilities owed by the Company and make a cash payment of $230,000 in full settlement of all outstanding accounts receivable and all of its contractual obligations to the Company. The transaction resulted in the recognition of cancellation fee income of $189,938 in 1997. The $230,000 payment was received in full in January 1998.
Compensation paid to the Company's President, Chief Executive Officer and Chairman amounted to $54,254 and $22,500 for the periods January 1, 1997 to July 3, 1997 and July 4, 1997 to December 31, 1997, respectively. In 1998, the Company's President, Chief Executive Officer and Chairman entered into an employment agreement with the Company at an annual salary of $240,000 in 1998 and $264,000 in 1999.
ARTIFICIAL LIFE, INC. (Formerly Neurotec International Corp.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) Periods January 1, 1997 to July 3, 1997 and July 4, 1997 to December 31, 1997 and the Years Ended December 31, 1998 and 1999
On June 29, 1998, the Company issued a note payable to an officer/stockholder in the amount of $500,000. The note is unsecured and bears interest at 10%. Payment of principal and accrued interest is due on January 1, 2000. Interest accrued during the years ended December 31, 1998 and 1999 amounted to $25,000 and $50,000, respectively, on the note payable. Subsequent to year-end, the note was extended to April 30, 2000.
In 1998, the Company made advances totaling $40,000 to Artificial Life Ventures, a company originally owned by a stockholder and an officer/stockholder of the Company. The advances are unsecured, bear interest at 10% and were due on December 31, 1999. In 1999, the Company purchased all of the outstanding stock of this affiliate.
The Company pays expenses on behalf of and provides cash advances to officer/stockholders from time to time. Amounts outstanding are non-interest bearing and due on demand.
See also Notes 1 and 9.
ARTIFICIAL LIFE, INC. (Formerly Neurotec International Corp.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) Periods January 1, 1997 to July 3, 1997 and July 4, 1997 to December 31, 1997 and the Years Ended December 31, 1998 and 1999
4. Income Taxes
The income tax provision (benefit) consists of:
The difference between actual income tax expense and expected income tax expense computed by applying the U.S. federal income tax rate of 34% to income (loss) before income taxes is explained as follows:
ARTIFICIAL LIFE, INC. (Formerly Neurotec International Corp.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) Periods January 1, 1997 to July 3, 1997 and July 4, 1997 to December 31, 1997 and the Years Ended December 31, 1998 and 1999
The tax effects of temporary differences that give rise to the deferred tax assets and deferred tax liabilities at December 31, 1998 and 1999 are presented below:
Successor -------------------------- December 31, 1998 1999 ------------ ------------
Deferred tax assets: Federal net operating loss carryforward $ 687,839 $ 1,999,003 State net operating loss carryforward 190,476 554,361 Foreign net operating loss carryforward - 593,172 Equity in loss of unconsolidated subsidiary - 204,928 Start-up costs capitalized for income tax purposes 23,793 1,087 Other 4,182 4,182 ------------ ------------ 906,290 3,356,733 Valuation allowance on deferred tax asset (896,480) (3,348,622) ------------ ------------ 9,810 8,111 ------------ ------------ Deferred tax liabilities: Prepaid rent deducted for income tax purposes 8,111 8,111 Other 1,699 - ------------ ------------ 9,810 8,111 ------------ ------------
Net deferred tax asset $ - $ - ============ ============
The change in the valuation allowance on deferred tax assets is as follows:
ARTIFICIAL LIFE, INC. (Formerly Neurotec International Corp.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) Periods January 1, 1997 to July 3, 1997 and July 4, 1997 to December 31, 1997 and the Years Ended December 31, 1998 and 1999
At December 31, 1999, the Company has approximately $6,000,000 of federal and state net operating loss carryforwards expiring in 2019 and 2004, respectively. The net operating loss carryforwards may be subject to annual limitations based on ownership changes in the Company's common stock as provided in Section 382 of the Internal Revenue Code. In addition, the Company's German subsidiary has available approximately $1,000,000 of net operating loss carryforwards that can be used to reduce the subsidiaries future taxable income.
5. Commitments
Consortium Agreement
Effective October 10, 1995, the Company entered into a consortium agreement with the Massachusetts Institute of Technology ("MIT"). Under the agreement, MIT will conduct research projects for the "Things That Think Consortium." The Consortium is an international association of corporate members who have joined "to address the future of computation as it is increasingly imbedded in things other than computers." The term of the agreement is for five years through October 9, 2000. The agreement provides for early termination, with one year written notice, as well as renewal options. The Company is obligated to pay an annual membership fee of $125,000 under the agreement. The Company was sharing 50% of this cost with its former parent through June 1997.
On August 6, 1997, the Company obtained a suspension of the contract until February 5, 1998, at which time the contract resumed under its original terms. The Company will be solely responsible for the $125,000 annual cost through October 9, 2000. Total costs incurred by the Company in connection with the agreement amounted to $32,598 for the period January 1, 1997 to July 3, 1997, and $125,000 for each of the years ended December 31, 1998 and 1999.
ARTIFICIAL LIFE, INC. (Formerly Neurotec International Corp.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) Periods January 1, 1997 to July 3, 1997 and July 4, 1997 to December 31, 1997 and the Years Ended December 31, 1998 and 1999
Leases
The Company leases office and other space and various office equipment under various noncancellable leases. Future minimum annual lease payments, exclusive of additional operating costs, are as follows:
Rent expense for the periods January 1, 1997 to July 3, 1997 and July 4, 1997 to December 31, 1997 and the years ended December 31, 1998 and 1999 amounted to approximately $135,900, $92,400, $253,300, and $377,300, respectively. The 1998 and 1999 rent expense is net of approximately $20,400 and $86,000, respectively, which was recorded as part of capitalized software development costs.
Employment Contract
The Company has an employment agreement with its chief executive officer. The agreement is three years in length and provides for a minimum salary level. The agreement includes severance payments under certain conditions of approximately three times the officer's annual compensation. In addition the chief executive officer of the Company is entitled to receive an annual incentive bonus of 3% of the Company's profits from operations.
6. Profit Sharing Plan
Effective October 1, 1995, the Company implemented a 401(k) profit sharing plan for the benefit of all its United States employees. Employees are eligible to participate after twelve months of service and may contribute up to 15% of their compensation subject to statutory limitations. The Company matches 50% of employee contributions up to 1 1/2% of the employee's compensation.
Profit sharing expense for the periods January 1, 1997 to July 3, 1997 and July 4, 1997 to December 31, 1997 and the years ended December 31, 1998 and 1999 amounted to approximately $4,800, $3,700, $10,500, and $21,100, respectively.
ARTIFICIAL LIFE, INC. (Formerly Neurotec International Corp.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) Periods January 1, 1997 to July 3, 1997 and July 4, 1997 to December 31, 1997 and the Years Ended December 31, 1998 and 1999
7. Stockholders' Equity
Public Offering
In August 1998, the Company executed a letter of intent to proceed with a proposed initial public offering of the Company's stock (the "IPO"). The IPO was consummated on December 17, 1998. Expenses incurred in connection with the IPO amounted to $2,597,227, resulting in net proceeds of $9,302,773 to the Company. Upon consummation of the IPO, under the terms of the letter of intent, the underwriters managing the offering will have the right to appoint one member of the Board of Directors. The right to have a representative on the Company's board extends for the term of the Warrant (defined below). The Company has delivered a warrant (the "Warrant") to the underwriters at the closing of the IPO equal to ten percent of the total number of shares sold pursuant to the IPO, 160,000 shares. The Warrant is exercisable any time after one year from the date of closing for a period of four years at a price equal to 120% of the offering price per share, or $10.20 per share. In December 1999, the underwriters exercised 140,000 shares of the Warrant using a net exercise feature resulting in the issuance of 54,810 shares of common stock.
In December 1998 and January 1999, the Underwriter exercised its entire over-allotment option. Under the option, the Underwriter purchased 40,000 additional shares from the Company and 200,000 additional shares from the Company's major stockholder. The shares were purchased at the public offering price of $8.50 per share less the underwriting discounts, commissions and expenses. Net proceeds received by the Company for its portion of the overallotment exercised in January amounted to $302,600, net of expenses of $37,400.
Common Stock
In June 1998, the Company sold 53,278 shares of non-voting common stock and the majority stockholder of the Company sold 409,836 shares of voting common stock through private placements to foreign investors based on arms-length negotiations with unrelated parties. The shares were sold for $3.66 per share. Expenses incurred in connection with the private placements amounted to $13,633. As a result, the Company received net proceeds of $181,367. This stock was unregistered and was subject to restrictions on resale in the United States pursuant to Regulation S promulgated under the Securities Act of 1933, as amended. Upon the closing of the IPO, non-voting common stock was converted into voting common stock.
Subsequent to the sale of stock by the majority stockholder, the Company received a loan of $500,000 from the stockholder.
On September 23, 1998, the Company sold 824,000 shares of voting common stock for $5.00 per share through private placements to foreign investors. Expenses incurred in connection with the private placements amounted to $173,519 resulting in net proceeds of $3,946,481 being received by the Company. The stock was unregistered and was subject to restrictions on resale in the United States pursuant to Regulation S promulgated under the Securities Act of 1933, as amended. Upon the closing of the IPO, the Company registered 164,800 of these shares for inclusion in the public offering.
ARTIFICIAL LIFE, INC. (Formerly Neurotec International Corp.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) Periods January 1, 1997 to July 3, 1997 and July 4, 1997 to December 31, 1997 and the Years Ended December 31, 1998 and 1999
Stock Option Plan
On April 1, 1998, the Company adopted the 1998 Equity Incentive Plan (the "Plan") which provides for the issuance of both non-statutory and incentive stock options to employees, officers, directors and consultants of the Company. At the time the Company reserved 409,811 shares of common stock to be issued under the Plan.
On September 25, 1998, the Plan was amended to increase the shares reserved for issuance under the Plan to a total of 1,200,000 shares; 761,476 shares of voting common stock and 438,524 shares of non-voting common stock. All options issued prior to June 30, 1998 were for voting common stock. With the amendment of the authorized common stock at the time of the IPO, all non-voting common stock options were converted to voting common stock options.
On July 1, 1999, the Plan was amended to increase the shares reserved for issuance under the Plan to a total of 2,700,000.
ARTIFICIAL LIFE, INC. (Formerly Neurotec International Corp.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) Periods January 1, 1997 to July 3, 1997 and July 4, 1997 to December 31, 1997 and the Years Ended December 31, 1998 and 1999
A summary of the status of the Company's stock options under the Plan as of December 31, 1998 and 1999 and the changes during the years then ended is presented below:
In 1999, options for 184,426 shares were exercised using a net exercise feature resulting in the issuance of 139,426 shares.
The following table summarizes information about stock options outstanding under the Plan at December 31, 1999:
ARTIFICIAL LIFE, INC. (Formerly Neurotec International Corp.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) Periods January 1, 1997 to July 3, 1997 and July 4, 1997 to December 31, 1997 and the Years Ended December 31, 1998 and 1999
The Company applies Accounting Principles Board Opinion No. 25 and related interpretations in accounting for its Plan.
Pro forma information regarding net loss and net loss per share is required by SFAS No. 123, which also requires that the information be determined as if the Company had accounted for its employee stock options under the fair value method. In 1998, prior to the completion of the initial public offering of common stock, the fair value of each option grant was estimated using the minimum value method. The minimum value method differs from other methods of valuing options, such as the Black-Scholes option pricing model, because it does not consider the effect of expected volatility. In 1999, the Company estimated the fair value of options granted using the Black-Scholes option pricing model. The fair value of options was estimated at the date of grant using the following weighted average assumptions:
1998 1999 ---- ---- Risk Free interest rate................... 5.4% 6.0% Dividend yield............................ None None Expected life of options in years......... .75 1.50 Expected volatility....................... None 60.0%
Option valuation models require the input of highly subjective assumptions including the expected life of the options and their expected volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options. The Company's pro forma information for 1998 and 1999 is as follows:
1998 1999 ---- ---- Pro forma net loss................ $(2,321,637) $(7,221,251) Pro forma net loss per share...... $ (0.32) $ (0.75)
The pro forma net loss per share above is calculated using the weighted average number of shares of common stock outstanding as described in Note 2. The weighted average fair value of options granted during the year ended December 31, 1998 and 1999 was $0.17 and $2.75, respectively.
Other Stock Options - -------------------
In November 1999, the Company issued stock options for 5,000 shares of common stock at an exercise price of $14.50 per share in connection with its acquisition of the remaining 49% of the outstanding stock of Artificial Life Ventures. The options have a three year life and vest in equal amounts on the first, second and third anniversary of the grant date. The fair value of the options, determined using the Black-Scholes option pricing model, was $25,000.
ARTIFICIAL LIFE, INC. (Formerly Neurotec International Corp.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) Periods January 1, 1997 to July 3, 1997 and July 4, 1997 to December 31, 1997 and the Years Ended December 31, 1998 and 1999
8. Notes Receivable From Stockholders
In connection with the exercise of stock options on July 31, 1998, the Company received notes receivable in the amount of $93,682. The notes are due in biweekly installments through July 31, 2000 with interest at 9%. At December 31, 1998 and 1999, the outstanding balance of these notes receivable amounted to $79,423 and $8,607, respectively.
In connection with the exercise of options on May 7, 1999, the Company received a note receivable in the amount of $674,999. The note is due on May 7, 2000 with interest at 15%. The outstanding balance of this note was $741,374, including accrued interest of $66,375, at December 31, 1999.
9. Accrued Expenses
Accrued expenses at December 31, 1998 and 1999 consist of the following:
Successor ------------------------------ December 31, December 31, 1998 1999 ------------ ------------
Accrued salaries......................... $ 25,282 $ 81,401 Accrued vacations........................ 28,292 144,495 Accrued and withheld payroll taxes....... 12,063 81,803 Accrued professional fees................ 40,099 214,833 Accrued state excise tax................. 21,103 -- Accrued interest on note payable to officer/stockholder.................... 25,000 -- Other liabilities........................ 19,428 63,751 ---------- ---------- Total accrued expenses......... $ 171,267 $ 586,283 ========== ==========
ARTIFICIAL LIFE, INC. (Formerly Neurotec International Corp.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Continued) Periods January 1, 1997 to July 3, 1997 and July 4, 1997 to December 31, 1997 and the Years Ended December 31, 1998 and 1999
10. JOINT VENTURE
In April 1999, the Company entered into a joint venture with two international retailers in the field of e-commerce. The main focus of this joint venture is to sell consumer goods over the Internet using deep discounts and high volume, both in terms of transactions and web visits. As part of the transaction, the Company will license its SmartBot technology to the joint venture. In addition, the Company will provide products and software development and consulting services to the joint venture and receive payments therefor. The partners in the joint venture will be responsible for using their purchasing relationships to obtain certain consumer products which will be sold on the joint venture's e-commerce Website. The Company has allocated up to $2,150,000 of the proceeds from its IPO to purchase its 50% interest in this joint venture and to meet its obligations to contribute additional capital to the joint venture. As of December 31, 1999, $1,022,269 was invested by the Company in the joint venture. In March, 2000 the Company agreed to invest an additional $938,550 in the joint venture. Under the terms of the joint venture agreement, the Company may market any e-commerce applications it develops to other e-commerce companies.
The Company accounts for its investment in the joint venture on the equity method. The summarized unaudited financial information of the joint venture since its inception is as follows:
Unaudited ----------- Earnings data: Revenues $ 31,513 Operating loss (1,003,357) Net loss (1,017,768) Company's equity in net loss (508,884) Balance sheet data: Current assets 455,317 Non-current assets 2,187,530 Current liabilities 1,061,783 Non-current liabilities 677,988 Net assets 903,076 Company's equity in net assets 451,538
The Company's investment in unconsolidated subsidiary at December 31, 1999 is reduced by the elimination of unrealized intercompany profits as of December 31, 1999 in the amount of $327,200.
ARTIFICIAL LIFE, INC. (Formerly Neurotec International Corp.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (Concluded) Periods January 1, 1997 to July 3, 1997 and July 4, 1997 to December 31, 1997 and the Years Ended December 31, 1998 and 1999
11. Segment Information
The Company, whose operations consist of a single line of business, develops, markets and supports "intelligent software robots," software programs that the Company designs to automate and simplify time-consuming and complex business-related internet functions.
At December 31, 1998, the Company had operations located outside the United States in Switzerland and Russia. The Company's operations in Europe commenced late in 1998 and generated no revenues as of December 31, 1998. In 1999, the Company commenced operations in Germany.
Other financial data for the years ended December 31, 1998 and 1999 is as follows:
The Company's entire operations were located in the United States during the year ended December 31, 1997.
12. SUBSEQUENT EVENTS
In February 2000, the Company sold 152,500 shares of common stock through private placements with two foreign investors at prices which approximated quoted market prices on the dates of the sales. Total proceeds to the Company amounted to $4,112,500.