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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 20-F
|_| REGISTRATION STATEMENT PURSUANT TO SECTION 12(b) OR (g) OF THE SECURITIES
EXCHANGE ACT OF 1934 OR
|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 for the fiscal year ended December 31, 2003
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from _________________ to ________________
Commission file number 000-26495
COMMTOUCH SOFTWARE LTD.
(Exact name of Registrant as specified in its charter and
translation of Registrant's name into English)
Israel
(Jurisdiction of incorporation or organization)
1A Hazoran Street
Poleg Industrial Park,
P.O. Box 8511
Netanya 42504, Israel
011-972-9-863-6888
(Address of principal executive offices)
Securities registered or to be registered pursuant to Section 12(b) of the Act.
Title of each class Name of each exchange on which registered
------------------- -----------------------------------------
N/A None
Securities registered or to be registered pursuant to Section 12(g) of the Act.
Ordinary Shares, par value NIS 0.05 per share
(Title of Class)
Securities for which there is a reporting obligation pursuant to
Section 15(d) of the Act.
None
Indicate the number of outstanding shares of each of the issuer's
classes of capital or common stock as of the close of the period covered by the
annual report (December 31, 2003).
Ordinary Shares, par value NIS 0.05 37,104,615 (34,278,498 as of
12.31.03, plus shares issued
in January 2004 due to
exercise of warrants in late
December 2003)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes |X| No |_|
Indicate by check mark which financial statement item the registrant
has elected to follow. Item 17 |_| Item 18 |X|
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PART I
Item 1. Identity of Directors, Senior Management and Advisers.
Not applicable.
Item 2. Offer Statistics and Expected Timetable.
Not Applicable
Item 3. Key Information.
Unless otherwise indicated, all references in this document to "Commtouch," "the
Company," "we," "us" or "our" are to Commtouch Software Ltd. or its wholly-owned
subsidiary, Commtouch Inc., as relating to consolidated financial information
contained herein former wholly-owned subsidiaries Commtouch Latin America Inc.
(dissolved), Commtouch (UK) Ltd. (dissolved) and Wingra, Inc. (sold), and former
majority-owned subsidiary, Commtouch K.K. (Japan) (during 2002 Commtouch
divested itself of its majority holdings and retained an equity interest in this
company, which is now known as Imatrix Corporation).
The selected consolidated statements of operations data for the years ended
December 31, 2001, 2002 and 2003 and the selected consolidated balance sheet
data as of December 31, 2002 and 2003 have been derived from the Consolidated
Financial Statements of Commtouch included elsewhere in this report. The
selected consolidated statements of operations data for the years ended December
31, 1999 and 2000 and the selected consolidated balance sheet data as of
December 31, 1999, 2000 and 2001 have been derived from the Consolidated
Financial Statements of Commtouch not included elsewhere in this report. Our
historical results are not necessarily indicative of results to be expected for
any future period. The data set forth below should be read in conjunction with
"Item 5. Operating and Financial Review and Prospects" and the Consolidated
Financial Statements and the Notes thereto included elsewhere herein:
Year Ended December 31,
------------------------------------------------------------------
1999 2000 2001 2002 2003
--------- --------- --------- --------- ---------
(USD in thousands, except per share data)
Consolidated Statements of Operations Data:
Revenues:
Email services ............................................ $ 4,251 $ 17,771 $ 13,318 $ 3,238 $ 329
Software licenses, maintenance and services ............... -- 1,000 270 200 --
--------- --------- --------- --------- ---------
Total revenues .......................................... 4,251 18,771 13,588 3,438 329
Cost of revenues ............................................. 3,643 11,800 13,962 1,675 581
--------- --------- --------- --------- ---------
Gross profit (loss) ....................................... 608 6,971 (374) 1,763 (252)
--------- --------- --------- --------- ---------
Operating expenses:
Research and development, net ............................. 2,942 10,244 5,884 2,246 1,476
Sales and marketing ....................................... 7,722 26,534 12,894 1,176 1,875
General and administrative ................................ 4,328 13,455 10,337 2,588 1,308
Amortization of prepaid marketing expenses ................ 3,263 4,508 -- -- --
Write-off of property and equipment and other ............. -- -- 10,166 750 --
Amortization of stock-based employee
deferred compensation ................................... 3,436 3,050 2,204 551 247
--------- --------- --------- --------- ---------
Total operating expenses ................................ 21,691 57,791 41,485 7,311 4,906
--------- --------- --------- --------- ---------
Operating loss ............................................... (21,083) (50,820) (41,859) (5,548) (5,158)
Interest and other income (expenses), net .................... 1,232 2,886 583 (60) (1,967)
Equity in earnings (losses) of affiliate ..................... -- -- -- (56) 291
Write-off of impaired long-term investments .................. -- (5,000) (2,000) -- --
Minority interest ............................................ -- 55 285 74 --
--------- --------- --------- --------- ---------
Loss from continuing operations .............................. (19,851) (52,879) (42,991) (5,590) $ (6,834)
Gain on disposal of Wingra ................................ -- -- -- 1,014 --
Discontinued operations - Wingra .......................... -- (1,346) (18,016) (335) --
--------- --------- --------- --------- ---------
Income (Loss) from sale of
discontinued operations ................................... -- (1,346) (18,016) 679 --
--------- --------- --------- --------- ---------
Net Loss ..................................................... $ (19,851) $ (54,225) $ (61,007) $ (4,911) $ (6,834)
--------- --------- --------- --------- ---------
Basic and diluted net loss per share
Loss from continuing operations ........................... $ (2.65) $ (3.42) $ (2.51) $ (0.27) $ (0.28)
Income (Loss) from sale of discontinued
operations .............................................. -- (0.09) (1.05) 0.03 $ --
--------- --------- --------- --------- ---------
Net loss ..................................................... $ (2.65) $ (3.51) $ (3.56) $ (0.24) $ (0.28)
--------- --------- --------- --------- ---------
Weighted average number of shares used in
computing basic and diluted net loss per share ............... 7,487 15,462 17,152 20,854 24,573
--------- --------- --------- --------- ---------
Year Ended December 31,
------------------------------------------------------------------
1999 2000 2001 2002 2003
--------- --------- --------- --------- ---------
(USD in thousands)
Consolidated Balance Sheet Data:
Cash and cash equivalents ................................. $ 65,996 $ 20,831 $ 2,248 $ 1,388 $ 4,125
Marketable securities ..................................... 18,050 8,607 -- -- --
Working capital (deficit) ................................. 88,053 23,768 (607) 549 3,965
Total assets .............................................. 100,336 77,280 9,545 2,984 6,883
Long-term liabilities ..................................... 497 1,825 940 413 2,931
Shareholders' equity ...................................... 95,312 61,728 4,059 1,437 2,457
FORWARD LOOKING STATEMENTS
This report contains forward-looking statements that involve risks and
uncertainties. These statements relate to our future plans, objectives, beliefs,
expectations and intentions. In some cases, you can identify forward-looking
statements by our use of words such as "expects," "anticipates," "believes,"
"intends," "plans," "seeks" and "estimates" and similar expressions. Our actual
results, levels of activity, performance or achievements may differ materially
from those expressed or implied by these forward-looking statements. Factors
that could cause or contribute to these differences include those discussed
below and elsewhere in this report.
RISK FACTORS
You should carefully consider the following risk factors before you decide to
buy our ordinary shares. You should also consider the other information in this
report. If any of the following risks actually occur, our business, financial
condition, operating results or cash flows could be materially adversely
affected. This could cause the trading price of our ordinary shares to decline,
and you could lose part or all of your investment. The risks described below are
not the only ones facing us. Additional risks not presently known to us, or that
we currently deem immaterial, may also impair our business operations.
Business Risks
If the market does not respond favorably to our current and future anti-spam
solutions, we will fail to generate revenues.
Our success will depend on the acceptance and use of our anti-spam solutions by
enterprise and ISP customers. We cannot estimate the size or growth rate of the
potential market for our anti-spam offerings. If the market for anti-spam
solutions fails to grow or grows more slowly than we currently anticipate, our
business will suffer dramatically. Even if that market grows, our solutions may
not achieve broad market acceptance and our business could fail. Since we
released our first anti-spam solution for general distribution only in late June
2003, and anti-spam solutions to be released by us in the future remain
unproven, we still do not have enough experience to evaluate whether our
offerings will achieve broad market acceptance.
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Our Business May be Adversely Affected as a Consequence of Legislation Imposing
Legal Penalties On Distributors of Unsolicited Email
On December 16, 2003, President Bush signed into law the Controlling the Assault
of Non-Solicited Pornography and Marketing Act of 2003 (CAN-SPAM Act), which
establishes a framework of administrative, civil, and criminal tools to combat
spam. The law establishes both civil and criminal prohibitions to assist in
deterring the most offensive forms of spam, including unmarked sexually-oriented
messages and e-mails containing fraudulent headers. Under the law, senders of
email are required to honor a request by a consumer not to receive any further
unsolicited messages.
In addition, various state legislatures have enacted laws aimed at regulating
the distribution of unsolicited email.
Companies that send business-related e-mail messages from or to the countries in
the European Union should be aware that each member state in the European Union
was obligated by October 2003 to implement the Electronic Communications
Directive that imposes restrictions on the use of unsolicited e-mail for
commercial purposes.
These and similar legal measures may have the effect of reducing the amount of
unsolicited email that is distributed and hence diminish the need for our
anti-spam solutions. Any such developments would have an adverse impact on our
revenues.
Dependence upon resellers and product concentration
The Company expects that it will continue to be dependent upon resellers for a
significant portion of its revenues, which will be derived from sales of the
Company's anti-spam solutions. Also, the Company is still developing its
distribution channels and is currently dependent on a relatively small number of
its global resellers/channel partners to close the majority of sales
transactions. If anticipated orders from these resellers fail to materialize, or
one of the key resellers/distribution channels ceases the promotion of the
Company's business, operating results and financial condition will be materially
adversely affected.
Our future revenues are difficult to predict and our quarterly operating results
may fluctuate which could adversely affect the value of your investment.
Because we have a limited history with our relatively new anti-spam solutions
and because of the emerging nature of the markets in which we compete, our
revenue is difficult to predict. Our current and future expense levels are to a
large extent fixed. We may be unable to adjust spending quickly to compensate
for any revenue shortfall, and any significant revenue shortfall would have an
immediate negative effect on our results of operations and share price.
A number of factors, many of which are enumerated in this "Risk Factors"
section, are likely to cause fluctuations in our operating results and/or cause
our share price to decline. Other factors which may cause such fluctuations
include:
o Our ability to successfully develop and market our anti-spam solutions
to new markets, both domestic and international;
o The market acceptance of our new anti-spam solutions;
o The size, timing and fulfillment of orders for our new anti-spam
solutions;
o Our ability to expand our workforce with qualified personnel, as may
be needed;
o Unanticipated bugs or other problems arising in providing our new
anti-spam solutions to customers;
o The success of our resellers' sales efforts to potential customers;
o The solvency of our resellers and their ability to allocate sufficient
resources towards the marketing of our new anti-spam solutions to
their potential customers;
o The rate of adoption of anti-spam solutions by customers in the
current economic environment;
o The threat of de-listing by the NASDAQ;
o The receipt or payment of irregular or nonrecurring revenues or
expenses;
o Our ability to successfully develop and market new, modified and/or
upgraded solutions, as may be needed;
o The substantial decrease in information technology spending;
o Pricing of our solutions;
o Our ability to timely collect fees owed by resellers/customers; and
3
o Effectiveness of our customer support, whether provided by our
resellers or directly by Commtouch.
Because of differing operational factors and the material changes to our
business model, period-to-period comparisons of our operating results are not a
good indication of our future performance. It is likely that our operating
results in some quarters will be below market expectations. Because we have been
and will be going to market with new solutions and have been marketing our
enterprise solution only since late June 2003, it is difficult to evaluate our
business and prospects.
We commenced operations in 1991. Up to 1998, we focused on selling, maintaining
and servicing stand-alone email client software products for mainframe and
personal computers. From 1998 through 2001, we were a provider of outsourced
Web-based email services and, during the first half of 2002, we concentrated on
marketing our software messaging solution. In mid-2002, we began focusing
exclusively on completing development of and selling our new anti-spam
solutions. This change required us to once again adjust our business processes
and to readjust the workforce at Commtouch (predominantly, the sales force).
Therefore, we have little operating history as a provider of our new anti-spam
solutions upon which you may be able to evaluate our business and prospects. It
is still too early to judge whether this business will succeed.
We have many established competitors who are offering a multitude of solutions
to the spam problem
The market for anti-spam solutions is intensely competitive and we expect it to
be increasingly competitive. Increased competition could result in pricing
pressures, low operating margins and the realization of little or no market
share, any of which could cause our business to suffer.
In the market for anti-spam solutions, there are a large number of providers
offering "content filtering" solutions (solutions focusing solely on the content
of potential spam email). Other providers that offer forms of software (gateway)
and/or service based solutions and which may be viewed as direct competitors to
Commtouch include Brightmail(R) and Postini(R). There is a great likelihood
that, as the market for anti-spam solutions further develops and given the
difficult technological hurdles in attempting to create an effective solution,
established Internet security players will enter the market, who may be able to
leverage their market position and resources to capture a portion of the
anti-spam market.
As this market continues to develop, a number of companies with greater
resources than ours could attempt to increase their presence in this market by
acquiring or forming strategic alliances with our competitors or business
partners. Competitors could introduce products with superior features,
scalability and functionality at lower prices than our products and could also
bundle existing or new products with other more established products that
discourage users from purchasing our products. In addition, because there are
relatively low barriers to entry for the software market, we expect additional
competition from other established and emerging companies. Increased competition
is likely to result in price reductions, reduced gross margins and loss of
market share, any of which could harm our business.
Also, there are companies that develop and maintain in-house anti-spam
solutions, such as Microsoft(R) and Yahoo(R). These and other companies could
potentially leverage their existing capabilities and relationships to enter the
anti-spam industry.
Our market's level of competition is likely to increase as current competitors
increase the sophistication of their offerings and as new participants enter the
market. In the future, as we expand our offerings, we may encounter increased
competition in the development and distribution of these solutions. Many of our
current and potential competitors have longer operating histories, larger
customer bases, greater brand recognition and greater financial, technical,
sales, marketing and other resources than we do and may enter into strategic or
commercial relationships on more favorable terms. Some of these competitors have
research and development capabilities that may allow them to develop new or
improved products that may compete with product lines we market and distribute.
New technologies and the expansion of existing technologies may increase
competitive pressures on us. We may not be able to compete successfully against
current and future competitors.
(R)Brightmail, Postini, Microsoft and Yahoo are trademarks of Brightmail, Inc.,
Postini, Inc., Microsoft Corporation and Yahoo! Inc. respectively.
4
Our ability to increase our revenues will depend on our ability to successfully
execute our sales and marketing plan
The complexity of the underlying technological base of our anti-spam solutions
and the current landscape of the anti-spam market require highly trained sales
and marketing personnel to educate prospective resellers and customers regarding
the use and benefits of our solutions. It may take time for our current and
future employees and resellers to learn how to most effectively market our
solutions. Additionally, we are unable to predict the possibility of success
selling newly introduced solutions for which we have little marketing experience
and on which we are relying to produce a substantial portion of our revenues in
the future. As a result of these factors, our sales and marketing organization
may not be able to compete successfully against bigger and more experienced
sales and marketing organizations of our competitors.
We have a history of losses and may never achieve profitability
We incurred net losses of approximately $61.0 million in 2001, $4.9 million in
2002 and $6.8 million in 2003. As of December 31, 2003 and March 31, 2004, we
had an accumulated deficit of approximately $158.5 million and approximately $
160.1 million, respectively. We entered a new and unstable market due to
launching the anti-spam solution, we have not achieved profitability in any
period, and we might continue to incur net losses in the future. If we do not
achieve profitability, our share price may decline further.
Possible need for additional funds
The Company remains very thinly capitalized. As such, we might become dependent
upon raising additional funds to finance our business. Our cash balance at
December 31, 2003 and March 31, 2004 was approximately $4.1 million and
approximately $4.6 million, respectively. In connection with the two private
placements that occurred in July 2003, we raised $3,040,000. In addition, upon
the exercise of certain warrants by the previous convertible loan holders and
the closing of the new convertible loan transaction entered into by the Company
in late November 2003, the Company received an additional amount of
approximately $4,000,000. See "Risk Factors--Investment Risks--We may need
additional capital" below. If we are unable to raise additional funds, the
Company could fail. There can be no assurance that we will be able to raise
necessary funds or that we will be able to do so on terms acceptable to us. If
needed, our inability to obtain adequate capital would limit our ability to
continue our operations. Any such additional funding may result in significant
dilution to existing shareholders.
On May 18, 2004, the Company entered into a definitive agreement for the private
placement of ordinary shares of the Company to existing institutional investors
for gross proceeds of approximately $3.9 million. The investment is contingent
upon shareholders approval and additional closing conditions. In the past we
have received funds for the development of our business from the State of Israel
through the Office of the Chief Scientist, or the OCS. Grants received from the
OCS through 2002 that the Company potentially will be obligated to repay totaled
approximately $800,000.
Risk of Litigation
Legal proceedings can be expensive, lengthy and disruptive to normal business
operations, regardless of their merit. Moreover, the results of complex legal
proceedings are difficult to predict and an unfavorable resolution of a lawsuit
or proceeding could have a material adverse effect on the Company's business,
results of operations or financial condition.
In May 2003, Commtouch settled the shareholder class action lawsuit filed on
behalf of shareholders against the company in early 2001. The litigation was
initiated against the company and two members of management in response to the
company's announcement that it had decided to restate unaudited earnings for the
first three quarters of 2000, alleging violations of the antifraud provisions of
the Securities Exchange Act of 1934.
Indemnification of Directors and Officers
The Company has agreements with its directors, subject to Israeli law, that
provide for the Company to indemnify these directors for any of the following
obligations or expenses incurred as a result of an act or omission of such
persons in their capacity as directors: (a) any monetary obligation imposed upon
them for the benefit of a third party by a judgment, including a settlement or
an arbitration decision, confirmed by the court, and (b) reasonable litigation
expenses, including legal fees, actually incurred by such a director or imposed
upon the director by a court order, in a proceeding brought against him/her by
5
or on behalf of the Company or by others, or in connection with a criminal
proceeding in which he/she was acquitted, or in connection with a criminal
action which does not require criminal intent in which he/she was convicted.
Risk due to economic conditions
Should economic conditions fail to improve, our ability to sell our new
anti-spam solutions could be negatively impacted. Furthermore, even if we are
successful in selling our solutions, our ability to collect outstanding
receivables may be significantly impacted by liquidity issues of our resellers'
customers and/or OEM partners' customers and/or our resellers/OEM partners
themselves, which may negatively affect our ability to recognize future revenue
based on sales. As a result, we may experience shortfalls in our future
revenues.
The loss of our key employees would adversely affect our ability to manage our
business, therefore causing our operating results to suffer and the value of
your investment to decline
Our success depends on the skills, experience and performance of our senior
management and other key personnel. The loss of the services of any of our
senior management or other key personnel, including Gideon Mantel, our Chief
Executive Officer and Amir Lev, our President and Chief Technical Officer, could
materially and adversely affect our business. The loss of our software
developers may also adversely affect our anti-spam solutions, therefore causing
our operating results to suffer and the value of your investment to decline. We
do not have employment agreements inclusive of set periods of employment with
any of these key personnel. We cannot prevent them from leaving at any time. We
do not maintain key-person life insurance policies on any of our employees.
Our low head-count of 48 employees (as of March 31, 2004) continues to strain
our operational resources, and although the Company added additional sales and
support personnel during 2003 and early 2004, the lack of sufficient personnel
may compromise our ability to enhance revenues.
Our business and operating results could suffer if we do not successfully
address the risks inherent in doing business overseas
At December 31, 2003, we had sales offices in Israel and the United States. We
have also begun marketing of our anti-spam solutions in international markets by
utilizing appropriate distributorship channels. However, we may not be able to
compete effectively in international markets due to various risks inherent in
conducting business internationally, such as:
o differing technology standards;
o inability of distribution channels to successfully market our
anti-spam solutions;
o export restrictions, including export controls relating to encryption
technologies;
o difficulties in collecting accounts receivable and longer collection
periods;
o unexpected changes in regulatory requirements;
o political and economic instability;
o potentially adverse tax consequences;
o the adoption of new legal penalties which may discourage the
distribution of unsolicited email messages; and
o potentially reduced protection for intellectual property rights.
Any of these factors could adversely affect the Company's prospective
international sales and, consequently, business and operating results.
Terrorist attacks such as the attacks that occurred in New York and Washington,
D.C. on September 11, 2001 and other attacks or acts of war may adversely affect
the markets on which our ordinary shares trade, our financial condition and our
results of operations
On September 11, 2001, the United States was the target of terrorist attacks of
unprecedented scope. These attacks caused major instability in the U.S. and
other financial markets. There could be further acts of terrorism in the United
6
States or elsewhere that could have a similar impact. Leaders of the U.S.
government have announced their intention to actively pursue and take military
and other action against those behind the September 11, 2001 attacks and to
initiate broader action against national and global terrorism. In this regard,
the U.S. recently led a coalition of forces in attacks on Afghanistan and Iraq.
The worldwide ramifications of such attacks are unknown at this time. Armed
hostilities or further acts of terrorism would cause further instability in
financial markets and could directly impact our financial condition and our
results of operations.
Technology Risks
We might not have the resources or skills required to adapt to the changing
technological requirements and shifting preferences of our customers and their
users.
The spam and anti-spam industry is characterized by difficult technological
challenges, sophisticated "spammers" and constantly evolving spam practices and
targets that could render our anti-spam solutions and proprietary technology
ineffective. Our success depends, in part, on our ability to continually enhance
our existing anti-spam solutions and to develop new solutions, functions and
technology that address the potential needs of prospective customers and their
users. The development of proprietary technology and necessary enhancements
entails significant technical and business risks and requires substantial
expenditures and lead-time. We may not be able to keep pace with the latest
technological developments. We may not be able to use new technologies
effectively or adapt to customer or end user requirements or emerging industry
standards. Also, we must be able to act more quickly than our competition, and
may not be able to do so.
Our software may be adversely affected by defects, which could cause our
customers or end users to stop using our solutions
Our anti-spam solutions are based in part upon new and complex software. Complex
software often contains defects, particularly when first introduced or when new
versions are released. Although we conduct extensive testing, we may not
discover software defects that affect our new or current solutions or
enhancements until after they are delivered. Although we have not experienced
any material software defects to date in our anti-spam solutions offering, it is
possible that, despite testing by us, defects may exist in the software we
license. These defects could cause interruptions in our anti-spam solutions for
customers that could damage our reputation, create legal risks, cause us to lose
revenue, delay market acceptance or divert our development resources, any of
which could cause our business to suffer.
Investment Risks
We may need additional capital
We have invested heavily in technology development. We expect to continue to
spend financial and other resources on developing and introducing new offerings
and maintaining our corporate organizations and strategic relationships. We also
expect to invest resources in research and development projects to develop
enhanced anti-spam solutions for enterprises and, possibly, other target
markets.
Based on the cash balance at December 31, 2003, the payment in January 2004 of
approximately $1 million on behalf of warrants exercises by previous convertible
note holders, current projections of revenues, additional signed financing
agreements with investors, related expenses and the ability to further curtail
certain discretionary expenses, the Company believes it has sufficient cash to
continue operations for at least the next twelve months.
If we cannot satisfy Nasdaq's maintenance requirements, it may delist our
ordinary shares from its Smallcap Market and we may not have an active public
market for our ordinary shares. The absence of an active trading market would
likely make our ordinary shares an illiquid investment.
Our ordinary shares are quoted on the Nasdaq SmallCap Market. To continue to be
listed, we are required to maintain shareholders' equity of at least $2,500,000,
or market value of our outstanding shares (excluding shares held by company
insiders and principal shareholders) of at least $35,000,000, or we must have
realized at least $500,000 in net income from continuing operations in our last
fiscal year or in two of our last three fiscal years. Since our share price as
quoted on the Nasdaq dropped below a price that lowered our market value to
below $35,000,000 and our shareholders' equity was below $2.5 million, we
received a Nasdaq Staff Determination letter on May 10, 2004 indicating that
Commtouch had failed to comply with the stockholders' equity, net income and
7
market value of publicly held shares requirements for continued listing, as set
forth in Nasdaq's Marketplace Rule 4320(e)(2)(B), and that its securities were
therefore subject to delisting from The Nasdaq SmallCap Market (as noted below,
Commtouch's submission of an appeal has automatically delayed the delisting
process). The subject rule requires compliance with at least one of the above
requirements in order to maintain listing with the Nasdaq.
Commtouch has appealed the Nasdaq Staff Determination and has requested a
hearing before a Nasdaq Listing Qualifications Panel to review the Staff
Determination. The hearing is set for June 17, 2004. The hearing request has
stayed the delisting of Commtouch's securities pending the Panel's decision,
which means that in the interim period the Company's shares will continue to be
traded on the Nasdaq SmallCap Market. There can be no assurance the Panel will
grant Commtouch's request for continued listing although the Company is working
on a plan for compliance with the Nasdaq listing rules.
Accordingly, there can be no assurance that we will continue to comply with the
Nasdaq listing requirements for listing on the Nasdaq SmallCap Market.
On May 18, 2004, the Company entered into a definitive agreement for the private
placement of 5,131,583 ordinary shares of the Company at a purchase price of
$0.76 per share to mostly existing institutional investors for gross proceeds to
the Company of approximately $3.9 million.
If we will not be in compliance with any of these tests in the future, Nasdaq
may delist our ordinary shares. If this occurs, trading in our shares may be
conducted in the over-the-counter market in the so-called "pink sheets" or, if
available, the "OTC Bulletin Board Service." As a result, an investor would
likely find it significantly more difficult to dispose of, or to obtain accurate
quotations as to the value of, our shares.
Also, Nasdaq may delist our ordinary shares if it deems it necessary to protect
investors and the public interest.
If our shares are delisted, they may become subject to the SEC's "penny stock"
rules and be more difficult to sell. In addition, it may cause the occurrence of
an event of default according to the November Securities Purchase Agreement
signed on November 26, 2003, and thus may result in the redemption of the notes
by the lenders, and/or penalties to be paid in cash.
SEC rules require brokers to provide information to purchasers of securities
traded at less than $5.00 and not traded on a national securities exchange or
quoted on the Nasdaq Stock Market. If our shares become "penny stock" that is
not exempt from these SEC rules, these disclosure requirements may have the
effect of reducing trading activity in our shares and making it more difficult
for investors to sell. The rules require a broker-dealer to deliver a
standardized risk disclosure document prepared by the SEC that provides
information about penny stocks and the nature and level of risks in the penny
stock market. The broker must also give bid and offer quotations and broker and
salesperson compensation information to the customer orally or in writing before
or with the confirmation. The SEC rules also require a broker to make a special
written determination that the penny stock is a suitable investment for the
purchaser and receive the purchaser's written agreement to the transaction
before a transaction in a penny stock.
Our directors, executive officers and principal shareholders will be able to
exert significant influence over matters requiring shareholder approval and
could delay or prevent a change of control.
Our directors and affiliates of our directors, our executive officers and our
shareholders who currently individually beneficially own over five percent of
our ordinary shares, beneficially own, in the aggregate, approximately 39.34% of
our outstanding ordinary shares as of March 31, 2004 plus warrants and options
exercisable within 60 days thereof. If they vote together (especially if they
were to convert all beneficial holdings into shares entitled to voting rights in
the Company), these shareholders will be able to exercise significant influence
over all matters requiring shareholder approval, including the election of
directors and approval of significant corporate transactions. This concentration
of ownership could also delay or prevent a change in control of Commtouch. The
above percentage of beneficial ownership includes warrants and options totaling
2.79% of the outstanding ordinary shares which are underwater as of March 31,
2004.
These significant shareholders will be able to significantly influence and
possibly exercise control over most matters requiring approval by our
shareholders, including the election of directors and approval of significant
corporate transactions. This concentration of ownership may also have the effect
of delaying or preventing a change in control. In addition, conflicts of
8
interest may arise as a consequence of these significant shareholders control
relationship with us, including:
o conflicts between significant shareholders, and our other shareholders
whose interests may differ with respect to, among other things, our
strategic direction or significant corporate transactions;
o conflicts related to corporate opportunities that could be pursued by
us, on the one hand, or by these shareholders, on the other hand; or
o conflicts related to existing or new contractual relationships between
us, on the one hand, and these shareholders, on the other hand.
Furthermore, InfoSpace holds the right to name one director to our Board as long
as it continues to hold at least 620,022 shares, including the shares issuable
upon exercise of the InfoSpace warrant. It named Thomas Camp to the Board under
this provision, who resigned on August 22, 2001 and was not replaced by
Infospace.
Substantial sales of our ordinary shares could adversely affect our share price.
The sale, or availability for sale, of substantial quantities of our ordinary
shares may have the effect of further depressing its market price. A large
number of our ordinary shares which were previously subject to resale
restrictions, are currently eligible for resale. In addition a significant
number of shares are eligible for resale in the future, i.e. those shares that
may be issued if the lenders in the new convertible loan transaction of November
2003 decide to exercise warrants and/or convert the Company's loan obligations
to equity, as well as those shares that will be eligible for resale due to the
exercise of other warrants issued during 2003. These shares will dilute existing
shareholders.
Risk of failure to honor registration rights for the 2002 and 2003 private
placements
According to the agreements with the Selling Securityholders under Registration
Statements on Forms F-3 filed with the SEC on May 15, 2002, October 20, 2003 and
January 6, 2004, should the Company fail to maintain the effectiveness of those
Registration Statements for the periods stated in the respective agreements, the
Company risks having imposed on it liquidated damages as defined in those
agreements. For details about the penalties for the 2002 private placement,
refer to Exhibit 2.8 of the Report on Form 20F filed on April 26, 2002. For
details about the penalties for the July 2003 private placements, refer to the
Report on Form 6K for the month of July, filed on July 28, 2003, and for the
month of August filed on August 15, 2003. For details about the penalties for
the November 2003 private placement, refer to Form 6K for the month of November,
filed December 2, 2003. For details about the penalties for the May 2004 private
placement, refer to Form 6K for the month of May, filed May 19, 2004.
Risk of occurrence of event of default under Securities Purchase Agreement
The Company is required to abide by the terms and provisions of the Securities
Purchase Agreement of November 2003. Upon failure to do so, for example, failure
to pay principal or interest, we would be in default of the agreement. For
details about the events of default, refer to the Report on Form 6K for the
month of December, filed on December 2, 2003.
The lenders were granted security interests in all of the Company's assets. If
an event of default were not cured by the Company, the loan would accelerate and
all amounts due under the loan would immediately become due and payable. If the
Company were unable to repay the loan amounts, the lenders, among other things,
would have the right to foreclose on their security interests in the Company's
assets by seizing and selling all the Company's assets.
Intellectual Property Risks
If we fail to adequately protect our intellectual property rights or face a
claim of intellectual property infringement by a third party, we could lose our
intellectual property rights or be liable for significant damages.
We regard our patent pending technology, copyrights, service marks, trademarks,
trade secrets and similar intellectual property as critical to our success, and
rely on patent, trademark and copyright law, trade secret protection and
confidentiality or license agreements with our employees and customers to
protect our proprietary rights. Third parties may infringe or misappropriate our
patent pending technology, trade secrets, copyrights, trademarks and similar
proprietary rights. We have recently converted two provisional patent
applications into a formal patent application, and we expect to file at least
one additional provisional patent application covering certain aspects of our
anti-spam technology. We may seek to patent certain additional software or other
technology in the future. Any such patent applications might not result in
patents issued within the scope of the claims we seek, or at all. We cannot be
certain that our software does not infringe issued patents that may relate to
9
our anti-spam solutions. In addition, because patent applications in the United
States are not publicly disclosed until the patent is issued, applications
previously may have been filed which relate to our anti-spam solutions.
Other parties may assert infringement claims against us. We may also be subject
to legal proceedings and claims from time to time in the ordinary course of our
business, including claims of alleged infringement of the patents, trademarks
and other intellectual property rights of third parties by ourselves and our
licensees. Such claims, even if not meritorious, could result in the expenditure
of significant financial and managerial resources.
Despite our precautions, unauthorized third parties may copy certain portions of
our technology or reverse engineer or obtain and use information that we regard
as proprietary. In addition, the laws of some foreign countries do not protect
proprietary rights to the same extent as do the laws of the United States. Our
means of protecting our proprietary rights in the United States or abroad may
not be adequate and competitors may independently develop similar technology.
We also continue to hold a perpetual mail server license which was previously
utilized in our hosted email service offering, and may license other technology
as the need arises. We cannot be certain that, apart from the mail server
license, other third-party content licenses will be available to us on
commercially reasonable terms or that we will be able to successfully integrate
the technology into our products. These third-party licenses may expose us to
increased risks, including risks associated with the assimilation of new
technology, the diversion of resources from the development of our own
proprietary technology, and our inability to generate revenues from new
technology sufficient to offset associated acquisition and maintenance costs.
The inability to obtain any of these licenses could result in delays in product
development until equivalent technology can be identified, licensed and
integrated. Any such delays could cause our business/financial condition and
operating results to suffer.
Governmental regulation and legal uncertainties could impair the growth of the
Internet, decrease the distribution of unsolicited bulk (spam) email and
decrease demand for our anti-spam solutions or increase our cost of doing
business.
While laws aimed at curtailing the spread of spam have been adopted by the U.S.
federal government and some states (see above Risk Factors - Business Risks),
enforcement has not been widespread and generally there has been a continuing
trend of increasing spam traffic. The growth and development of the spam market
may prompt calls for more stringent Internet user protection laws that may limit
the ability of companies promoting or delivering spam online. Moreover, the
applicability to the Internet of existing laws in various jurisdictions
governing issues such as property ownership, sales and other taxes, libel and
personal privacy is uncertain and may take years to resolve. The adoption of
additional laws or regulations, or the application of existing laws or
regulations to the Internet, may impair the growth of the Internet or commercial
online services. All or some of the above laws could decrease the demand for our
anti-spam solutions and increase our cost of doing business, or otherwise harm
our business and operating results.
Risks Relating to Operations in Israel
We have important facilities and resources located in Israel, which has
historically experienced severe economic instability and military and political
unrest.
We are incorporated under the laws of the State of Israel. Our principal
research and development facilities are located in Israel. Although the
substantial majority of our past sales were made to customers outside Israel, we
are nonetheless directly influenced by the political, economic and military
conditions affecting Israel. Any major hostilities involving Israel, or the
interruption or curtailment of trade between Israel and its present trading
partners, could significantly harm our business, operating results and financial
condition.
Israel's economy has been subject to numerous destabilizing factors, including a
period of rampant inflation in the early to mid-1980's, low foreign exchange
reserves, fluctuations in world commodity prices, military conflicts and civil
unrest. In addition, Israel and some companies doing business with Israel have
been the subject of an economic boycott by Arab countries since Israel's
establishment. These restrictive laws and policies may have an adverse impact on
our operating results, financial condition or expansion of our business.
Since the establishment of the State of Israel in 1948, a state of hostility has
existed between Israel and most of the Arab countries in the region. Peace talks
between Israel and the Palestinian Authority began in the early 1990s, but they
broke down in mid-2000. Attacks on Israel by Palestinian terrorists, and
military responses by Israel, have accelerated considerably since late 2000. We
cannot predict whether or when a peace process will resume, whether a full
resolution of these problems will be achieved, the nature of any such resolution
or any consequences that any of these factors may have on us. Any future armed
10
conflicts or political instability in the region could negatively affect our
business or harm our results of operations.
Our results of operations may be negatively affected by the obligation of key
personnel to perform military service.
Certain of our officers and employees are currently obligated to perform annual
reserve duty in the Israel Defense Forces and are subject to being called for
active military duty at any time. Although Commtouch has operated effectively
under these requirements since its inception, we cannot predict the effect of
these obligations on Commtouch in the future. Our operations could be disrupted
by the absence, for a significant period, of one or more of our officers or key
employees due to military service.
Because a substantial portion of our revenues historically have been generated
in U.S. dollars and a portion of our expenses have been incurred in New Israeli
Shekels, our results of operations may be adversely affected by inflation and
currency fluctuations.
We have generated a substantial portion of our revenues in U.S. dollars and
incurred a portion of our expenses, principally salaries and related personnel
expenses in Israel, in New Israeli Shekels, commonly referred to as NIS. As a
result, we have been exposed to the risk that the rate of inflation in Israel
will exceed the rate of devaluation of the NIS in relation to the dollar or that
the timing of any devaluation may lag behind inflation in Israel. In 2002 and
for a number of years prior to 1999, the rate of devaluation of the NIS against
the dollar exceeded the rate of inflation. This trend was reversed in 2003. We
cannot predict the trend for future years. If the dollar cost of our operations
in Israel increases, our dollar-measured results of operations will be adversely
affected. Our operations also could be adversely affected if we are unable to
guard against currency fluctuations in the future. Accordingly, we may enter
into currency hedging transactions to decrease the risk of financial exposure
from fluctuations in the exchange rate of the dollar against the NIS. These
measures, however, may not adequately protect us from material adverse effects
due to the impact of inflation in Israel.
The government programs and benefits which we currently receive require us to
meet several conditions and may be terminated or reduced in the future.
Prior to 1998, we received grants from the Government of Israel, through the
Office of the Chief Scientist (OCS), for the financing of a significant portion
of our research and development expenditures in Israel. In 2001 and 2002, we
applied for additional grants and we may apply for additional grants in the
future. In 1999 and 2000, we did not receive any grants from the OCS. In 2001 we
received $0.6 million and in 2002 we received $0.2 million. While we submitted
an application for an additional grant in 2003, we decided not to draw any funds
thereunder during 2003. The OCS budget has been subject to reductions which may
affect the availability of funds for this prospective grant and other grants in
the future. Therefore, we cannot be certain that we will continue to receive
grants at the same rate, or at all. In addition, the terms of any future OCS
grants may be less favorable than our past grants.
In connection with research and development grants received from the OCS, we
must pay royalties to the OCS on the revenue derived from the sale of products,
technologies and services developed with grants from the OCS. We account for
these royalties by recording an accrual in our financial statements. Because we
determined that no revenue is expected from some of these projects, as of
December 31, 2001 we decided to write down the related $0.4 million accrual we
recorded in past years. The OCS subsequently confirmed the status of these
projects as being non-royalty-bearing. The OCS would be entitled to revisit the
status of these projects in the future if the Company were to commence utilizing
technology developed under these projects.
The terms of the OCS grants and the law pursuant to which the grants are made
restrict our ability to manufacture products or transfer technologies developed
using OCS grants outside of Israel. This restriction may limit our ability to
enter into agreements for those products or technologies, without OCS approval.
We cannot be certain that the approvals of the OCS will be obtained on terms
that are acceptable to us, or at all. In connection with our grant applications,
we have made representations and covenants to the OCS. The funding from the OCS
is subject to the accuracy of these representations and covenants and to our
compliance with the conditions and restrictions imposed by the OCS. If we fail
to comply with any of these conditions or restrictions, we could be required to
repay any grants previously received, together with linkage adjustment to the
Israeli consumer price index and interest, and would likely be ineligible to
receive OCS grants in the future.
Grants received from the OCS through 2002 that the Company potentially will be
obligated to repay totaled approximately $800,000.
The tax benefits we are currently entitled to from the Government of Israel may
be reduced or terminated in the future.
11
Pursuant to the Law for the Encouragement of Capital Investments, the Government
of Israel through the Investment Center has granted "approved enterprise" status
to a portion of our capital investment programs. The portion of our income
derived from our approved enterprise program will be exempt from tax for a
limited period of two years commencing in the first year in which we have
taxable income, and will be subject to a reduced tax for an additional period of
five to eight years dependent on the percentage of holdings of our shares by
foreign shareholders. The benefits available to an approved enterprise are
conditioned upon the fulfillment of specified conditions, including a required
amount of investments in fixed assets and a portion of these investments being
made with net proceeds of equity capital raised by us as stipulated in
applicable law and in the specific certificates of approval. If we fail to
comply with these conditions, in whole or in part, we may be required to pay
additional taxes (together with linkage adjustment to the Israeli consumer price
index and interest) for the period in which we benefited from the tax exemption
or reduced tax rates and would likely be denied these benefits in the future. In
addition, the law and regulations prescribing the benefits provide for an
expiration date for the grant of new benefits. The expiration date has been
extended several times in the past. The expiration date currently in effect is
June 30, 2004 (which may be extended by ministerial decision until December 31,
2004), and no new benefits will be granted after that date unless the expiration
date is extended. We cannot assure you that new benefits will be available after
June 30, 2004 or that benefits will be continued in the future at their current
levels or at all.
Israeli courts might not enforce judgments rendered outside of Israel and it
might therefore be difficult for an investor to recover any judgment against any
of our officers or directors resident in Israel.
We are organized under the laws of Israel, and we maintain significant
operations in Israel. Certain of our officers and directors named in this report
reside outside of the United States. Therefore, you might not be able to enforce
any judgment obtained in the U.S. against us or any of such persons. You might
not be able to bring civil actions under U.S. securities laws if you file a
lawsuit in Israel. However, we have been advised by our Israeli counsel that,
subject to several limitations, Israeli courts may enforce a final judgment of a
U.S. court for liquidated amounts in civil matters after a hearing in Israel. We
have appointed Commtouch Inc., our U.S. subsidiary, as our agent to receive
service of process in any action against us arising from this report. We have
not given our consent for our agent to accept service of process in connection
with any other claim and it may therefore be difficult for an investor to effect
service of process against us or any of our non-U.S. officers, directors and
experts relating to any other claims. If a foreign judgment is enforced by an
Israeli court, it may be payable in Israeli currency.
Provisions of Israeli law may delay, prevent or make difficult an acquisition of
Commtouch, which could prevent a change of control and therefore depress the
price of our shares.
Israeli corporate law regulates mergers, votes required to approve mergers and
acquisitions of shares through tender offers, requires special approvals for
transactions involving significant shareholders and regulates other matters that
may be relevant to these types of transactions. Furthermore, Israel tax
considerations may make potential transactions unappealing to us or to some of
our shareholders and tax reform in Israel can reduce potential tax benefits, and
limit our potential profitability.
Item 4. Information on the Company.
Overview
We are a provider of anti-spam solutions to enterprise customers. The Company
offers its enterprise anti-spam solution to small, medium and large enterprises
through a variety of distribution channels, namely various reseller channels.
The solutions are also available for integration with security, content
filtering, anti-virus and other filtering solutions through alliances and
strategic partnerships, including OEM (Original Equipment Manufacturer)
arrangements. In the middle of 2004, the Company is expected to release a first
version of its ISP (Internet Service Provider) anti-spam solution. The solutions
are marketed worldwide through the Company's internal sales force and external
distribution channels.
In its previous capacity as a dedicated email service provider to millions of
users, the Company found it necessary to design an effective strategy to
eliminate millions of unsolicited commercial email messages daily. It is this
strategy that has led the Company to develop and deliver its current anti-spam
solutions, which are positioned to tackle sophisticated spam attacks. A
combination of proprietary and patent-pending technologies makes it possible for
Commtouch to detect, alert and block most spam attacks as they are distributed
over the Internet.
12
Commtouch Offerings
We offer a comprehensive enterprise class anti-spam solution (known as
"Commtouch Anti-Spam Enterprise Gateway"), consisting of both a software element
(the "Enterprise Gateway") and a service component (the "Detection Center"). At
the Enterprise Gateway, messages are filtered at the organization's entry point,
before being distributed to recipients, with added user-level controls and a top
level of secure spam detection services from the Detection Center, all allowing
for real-time reaction to worldwide spam attacks. At the heart of the solution,
however, is the Detection Center, which detects new spam attacks as soon as they
are launched and distributed over the Internet. The Detection Center provides
real-time spam detection services to enterprise customers by maintaining
constant communication with Enterprise Gateways that are locally installed at
customer premises in different locations worldwide. The Detection Center
collects information from multiple sources about new spam attacks, analyzes the
input using Commtouch patent-pending technology, identifies and detects spam,
classifies the data, matches its stored information against outstanding queries
for spam detection from Enterprise Gateways and replies in real-time back to the
Enterprise Gateways with a prioritized and accurate resolution. The whole
process takes no more than 300ms. Enterprise privacy is kept at a maximum
because the content of incoming email messages is not seen by the Detection
Center.
In particular, enterprise anti-spam solution operates to help eliminate spam as
follows:
Inbound email enters the Enterprise Gateway, a software add-on to the
enterprise SMTP server.
The Enterprise Gateway matches key characteristics of the message with
predefined spam policies created by IT managers or end-users.
If the Enterprise Gateway does not match the message to a known source,
either spam or not spam, it compares characteristics of the incoming
message against the Enterprise Gateway database of recently identified
spam.
If the message remains suspicious, the Enterprise Gateway queries the
Detection Center for remote spam detection and classification services.
The outgoing query consists of encrypted digital signatures taken from
e-mail information to ensure enterprise security and confidentiality.
The Detection Center weighs the values of the outstanding query against its
vast database of real-time information about known spam messages and
sources of spam, and replies to the Enterprise Gateway with a unique and
up-to-date classification.
The Enterprise Gateway applies a locally predefined action to the message
and may store the information internally to match against new incoming
messages bearing similar characteristics.
In addition to working with Microsoft Exchange server platforms, during the
first half of 2004 Commtouch will be releasing an enterprise class anti-spam
solution that will work with a Lotus Notes server platform.
We also offer an anti-spam solution by way of a Software Development Kit
("SDK"). The SDK enables third-party vendors to integrate the Commtouch
anti-spam solution advantages into their existing offerings, providing them with
full spam identification and spam classification services from the Detection
Center. These vendors benefit from Commtouch expertise in blocking spam and
other unwanted email traffic without the need to develop and dedicate a service
department in-house. The SDK enables full communication with the remote
Detection Center, receiving results to queries about suspicious messages. Each
such vendor has the flexibility to determine how best to integrate the SDK into
their solution. For example, if the Detection Center classifies a specific
message as spam, the vendor's application may respond by either quarantining the
message, rejecting it completely or sending a bounce-back message to its sender
or any other option provided by the vendor's specific application.
The SDK consists of a set of APIs, which receive incoming messages as input from
the vendor's application, returning the status of the message as output from the
SDK. Each vendor can implement its solution differently, making the unique
advantages of SDK flexible to match particular needs.
Products that may benefit from integration of the SDK solution include:
o Anti-virus applications
o Content filtering solutions
13
o Firewall systems
o Security servers
o Telco and cellular phone systems
o Internet Service Provider services
o Anti-spam applications
o Other network appliances
Further, we are in the infancy stage of marketing an Internet Solution Provider
anti-spam solution ("ISP Solution"). ISPs purchasing this solution will install
Commtouch software ("engine") on a front end server (in front of the ISP's
messaging server), which will initially receive and classify email, in
conjunction with the detection capabilities of the Commtouch Detection Center.
ISPs will be allowed the flexibility of defining which Internet protocols (IPs)
will be banned from delivering messages to their messaging system, and those
messages that are allowed to enter but are suspected of being spam will be
delivered to end users with a special tag identifying them as suspected spam.
Competitive Landscape
The markets in which Commtouch competes are intensely competitive and rapidly
changing. We believe there is no single competitor that offers the complete
package of anti-spam protection that Commtouch provides. We are aware of
competitors that provide anti-spam products either alone or as part of a
complete messaging system or email security system.
Commtouch's principal competition is from companies that offer various e-mail
content filtering products. Companies that sell products that compete with some
of the features within our products include Brightmail, Postini, Tumbleweed,
CipherTrust, SurfControl, Clearswift Technologies, and Trend Micro Incorporated.
The principal competitive factors in our industry include price, product
functionality, product integration, platform coverage and ability to scale,
worldwide sales infrastructure and global technical support. Some of our
competitors have greater financial, technical, sales, marketing and other
resources than we do, as well as greater name recognition and a larger installed
customer base. Additionally, some of these competitors have research and
development capabilities that may allow them to develop new or improved products
that may compete with product lines we market and distribute.
We expect that the market for anti-spam solutions will become more consolidated
with larger companies being better positioned to compete in such an environment
in the long term. As this market continues to develop, a number of companies
with greater resources than ours could attempt to increase their presence in
this market by acquiring or forming strategic alliances with our competitors or
business partners. Our success will depend on our ability to adapt to these
competing forces, to develop more advanced products more rapidly and less
expensively than our competitors, and to educate potential customers as to the
benefits of licensing our products rather than developing their own products.
Competitors could introduce products with superior features, scalability and
functionality at lower prices than our products and could also bundle existing
or new products with other more established products that discourage users from
purchasing our products. Increased competition is likely to result in price
reductions, reduced gross margins and loss of market share, any of which could
harm our business.
See also disclosure under "Item 3. Key Information- RISK FACTORS--Business
Risks--We have many established competitors who are offering solutions to the
spam problem."
Financing Transactions During 2003
To enhance the Company's overall financial position, the Company entered into
the following financing transactions during 2003:
a. On January 29, 2003, Commtouch entered into a Convertible Loan Agreement
("the January Loan"), with certain lenders. The Company received the total loan
amount of $1,250 thousand from the lenders, which bore interest at a rate of ten
percent per annum, and convertible into ordinary shares of the Company at the
price of $0.25 per share. In connection with the January Loan, the Company also
issued warrants exercisable for purchase of up to 5,000,000 of the Company's
14
ordinary shares, each one-third of the warrants exercisable within five years at
prices per ordinary share of $0.25, $0.33 and $0.50 respectively.
A more complete description of this convertible loan transaction may be found in
the Company's Form 6-K filed with the SEC for the month of April 2003, which is
incorporated herein by reference under Exhibit 2.9 to this Form 20-F. This
description is qualified in its entirety by reference to the text of the
Convertible Loan Agreement, as amended, which is listed in this Form 20-F under
Exhibits 2.9.1 through 2.9.11.
b. On July 10, 2003, Commtouch entered into an ordinary shares and Warrants
Purchase Agreement with certain investors named therein. Under this agreement,
the company received an investment of $1,440 thousand, and issued to the
investors 2,880,000 ordinary shares and warrants to purchase within five years
1,440,000 ordinary shares at an exercise price of $0.50. Warrants totaling
325,000 shares were exercised in 2003, leaving 1,115,000 warrants outstanding as
at December 31, 2003. These warrants remain exercisable and expire on August 11,
2008.
A more complete description of this equity purchase transaction may be found in
the Company's Form 6-K filed with the SEC for the month of July 2003, which is
incorporated herein by reference under Exhibit 4.10 to this Form 20-F. This
description is qualified in its entirety by reference to the text of the
Ordinary Shares and Warrants Purchase Agreement, which is listed in this Form
20-F under Exhibit 4.10.1.
c. On July 29, 2003, Commtouch entered into two identical ordinary shares and
Warrants Purchase Agreements with certain investors named therein. Under these
agreements, the company received investments totaling $1,600 thousand, and
issued to the investors 2,666,667 ordinary shares and warrants to purchase
within five years 1,600,000 ordinary shares at an exercise price of $0.65. These
warrants remain exercisable and expire on August 11, 2008.
A more complete description of these equity purchase transactions may be found
in the Company's Form 6-K filed with the SEC for the month of August 2003
(August 15), which is incorporated herein by reference under Exhibit 4.11 to
this Form 20-F. This description is qualified in its entirety by reference to
the text of the Ordinary Shares and Warrants Purchase Agreements, which are
listed in this Form 20-F under Exhibits 4.11.1 and 4.11.2.
d. On November 26, 2003, the Company signed an agreement (the "November Notes
Agreement") for a private placement of $3,000 thousand in senior convertible
notes (the "November Notes") and related warrants (the "November Warrants") with
a group of institutional investors. The notes mature in three years and bear
interest at a rate of 8% per annum. The notes are convertible at any time, at
the lenders' option, into the Company's ordinary shares at a fixed conversion
price of $1.153. The lenders also received warrants to purchase 600,000 shares
of the Company, exercisable within three year at an exercise price of $1.153 per
share. The issuance of the November Notes was contingent on the conversion of
the January Loan and the exercise of the January Warrants into equity. The
lenders retain the option to invest an additional $3 million on similar terms to
those of the original loan, with such option open for six months as from January
20, 2004 (the date that a registration statement covering the initial loan was
declared effective by the SEC).
A more complete description of this convertible loan transaction may be found in
the Company's Form 6-K filed with the SEC for the month of November 2003 (filed
December 2, 2003), which is incorporated herein by reference under Exhibit 2.10
to this Form 20-F. This description is qualified in its entirety by reference to
the text of the Securities Purchase Agreement, which is listed in this Form 20-F
under Exhibits 2.10.1 through 2.10.7.
Intellectual Property
We regard our patent pending anti-spam technology, copyrights, service marks,
trademarks, trade secrets and similar intellectual property as critical to our
success, and rely on patent, trademark and copyright law, trade secret
protection and confidentiality and/or license agreements with our employees,
customers, partners and others to protect our proprietary rights. We are only
actively maintaining our registered trademark for "COMMTOUCH", which is
currently registered in the U.S., Canada, India, Israel, European Union, China,
Mexico, Norway, Taiwan, Russian Federation, South Korea and Australia. While
previous registrations of PRONTO (Canada and South Korea); COMMTOUCH SOFTWARE
(Australia and New Zealand); PRONTO MAIL (New Zealand) may still be in force, we
are not currently actively maintaining these trademarks. The Company may decide
to actively maintain some or all of these trademarks in the future, as
circumstances may justify. We also have a pending trademark application for
COMMTOUCH in Brazil. We are also claiming trademark rights in "RPD" (Recurrent
Pattern Detection), as applicable to our anti-spam solutions, as from at least
September 2003.
15
It may be possible for unauthorized third parties to copy or reverse engineer
certain portions of our products or obtain and use information that we regard as
proprietary. In addition, the laws of some foreign countries do not protect
proprietary rights to the same extent as do the laws of the United States. There
can be no assurance that our means of protecting our proprietary rights in the
United States or abroad will be adequate or that competing companies will not
independently develop similar technology.
Other parties may assert infringement claims against us. We may also be subject
to legal proceedings and claims from time to time in the ordinary course of our
business, including claims of alleged infringement by us and/or our licensees of
the trademarks and other intellectual property rights of third parties. Such
claims, even if not meritorious, could result in the expenditure of significant
financial and managerial resources.
We also continue to hold a perpetual mail server license which was utilized in
our hosted email service offering, and may license other technology as the need
arises. We cannot be certain that, apart from the mail server license, other
third-party content licenses will be available to us on commercially reasonable
terms or that we will be able to successfully integrate the technology into our
products. These third-party licenses may expose us to increased risks, including
risks associated with the assimilation of new technology, the diversion of
resources from the development of our own proprietary technology, and our
inability to generate revenues from new technology sufficient to offset
associated acquisition and maintenance costs. The inability to obtain any of
these licenses could result in delays in product development until equivalent
technology can be identified, licensed and integrated. Any such delays could
cause our business/financial condition and operating results to suffer.
Government Regulation
Laws aimed at curtailing the spread of spam have been adopted by the federal
government, i.e. CAN-SPAM Act, and some states, with the CAN-SPAM Act
superseding some state laws or certain elements thereof. See also disclosure
under "Item 3. Key Information- RISK FACTORS--Business Risks-- "Our Business May
be Adversely Affected as a Consequence of Legislation Imposing Legal Penalties
On Distributors of Unsolicited Email". Despite this legislation, we have not
seen an abatement in the amount of spam traffic on the Internet.
The growth and development of the spam market may prompt calls for more
stringent Internet user protection laws that may limit the ability of companies
promoting or delivering spam online. Moreover, the applicability to the Internet
of existing laws in various jurisdictions governing issues such as property
ownership, sales and other taxes, libel and personal privacy is uncertain and
may take years to resolve. The adoption of additional laws or regulations, or
the application of existing laws or regulations to the Internet, may impair the
growth of the Internet or commercial online services. All or some of the above
laws could decrease the demand for our anti-spam solutions and increase our cost
of doing business, or otherwise harm our business and operating results.
Employees
As of December 31, 2003, 2002 and 2001, we had 40, 22 and 92 full-time
employees, respectively. None of our U.S. employees are covered by a collective
bargaining agreement. As of March 31, 2004, we had 48 employees. We believe that
our relations with our employees are good.
Israeli law and certain provisions of the nationwide collective bargaining
agreements between the Histadrut (General Federation of Labor in Israel) and the
Coordinating Bureau of Economic Organizations (the Israeli federation of
employers' organizations) apply to Commtouch's Israeli employees. These
provisions principally concern the maximum length of the workday and workweek,
minimum wages, contributions to a pension fund, insurance for work-related
accidents, procedures for dismissing employees, determination of severance pay
and other conditions of employment. Furthermore, pursuant to such provisions,
the wages of most of Commtouch's Israeli employees are subject to cost of living
adjustments, based on changes in the Israeli Consumer Price Index. The amounts
and frequency of such adjustments are modified from time to time. Israeli law
generally requires the payment of severance pay upon the retirement or death of
an employee or upon termination of employment by the employer or, in certain
circumstances, by the employee. We currently fund our ongoing severance
obligations by making monthly payments for insurance policies and by an accrual.
A general practice in Israel followed by Commtouch, although not legally
required, is the contribution of funds on behalf of certain employees to an
individual insurance policy known as "Managers' Insurance." This policy provides
a combination of savings plan, insurance and severance pay benefits to the
insured employee. It provides for payments to the employee upon retirement or
death and secures a substantial portion of the severance pay, if any, to which
the employee is legally entitled upon termination of employment. Each
participating employee contributes an amount equal to 5% of such employee's base
salary, and the employer contributes between 13.3% and 15.8% of the employee's
base salary. Full-time employees who are not insured in this way are entitled to
a savings account, to which each of the employee and the employer makes a
monthly contribution of 5% of the employee's base salary. We also provide
16
certain Israeli employees with an Education Fund, to which each participating
employee contributes an amount equal to 2.5% of such employee's base salary, and
the employer contributes an amount equal to 7.5% of the employee's base salary,
up to a certain maximum base salary.
Description of Property
The legal name of the Company is Commtouch Software Ltd., and its principal
executive offices are located at 1A Hazoran Street, Poleg Industrial Park,
P.O.Box 8511, Netanya 42504, Israel, where our telephone number is
011-972-9-863-6888. The Company's wholly owned subsidiary, Commtouch Inc., is
located at 1300 Crittenden Lane, Suite 103, Mountain View, California 94043,
where our telephone number is (650) 864-2000. All of our facilities are leased.
We were incorporated as a limited liability company in Israel under the laws of
Israel on February 5, 1991. Our Articles of Association are on file in Israel
with the office of the Israeli Registrar of Companies and available for public
inspection from the Registrar.
Revenues for Last Three Financial Years
See Item 5. Operating and Financial Review and Prospects-"Revenue Sources" and
the F pages to this Form 20-F below.
Capital Expenditures and Divestitures for Last Three Financial Years
Commtouch divested itself of four subsidiary companies during the last three
financial years: 1) Commtouch (UK) Ltd, which was dissolved during 2003, 2)
Commtouch Latin America Inc., which was dissolved during 2002, 3) Wingra, Inc.
("Wingra"), which was sold during 2002 and 4) Commtouch K.K. (Japan) (now known
as Imatrix Corporation), which we previously owned a majority of and, during
2002, reduced such holdings to a 32% interest and is being accounted for under
the equity method.
Item 5. Operating and Financial Review and Prospects.
The following discussion should be read in conjunction with the Consolidated
Financial Statements and the Notes thereto included elsewhere in this report.
This discussion contains forward-looking statements based upon current
expectations that involve risks and uncertainties. Any statements contained
herein that are not statements of historical fact may be deemed to be
forward-looking statements. For example, the words "expects," "anticipates,"
"believes," "intends," "plans," "seeks" and "estimates" and similar expressions
are intended to identify forward-looking statements. Commtouch's actual results
and the timing of certain events may differ significantly from those projected
in the forward-looking statements. Factors that might cause future results to
differ materially from those projected in the forward-looking statements
include, but are not limited to, those set forth under "Item 3. Key
Information." and in the Company's other filings with the Securities and
Exchange Commission.
Overview
During 2003, our business was to develop and sell, through a reseller program,
anti-spam solutions to enterprise class customers. During 2002, we outsourced
integrated Web-based email and messaging solutions to a few businesses that
remained as customers following the transfer of our consumer outsource web-based
email business and sale of our Hosted Exchange email business during late 2001
and early 2002 in transactions with MailCentro Inc. and Telecomputing, Inc.
respectively. During early 2002, concurrent with the divestiture of the
Company's above-stated businesses, the Company began marketing to service
providers its messaging software platform ("CMP"), which had been in development
by the Company prior to that time. Following a concerted effort to penetrate the
email server market and a determination that the continuing unfavorable economic
conditions would hamper potential sales of CMP, and given the Company's inherent
knowledge of anti-spam solutions based on its many years as an ASP in the
outsourced email market and the growing worldwide attention that has been
directed to the problem of spam, the Company transitioned its focus to the
anti-spam market in mid-2002. While no uniform definition of spam exists, the
Company generally defines "spam" as the sending of unsolicited bulk email for
commercial and non-commercial purposes.
17
In February 2002, the Company sold off its migration service business, Wingra,
to Wingra's senior management. The operations of Wingra were eliminated from the
operations of the entity as a result of the disposal transaction. The Company
ceased its activity in the migration service business. The results of operations
including revenue, operating expenses and other income and expense, of Wingra
for 2001, have been reclassified in the accompanying statements of operations as
discontinued operations.
Critical Accounting Policies and Estimates
Operating and Financial Review and Prospects are based upon the Company's
consolidated financial statements, which have been prepared in accordance with
accounting principles generally accepted in the United States. The preparation
of these financial statements requires management to make estimates and
judgments that affect the reported amounts of assets, liabilities, revenues and
expenses and related disclosure of contingent assets and liabilities. Management
believes the critical accounting policies and areas that require the most
significant judgments and estimates to be used in the preparation of the
consolidated financial statements are revenue recognition and commitments and
contingencies.
Revenue recognition
Revenue is recognized when the earnings process is complete, as evidenced by an
agreement between the customer and the company, when delivery has occurred or
services have been rendered, when the fee is fixed or determinable and when
collection is probable. The company's revenue recognition policy is discussed in
Note 2 of Notes to Consolidated Financial Statements. The recognition of revenue
in conformity with accounting principles generally accepted in the United States
requires the company to make estimates and assumptions that affect the reported
amounts of revenue. Estimates related to the recognition of revenue include the
accumulated provision for revenues subject to refund and other. As additional
information becomes available, or actual amounts are determinable, the recorded
estimates are revised. Consequently, current operating results can be affected
by revisions to prior accounting estimates.
Contingencies
Commtouch periodically records the estimated impacts of various conditions,
situations or circumstances involving uncertain outcomes. These events are
called "contingencies", and Commtouch's accounting for such events is prescribed
by Statement of Financial Accounting Standards No. 5, "Accounting for
Contingencies" ("SFAS No. 5") SFAS No. 5 defines a contingency as "an existing
condition, situation, or set of circumstances involving uncertainty as to
possible gain or loss to an enterprise that will ultimately be resolved when one
or more future events occur or fail to occur."
SFAS No. 5 does not permit the accrual of gain contingencies under any
circumstances. For loss contingencies, the loss must be accrued if (1)
information is available that indicates it is probable that the loss has been
incurred, given the likelihood of the uncertain future events; and (2) that the
amount of the loss can be reasonably estimated.
The accrual of a contingency involves considerable judgment on the part of
management. Commtouch uses its internal expertise, and outside experts (such as
lawyers, tax specialists and engineers), as necessary, to help estimate the
probability that a loss has been incurred and the amount (or range) of the loss.
The Company has recorded contingencies in situations where management determined
it was probable a loss had been incurred and the amount could be reasonably
estimated.
Revenue Sources
Service Fees.
We started to recognize revenues from anti-spam solutions during the third
quarter of 2003. Revenues associated with the sale of anti-spam solutions are
recognized ratably over the period in which services are provided, which is
usually one to two years.
During 2000 - 2002, most of our email service revenues resulted from contracts
that required our customers to pay us a monthly per emailbox price subject to a
minimum commitment fee and fees for direct marketing and communications
services. In addition, the Company recognized revenue from sales of software
licenses to end users. During that time, we recognized no revenues from our new
anti-spam offering.
Direct E-marketing. During 2002, we did not recognize any revenues from this
type of activity, as our business model had changed (see above discussion under
"Overview"). Prior to 2002, because of our installed user base and our
18
agreements with our customers, we could assist e-commerce companies (those
seeking marketing channels) in distributing their services to our customers' end
users who opted to receive offers by email. We shared with our customers the
revenues from this direct e-marketing, which were earned either on a per-message
basis, a referral basis, or as a commission on products sold. In 2001 and 2000,
no direct e-marketing customer provided more then 10% of revenues.
Results of Operations
The following table sets forth financial data for the years ended December 31,
2001, 2002 and 2003 (in thousands):
Year Ended December 31,
---------------------------------------------
2001 2002 2003
-------- -------- --------
Revenues:
Email services ............................................................ $ 13,318 $ 3,238 $ 329
Software license revenues ................................................. 270 200 --
-------- -------- --------
Total revenues ............................................................ 13,588 3,438 329
Cost of revenues ............................................................. 13,962 1,675 581
-------- -------- --------
Gross profit (loss) ....................................................... (374) 1,763 (252)
-------- -------- --------
Operating expenses:
Research and development, net ............................................. 5,884 2,246 1,476
Sales and marketing ....................................................... 12,894 1,176 1,875
General and administrative ................................................ 10,337 2,588 1,308
Amortization of stock-based employee deferred compensation ................ 2,204 551 247
Write-off of property and equipment and other ............................. 10,166 750 --
-------- -------- --------
Total operating expenses .................................................. 41,485 7,311 4,906
-------- -------- --------
Operating loss ............................................................... (41,859) (5,548) (5,158)
Interest and other income, net ............................................ 583 (60) (1,967)
Equity in earnings (losses) of affiliate .................................. -- (56) 291
Write-off impaired long-term investments .................................. (2,000) -- --
Minority interest ......................................................... 285 74 --
-------- -------- --------
Loss from continuing operations .............................................. (42,991) (5,590) (6,834)
Gain on disposal of Wingra ................................................... -- 1,014 --
Discontinued Operations - Wingra ............................................. (18,016) (335) --
-------- -------- --------
Income (Loss) from sale of discontinued operations ........................... (18,016) 679 --
-------- -------- --------
Net loss ..................................................................... $(61,007) $ (4,911) $ (6,834)
======== ======== ========
Comparison of Years Ended December 31, 2003 and 2002
Revenues. Due to the sale of its migration (Wingra Inc.) and hosted exchange
services, as well as its consumer class business in 2001, the Company's revenues
for 2003 had decreased significantly comparing to 2002, mainly because of the
Company's change of focus during 2003.
Revenues decreased $3.1 million from $3.4 million in 2002 to $0.3 million in
2003. 2003 revenues represent royalty income from email services and from sales
of anti-spam solutions (see Note 2h to the Notes to Consolidated Financial
Statements). We are expecting revenues to rise from $0.3 million in 2003, as the
anti-spam solutions will be available for the full year and as we gain market
share. In 2003 and 2002, we had three and two customers, respectively, whose
revenue exceeded 10% of the Company's revenues, representing 70% and 57% of the
2003 and 2002 revenues, respectively.
Cost of Revenues. Cost of revenues decreased 65% from $1.7 million in 2002 to
$0.6 million in 2003. Cost of revenues is not expected to increase at the same
rate as revenues from the anti-spam solution increases. The cost includes costs
19
of running the anti-spam detection center, which are not as labor intensive as
when we were providing hosted email services.
Research and Development, Net. Research and development expenses decreased 32%
from $2.2 million in 2002 to $1.5 million in 2003 due to the decrease in
personnel and other related costs. In 2003 and 2002, we received royalty-bearing
grants totaling zero and $0.2 million, respectively, from the Israeli
government, which were recorded as a reduction of research and development
costs. The Israeli government requires beneficiaries of such grants to pay
royalties to the Israeli government based on the revenues derived from the sale
of products, technologies and services developed with such grants. It is
possible that an obligation to pay royalties in 2004 and future years may be
imposed on the Company, as we started to generate revenues from our anti-spam
solutions in the middle of 2003, although it is the Company's position that no
royalty bearing technologies are utilized in relation to its anti-spam
solutions. The ultimate liability is subject to review by the OCS.
Sales and Marketing. Sales and marketing expenses increased 59% from $1.2
million in 2002 to $1.9 million in 2003, due to the increase in personnel in
connection with the launch of our new product in the middle of 2003.
General and Administrative. General and administrative expenses decreased 49%
from $2.6 million in 2002 to $1.3 million in 2003, due primarily to curtailment
of costs. These expenses include net income from the recovery of notes
receivables totaling $0.3 million related to notes granted to former employees
during 1999, for which a valuation allowance was recorded in 2002.
Amortization of Stock-Based Employee Deferred Compensation. Our stock-based
employee deferred compensation expenses decreased 55% from $0.6 million for 2002
to $0.2 million for 2003. The deferred compensation is being amortized using the
sum-of-digits method over the vesting schedule, generally four years.
Amortization of these amounts concluded during the third quarter of 2003.
Deferred compensation expenses also included $0.2 million in each of the years
in 2003 and 2002, respectively, relating to the repricing of stock options
during 2001. The total amortization charge of $1.0 million related to the
repricing is amortized using the straight-line method over a three year vesting
schedule, which will conclude by the middle of 2004.
Interest and Other Income, Net. Our interest and other income, net, increased
from a net loss of $0.1 million for 2002 to $2 million for 2003, due primarily
to a non-cash charge of $1.9 million in 2003 relating to the issuance of
convertible loans and warrants.
Minority Interest. At December 31, 2002, the Company owned 32% of the equity and
voting rights of Imatrix (formerly Commtouch, K.K. (Japan)). During 2002, the
Company's investment in Imatrix changed from a consolidated subsidiary to an
equity investment; as such we ceased to have minority interest in 2003.
Income Taxes. As of December 31, 2003, we had approximately $31.5 million of
Israeli net operating loss carry-forwards. We also had U.S. federal net
operating loss carry-forwards available to offset future taxable income. The
Israeli net operating loss carry-forwards have no expiration date. The U.S. net
operating loss carry-forwards will expire in various amounts in the years 2009
to 2023. Utilization of U.S. net operating losses may be subject to the
substantial annual limitation due to the "change in ownership" provisions of the
Internal Revenue Code of 1986 and similar state provisions. The annual
limitation may result in the expiration of net operating losses before
utilization.
Comparison of Years Ended December 31, 2002 and 2001
Revenues. Email service revenues decreased 74% from $13.3 million in 2001 to
$3.2 million in 2002. We recognized revenue of $0.3 million, from the sale of
licenses in 2001 and $0.2 million in 2002. In 2002 we had two customers whose
revenue exceeded 10%, representing 57% of the 2002 revenues. No customer
accounted for more than 10% of revenues in 2001.
Cost of Revenues. Cost of revenues decreased 88% from $14.0 million in 2001 to
$1.7 million in 2002.We have decreased our hosting infrastructure costs due to
the agreement with MailCentro and sale of the Hosted Exchange business.
Research and Development, Net. Research and development expenses decreased 62%
from $5.9 million in 2001to $2.2 million in 2002 due to the decrease in
personnel and other related costs. In 2002 and 2001, we received royalty-bearing
grants totaling $0.2 and $0.6 million, respectively, from the Israeli
government, which were recorded as a reduction of research and development
costs. During 2001, we reduced research and development personnel by eliminating
certain projects, while only maintaining a core project aligned with our
strategic direction.
20
Sales and Marketing. Sales and marketing expenses decreased 91% from $12.9
million in 2001 to $1.2 million in 2002, due to the agreement with MailCentro
and sale of the Hosted Exchange business, as well as the change in business
strategy.
General and Administrative. General and administrative expenses decreased 75%
from $10.3 million in 2001 to $2.6 million in 2002, due primarily to curtailment
of costs.
Amortization of Stock-Based Employee Deferred Compensation. Our stock-based
employee deferred compensation expenses decreased 75% from $2.2 million for 2001
to $0.6 million for 2002. The deferred compensation is being amortized using the
sum-of-digits method over the vesting schedule, generally four years.
Amortization of these amounts concluded during the third quarter of 2003.
Deferred compensation expenses also included $0.2 million and $0.3 million in
2002 and 2001, respectively, relating to the repricing of stock options during
2001. The total amortization charge of $1.0 million related to the repricing is
amortized using the straight-line method over a three year vesting schedule.
Write-off of Impaired Intangibles and Other Assets. Impairment and other charges
consist of costs and/or charges that are not directly associated with other
expense classification or ongoing operations. The Company periodically assesses
the recoverability of the carrying amount of intangible assets, property and
equipment and provides for any possible impairment loss based upon the
difference between the carrying amount and fair value of such assets. In 2002,
the company had written off $0.8 million regarding unused property and
equipment. In 2001, impairment and other charges of $23.4 million included a
$13.3 million impairment of goodwill and other intangibles related to our
acquisition of Wingra, Inc., $4.4 million impairment of leasehold improvements
at unused leased facilities, $3.6 million impairment of computer hardware which
is idle and not being used, an accrual of $1.0 million for costs related to
early termination of these unused facilities and a $1.1 million write-off of a
customer relationship module (a software tool for managing customer relations),
which portion will no longer be utilized. The impairment charges of the goodwill
and other intangible assets were classified to discontinued operation due to the
divestiture of Wingra in 2002.
Interest and Other Income, Net. Our interest and other income, net, decreased
from a net income of $.6 million for 2001 to a net loss of $0.1 million for
2002, due primarily to decreased interest income earned from cash equivalents,
as the funds depleted in 2002.
Write-Off of Impaired Long-term Investments. The Company invested $7 million in
the first nine months of 2000 in certain Internet centric companies in which the
Company believed it had a significant ongoing strategic interest. However, due
to the economic slowdown and the significant decline in capital available to and
valuations of these privately funded Internet centric companies, the Company
believed that these investments were fully impaired. Accordingly, the Company
recorded a charge of $2.0 million in 2001 to reflect impairment of these assets.
Minority Interest. At December 31, 2001 and 2002, the Company owned 70.6% and
32%, respectively, of the equity and voting rights of Commtouch, K.K. (Japan).
Income Taxes. As of December 31, 2002, we had approximately $28.0 million of
Israeli net operating loss carry-forwards. We also had U.S. federal net
operating loss carry-forwards available to offset future taxable income. The
Israeli net operating loss carry-forwards have no expiration date. The U.S. net
operating loss carry-forwards will expire in various amounts in the years 2008
to 2022. Utilization of U.S. net operating losses may be subject to the
substantial annual limitation due to the "change in ownership" provisions of the
Internal Revenue Code of 1986 and similar state provisions. The annual
limitation may result in the expiration of net operating losses before
utilization.
Quarterly Results of Operations (Unaudited)
The following table sets forth certain unaudited quarterly statements of
operations data for the eight quarters ended December 31, 2003. This information
has been derived from the Company's consolidated unaudited financial statements,
which, in management's opinion, have been prepared on the same basis as the
audited consolidated financial statements, and include all adjustments,
consisting only of normal recurring adjustments, necessary for a fair
presentation of the information for the quarters presented. This information
should be read in conjunction with our audited consolidated financial statements
and the notes thereto included elsewhere in this report. The operating results
for any quarter are not necessarily indicative of the operating results for any
future period.
21
Three Months Ended
-------------------------------------------------------------------------------------
Mar. 31, Jun 30, Sept. 30, Dec. 31, Mar. 31, Jun. 30, Sept. 30, Dec. 31,
2002 2002 2002 2002 2003 2003 2003 2003
------- ------- ------- ------- ------- ------- ------- -------
(in thousands)
(unaudited)
Email service revenues ..................... $ 1,271 $ 1,005 $ 525 $ 637 $ 106 $ 70 $ 84 $ 69
Cost of email service revenues ............. 933 406 153 183 174 143 130 134
------- ------- ------- ------- ------- ------- ------- -------
Gross profit (loss) ........................ 338 599 372 454 (68) (73) (46) (65)
------- ------- ------- ------- ------- ------- ------- -------
Operating expenses:
Research and
development, net ........................ 573 530 621 522 346 362 387 381
Sales and marketing ........................ 521 244 221 190 188 340 609 738
General and administrative ................. 766 421 379 1,022 442 332 561 (27)
Amortization of stock-based
employee compensation ................... 138 138 138 137 63 63 63 58
Write-off of property and
equipment and other ..................... -- -- -- 750 -- -- -- --
------- ------- ------- ------- ------- ------- ------- -------
Total operating expenses ................... 1,998 1,333 1,359 2,621 1,039 1,097 1,620 1,150
------- ------- ------- ------- ------- ------- ------- -------
Operating loss ............................. (1,660) (734) (987) (2,167) (1,107) (1,170) (1,666) (1,215)
Interest and other income
(expenses), net ......................... 44 (20) (48) (36) (37) (105) (141) (1,684)
Equity in earnings
(losses) of affiliate ................... -- 18 (47) (27) -- 238 44 9
Minority interest .......................... 63 11 -- -- -- -- -- --
------- ------- ------- ------- ------- ------- ------- -------
Loss from continuing
operations .............................. (1,553) (725) (1,082) (2,230) (1,144) (1,037) (1,763) (2,890)
------- ------- ------- ------- ------- ------- ------- -------
Gain on disposal of Wingra ................. 1,014 -- -- -- -- -- -- --
Discontinued
operations - Wingra ..................... (335) -- -- -- -- -- -- --
------- ------- ------- ------- ------- ------- ------- -------
Income from sale of
discontinued operations ................. 679 -- -- -- -- -- -- --
------- ------- ------- ------- ------- ------- ------- -------
Net loss ................................... $ (874) $ (725) $(1,082) $(2,230) $(1,144) $(1,037) $(1,763) $(2,890)
======= ======= ======= ======= ======= ======= ======= =======
Fluctuations in Quarterly Results
We have incurred operating losses since inception, and we cannot be certain that
we will achieve profitability on a quarterly or annual basis in the future. Our
results of operations have fluctuated and are likely to continue to fluctuate
significantly from quarter to quarter as a result of a variety of factors, many
of which are outside of our control including entering a new and unstable market
due to launching the anti-spam product. A relatively large expense in a quarter
could have a negative effect on our financial performance in that quarter.
Additionally, as a strategic response to a changing competitive environment, we
may elect from time to time to make certain pricing, service, marketing or
acquisition decisions that could have a negative effect on our quarterly
financial performance. Other factors that may cause our future operating results
to fluctuate include, but are not limited to:
o continued growth of the Internet, email usage and the spread of spam
email;
o demand for anti-spam solutions;
o our ability to attract and retain customers and maintain customer
satisfaction;
o our ability to upgrade, develop and maintain our systems and
infrastructure;
o the amount and timing of operating costs and capital expenditures
relating to expansion of our business and infrastructure;
o the size, timing and fulfillment of orders for our anti-spam
solutions;
o the receipt or payment of irregular or nonrecurring revenues or
expenses;
o technical difficulties or system outages;
22
o foreign exchange rate fluctuations;
o the announcement or introduction of new or enhanced solutions by our
competitors;
o our ability to attract and retain qualified personnel with Internet
industry expertise, particularly sales and marketing personnel;
o the pricing policies of our competitors;
o failure to increase our sales; and
o governmental regulation relating to the Internet, and spam practices
in particular.
In addition to the factors set forth above, our operating results will be
impacted by the extent to which we incur non-cash charges associated with
stock-based arrangements with employees and non-employees.
Liquidity and Capital Resources
We have financed our operations principally from the issuance of equity
securities and, to a lesser extent from private loans, bank loans and research
and development grants from the Israeli government.
As of December 31, 2003 and March 31, 2004 respectively, we had approximately
$4.1 million and approximately $ 4.5 million of cash to fund operations in 2004.
In 2003 we utilized $4.5 million of cash to fund operating losses. Net cash
provided by financing activities were approximately $7.2 million mainly due to
proceeds from the issuance of shares, and receipt of two convertible loans (one
convertible loan was converted into equity). Net cash utilized from investing
activities was insignificant.
As of December 31, 2003 and March 31, 2004, we had working capital of $4.0
million and $2.9 million, respectively.
According to the November Notes Agreement, any delay in registration and/or
effectiveness of the November Notes according to the registration requirements,
can cause the occurrence of an event of default and redemption of the notes by
the lenders, and/or penalties to be paid in cash.
On May 18, 2004, the Company entered into a definitive agreement for the private
placement of ordinary shares of the Company to existing institutional investors
for gross proceeds of approximately $3.9 million. The investment is contingent
upon shareholders approval and additional closing conditions.
Based on the cash balance at December 31, 2003, current projections of revenues,
related expenses, and the completion of the convertible loan transaction, the
Company believes it has sufficient cash to continue operations for at least the
next twelve months through December 31, 2004.
Effective Corporate Tax Rates
Our tax rate will reflect a mix of the U.S. statutory tax rate on our U.S.
income and the Israeli tax rate discussed below. We expect that most of our
taxable income will be generated in Israel. Israeli companies are generally
subject to corporate tax at the rate of 36% of taxable income. A part of our
income, however, is derived from the Company's capital investment program with
Approved Enterprise status under the Law for the Encouragement of Capital
Investments in three separate plans, and is therefore eligible for certain tax
benefits. The Company has three approved programs, out of which two were
cancelled in prior years. Pursuant to these benefits, we will enjoy a tax
exemption on income derived during the first two years in which such investment
plans produce taxable income (provided that we do not distribute such income as
a dividend) and a reduced tax rate of 10% to 25% for an additional period of
five to eight years depending on the level of foreign investment in Commtouch.
All of these tax benefits are subject to various conditions and restrictions.
There can be no assurance that we will obtain approval for additional Approved
Enterprise programs, or that the provisions of the law will not change. The
period of tax benefits is subject to limits of 12 years from the year of
commencement of production, or 14 years from the grant of approval, whichever is
earlier. Moreover, notwithstanding our Approved Enterprise status in Israel, we
may be required to pay income or withholding taxes in other countries. Since we
have incurred tax losses in every year through 2003, we have not yet used the
tax benefits for which we are eligible. See Item 10 below for a discussion on
tax reform.
23
Impact of Inflation and Currency Fluctuations
Most of our sales are in U.S. dollars. However, a portion of our costs relates
to our operations in Israel. A substantial portion of our operating expenses in
Israel, primarily our research and development expenses, is denominated in NIS.
Costs not denominated in U.S. dollars are translated to U.S. dollars, when
recorded, at prevailing rates of exchange. This is done for the purposes of our
financial statements and reporting. Costs not denominated in U.S. dollars will
increase if the rate of inflation in Israel exceeds the devaluation of the
Israeli currency as compared to the U.S. dollar or if the timing of such
devaluation lags considerably behind inflation. Consequently, we are and will be
affected by changes in the prevailing NIS/U.S. dollar exchange rate.
The annual rate of inflation in Israel was-1.9% in 2003, 6.5% in 2002 and 1.4%
in 2001. The NIS was devalued against the U.S. dollar by approximately -6.4% in
2003, 7.3% in 2002and 9.3% in 2001. The representative dollar exchange rate for
converting the NIS to U.S. dollars, as reported by the Bank of Israel, was NIS
4.379 for one U.S. dollar on December 31, 2003. Note that the representative
dollar exchange rate was NIS 4.528 at March 31, 2004.
Because exchange rates between the NIS and the dollar fluctuate continuously,
exchange rate fluctuations and especially larger periodic devaluations will have
an impact on our operating results and period-to-period comparisons of our
results. The effects of foreign currency re-measurements are reported in the
consolidated financial statements for relevant periods in the statement of
operations.
The Company's affiliates (Imatrix's) functional currency is the Japanese Yen.
Consequently Imatrix's results of operations are translated into USD. Because
exchange rates between the Yen and the dollar fluctuate continuously, exchange
rate fluctuations will have an impact on the Company's equity in earnings and
losses of affiliate.
Item 6. Directors, Senior Management and Employees
The following table sets forth certain information regarding our directors at
March 31, 2004:
Beneficial
Ownership
Name Age >1%(3) Position
----- ---- ---------- --------
Amir Lev............................ 43 2.8% Director
Carolyn Chin(1)..................... 56 1.1% Chairman of the Board of Directors
Gideon Mantel(1).................... 44 5.9% Director
Nahum Sharfman(1)................... 55 3.8% Director
Lloyd E. Shefsky(2)(4).............. 63 1.8% Director
Richard Sorkin...................... 42 -- Director
Udi Netzer (2)...................... 48 -- Director (Outside Director)
Ofer Segev(1)(2).................... 44 -- Director (Outside Director)
-----------------
(1) Member of the Compensation Committee
(2) Member of the Audit Committee
(3) For purposes of this table, a person or group of persons is deemed to have
beneficial ownership of shares of the Company's common stock which such
person or group has the right to acquire on or within 60 days after March
31, 2004. Unless otherwise indicated, to the Company's knowledge the person
named has sole voting and investment power and the right to receive the
economic benefits, or share such power and rights with such person's
spouse, with respect to all shares held by that person. Warrants and
options that were underwater as of March 31, 2004 were included in the
calculation of beneficial ownership.
(4) This percentage represents Mr. Shefsky's individual holdings and holdings
of LENE L.P., for which he acts as General Partner.
24
Other Management Employees:
The following table sets forth the names and positions of our management
employees at March 31, 2004:
Name Age Ownership >1% Position
------ ---- -------------- ----------
Gideon Mantel............ 44 See table above CEO
Amir Lev................. 43 See table above President and Chief Technical Officer
Devyani Patel............ 43 -- Vice President, Finance
Avner Amram.............. 42 -- Executive Vice President, Commtouch Inc.
Gary Davis............... 42 -- General Counsel and Corporate Secretary
Udi Trugman.............. 33 -- Vice President, Research and Development,
Commtouch Software Ltd.
Ronni Zehavi............. 38 -- Vice President, Operations, Commtouch Software Ltd.
Haggai Carmon............ 45 -- Vice President, Marketing, Commtouch Software Ltd.
Timothy Straight......... 49 -- Vice President, Sales, Commtouch Inc.
Mark Uicker.............. 40 -- Vice President, Business Development, Commtouch Inc.
Amir Lev is a co-founder of Commtouch and has served as its Chief Technology
Officer and as a Director since its inception in 1991. Mr. Lev was also the
General Manager of Commtouch from January 1997 through April 2000, and in May
2000 became President. Mr. Lev received a B.A. in Computer Science and Economics
from Hebrew University, Jerusalem.
Carolyn Chin has served as the Chairman of the Board of Directors since May
2001. Ms. Chin has served as a Director of Commtouch since August 2000. Ms. Chin
has 30 years of experience in information technology, marketing, media,
telecommunications, retailing, health care, education and small business market
segments. She has held a number of senior executive positions including at:
Reuters, Market XT, IBM, Citibank, AT&T, Macy's and in the US Government. She
has served on over 30 boards and committees. Ms. Chin has also received numerous
honors including selection as a White House Fellow and the Committee of 100
(prominent Chinese-Americans). She graduated with an MBA from the Harvard
Business School and a BS in Management Engineering from Rensselaer Polytechnic
Institute.
Gideon Mantel is a co-founder of Commtouch and served as its Chief Financial
Officer from its inception in February 1991 until October 1995, when he became
Commtouch's Chief Operating Officer. In November 1997, he became Commtouch's
Chief Executive Officer. He has also served as a director of Commtouch since
inception. Mr. Mantel received a B.A. in Political Science and an M.B.A from Tel
Aviv University.
Nahum Sharfman rejoined the Board in March 2000. Mr. Sharfman is a co-founder of
Commtouch and served as its Chief Executive Officer and Chairman of the Board
from its inception in February 1991. In November 1997 Mr. Sharfman resigned as
Chief Executive Officer to become a founder of Dealtime.com. Mr. Sharfman
remained Chairman of the Board of Commtouch and a Director until January 1999.
Prior to founding Commtouch, Mr. Sharfman spent eleven years with National
Semiconductor Corporation in various development and management roles. Mr.
Sharfman received a Ph.D. in High Energy Nuclear Physics from Carnegie Mellon
University and M.S. and B.S. degrees in Physics from the Technion- Israel
Institute of Technology, Haifa.
Richard Sorkin has served as a Director of Commtouch since July 1999. Since June
1998, Mr. Sorkin has served as an advisor to several early-stage Internet
companies and is a director of several private companies. From June 1998 to
April 1999 he was the Chairman of the Board of Directors of ZIP2, an Internet
media company which was sold to Compaq. From May 1996 to June 1998, he was Chief
Executive Officer of ZIP2 and from May 1993 to March 1996 he held various
executive positions with Creative Technology, Ltd., a leading provider of
multi-media hardware. Mr. Sorkin received a B.A. with honors in Economics from
Yale University and an M.B.A. from Stanford University.
Udi Netzer has served as a Director of Commtouch since February 2002. Mr. Netzer
is also currently the active Chairman of Eyeblaster, Inc., a rich media ad
management system that allows publishers, agencies and advertisers to
independently create and manage out-of-banner advertising campaigns. Mr. Netzer
has over 15 years' experience in various sales, marketing and executive
positions with companies such as 3Com, Netmanage, and VCON. As a partner in
Evergreen, Mr. Netzer was one of the first venture capitalists in Israel.
25
Ofer Segev has served as a Director of Commtouch since February 2002. Mr. Segev
has been CEO of Teleknowledge since January 2002 and its CFO from May 2001. From
May 2000 to April 2001 served as CFO for Tundo. Prior to his position at Tundo,
Segev spent 15 years with Ernst & Young. Segev has a BA in economics and
accounting from Bar Ilan University in Israel, and has studied at the Kellogg
Graduate School of Management at Northwestern University.
Lloyd E. Shefsky has served as a Director of Commtouch since October 2003. He is
a Clinical Professor of Entrepreneurship and Co-Director of the Center for
Family Enterprises at the Kellogg School of Management and has taught in several
countries. In 1970, he founded the Chicago law firm, Shefsky & Froelich Ltd.,
where he is Of Counsel since 1996. Since 1981 he has represented the Government
of Israel throughout the Midwestern U.S. For nearly forty years he has
represented hundreds of entrepreneurs and their companies, and during the past
twenty-five years, such representation has included numerous Israeli companies
with U.S. operations. Mr. Shefsky authored Entrepreneurs Are Made Not Born,
which was translated into five foreign languages. He received his J.D. from the
University of Chicago Law School, a B.S.C. from De Paul University (accounting),
is a member of the Illinois and Florida Bars, and has a CPA certificate in
Illinois.
Avner Amram joined Commtouch in 1996 and currently serves as Executive Vice
President. Mr. Amram has over 15 years of experience in the areas of technology,
operational management and leadership, and is also a founder of CVDO. Before
2002, Mr. Amram served as COO of Commtouch and was responsible for worldwide
operations. Mr. Amram also held a number of positions at Commtouch prior to
being appointed COO. From 1995 to 1996, Mr. Amram served as project manager for
Medatech, a leading provider of customer relationship management (CRM)
solutions, developing and managing complex installations at large organizations.
Prior to Medatech, Mr. Amram acted as General Manager of Fuga Nursery in Israel,
where he was responsible for operations, production, marketing and distribution.
Mr. Amram holds a Bachelors of Science (BSC), in Computer Engineering and
graduated Cum Laude from the Technion, Israel Institute of Technology.
Devyani Patel joined Commtouch in 1996 as a consultant and became a full-time
employee in early 1999. She served as Corporate Controller for Commtouch until
November 2001 when she was appointed as the Vice President of Finance. Ms. Patel
has over 20 years of accounting and finance experience, including technology
industry experience. Ms. Patel graduated from the University of Kent,
Canterbury, England in Accounting and Law.
Gary Davis joined Commtouch in September 1999 and serves as General Counsel and
Corporate Secretary. Mr. Davis has over 18 years of legal experience in both
private law firm and corporate practices. Mr. Davis is certified to practice law
in both the State of Israel and California. Prior to September 1999, Mr. Davis
was in-house counsel to Israel Military Industries and Elta Electronics
Industries. He received a B.A. in Political Economy of Industrial Societies from
U.C. Berkeley and a J.D. in law from Golden Gate University.
Udi Trugman joined Commtouch in December 1996 and serves as Vice President of
Research and Development. Prior to 2002, Mr. Trugman was Senior Director of
Systems in the R&D group. Mr. Trugman has over 15 years of software development
and management experience. Prior to working at Commtouch, Mr. Trugman
specialized in development of commercial applications.
Ronni Zehavi joined Commtouch in June 1999 and serves as Vice President of
Operations. Prior to joining Commtouch, Mr. Zehavi was Human Resources and
Training Manager for "Mondex - ecach", a subsidiary company of International
Mastercard from 1997 to 1999. From 1994 to 1997, Mr. Zehavi was an
Organizational Consultant in a counseling firm. Mr. Zehavi received his M.A.
degree in Organizational Sociology from Bar-Ilan University and his B.A. degree
in History and Educational Psychology from Tel-Aviv University.
Haggai Carmon joined Commtouch in January 2002 and serves as Vice President of
Marketing. From 1998 to 2002, Mr. Carmon was Vice President of Corporate
Marketing and of Sales in Asia-Pacific for VCON Telecommunications, a public
vendor of corporate videoconferencing solutions, and was also responsible for
international pre-sales and technical support. Prior to that, Mr. Carmon was at
NetManage Ltd., a public software company of TCP/IP applications for Windows, a
founder and CEO of Applico, a Computer-aided Design for Architecture service
firm and managed a college of Fine Arts. Mr. Carmon has over 15 years of
experience in technology and international management.
Tim Straight joined Commtouch in July 2003 and serves as Vice President of
Sales. Mr Straight is a 20-year veteran of technology sales, and was most
recently Western Region Director at NetScreen Technologies. He is responsible
for Commtouch's North American sales objectives, continuing the development of
the channel operations as well as building existing and future OEM
relationships. Prior to joining Netscreen, Mr Straight held domestic and
international sales and business development positions with Mirapoint, Gadzoox
Networks, Vitalsigns Software, CheckPoint Software Technologies, and
26
Synoptics/Bay Networks. He has a Bachelors degree in Journalism from the
University of Rhode Island.
Mark Uicker was appointed Vice President of Business Development in December of
2003. He is responsible for managing all of Commtouch's relationships with OEM
partners, identifying and pursuing new business opportunities as well as
negotiating agreements to embed and license Commtouch's anti-spam detection
engine in OEM enterprise, service provider and consumer software applications
and messaging and security appliances. Mr. Uicker brings 14 years experience in
the software business to Commtouch, his most recent position having been vice
president of business development, in charge of channel sales at Kaon
Interactive. Uicker previously served as vice president of OEM sales and
business development at anti-spam vendor Elron Software (acquired by Zix
Corporation in fall 2003).
Election of Directors
Directors (other than outside directors, as explained below) are elected by
shareholders at the annual general meeting of the shareholders and hold office
until the next annual general meeting following the general meeting at which
such Director is elected and until his successor is elected, or until he is
removed. An annual general meeting must be held at least once in every calendar
year, but not more than fifteen months after the preceding annual general
meeting. Directors may be removed and other directors may be elected in their
place or to fill vacancies in the Board of Directors at any time by the holders
of a majority of the voting power at a general meeting of the shareholders.
Until a vacancy is filled by the shareholders, the Board of Directors may
appoint new directors temporarily to fill vacancies on the Board of Directors.
The Articles of Association of Commtouch authorize the shareholders to
determine, from time to time, the number of directors. The number was most
recently fixed at nine directors. There are no family relationships among any of
the directors, officers or key employees of Commtouch.
Alternate Directors
The Articles of Association of Commtouch provide that any director may appoint
another person to serve as an alternate director and may remove such alternate.
Any alternate director possesses all the rights and obligations of the director
who appointed him, except that the alternate has no standing at any meeting
while the appointing director is present, the alternate may not in turn appoint
an alternate for himself (unless the instrument appointing him otherwise
expressly provides) and the alternate is not entitled to remuneration. A person
who is not qualified to be appointed as a director, or a person who already
serves as a director or an alternate director, may not be appointed as an
alternate director. Unless the appointing director limits the time or scope of
the appointment, the appointment is effective for all purposes until the
appointing director ceases to be a director or terminates the appointment. The
appointment of an alternate director does not in itself diminish the
responsibility of the appointing director as a director.
Independent and Outside Directors
The Israel Companies Law requires Israeli companies with shares that have been
offered to the public in or outside of Israel to appoint at least two outside
directors. No person may be appointed as an outside director if the person or
the person's relative, partner, employer or any entity under the person's
control has or had, on or within the two years preceding the date of the
person's appointment to serve as outside director, any affiliation with the
company or any entity controlling, controlled by or under common control with
the company. The term affiliation includes:
o an employment relationship;
o a business or professional relationship maintained on a regular basis;
o control; and
o service as an office holder.
No person may serve as an outside director if the person's position or other
business activities create, or may create, a conflict of interest with the
person's responsibilities as an outside director or may otherwise interfere with
the person's ability to serve as an outside director. If, at the time outside
directors are to be appointed, all current members of the Board of Directors are
of the same gender, then at least one outside director must be of the other
gender.
Outside directors are to be elected by a majority vote at a shareholders'
meeting, provided that either:
27
o such majority includes at least one-third of the shares held by
non-controlling shareholders who are present and voting at the
meeting; or
o the total number of shares held by non-controlling shareholders voting
against the election of the director at the meeting does not exceed
one percent of the aggregate voting rights in the company.
The initial term of an outside director is three years and may be extended for
an additional three years. Outside directors may be removed only by the same
percentage of shareholders as is required for their election, or by a court, and
then only if the outside director ceases to meet the statutory qualifications
for their appointment or if they violate their fiduciary duty to the company.
Each committee of a company's Board of Directors must include at least one
outside director and the audit committee must include both outside directors. An
outside director is entitled to compensation as provided in the regulations
adopted under the Companies Law and is otherwise prohibited from receiving any
other compensation, directly or indirectly, in connection with service provided
as an outside director.
In addition, the Nasdaq SmallCap Market currently requires Commtouch to have at
least two independent directors on the Board of Directors and to maintain an
audit committee, at least a majority of whose members are independent of
management.
However, recent Nasdaq corporate governance Marketplace Rule changes require
that, by July 31, 2005 (representing an extended compliance period due to the
Company's status as a foreign private issuer), the Company have a majority of
independent directors, as defined under Marketplace Rule 4200(a)(15), unless the
Company has cause to request and receives an exemption under the rules from this
requirement, and an audit committee of three members, each of whom must:
(i) be independent as defined under Marketplace Rule 4200(a)(15);
(ii) meet the criteria for independence set forth in Exchange Act Rule
10A-3(b)(1) (subject to the exemptions provided in Exchange Act Rule
10A-3(c);
(iii) not have participated in the preparation of the financial statements
of the Company or any current subsidiary of the Company at any time
during the past three years; and
(iv) be able to read and understand fundamental financial statements,
including a company's balance sheet, income statement, and cash flow
statement.
Under limited circumstances, the Company may have one audit committee member not
independent in accordance with the above, but such a member would only be able
to serve for a maximum of two years.
Additionally, pursuant to Exchange Act Rule 10A-3(b)(1), by July 31, 2005,
members of the audit committee must meet that rule's definition of independence,
which requires that an audit committee member may not, except in his or her
capacity as a director or committee member, (i) accept directly or indirectly
any consulting, advisory, or other compensatory fee from the Company or any of
its subsidiaries (except for fixed amounts of compensation under a retirement
plan for prior service with the Company, provided that such compensation is not
contingent in any way on continued service), and (ii) be an "affiliated person"
of the Company or any of its subsidiaries.
The new Nasdaq rules also require that the Company (by July 31, 2005) certify
that it has, and will continue to have, at least one member of the audit
committee who has past employment experience in finance or accounting, requisite
professional certification in accounting, or any other comparable experience or
background which results in the individual's financial sophistication, including
being or having been a chief executive officer, chief financial officer or other
senior officer with financial oversight responsibilities. Also, under Item
401(h) of Regulation S-K, the Company is currently obligated to disclose whether
or not it has a "financial expert" on its audit committee, as defined under this
regulation (See Item 16A. Audit Committee Financial Expert).
Currently, we have appointed three directors to the audit committee who qualify
as independent directors under the current Nasdaq SmallCap Market requirements,
and we believe that these directors will also meet the definition of
independence under the new rules, when they become applicable to the Company
(assuming said directors continue to serve until such time). Furthermore, two
out of the three directors on the audit committee meet the qualification
requirements for outside directors, as required under the Israel Companies Law.
28
Audit Committee
As noted above, the Israel Companies Law and Nasdaq Marketplace Rules require
public companies to appoint an audit committee. The responsibilities of the
audit committee include identifying irregularities in the management of the
Company's business, approving management compensation and approving related
party transactions as required by law. An audit committee must consist of at
least three directors meeting the independence and outside director standards
under the Nasdaq Marketplace Rules, Exchange Act Rules and Israel Companies Law,
as described above under "Independent and Outside Directors." Furthermore, the
Israel Companies Law specifically prohibits the chairman of the Board of
Directors, any director employed by or otherwise providing services to a
company, and a controlling shareholder or any relative of a controlling
shareholder from being a member of the audit committee.
Internal Auditor
Under the Companies Law, the Board of Directors must appoint an internal
auditor, nominated by the audit committee. The role of the internal auditor is
to examine, among other matters, whether a company's actions comply with
relevant law and orderly business procedure. Under the Companies Law, the
internal auditor may be an employee of the company but not an interested party
or office holder, or a relative of an interested party or office holder, and he
or she may not be the company's independent accountant or its representative.
The Company appointed a qualified internal auditor during 2003.
Approval of Certain Transactions; Obligations of Directors, Officers and
Shareholders
The Israel Companies Law codifies the fiduciary duties that office holders,
including directors and executive officers, owe to a company. An office holder's
fiduciary duties consist of a duty of care and a duty of loyalty. The duty of
loyalty includes avoiding any conflict of interest between the office holder's
position in the company and such person's personal affairs, avoiding any
competition with the company, avoiding exploiting any corporate opportunity of
the company in order to receive personal advantage for such person or others,
and revealing to the company any information or documents relating to the
company's affairs which the office holder has received due to his or her
position as an office holder. Each person listed in the first table that appears
above at the beginning of this Item 6 is an office holder.
Under the Israel Companies Law, all arrangements as to compensation of office
holders who are not directors require approval of the Board of Directors unless
the Articles of Association provide otherwise. Arrangements regarding the
compensation of directors also require audit committee and shareholder approval.
The Israel Companies Law requires that an office holder promptly disclose any
personal interest that he or she may have and all related material information
known to him or her, in connection with any existing or proposed transaction by
the company. In addition, if the transaction is an extraordinary transaction,
the office holder must also disclose any personal interest held by the office
holder's spouse, siblings, parents, grandparents, descendants, spouse's
descendants and the spouses of any of the foregoing, or by any corporation in
which the office holder is a five percent or greater shareholder, director or
general manager or in which he or she has the right to appoint at least one
director or the general manager. An extraordinary transaction is defined as a
transaction not in the ordinary course of business, a transaction that is not on
market terms, or a transaction that is likely to have a material impact on the
company's profitability, assets or liabilities.
In the case of a transaction that is not an extraordinary transaction, after the
office holder complies with the above disclosure requirement, only Board
approval is required unless the Articles of Association of the company provide
otherwise. Such approval must determine that the transaction is not adverse to
the company's interest. If the transaction is an extraordinary transaction, then
in addition to any approval required by the Articles of Association, it also
must be approved by the audit committee and by the Board and, under specified
circumstances, by a meeting of the shareholders. An Israeli company whose shares
are publicly traded shall not be entitled to approve such a transaction unless,
at the time the approval was granted, two members of the audit committee were
outside directors and at least one of them was present at the meeting at which
the audit committee decided to grant the approval. An office holder who has a
personal interest in a matter that is considered at a meeting of the Board of
Directors or the audit committee generally may not be present at this meeting or
vote on this matter.
The Israel Companies Law applies the same disclosure requirements to a
controlling shareholder of a public company, which includes a shareholder that
holds 25% or more of the voting rights if no other shareholder owns more than
50% of the voting rights in the company. Extraordinary transactions with a
controlling shareholder or in which a controlling shareholder has a personal
interest, and the terms of compensation of a controlling shareholder who is an
office holder, require the approval of the audit committee, the Board of
Directors and the shareholders of the company. The shareholder approval must
29
either include at least one-third of the disinterested shareholders who are
present, in person or by proxy, at the meeting or, alternatively, the total
shareholdings of the disinterested shareholders who vote against the transaction
must not represent more than one percent of the voting rights in the company.
Under the Israel Companies Law, a shareholder has a duty to act in good faith
towards the company and other shareholders and refrain from abusing his or her
power in the company, including, among other things, in respect to his or her
voting at the general meeting of shareholders on the following matters:
o any amendment to the Articles of Association;
o an increase of the company's authorized share capital;
o a merger; or
o approval of interested party transactions that require shareholder
approval.
In addition, any controlling shareholder, any shareholder who can determine the
outcome of a shareholder vote and any shareholder who, under the company's
Articles of Association, can appoint or prevent the appointment of an office
holder, is under a duty to act with fairness towards the company. The Israel
Companies Law does not describe the substance of this duty.
Compensation Committee Interlocks
The Compensation Committee, which was established by the Board in January 1996,
is responsible for determining salaries, incentives and other forms of
compensation for Commtouch's directors, officers and other employees and for
administering various incentive compensation and benefit plans. The Compensation
Committee consists of the Chief Executive Officer and three other Directors.
Ofer Segev, as an outside director, Carolyn Chin and Nahum Sharfman are
currently the three other directors on the Compensation Committee.
Indemnification of Directors and Officers; Limitations on Liability
Israeli law permits a company to insure an office holder in respect of
liabilities incurred by him or her as a result of the breach of his or her duty
of care to the company or to another person, or as a result of the breach of his
or her fiduciary duty to the company, to the extent that he or she acted in good
faith and had reasonable cause to believe that the act would not prejudice the
company. A company can also insure an office holder for monetary liabilities as
a result of an act or omission that he or she committed in connection with his
or her serving as an office holder. Moreover, a company can indemnify an office
holder for (a) monetary liability imposed upon him or her in favor of other
persons pursuant to a court judgment, including a settlement or an arbitrator's
decision confirmed by the court, and (b) reasonable litigation expenses,
including legal fees, actually incurred by such a director or imposed upon the
director by a court order, in an action, suit or proceeding brought against him
or her by or on behalf of the company or by others, or in connection with a
criminal proceeding in which he or she was acquitted, or in connection with a
criminal action which does not require criminal intent in which he or she was
convicted, in each case in connection with his or her activities as an office
holder. Our Articles of Association allow us to insure and indemnify office
holders to the fullest extent permitted by law provided such insurance or
indemnification is approved in accordance with the Israel Companies Law. The
Company has acquired directors' and officers' liability insurance covering the
officers and directors of the Company and its subsidiaries for certain claims.
In addition, the Company entered into an undertaking to indemnify the directors
of the Company in connection with the shareholder-instigated class action
lawsuit, subject to certain limitations, and this undertaking was ratified by
shareholders (as this lawsuit has been settled, it is not anticipated that this
undertaking will result in any liability to the Company). Further, at the annual
meeting of shareholders held on November 18, 2002, the shareholders approved a
form of indemnification, exculpation and insurance agreement that is applicable
to all directors serving the Company.
Compensation of Directors and Officers.
The directors of Commtouch can be remunerated by Commtouch for their services as
directors to the extent such remuneration is approved by Commtouch's audit
committee, Board of Directors and shareholders. Directors currently do not
receive cash compensation for their services as directors but are reimbursed for
their expenses for each Board of Directors meeting attended. However, see Item
10 "Amended and Restated 1999 Non-Employee Directors Stock Option Plan".
The aggregate direct remuneration paid by Commtouch to all directors and
executive officers (8 persons) in 2003 was approximately $0.6million. During the
same period Commtouch accrued or set aside approximately $30,000 for the same
30
group to provide pension, retirement or similar benefits. As of December 31,
2003, directors and executive officers of Commtouch (8 persons) held stock
options to purchase an aggregate of 3,931,227 ordinary shares.
Options to Purchase Securities from Registrant or Subsidiaries.
As of December 31, 2003, 7,066,635 stock options to purchase ordinary shares had
been granted to employees, consultants, executive officers and non-employee
directors under the Company's stock option plans, net of cancelled options. Of
that number 6,249,108 had not been exercised and had exercise prices ranging
from $0.01 to $35 per share and a weighted average per share exercise price of
$0.31, and were held by 35 persons; these options have termination dates ranging
from February 2006 to December 2013. At December 31, 2003, the persons named in
Item 6 as a group (8 persons - executive officers and directors only) held
vested options to acquire 3,931,227 ordinary shares. Reference is also made to
the information contained in Item 7 below.
Employees
See Item 4: Employees
Item 7. Major Shareholders and Related Party Transactions.
The following table presents information with respect to beneficial ownership of
our ordinary shares as of March 31, 2004, including:
o each person or entity known to Commtouch to own beneficially more than
five percent of Commtouch's ordinary shares, and
o all executive officers and directors as a group.
Beneficial ownership is determined in accordance with the rules of the
Securities and Exchange Commission and includes voting or investment power, or
the right to receive the economic benefits of ownership, with respect to shares.
To our knowledge, except under applicable community property laws or as
otherwise indicated, the persons named in the table have sole voting and sole
investment control and rights to receive economic benefits with respect to all
shares beneficially owned. The applicable percentage of ownership for each
shareholder is based on 37,319,562 ordinary shares outstanding as of March 31,
2004. Ordinary shares issuable upon exercise of options and other rights held
and exercisable on or within sixty days of March 31, 2004 are deemed outstanding
for the purpose of computing the percentage ownership of the person holding
those options and other rights and for all directors and officers as a group,
but are not deemed outstanding for computing the percentage ownership of any
other person. Major shareholders in the Company have the same voting rights as
all other shareholders.
Amount Percent of
Owned Class
---------- ----------
Israel Seed IV, L.P. 3,747,088 9.5%
Gideon Mantel 2,262,960 5.9%
OZF Ltd. 3,206,138 8.4%
KKB Ventures LLC 2,423,457 6.4%
XDL Capital Corp. 1,940,704 5.1%
All directors and officers as a group (8 persons) 6,202,497 14.3%
(1) The above percentage includes warrants and options which are underwater as
of March 31, 2004: 2.7% of class
Significant Changes in Percentage Ownership During the Past Three Years
o The percentage beneficial ownership of Israel Seed IV, L.P., at
December 31, 2003 is 9.5%. This investor was a significant participant
in the July 29, 2003 and November 26, 2003 private placements.
o The percentage beneficial ownership of InfoSpace (formerly Go2Net),
which at December 31, 2002 was 8.7%, has dropped well below the five
percent threshold, due to InfoSpace's sale of 896,057 shares and the
increase in the outstanding shares of the Company during 2003. To the
best of the Company's knowledge, InfoSpace is no longer a major
shareholder in the Company. InfoSpace still possesses a warrant to
purchase 1,136,000 ordinary shares at an original exercise price of
$12.80 per share (subject to adjustment as described below). The
31
warrant is non-forfeitable, fully vested and immediately exercisable,
and will expire five years from the date of the original email service
agreement (July 16, 2004). If Infospace does not exercise this warrant
and continue to hold an amount of warrant shares representing
twenty-five percent of its and Vulcan Ventures original shareholdings
purchased in 1999, they will lose the right to appoint one director to
the Board of the Company. At InfoSpace's option, the warrant is
exercisable pursuant to a cashless exercise based on the average
closing price of the ordinary shares for the five days preceding the
exercise. The holder of the warrant is required to avoid becoming a
10% or greater shareholder of the Company as a result of any exercise
of the warrant. The holder of the warrant is given the opportunity to
profit from a rise in the market price of the ordinary shares and the
warrant. The warrant includes provisions which adjust the exercise
price upon the occurrence of certain events which might otherwise
dilute the value of the warrant, and the Company believes that
following certain of the Company's recent and prospective future
financing activities, the exercise price is projected to be
approximately $4.91.
o Nahum Sharfman, who at December 31, 2002, owned beneficially 6.05% of
the Company, is no longer a major shareholder in the Company, due to
the increase in outstanding shares of the Company during 2003.
o Jan Eddy, who at December 31, 2001, owned beneficially 5% in the
Company, is no longer a major shareholder due both to her sale of
shares in the Company and the increase in the outstanding shares of
the Company during 2002 and 2003.
Interest of Management in Certain Transactions.
Lloyd Shefsky became a Director of Commtouch in October 2003. Prior to that
time, Lene L.P., for which Mr. Shefsky acts as a General Partner, undertook to
loan the Company $50,000 under the Convertible Loan Agreement of January 29,
2004. On May 15, 2003, pursuant to Addendum 2 to the Convertible Loan Agreement,
Mr. Shefsky personally committed to loan the Company $25,000. As a result of
these two investments, and pursuant to Addendum 3 to the Convertible Loan
Agreement of November 18, 2003 under which the various lenders committed to
converting their loan into equity in the Company, the combined beneficial
shareholdings of Mr. Shefsky and Lene L.P. as of December 31, 2003 amounted to
677,438 ordinary shares, or approximately 2% of the Company's outstanding shares
at that date.
Option Exercises and Purchases of Shares By Certain Officers
Gideon Mantel is the Chief Executive Officer and a Director of Commtouch. On
March 17, 1999, Mr. Mantel exercised certain options granted to him by
Commtouch. In consideration for the Ordinary Shares purchased pursuant to the
exercise of the options, he provided Commtouch with a full-recourse promissory
note dated March 17, 1999 in the original principal amount of $341,272. The
promissory note bears interest at 4.83% annually, with payments of interest only
due on March 17 of each year and with the balance due and payable on the fourth
anniversary of the date of the promissory note. This loan was used by Mr. Mantel
to purchase 286,120 ordinary shares of Commtouch at a weighted average purchase
price of $1.19 per share. The promissory note is collateralized by a pledge of
the stock purchased. The outstanding principal amount of the note as of December
31, 2003 is approximately $102,000.
Item 8. Financial Information.
See Item 18: Financial Statements If the Company decides to distribute a cash
dividend out of income that has been tax exempt due to an "Approved Enterprise"
status under the Law for the Encouragement of Capital Investments, 1959, the
amount of cash dividend will be subject to corporate tax at the rate then in
effect under Israeli law. The Company has never declared or paid cash dividends
on its ordinary shares and does not anticipate paying any cash dividends in the
foreseeable future. The Company intends to retain future earnings to finance the
development of its business.
Item 9. The Offer and Listing.
The Company's Ordinary Shares have traded publicly on The Nasdaq Stock Market
under the symbol "CTCH" since July 13, 1999.
The following table lists the high and low closing sales prices for the
Company's Ordinary Shares, for the periods indicated, as reported by The Nasdaq
Stock Market:
32
High Low
------ --------
1999(beginning July 13, 1999): $49.12 $11.0625
2000: .......................................... $66.50 $ 7.44
2001: .......................................... $ 3.81 $ 0.20
2002: .......................................... $ 0.42 $ 0.06
2003: .......................................... $ 1.47 $ 0.10
2002:
First Quarter .................................. $ 0.42 $ 0.23
Second Quarter ................................. $ 0.25 $ 0.11
Third Quarter .................................. $ 0.15 $ 0.08
Fourth Quarter ................................. $ 0.22 $ 0.06
2003:
First Quarter .................................. $ 0.16 $ 0.10
Second Quarter ................................. $ 0.69 $ 0.16
Third Quarter .................................. $ 0.96 $ 0.55
Fourth Quarter ................................. $ 1.47 $ 0.79
2004:
First Quarter .................................. $ 1.24 $ 0.83
Most Recent Six Months:
December 2003 .................................. $ 1.15 $ 0.79
January 2004 ................................... 1.24 0.84
February 2004 .................................. 1.15 0.91
March 2004 ..................................... 1.06 0.83
April 2004 ..................................... 1.09 0.85
May 2004 ....................................... 0.92 0.57
Item 10. Additional Information.
Under current Israeli regulations, any dividends or other distributions paid in
respect of ordinary shares purchased by non-residents of Israel with certain
non-Israeli currencies (including dollars) will be freely repatriable in such
non-Israeli currencies at the rate of exchange prevailing at the time of
conversion, provided that Israeli income tax has been paid on, or withheld from,
such payments.
Neither the Articles of Association of the Company nor the laws of the State of
Israel restrict in any way the ownership or voting of ordinary shares by
non-residents of Israel, except with respect to subjects of countries which are
at a state of war with Israel.
DESCRIPTION OF SHARES
Set forth below is a summary of the material provisions governing our share
capital. This summary is not complete and should be read together with our
Memorandum of Association and Restated and Amended Articles of Association,
copies of which have been filed as exhibits to this and our prior Annual Reports
on Form 20-F, as amended (subject to further amendment of our Articles of
Association from time to time).
As of December 31, 2003, our authorized share capital consisted of 75,000,000
ordinary shares, NIS 0.05 par value. As of December 31, 2003, there were
37,104,615 ordinary shares issued and outstanding.
33
DESCRIPTION OF ORDINARY SHARES
All issued and outstanding ordinary shares of Commtouch are duly authorized and
validly issued, fully paid and nonassessable. The ordinary shares do not have
preemptive rights. Our Memorandum of Association, Articles of Association and
the laws of the State of Israel do not restrict in any way the ownership or
voting of ordinary shares by non-residents of Israel, except with respect to
subjects of countries which are in a state of war with Israel.
DIVIDEND AND LIQUIDATION RIGHTS
The ordinary shares are entitled to their full proportion of any cash or share
dividend declared.
Subject to the rights of the holders of shares with preferential or other
special rights that may be authorized, the holders of ordinary shares are
entitled to receive dividends in proportion to the sums paid up or credited as
paid up on account of the nominal value of their respective holdings of the
shares in respect of which the dividend is being paid (without taking into
account the premium paid up on the shares) out of assets legally available
therefor and, in the event of our winding up, to share ratably in all assets
remaining after payment of liabilities in proportion to the nominal value of
their respective holdings of the shares in respect of which such distribution is
being made, subject to applicable law. Declaration of a dividend requires Board
of Director approval.
SPECIAL PROVISIONS IN ARTICLES/MEMORANDUM OF ASSOCIATION RELATING TO DIRECTORS
The discussion regarding approval of director compensation and transactions with
the Company under "Item 6. Directors, Senior Management and Employees - Approval
of Certain Transactions; Obligations of Directors, Officers and Shareholders" is
incorporated herein by reference.
VOTING, SHAREHOLDER MEETINGS AND RESOLUTIONS
Holders of ordinary shares have one vote for each ordinary share held on all
matters submitted to a vote of shareholders. Such rights may be affected by the
future grant of any special voting rights to the holders of a class of shares
with preferential rights. Once the creation of a class of shares with preference
rights has been approved, the Board of Directors may issue preferred shares,
unless the Board is limited from doing so by the Articles of Association or a
contractual provision.
An annual general meeting must be held once every calendar year at such time
(not more than 15 months after the last preceding annual general meeting) and at
such place, either within or outside the State of Israel, as may be determined
by the Board of Directors. The quorum required for a general meeting of
shareholders consists of at least two shareholders present in person or by proxy
and holding at least one-quarter of the voting rights of the issued share
capital. A meeting adjourned for lack of a quorum may be adjourned to the same
day in the next week at the same time and place, or to such time and place as
the Board of Directors may determine in a notice to shareholders. At such
reconvened meeting any two shareholders entitled to vote and present in person
or by proxy will constitute a quorum. Shareholder resolutions will be deemed
adopted if approved by the holders of a majority of the voting power represented
at the meeting, in person or by proxy, and voting thereon.
ANTI-TAKEOVER PROVISIONS UNDER ISRAELI LAW
Under the Companies Law, a merger is generally required to be approved by the
shareholders and board of directors of each of the merging companies. If the
share capital of the company that will not be the surviving company is divided
into different classes of shares, the approval of each class is also required.
In addition, a merger can be completed only after all approvals have been
submitted to the Israeli Registrar of Companies and at least seventy days have
passed from the time that a proposal for approval of the merger was filed with
the Registrar.
The Companies Law provides that an acquisition of shares in a public company
must be made by means of a tender offer if as a result of the acquisition the
purchaser would become a 25% shareholder of the company. This rule does not
apply if there is already another 25% shareholder of the company. Similarly, the
Companies Law provides that an acquisition of shares in a public company must be
34
made by means of tender offer if as a result of the acquisition the purchaser
would become a 45% shareholder of the company, unless someone else already holds
a majority of the voting power of the company. These rules do not apply if the
acquisition is made by way of a merger. Regulations promulgated under the
Companies Law provide that these tender offer requirements do not apply to
companies whose shares are listed for trading outside of Israel if, according to
the law in the country in which the shares are traded, including the rules and
regulations of the stock exchange on which the shares are traded, either:
o there is a limitation on acquisition of any level of control of the
company; or
o the acquisition of any level of control requires the purchaser to do
so by means of a tender offer to the public.
Finally, Israeli tax law treats specified acquisitions, including a
stock-for-stock swap between an Israeli company and a foreign company, less
favorably than does U.S. tax law. For example, Israeli tax law may subject a
shareholder who exchanges his ordinary shares for shares in a foreign
corporation to taxation before it would become taxable in the United States, and
even though the investment has not become liquid.
TRANSFER OF SHARES AND NOTICES
Fully paid ordinary shares that are issued and not subject to any legal
restrictions on transference may be transferred freely. Each shareholder of
record is entitled to receive at least twenty-one days' prior notice of
shareholder meetings. For purposes of determining the shareholders entitled to
notice and to vote at such meeting, the Board of Directors may fix a record date
not exceeding 40 days prior to the date of any shareholder meeting.
MODIFICATION OF CLASS RIGHTS
If at any time the share capital is divided into different classes of shares,
then, unless the conditions of allotment of such class provide otherwise, the
rights, additional rights, advantages, restrictions and conditions attached or
not attached to any class, at any given time, may be modified, enhanced, added
or abrogated by resolution at a meeting of the holders of the shares of such
class.
DESCRIPTION OF INVESTOR AND SERVICE PROVIDERS OPTIONS AND WARRANTS
INFOSPACE WARRANT
The discussion regarding the Infospace warrant under Item 5. Operating and
Financial Review and Prospects--Strategic Transaction with Go2Net (InfoSpace)
and Item 7. "Major Shareholders and Related Party Transactions-- Significant
Changes in Percentage Ownership During the Past Three Years" is incorporated
herein by reference.
EQUITY OFFICE PROPERTIES WARRANT
The discussion regarding the Equity Office Properties warrant under Item 18,
Note 10 to the Notes to Consolidated Financial Statements - Shareholders' Equity
is incorporated herein by reference.
COMPAQ WARRANT
The discussion regarding the Compaq warrant under Item 18, Note 10 to the Notes
to Consolidated Financial Statements - Shareholders' Equity is incorporated
herein by reference.
FEBRUARY 2002 INVESTMENT ROUND WARRANTS
The discussion regarding the February 2002 investment round warrants under Item
18, Note 10 to the Notes to Consolidated Financial Statements - Shareholders'
Equity is incorporated herein by reference.
JANUARY 2003 CONVERTIBLE LOAN WARRANTS
The discussion regarding the January 2003 convertible loan warrants under Item
18, Note 10 to the Notes to Consolidated Financial Statements - Shareholders'
Equity is incorporated herein by reference.
35
JULY 2003 INVESMENT ROUNDS WARRANTS
The discussion regarding the two July 2003 investment rounds warrants under Item
18, Note 10 to the Notes to Consolidated Financial Statements - Shareholders'
Equity is incorporated herein by reference.
NOVEMBER 2003 CONVERTIBLE LOAN WARRANTS
The discussion regarding the November 2003 convertible loan warrants under Item
18, Note 10 to the Notes to Consolidated Financial Statements - Shareholders'
Equity is incorporated herein by reference.
AGRON WARRANT
The discussion regarding the Agron warrant under Item 18, Note 10 to the Notes
to Consolidated Financial Statements - Shareholders' Equity is incorporated
herein by reference.
REGISTRATION RIGHTS
The holders of convertible preferred shares which were converted into 7,109,800
ordinary shares (the "Registrable Securities") upon effectiveness of the initial
public offering, have certain rights to register those shares under the
Securities Act. If requested by holders of a majority of the Registrable
Securities after the second anniversary of the date of the initial public
offering, Commtouch must file a registration statement under the Securities Act
covering all Registrable Securities requested to be included by all holders of
such Registrable Securities. Commtouch may be required to effect up to two such
registrations. Commtouch has the right to delay any such registration for up to
120 days under certain circumstances, but not more than once during any 12-month
period.
In addition, if Commtouch proposes to register any of its ordinary shares under
the Securities Act other than in connection with a company employee benefit plan
or a corporate reorganization pursuant to Rule 145 under the Securities Act, or
a registration on any registration form that does not permit secondary sales or
does not include substantially the same information as would be required to be
included in a registration statement covering the sale of Registrable
Securities, the holders of Registrable Securities may require Commtouch to
include all or a portion of their shares in such registration, although the
managing underwriter of any such offering has certain rights to limit the number
of shares in such registration. Further, a majority of the holders of
Registrable Securities may require Commtouch to register all or any portion of
their Registrable Securities on Form F-3, subject to certain conditions and
limitations. All expenses incurred in connection with all registrations (other
than fees, expenses and disbursements of counsel retained by the holders of the
Registrable Shares, and underwriters' and brokers' discounts and commissions)
will be borne by Commtouch.
The registration rights described in the preceding two paragraphs expire five
years after the closing date of our initial public offering (July 16, 2004).
In addition, the Company granted registration rights as follows:
a. to InfoSpace, Vulcan Ventures and Microsoft, pursuant to which their
holdings in the Company (including the warrant issued to InfoSpace)
were registered on January 7, 2000;
b. under the terms of the Wingra acquisition agreement, we were required
to register the 1,568,869 shares issuable to the Wingra investors and
employees, including shares issuable under options and warrants
described above. The registration statements were filed to fulfill
this requirement and became effective, respectively, on September 6,
2001 and July 20, 2001;
c. to investors under the private placement of February 27, 2002, whereby
Commtouch issued approximately 4.4 million ordinary shares against the
investment of approximately $1.3 million. The investors in the private
placement also received five-year warrants to purchase up to an
additional 2.66 million ordinary shares (approximately). The shares
issued under this private placement, including shares to be issued
upon the exercise of the warrants, were registered on May 28, 2002;
d. to lenders under the Convertible Loan Agreement of January 29, 2003,
as amended, whereby a loan amount of $1,250,000 was provided to the
Company and subsequently converted into equity in the Company.
Following conversion, on January 20, 2004, the Company registered
11,304,432 ordinary shares on behalf of the lenders, with 5,652,216
representing shares issuable upon exercise of warrants (with a term of
five years).
36
e. to investors under the two private placements of July 10, 2003 and
July 29, 2003, whereby Commtouch issued 5,546,667 ordinary shares
against the investment of $3,040,000. The investors in the private
placement also received five-year warrants to purchase up to an
additional 3,040,000 ordinary shares. The shares issued under these
private placements, including shares to be issued upon the exercise of
the warrants, were registered on November 3, 2003; however, given a
delay in the registration process, additional "liquidated damages"
shares totaling 40,926 ordinary shares were issued to the investors
and registered on January 20, 2004;
f. to lenders under the Securities Purchase Agreement of November 26,
2004, as amended, whereby a loan amount of $3,000,000 was provided to
the Company. Under this agreement, the Company (i) granted rights to
convert the loan into equity at a conversion price of $1.153 per
Ordinary Share, and (ii) issued warrants exercisable for purchase of
up to 600,000 of the Company's Ordinary Shares, exercisable within
three years at a price per Ordinary Share of $1.153. Pursuant to the
agreement, the Company registered 4,162,479 ordinary shares with the
SEC on January 20, 2004. For six months as from January 20, 2004, the
lenders retain the option to invest an additional $3 million on
similar terms to those of the original loan, including those relating
to the registration of additional shares and shares underlying
warrants; and
g. piggy-back registration rights were included in all warrants detailed
above in this Item 10.
ACCESS TO INFORMATION
We file reports with the Israeli Registrar of Companies regarding our registered
address, our registered capital, our shareholders of record and the number of
shares held by each, the identity of the directors and details regarding
security interests on our assets. In addition, Commtouch must file with the
Israeli Registrar of Companies its Articles of Association and any amendments
thereto. The information filed with the Registrar of Companies is available to
the public. In addition to the information available to the public, our
shareholders are entitled, upon request, to review and receive copies of all
minutes of meetings of our shareholders.
TRANSFER AGENT AND REGISTRAR
The transfer agent and registrar for our ordinary shares is Wells Fargo Bank
Minnesota N.A.
MATERIAL CONTRACTS DURING PAST TWO YEARS.
Consulting and Fundraising Agreements
On September 1, 2002, Commtouch entered into two agreements with AxcessNet Ltd.,
one for the providing of consulting services to Commtouch ("agreement 1") and
the other for the facilitating of fundraising and strategic commercial
transactions ("agreement 2"). Under agreement 1, AxcessNet is to receive a
payment of $140,000 in cash and some warrants. Agreement 1 was due to expire on
August 31, 2003, but was extended twice, once until December 31, 2003, with
AxcessNet receiving $15,000 per month during this extended period, and again for
an additional year commencing January 1, 2004, with AxcessNet receiving $10,000
per month during this extended period (unless terminated earlier, at the
Company's discretion). Under agreement 2, as amended on December 1, 2002,
AxcessNet is entitled to receive 5% of proceeds received by Commtouch from
fundraising activities (and in the case of a business combination, a minimum fee
of $100,000), as well as from commercial transactions entered into by Commtouch
through the efforts of AxcessNet. The compensation to be paid under agreement 2
is payable in either cash or warrants, at AxcessNet's discretion, but if the
warrants are to exceed 250,000, Commtouch has the right to pay any excess in
cash. Furthermore, in the event that Commtouch is acquired by a third party, any
continuing payment obligations of Commtouch to AxcessNet under agreement 2 at
the time of such acquisition may be fully liquidated by a payment of the lesser
of twenty four months worth of payments or the number of months remaining under
Commtouch's obligations to AxcessNet. During their relationship under agreement
1 and agreement 2, Commtouch and AxcessNet have been working together closely in
furtherance of the Company's business, and are in constant communications with
one another. AxcessNet was also a lender under the Convertible Loan Agreement of
January 29, 2003 (see Exhibits 2.9.1 - 2.9.11), with its interest converting to
equity in the Company on December 26, 2003.
Lease Termination Agreement between Young Woo & Assoc., LLC and Commtouch Inc.
and Commtouch Software Ltd. (as guarantor) dated September 6, 2002
37
Pursuant to the agreement with Young Woo, Commtouch and Young Woo agreed to
terminate the New York facilities lease agreement. Within the framework of this
agreement Commtouch made certain payments to Young Woo and transferred ownership
to certain furniture, and Young Woo released Commtouch from the remainder
(approximately two years) of the lease term under the original agreement and the
related guarantee.
Surrender Agreement between Omni South Beach, L.P. and Commtouch Latin America
Inc. dated August 31, 2002
Pursuant to the agreement with Omni, Commtouch and Omni agreed to terminate the
Miami facilities lease agreement. Within the framework of this agreement
Commtouch made certain payments to Omni, terminated a sublease agreement with a
third party sublessee of Commtouch and transferred ownership to certain
furniture to Omni, and Omni released Commtouch from the remainder (approximately
five years) of the lease term under the original agreement.
Convertible Loan Agreement of January 2003
See "Item 4. Information on the Company - Financing Transactions During 2003".
Two Private Placements of July 2003
See "Item 4. Information on the Company - Financing Transactions During 2003".
Securities Purchase Agreement of November 2003
See "Item 4. Information on the Company - Financing Transactions During 2003".
Amended and Restated 1999 Non-Employee Directors Stock Option Plan
The allotment of shares under the original 1999 Non-Employee Directors Stock
Option Plan was in the amount of 180,000 ordinary shares, with an additional
allotment in 2000 bringing the plan's total allotment to 500,000 shares, an
allotment in 2001 bringing the plan's total to 750,000 ordinary shares, two
allotments during 2002 totaling 700,000 ordinary shares bringing the plan's
total to 1,450,000 and a further allotment in December 2003 of 840,000, bringing
the plan's total to 2,290,000. During 1999, each individual who first joined the
Board of Directors as a non-employee director on or after the effective date of
the initial public offering received an option grant for 10,000 options.
Subsequent to July 2000, individuals who joined the Board received an initial
grant of 30,000 options, and pursuant to an amendment to the plan approved by
shareholders on December 26, 2003, new directors are entitled to an initial
grant of 150,000 options. As from December 26, 2003, directors who are reelected
at the annual meeting of shareholders are entitled to additional grants of
50,000 options. Prior to that time, directors reelected at the August 10, 2000
annual meeting of shareholders were entitled to a grant of 10,000 options,
directors reelected at the August 22, 2001 annual meeting of shareholders were
entitled to a grant of 33,750 options, those directors in office immediately
after the extraordinary general meeting of shareholders on February 25, 2002
were granted a one-time option grant of 150,000 options and those directors in
office immediately after the annual meeting of shareholders on November 18, 2002
were granted a one-time option grant of 50,000 options. Also, in addition to the
grant of shares for her reelection as a director in August 2001, Carolyn Chin,
in recognition of her activities as Chairman of the Board, received an
additional grant of 221,250 options.
Each option granted under the Non-Employee Directors Plan originally was to have
become exercisable with respect to one-fourth of the number of shares covered by
such option three months after the date of grant and with respect to one-third
of the remaining shares subject to the option every three months thereafter;
however, this changed pursuant to an amendment to the plan approved by
shareholders at the August 10, 2000 annual meeting of shareholders, such that
options become exercisable at a rate of 1/16th of the shares every three months.
Each option has an exercise price equal to the fair market value of the ordinary
shares on the grant date of such option. However, certain options outstanding
and unexercised at the time of the effective date of the Tender Offer Statement
of July 20, 2001, as amended, were repriced in accordance with the terms of the
Tender Offer Statement, as amended. Each option has a maximum term of ten years,
but will terminate earlier if the optionee ceases to be a member of the Board of
Directors.
Amended and Restated Articles of Association
See the discussion under Item 4 "Information on the Company - Description of
Property" for an indication of where the Company's Amended and Restated Articles
of Association may be inspected. In addition, the Articles are attached as an
exhibit to this Form 20-F.
38
ISRAELI TAXATION AND INVESTMENT PROGRAMS
The following discussion summarizes the material Israeli tax consequences
relating to Commtouch, its shareholders and ownership and disposition of its
ordinary shares. This summary does not discuss all aspects of Israeli tax law
that may be relevant to a particular investor in light of his personal
investment circumstances or to certain types of investors subject to special
treatment under Israeli law (for example, traders in securities or persons that
own, directly or indirectly, 10% or more of Commtouch's outstanding voting
shares). The following also includes a discussion of certain Israeli government
programs benefiting various Israeli businesses such as Commtouch. To the extent
that the discussion is based on new legislation yet to be subject to judicial or
administrative interpretation, there can be no assurance that the views
expressed herein will accord with any such interpretation in the future. This
discussion does not cover all possible tax consequences or situations, and
investors should consult their tax advisors regarding the tax consequences
unique to their situation.
Tax Reform
On January 1, 2003 a comprehensive tax reform took effect in Israel. Pursuant to
the reform, resident companies are subject to Israeli tax on income accrued or
derived in Israel or abroad. In addition, the concept of controlled foreign
corporation was introduced according to which an Israeli company may become
subject to Israeli taxes on certain income of a non-Israeli subsidiary if the
subsidiaries primary source of income is passive income (such as interest,
dividends, royalties, rental income or capital gains). The tax reform also
substantially changed the system of taxation of capital gains.
General Corporate Tax Structure
Israeli companies are generally subject to company tax at the rate of 36% of
taxable income. However, the effective tax rate payable by a company which
derives income from an approved enterprise may be considerably less, as further
discussed below.
Special Provisions Relating to Taxation under Inflationary Conditions
The Income Tax Law (Inflationary Adjustments), 1985, generally referred to as
the Inflationary Adjustments Law, represents an attempt to overcome the problems
presented to a traditional tax system by an economy undergoing rapid inflation.
The Inflationary Adjustments Law is highly complex. Its features, which are
material to us, can be described as follows:
o there is a special tax adjustment for the preservation of equity which
classifies corporate assets into fixed assets and non-fixed assets.
Where a company's equity, as defined in the law, exceeds the
depreciated cost of fixed assets, a deduction from taxable income that
takes into account the effect of the applicable annual rate of
inflation on the excess is allowed up to a ceiling of 70% of taxable
income in any single tax year, with the unused portion permitted to be
carried forward on a linked basis. If the depreciated cost of fixed
assets exceeds a company's equity, then the excess multiplied by the
applicable annual rate of inflation is added to taxable income;
o subject to specified limitations, depreciation deductions on fixed
assets and losses carried forward are adjusted for inflation based on
the increase in the consumer price index; and
o in specified circumstances, gains on traded securities, which might
otherwise be eligible for reduced rates of tax, will be liable to
company tax at the rate of 36%.
Law for the Encouragement of Industry (Taxes), 5729-1969
The Law for the Encouragement of Industry (Taxes), 1969, generally referred to
as the Industry Encouragement Law, provides several tax benefits for industrial
companies. An industrial company is defined as a company resident in Israel, at
least 90% of the income of which in a given tax year exclusive of income from
specified government loans, capital gains, interest and dividends, is derived
from an industrial enterprise owned by it. An industrial enterprise is defined
as an enterprise whose major activity in a given tax year is industrial
production activity.
39
Under the Industry Encouragement Law, industrial companies are entitled to a
number of corporate tax benefits, including:
o deduction of purchase of know-how and patents over an eight-year
period; and
o the right to elect, under specified conditions, to file a consolidated
tax return with additional related Israeli industrial companies and an
industrial holding company.
Under some tax laws and regulations, an industrial enterprise may be eligible
for special depreciation rates for machinery, equipment and buildings. These
rates differ based on various factors, including the date the operations begin
and the number of work shifts. An industrial company owning an approved
enterprise may choose between these special depreciation rates and the
depreciation rates available to the approved enterprise.
Eligibility for benefits under the Industry Encouragement Law is not subject to
receipt of prior approval from any governmental authority.
We believe that we currently qualify as an industrial company within the
definition of the Industry Encouragement Law. We cannot assure you that the
Israeli tax authorities will agree that we qualify, or, if we qualify, that we
will continue to qualify as an industrial company or that the benefits described
above will be available to us in the future.
Law for the Encouragement of Capital Investments, 5719-1959
The Law for the Encouragement of Capital Investments, 5719-1959, as amended (the
"Investment Law"), provides that a capital investment in production facilities
(or other eligible facilities) may, upon application to the Israel Investment
Center of the Ministry of Industry, Trade and Labor, be designated as an
Approved Enterprise. Each certificate of approval for an Approved Enterprise
relates to a specific capital investment program delineated both by its
financial scope, including its capital sources, and its physical
characteristics, such as the equipment to be purchased and utilized pursuant to
the program. The tax benefits under the Investment Law are not available for
income derived from products manufactured outside of Israel.
A company owning an Approved Enterprise may elect to receive either governmental
grants or an alternative package of tax benefits. Commtouch's three investment
plans have been granted the status of an Approved Enterprise under the
Investment Law, in three separate investment programs, in 1992, 1996 and 2000,
respectively, the second and third programs cancelled in early 2002 and in 2001.
With regard to the first program, Commtouch received long-term loans guaranteed
by the State of Israel. Under the terms of Commtouch's Approved Enterprise
program pursuant to the alternative package of tax benefits, income earned by
Commtouch from its Approved Enterprises will be tax exempt for a period of two
years, commencing with the year in which it first earns taxable income, and
subject to a reduced corporate tax rate of 10% to 25% for an additional period
of five to eight years, depending on the extent of foreign investments in the
Company. The benefits period is limited to twelve years from the year of
completion of the investment under the approved plan, or fourteen years from the
date of approval, whichever is earlier. The reduced corporate tax rate, to which
Commtouch's Approved Enterprise program will be subject, is dependent on the
level of foreign investment in Commtouch. A Foreign Investors Company ("FIC"),
as defined in the Investment Law, may enjoy benefits for an extended period of
up to ten years. A FIC is a company of which more than 25% of its shareholders
are non-Israeli residents.
In the event a company operates under more than one approval or only part of its
capital investments are approved (a "Mixed Enterprise"), its effective corporate
tax rate is the result of a weighted combination of the various applicable
rates. Notwithstanding our Approved Enterprise status in Israel, we may be
required to pay income or withhold taxes in other countries.
All dividends are considered to be attributable to the entire enterprise and
their effective tax rate is the result of a weighted combination of the
applicable tax rates. A company that has elected the alternative package of tax
benefits and pays a dividend out of income derived from the Approved Enterprise
during the exemption period will be subject to tax on the amount distributed, at
the rate that would have been applicable had it not elected the alternative
package of benefits (generally, 10%-25% depending on the extent of foreign
investment in the company). The Company currently intends to reinvest the amount
of its tax-exempt income and not to distribute such income as a dividend.
Dividends from Approved Enterprises are generally taxed at a rate of 15% (which
is withheld and paid by the company paying the dividend) if such dividend is
distributed during the benefits period or within twelve 12 years thereafter. The
twelve-year limitation does not apply to a FIC.
40
The Investment Law also provides that a company with an Approved Enterprise is
entitled to accelerated depreciation on its property and equipment included in
an approved investment program.
Future applications to the Investment Center will be reviewed separately, and
decisions as to whether to approve or reject an application for designation as
an Approved Enterprise will be based, among other things, on the then prevailing
criteria set forth in the Investment Law, on the specific objectives of the
applicant company set forth in such application and on certain financial
criteria of the applicant company. Accordingly, there can be no assurance that
any such applications will be approved. In addition, the benefits available to
an Approved Enterprise are conditional upon the fulfillment of certain
conditions stipulated in the Investment Law and related regulations and the
criteria set forth in the specific certificate of approval, as described above.
In the event that these conditions are violated, in whole or in part, the
Company would be required to refund the amount of tax benefits, with the
addition of linkage adjustment to the Israeli consumer price index and interest.
Capital Gains Tax on Sale of our Ordinary Shares by both residents and
non-residents of Israel.
Israeli law generally imposes a capital gains tax on the sale of capital assets
located in Israel, including shares in Israeli resident companies, by both
residents and non-residents of Israel, unless a specific exemption is available
or unless a treaty between Israel and the country of the non-resident provides
otherwise. Regulations promulgated under the Israeli Income Tax Ordinance
provided for an exemption from Israeli capital gains tax for gains accrued
before January 1, 2003 and derived from the sale of shares of an "Industrial
Company", as defined by the Industry Encouragement Law, that are traded on
specified non-Israeli markets, including The NASDAQ National Market, provided
that the sellers purchased their shares either in the company's initial public
offering or in public market transactions thereafter.
This exemption does not apply to shareholders who are in the business of trading
securities, or to shareholders that are Israeli resident companies subject to
the Income Tax (Adjustments for Inflation) Law- 1985, or to shareholders who
acquired their shares prior to an initial public offering. The Company believes
that it is currently an Industrial Company, as defined by the Industry
Encouragement Law. The status of a company as an Industrial Company may be
reviewed by the tax authorities from time to time. There can be no assurance
that the Israeli tax authorities will not deny the Company's status as an
Industrial Company, possibly with retroactive effect.
On January 1, 2003, the Law for Amendment of the Income Tax Ordinance (Amendment
No.132), 5762-2002, known as the tax reform, came into effect thus imposing
capital gains tax at a rate of 15% on gains accrued on or after January 1, 2003
from the sale of shares in Israeli companies publicly traded on a recognized
stock exchange outside of Israel. This tax rate does not apply to: (1) dealers
in securities; (2) shareholders that report in accordance with the Income Tax
Law (Inflationary Adjustment) - 1985; or (3) shareholders who acquired their
shares prior to an initial public offering. The tax basis of shares acquired
prior to January 1, 2003 will be determined in accordance with the average
closing share price in the three trading days preceding January 1, 2003.
Non-Israeli residents shall be exempt from Israeli capital gains tax on any
gains derived from the sale of shares publicly traded on a stock exchange
recognized by the Israeli Ministry of Finance, provided such shareholders did
not acquire their shares prior to an initial public offering. In any event, the
provisions of the tax reform shall not affect the exemption from capital gains
tax for gains accrued before January 1, 2003, as described in the previous
paragraph.
In addition, pursuant to the Convention Between the Government of the United
States of America and the Government of Israel with Respect to Taxes on Income,
as amended (the "United States- Israel Tax Treaty"), the sale, exchange or
disposition of ordinary shares by a person who qualifies as a resident of the
United States within the meaning of the United States-Israel Tax Treaty and who
is entitled to claim the benefits afforded to such person by the United States-
Israel Tax Treaty (a "Treaty United States Resident") generally will not be
subject to the Israeli capital gains tax unless such "Treaty United States
Resident" holds, directly or indirectly, shares representing 10% or more of the
Company's voting power during any part of the twelve- month period preceding
such sale, exchange or disposition, subject to certain conditions. However,
under the United States-Israel Tax Treaty, such "Treaty United States Resident"
would be permitted to claim a credit for such taxes against the United States
federal income tax imposed with respect to such sale, exchange or disposition,
subject to the limitations in United States laws applicable to foreign tax
credits. The United States-Israel Tax Treaty does not relate to United States
state or local taxes.
41
Non-residents of Israel are subject to income tax on income accrued or derived
from sources in Israel. These sources of income include passive income,
including dividends, royalties and interest, as well as non-passive income from
services rendered in Israel. On distribution of dividends other than bonus
shares or stock dividends, income tax is withheld at source, at the rate of 25%,
or 12.5% for dividends not generated by an approved enterprise if the
non-resident is a U.S. corporation and holds at least 10% of our voting power,
and 15% for dividends generated by an approved enterprise, unless in each case a
different rate is provided in a treaty between Israel and shareholder's country
of residence. Under the U.S.-Israel tax treaty, the maximum tax on dividends
paid to a holder of ordinary shares who is a U.S. resident will be 25%. However,
under the Investment Law, dividends generated by an approved enterprise are
taxed at the rate of 15%.
Taxation of Non-Resident Shareholders
Non-residents of Israel are subject to Israeli income tax on income accrued or
derived from sources in Israel, including passive income such as dividends,
royalties and interest. On distributions of dividends, other than bonus shares
and stock dividends, income tax at the rate of 25% is withheld at the source,
unless a different rate is provided in a treaty between Israel and the
shareholder's country of residence. If the dividends are distributed out of
Approved Enterprise earnings, the applicable tax rate would be 15%. Under the
United States- Israel Tax Treaty, the maximum tax on dividends paid to a holder
of ordinary shares who is a Treaty United States Resident will be 25%, however
the tax rate is reduced to12.5% for dividends not generated by an Approved
Enterprise to a corporation which holds 10% or more of the Company's voting
power during a certain period preceding the distribution of the dividend.
Dividends derived from an Approved Enterprise will still be subject to 15% tax
withholding.
A non-resident of Israel who has had dividend income derived or accrued in
Israel from which the applicable tax was withheld at source is currently exempt
from the duty to file an annual Israeli tax return with respect to such income,
provided such income was not derived from a business carried on in Israel by
such non-resident and that such non-resident does not derive other non-passive
income from sources in Israel.
Tax Benefits for Research and Development
Israeli tax law allows under certain conditions a tax deduction in the year
incurred for expenditures in scientific research and development projects, if
the expenditures are approved by the relevant Israeli Government Ministry
(determined by the field of research) and the research and development is for
the promotion of the enterprise. Expenditures not so approved are deductible
over a three-year period. However, expenditures made out of the proceeds of
government grants are not deductible, i.e. Commtouch will be able to deduct the
unfunded portion of the research and development expenditures and not the gross
amount.
Law for the Encouragement of Industrial Research and Development, 5744-1984
Under the Law for the Encouragement of Industrial Research and Development,
5744-1984 (the "Research Law") and the Instructions of the Director General of
the Ministry of Industry, Trade and Labor, research and development programs and
the plans for the intermediate stage between research and development, and
manufacturing and sales approved by a governmental committee of the Office of
Chief Scientist (OCS) (the "Research Committee") are eligible for grants of up
to 50% of the project's expenditures if they meet certain criteria. These grants
are issued in return for the payment of royalties from the revenues derived from
the sale of the product developed in accordance with the program, as follows: 3%
of revenues during the first three years, 4% of revenues during the following
three years, and 5% of revenues in the seventh year and thereafter, with the
total royalties not to exceed 100% of the dollar value of the OCS grant (or in
some cases up to 300%). Following the full payment of such royalties, there is
no further liability for payment.
The Israeli government further requires that products developed with
governmental grants be manufactured in Israel. However, in the event that any
portion of the manufacturing is not conducted in Israel, if approval is received
from the OCS, the Company would be required to pay royalties that are adjusted
in proportion to manufacturing outside of Israel as follows: when the
manufacturing is performed outside of Israel by the Company or an affiliate
company, the royalties are to be paid as described above with the addition of
1%, and when the manufacturing outside of Israel is not performed by the Company
or an affiliate the royalties paid shall be equal to the ratio of the amount of
grant received from the OCS divided by the amount of grant received from the OCS
42
and the investment(s) made by the Company in the project. The payback will also
be adjusted to 120%, 150% or 300% of the grant if the portion of manufacturing
that is performed outside of Israel is up to 50%, between 50% and 90%, or more
than 90%, respectively. The technology developed pursuant to the terms of these
grants may not be transferred to third parties without the prior approval of the
Research Committee. Such approval is not required for the export of any products
resulting from such research or development. Approval of the transfer of
technology may be granted only if the recipient abides by all the provisions of
the Research Law and regulations promulgated thereunder, including the
restrictions on the transfer of know-how and the obligation to pay royalties in
an amount that may be increased. The Company is subject to various provisions of
the Research Law and regulations.
In order to meet certain conditions in connection with the grants and programs
of the OCS, the Company has made certain representations to the Israel
government about the Company's future plans for its Israeli operations. From
time to time the extent of the Company's Israeli operations has differed and may
in the future differ, from the Company's representations. If, after receiving
grants under certain of such programs, the Company fails to meet certain
conditions to those benefits, including, with respect to grants received from
the OCS, the maintenance of a material presence in Israel, or if there is any
material deviation from the representations made by the Company to the Israeli
government, the Company could be required to refund to the State of Israel taxes
or other benefits previously received (together with linkage adjustment to the
Israeli consumer price index) and would likely be ineligible to receive OCS
grants in the future.
The Company has participated in programs sponsored by the OCS for the support of
research and development activities. Through December 31, 2002, the Company had
recorded grants from OCS aggregating approximately $1.4 million for certain of
the Company's research and development projects. These grants were recorded as a
reduction of research and development costs. The Company submitted an
application for an additional grant in 2003, but decided not to draw any funds
thereunder during 2003. As noted, the Israeli government requires beneficiaries
of such grants to pay royalties to the Israeli government based on the revenues
derived from the sale of products, technologies and services developed with such
grants. We believe that we have no obligation for royalties in 2002 or 2003,
related to the 2002 grants totaling $0.2 million, since we did not generate
revenue from the product developed with such grants, and for the same reason we
do not anticipate generating revenue that will trigger a repayment obligation to
the OCS during 2004. It is possible that an obligation to pay royalties in 2004
and future years may be imposed on the Company, as we started to generate
revenues from our anti-spam solutions in the middle of 2003, although it is the
Company's position that no royalty bearing technologies are utilized in relation
to its anti-spam solutions. The ultimate liability is subject to review by the
OCS.With regard to grants before 2002, the Company claims that all of these
programs, which were funded at a total of $1.2 million, had failed and therefore
it will not be obligated to pay royalties. In March 2002, the Company submitted
an application for project failure with regard to projects from 2001 and prior
years. This application was accepted by the OCS in August 2002. Accordingly, the
Company has determined that as of December 31, 2002 there are no contingent
liabilities for royalties under those projects. The OCS would be entitled to
revisit the status of these projects in the future if the Company were to
commence utilizing technology developed under these projects.
Each application to the OCS is reviewed separately, and grants are based on the
program approved by the Research Committee. Expenditures supported under other
incentive programs of the State of Israel are not eligible for OCS grants. As a
result, there can be no assurance that applications to the OCS will be approved
or, if approved, what the amounts of the grants will be.
Fund for the Encouragement of Marketing Activities
The Company has received grants relating to its overseas marketing expenses from
the Marketing Fund. These grants are awarded for specific expenses incurred by
the Company for overseas marketing and are based upon the expenses reported by
the Company to the Marketing Fund. All marketing grants recorded from the
Marketing Fund until 1997 are linked to the dollar and are repayable as
royalties at the rate of 3% of the amount of increases in export sales realized
by the Company from the Marketing Fund. Grants recorded beginning January 1,
1998 bear royalties of 4% plus interest at LIBOR rates. The Company will face
royalty obligations on grants from the Marketing Fund only to the extent it
actually achieves increases in export sales. The proceeds of these grants are
presented in the Company's consolidated Financial Statements as offsets to
marketing expenses. Through December 31, 2000, the Company had received grants
from the Marketing Fund in the amount of approximately $279,000.
43
U.S. TAX CONSIDERATIONS REGARDING ORDINARY SHARES
ACQUIRED BY U.S. TAXPAYERS
The following discussion summarizes the material U.S. federal income tax
consequences arising from the purchase, ownership and sale of the ordinary
shares. This summary is based on the provisions of the Internal Revenue Code of
1986, as amended (the "Code"), final, temporary and proposed U.S. Treasury
Regulations promulgated thereunder, and administrative and judicial
interpretations thereof, in effect as of the date of this report, all of which
are subject to change, possibly with retroactive effect. Commtouch will not seek
a ruling from the Internal Revenue Service with regard to the United States
federal income tax treatment relating to investment in the ordinary shares and,
therefore, no assurance exists that the Internal Revenue Service will agree with
the conclusions set forth below. The summary below does not purport to address
all federal income tax consequences that may be relevant to particular
investors. This summary does not address the consequences that may be applicable
to particular classes of taxpayers, including investors that hold ordinary
shares as part of a hedge, straddle or conversion transaction, insurance
companies, banks or other financial institutions, broker-dealers, tax-exempt
organizations and investors who own (directly, indirectly or through
attribution) 10% or more of Commtouch's outstanding voting stock. Further, it
does not address the alternative minimum tax consequences of an investment in
ordinary shares or the indirect consequences to U.S. Holders, as defined below,
of equity interests in investors in ordinary shares. This summary is addressed
only to holders that hold ordinary shares as a capital asset within the meaning
of Section 1221 of the Code, are U.S. citizens, individuals resident in the
United States for purposes of U.S. federal income tax, domestic corporations or
partnerships and estates or trusts treated as "United States persons" under
Section 7701 of the Code ("U.S. Holders").
EACH INVESTOR SHOULD CONSULT WITH HIS OR HER OWN TAX ADVISOR AS TO THE
PARTICULAR U.S. FEDERAL INCOME TAX CONSEQUENCES OF THE PURCHASE, OWNERSHIP AND
SALE OF ORDINARY SHARES, INCLUDING THE EFFECTS OF APPLICABLE STATE, LOCAL,
FOREIGN OR OTHER TAX LAWS AND POSSIBLE CHANGES IN THE TAX LAWS.
Tax Basis of Ordinary Shares
A U.S. Holder's tax basis in his or her ordinary shares will be the purchase
price paid therefore by such U.S. Holder. The holding period of each ordinary
share owned by a U.S. Holder will commence on the day following the date of the
U.S. Holder's purchase of such ordinary share and will include the day on which
such U.S. Holder sells the ordinary share.
Sale or Exchange of Ordinary Shares
A U.S. Holder's sale or exchange of ordinary shares will result in the
recognition of gain or loss by such U.S. Holder in an amount equal to the
difference between the amount realized and the U.S. Holder's basis in the
ordinary shares sold. Subject to the following discussion of the consequences of
Commtouch being treated as a Passive Foreign Investment Company or a Foreign
Investment Company, such gain or loss will be capital gain or loss if such
ordinary shares are a capital asset in the hands of the U.S. Holder. Gain or
loss realized on the sale of ordinary shares will be long-term capital gain or
loss if the ordinary shares sold had been held for more than one year at the
time of their sale. Long-term capital gains recognized by certain taxpayers
generally are subject to a reduced rate of federal tax (currently a maximum of
15%). If the U.S. Holder's holding period on the date of the sale or exchange
was one year or less, such gain or loss will be short-term capital gain or loss.
Short-term capital gains generally are subject to tax at the same rates as
ordinary income. In general, any capital gain recognized by a U.S. Holder upon
the sale or exchange of ordinary shares will be treated as U.S.-source income
for U.S. foreign tax credit purposes.
See discussion under this Item 10 "Israeli Taxation and Investment
Programs--Capital Gains and Income Taxes Applicable to Non-Israeli Shareholders"
for a discussion of taxation by Israel of capital gains realized on sales of
capital assets.
Taxation of Dividends Paid On Ordinary Shares
A U.S. Holder will be required to include in gross income as ordinary income the
amount of any distribution paid on ordinary shares, including any Israeli taxes
withheld from the amount paid, to the extent the distribution is paid out of our
current or accumulated earnings and profits as determined for United States
federal income tax purposes. Distributions in excess of these earnings and
profits will be applied against and will reduce the U.S. Holder's basis in the
ordinary shares and, to the extent in excess of this basis, will be treated as
gain from the sale or exchange of ordinary shares.
44
Recently enacted amendments to the Code, as amended, provide that dividend
income may be eligible for a reduced rate of taxation. Dividend income will be
taxed at the applicable long-term capital gains rate if the dividend is received
from a "qualified foreign corporation," and the shareholder of such foreign
corporation holds such stock for more than 60 days during the 120 day period
that begins on the date that is 60 days before the ex-dividend date for the
stock. The holding period is tolled for any days on which the shareholder has
reduced his risk of loss. A "qualified foreign corporation" is one that is
eligible for the benefits of a comprehensive income tax treaty with the United
States. A foreign corporation will be treated as qualified with respect to any
dividend paid, if its stock is readily tradable on an established securities
market. However, a foreign corporation will not be treated as qualified if it is
a Passive Foreign Investment Company (as discussed below) for the year in which
the dividend was paid or the preceding year.
Distributions of current or accumulated earnings and profits paid in foreign
currency to a U.S. Holder will be includible in the income of a U.S. Holder in a
U.S. dollar amount calculated by reference to the exchange rate on the day the
distribution is received. A U.S. Holder that receives a foreign currency
distribution and converts the foreign currency into U.S. dollars subsequent to
receipt will have foreign exchange gain or loss based on any appreciation or
depreciation in the value of the foreign currency against the U.S. dollar, which
will generally be U.S. source ordinary income or loss.
As described above, we will generally be required to withhold Israeli income tax
from any dividends paid to holders who are not resident in Israel. See "Israeli
Tax Considerations -- Taxation of Non-Resident Holders of Shares." If a U.S.
Holder receives a dividend from Commtouch that is subject to Israeli
withholding, the following would apply:
o You must include the gross amount of the dividend, not reduced by the
amount of Israeli tax withheld, in your U.S. taxable income.
o You may be able to claim the Israeli tax withheld as a foreign tax
credit against your U.S. income tax liability.
o The foreign tax credit is subject to significant and complex
limitations. Generally, the credit can offset only the part of your
U.S. tax attributable to your net foreign source passive income.
Additional special rules apply to taxpayers predominantly engaged in
the active conduct of a banking, insurance, financing or similar
business. Additionally, if we pay dividends at a time when 50% or more
of our stock is owned by U.S. persons, you may be required to treat
the part of the dividend attributable to U.S. source earnings and
profits as U.S. source income, possibly reducing the allowable credit,
unless you elect to calculate your foreign tax credit separately with
respect to Commtouch dividends.
o A U.S. Holder will be denied a foreign tax credit with respect to
Israeli income tax withheld from dividends received on the ordinary
shares to the extent the U.S. Holder has not held the ordinary shares
for at least 16 days of the 30-day period beginning on the date which
is 15 days before the ex-dividend date or to the extent the U.S.
Holder is under an obligation to make related payments with respect to
substantially similar or related property. Any days during which a
U.S. Holder has substantially diminished its risk of loss on the
ordinary shares are not counted toward meeting the 16-day holding
period required by the statute.
o If you do not elect to claim foreign taxes as a credit, you will be
entitled to deduct the Israeli income tax withheld from your Commtouch
dividends in determining your taxable income. Individuals who do not
claim itemized deductions, but instead utilize the standard deduction,
may not claim a deduction for the amount of the Israeli income taxes
withheld.
o If you are a U.S. corporation holding our stock, you cannot claim the
dividends-received deduction with respect to our dividends.
Special rules, described below, apply if Commtouch is a passive foreign
investment company.
45
Information Reporting and Backup Withholding
U.S. Holders generally are subject to information reporting requirements with
respect to dividends paid in the United States on ordinary shares. Existing
regulations impose back-up withholding on dividends paid in the United States on
ordinary shares unless the U.S. Holder provides IRS Form W-9 or otherwise
establishes an exemption. U.S. Holders are subject to information reporting and
back-up withholding at a rate of 28% on proceeds paid from the disposition of
ordinary shares unless the U.S. Holder provides IRS Form W-9 or otherwise
establishes an exemption.
Non-U.S. Holders generally are not subject to information reporting or back-up
withholding with respect to dividends paid on, or upon the disposition of,
ordinary shares, provided that the non-U.S. Holder provides a taxpayer
identification number, certifies to its foreign status, or otherwise establishes
an exemption.
Prospective investors should consult their tax advisors concerning the effect,
if any, of these Treasury regulations on an investment in ordinary shares. The
amount of any back-up withholding will be allowed as a credit against a U.S. or
Non-U.S. Holder's United States federal income tax liability and may entitle the
Holder to a refund, provided that specified required information is furnished to
the IRS.
Tax Consequences If We Are a Passive Foreign Investment Company
Generally, a foreign corporation is treated as a passive foreign investment
company ("PFIC") for United States federal income tax purposes for any tax year
if, in such tax year, either (i) 75% or more of its gross income is passive in
nature (the "Income Test"), or (ii) the average percentage of its assets during
such tax year that produce, or are held for the production of, passive income
(determined by averaging the percentage of the fair market value of its total
assets which are passive assets as of the end of each quarter of such year) is
50% or more (the "Asset Test").
Because less than 75% of our gross income in 2003 and in prior years constituted
passive income, as defined for purposes of the Income Test, we do not believe
that application of the Income Test would have resulted in our classification as
a PFIC for any of such years.
For 2001, 2002 and 2003, however, it is possible that we could be classified as
a PFIC under the Asset Test principally because a significant portion of our
assets continued to consist of the cash raised in connection with both a public
offering and a private offering of our ordinary shares in 2000, coupled with the
decline in the public market value of our ordinary shares during 2001, 2002 and
through the beginning of 2003 and the timing of the required valuations,
although there is no definitive method prescribed in the Code, United States
Treasury Regulations or administrative or judicial interpretations thereof for
determining the value of a foreign corporation's assets for purposes of the
Asset Test. While the legislative history of the United States Taxpayer Relief
Act of 1997 indicates that "the total value of a publicly-traded foreign
corporation's assets generally will be treated as equal to the sum of the
aggregate value of its outstanding stock plus its liabilities", there remains
substantial uncertainty regarding the valuation of a publicly-traded foreign
corporation's assets for purposes of the Asset Test, and it is arguable that
under alternative valuation methodologies, the value of our total assets as of
the relevant valuation dates in 2001, 2002 and/or 2003 would not result in our
classification as a PFIC during any or all of such years.
In view of the uncertainty regarding the valuation of our assets for purposes of
the Asset Test and the complexity of the issues regarding our treatment as a
PFIC, U.S. Shareholders are urged to consult their own tax advisors for guidance
as to our status as a PFIC. For those U.S. Shareholders who determine that we
were a PFIC and notify us in writing of their request for the information
required in order to effectuate the QEF Election described below, we will
promptly make such information available to them.
If we are treated as a PFIC for United States federal income tax purposes for
any year during a U.S. Shareholder's holding period of ordinary shares and the
U.S. Shareholder does not make a QEF Election or a "mark-to-market" election
(both as described below), any gain recognized by the U.S. Shareholder upon the
sale of ordinary shares (or the receipt of certain distributions) would be
treated as ordinary income. This income would be allocated over the U.S.
Shareholder's holding period with respect to his ordinary shares and an interest
charge would be imposed on the amount of deferred tax on the income allocated to
prior taxable years.
46
Although we generally will be treated as a PFIC as to any U.S. Shareholder if we
are a PFIC for any year during the U.S. Shareholder's holding period, if we
cease to satisfy the requirements for PFIC classification, then under such
circumstances, the U.S. Shareholder may avoid the consequences of PFIC
classification for subsequent years if he elects to recognize gain based on the
unrealized appreciation in the ordinary shares through the close of the tax year
in which we cease to be a PFIC. Additionally, if we are treated as a PFIC, a
U.S. Shareholder who acquires ordinary shares from a decedent would be denied
the normally available step-up in tax basis for these ordinary shares to fair
market value at the date of death and instead would have a tax basis equal to
the decedent's tax basis in these ordinary shares.
For any tax year in which we are treated as a PFIC, a U.S. Shareholder may elect
to treat his ordinary shares as an interest in a qualified electing fund (a "QEF
Election"), in which case, the U.S. Shareholder would be required to include in
income currently his proportionate share of our earnings and profits in years in
which we are a PFIC regardless of whether distributions of our earnings and
profits are actually distributed to the U.S. Shareholder. Any gain subsequently
recognized upon the sale by the U.S. Shareholder of his ordinary shares,
however, generally would be taxed as capital gain.
As an alternative to a QEF Election, a U.S. Shareholder may elect to mark his
ordinary shares to market annually, recognizing ordinary income or loss (subject
to certain limitations) equal to the difference between the fair market value of
his ordinary shares and the adjusted tax basis of his ordinary shares. Losses
would be allowed only to the extent of net mark-to-market gain accrued under the
election.
We cannot assure you that we will avoid becoming a PFIC. U.S. holders who hold
ordinary shares during a period when we are a PFIC will be subject to the
foregoing rules, even if we cease to be a PFIC. U.S. Holders are urged to
consult their tax advisors about the PFIC rules, including QEF elections.
CONDITIONS IN ISRAEL
Commtouch is incorporated under the laws of the State of Israel, and
substantially all of our research and development and significant executive
facilities are located in Israel. Accordingly, Commtouch is directly affected by
political, economic and military conditions in Israel. Our operations would be
materially adversely affected if major hostilities involving Israel should occur
or if trade between Israel and its present trading partners should be curtailed.
Political Conditions
Since the establishment of the State of Israel in 1948, a number of armed
conflicts have taken place between Israel and its Arab neighbors. A state of
hostility, varying from time to time in intensity and degree, has led to
security and economic problems for Israel. Despite a peace agreement between
Israel and Egypt signed in 1979, a peace agreement between Israel and Jordan
signed in 1994 and, since 1993, several agreements between Israel and
Palestinian Authority, Israel continues to face hostile actions and threats from
various elements in the region. Further, Israel has not entered into any peace
agreement with Syria or Lebanon, and there have been major difficulties
accompanied by violence in the negotiations with the Palestinians. We cannot be
certain as to how the current hostilities affecting the region will develop or
what effect they may have upon Commtouch.
Certain countries, companies and organizations continue to participate in a
boycott of Israeli firms. Commtouch does not believe that the boycott has had a
material adverse effect on Commtouch, but restrictive laws, policies or
practices directed towards Israel or Israeli businesses may have an adverse
impact on the expansion of Commtouch's business.
Generally, all male adult citizens and permanent residents of Israel under the
age of 51 are obligated to perform annual military reserve duty of up to 39
days, or longer under certain circumstances. Additionally, all such residents
are subject to being called to active duty at any time under emergency
circumstances. Currently, a majority of our officers and employees are obligated
to perform annual reserve duty. While we have operated effectively under these
requirements since we began operations, no assessment can be made as to the full
impact of such requirements on our workforce or business if conditions should
change, and no prediction can be made as to the effect on us of any expansion or
reduction of such obligations.
47
Economic Conditions
Israel's economy has been subject to numerous destabilizing factors, including a
period of rampant inflation in the early to mid-1980s, low foreign exchange
reserves, fluctuations in world commodity prices, military conflicts and civil
unrest. The Israeli government has, for these and other reasons, intervened in
various sectors of the economy, employing, among other means, fiscal and
monetary policies, import duties, foreign currency restrictions and controls of
wages, prices and foreign currency exchange rates. The Israeli government has
periodically changed its policies in all these areas.
Until May 1998, Israel imposed extensive restrictions on transactions in foreign
currency. These restrictions were largely lifted in May 1998, and since January
1, 2003, all exchange control restrictions have been removed, although there are
still reporting requirements for foreign currency transactions. However,
legislation remains in effect pursuant to which currency controls can be imposed
by administrative action at any time. Nonresidents of Israel who purchase our
ordinary shares are able to repatriate in non-Israeli currency both dividends
(after deduction of withholding tax) and the proceeds from the sale of the
shares.
Trade Agreements
Israel is a member of the United Nations, the International Monetary Fund, the
International Bank for Reconstruction and Development and the International
Finance Corporation. Israel is also a signatory to the General Agreement on
Tariffs and Trade, which provides for reciprocal lowering of trade barriers
among its members. In addition, Israel has been granted preferences under the
Generalized System of Preferences from Australia, Canada and Japan. These
preferences allow Israel to export the products covered by such programs either
duty-free or at reduced tariffs.
Israel has entered into preferential trade agreements with the European Union,
the United States and the European Free Trade Association. In recent years,
Israel has established commercial and trade relations with a number of the other
nations, including Russia, China and India, with which Israel had not previously
had such relations.
Assistance from the United States
Israel receives significant amounts of economic and military assistance from the
United States. There is no assurance that foreign aid from the United States
will continue at or near amounts received in the past. If the grants for
economic and military assistance are eliminated or reduced significantly, the
Israeli economy could suffer material adverse consequences.
Item 11. Qualitative and Quantitative Disclosure about Market Risk.
We develop our technology in Israel and seek to provide our software products
worldwide. As a result, our financial results could be affected by factors such
as changes in foreign currency exchange rates or weak economic conditions in
foreign markets. As most of our sales are currently made in U.S. dollars, a
strengthening of the dollar could make our anti-spam solutions less competitive
in foreign markets. Due to the nature and level of our debts, we have concluded
that there is currently no material market risk exposure. Therefore, no
quantitative tabular disclosures are required.
Interest Rate Risks
Our exposure to market risk for changes in interest rates in the U.S. relates
primarily to our long-term convertible loan. The fair value of our long-term
convertible loan is based upon their market values. Changes in U.S. interest
rates, could affect our financial results.
Item 12. Description of Securities Other than Equity Securities.
Not applicable.
48
PART II
Item 13. Defaults, Dividend Arrearages and Delinquencies.
Not applicable.
Item 14. Material Modifications to the Rights of Security Holders and Use of
Proceeds.
Not applicable.
Item 15. Controls and Procedures
(a) Under the supervision and with the participation of our management,
including our principal executive officer and principal financial officer, we
conducted an evaluation of the effectiveness of our disclosure controls and
procedures, as such term is defined under Rule 13a-15(e) promulgated under the
Exchange Act, as of the end of 2003. Based on their evaluation, our principal
executive officer and principal financial officer concluded that the Company's
disclosure controls and procedures are effective.
(b) There have been no significant changes (including corrective actions with
regard to significant deficiencies or material weaknesses) in our internal
controls or in other factors that could significantly affect these controls
subsequent to the date of the evaluation referenced in paragraph (a) above,
including any corrective actions with regard to significant deficiencies and
material weaknesses.
Item 16. Reserved
Item 16A. Audit Committee Financial Expert
The Board of Directors of the Company has determined that Mr. Ofer Segev is a
financial expert serving on the Audit Committee, and Mr. Segev is independent of
management pursuant to the independence standards set forth in Nasdaq
Marketplace Rule 4200(a)(15) and SEC Rule 10A-3(b)(1).
Item 16B. Code of Ethics
The Company, by way of Board of Director resolution, has adopted a Code of
Ethics applicable to its senior financial officers, including its principal
executive, financial and accounting officers. The Code of Ethics is posted on
the Company's website at www.commtouch.com, under the link to "investor
relations".
Item 16C. Fees to Auditors
Kost, Forer, Gabbay & Kasierer, a member of Ernst & Young International Ltd. or
Ernst & Young, has served as our Independent Public Accountants for each of the
fiscal years in the three-year period ended December 31, 2003, for which audited
financial statements appear in this annual report on Form 20-F. The following
table presents the aggregate fees for professional and other services rendered
by Kost, Forer , Gabbay & Kasierer for 2003 and 2002:
Year ended December 31,
---------------------------
2003 2002
-------- --------
Audit fees (1) $ 59,500 $137,352
Tax (2) 3,000 7,500
All other fees (3) 4,080 22,268
-------- --------
Total $ 66,580 $167,120
======== ========
49
(1) Audit fees consist of fees billed for the annual audit services engagement
and other audit services, which are those services that only the external
auditor can reasonably provide, and include the group audit; statutory
audits; consents; attest services; and assistance with and review of
documents filed with the SEC.
(2) Tax fees include fees billed for tax compliance services, including the
preparation of original and amended tax returns and claims for refund; tax
consultations, such as assistance and representation in connection with tax
audits and appeals, tax advice related to mergers and acquisitions,
transfer pricing, and requests for rulings or technical advice from taxing
authority; tax planning services; and expatriate tax planning and services.
(3) All other fees include fees billed for training; advisory services related
to government applications and process improvement and advice.
Audit Committee Pre-approval Policies and Procedures
Below is a summary of the current Policies and Procedures:
The main role of the Company's audit committee is to assist the Board of
Directors in fulfilling its responsibility for oversight of the quality and
integrity of the accounting, auditing and reporting practices of the Company.
The Audit Committee oversees the appointment, compensation, and oversight of the
public accounting firm engaged to prepare or issue an audit report on the
financial statements of the Company. The audit committee's specific
responsibilities in carrying out its oversight role include the approval of all
audit and non-audit services to be provided by the external auditor and the
quarterly review of the firm's non-audit services and related fees. These
services may include audit services, audit-related services, tax services and
other services, as described above. It is the policy of the audit committee to
approve in advance the particular services or categories of services to be
provided to the Company periodically. Additional services may be pre-approved by
the audit committee on an individual basis during the year.
PART III
Item 17. Financial Statements.
The Company has responded to Item 18.
Item 18. Financial Statements
(a) Financial Statements
Page
----
Report of Independent Auditors.......................................... F-1
Consolidated Balance Sheets............................................. F-2
Consolidated Statements of Operations................................... F-3
Statement of Changes in Shareholders' Equity............................ F-4
Consolidated Statements of Cash Flows................................... F-5
Notes to Consolidated Financial Statements.............................. F-8
(b) Financial Statement Schedule:
The following financial statement schedule of Commtouch Software Ltd. for each
of the three years in the period ended December 31, 2003 is filed as part of the
Annual Report and should be read in conjunction with the consolidated financial
statements of Commtouch Software Ltd.
Schedule II --Valuation and Qualifying Accounts
Schedules not listed above have been omitted because the information required to
be set forth therein is not applicable or is shown in the consolidated financial
statements or notes thereto.
50
Item 19 Exhibits
The list of exhibits required by this Item is incorporated by reference to the
Exhibit Index which precedes the exhibits to this report.
51
REPORT OF INDEPENDENT AUDITORS
To the Shareholders of COMMTOUCH SOFTWARE LTD.
We have audited the accompanying consolidated balance sheets of Commtouch
Software Ltd. ("the Company") and subsidiaries as of December 31, 2002 and 2003,
and the related consolidated statements of operations, changes in shareholders'
equity, and cash flows for each of the three years in the period ended December
31, 2003. Our audits also included the financial statement schedule listed in
the Index at item 18(b). These financial statements and schedule are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards, in the United States. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatements. 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 the Company's management, as well as evaluating
the overall financial statements presentation. We believe that our audits
provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above, present
fairly, in all material respects, the consolidated financial position of
Commtouch Software Ltd. and subsidiaries as of December 31, 2002 and 2003, and
the consolidated results of their operations and their cash flows for each of
the three years in the period ended December 31, 2003, in conformity with U.S.
generally accepted accounting principles. Also, in our opinion, the related
financial statement schedule, when considered in relation to the basic financial
statements taken as a whole, present fairly in all material respect the
information set forth therein.
Tel-Aviv, Israel
February 20, 2004
KOST, FORER, GABBAY & KASIERER
A Member of Ernst & Young Global
F-1
COMMTOUCH SOFTWARE LTD.
CONSOLIDATED BALANCE SHEETS
(USD in thousands, except share and per share data)
December 31,
--------------------------------
2002* 2003
--------- ---------
Assets
Current Assets:
Cash and cash equivalents ..................................................... $ 1,388 $ 4,125
Trade receivables, net ........................................................ 64 92
Receivables on account of shares .............................................. -- 955
Prepaid expenses .............................................................. 139 156
Other accounts receivable ..................................................... 92 132
--------- ---------
Total current assets .......................................................... 1,683 5,460
--------- ---------
Long-term lease deposits ...................................................... 5 5
Severance pay fund ............................................................ 264 391
Deferred expenses ............................................................. -- 236
Property and equipment, net ................................................... 1,029 452
Investment in affiliate ....................................................... 3 339
--------- ---------
$ 2,984 $ 6,883
--------- ---------
Liabilities and Shareholders' Equity
Current Liabilities:
Accounts payable .............................................................. $ 338 $ 479
Employees and payroll accruals ................................................ 424 418
Deferred revenues ............................................................. -- 222
Accrued expenses and other liabilities ........................................ 372 376
--------- ---------
Total current liabilities ..................................................... 1,134 1,495
--------- ---------
Other liabilities ............................................................. 135 --
Convertible loan, net ......................................................... -- 2,134
Accrued severance pay ......................................................... 278 425
Shares to be registered upon exercise of warrants ............................. -- 372
--------- ---------
413 2,931
--------- ---------
Commitments and Contingencies
Shareholders' Equity
Ordinary Shares, nominal value NIS 0.05 par value-
Authorized: 40,000,000 and 75,000,000 shares as of
December 31, 2002 and 2003; Issued and
outstanding: 22,219,696 and 37,104,615 shares
as of December 31, 2002 and 2003, respectively ................................ 290 456
Additional paid-in capital .................................................... 153,460 160,592
Accumulated other comprehensive income ........................................ -- 46
Deferred stock compensation ................................................... (277) (30)
Notes receivable from shareholders, net ....................................... (365) (102)
Accumulated deficit ........................................................... (151,671) (158,505)
--------- ---------
Total shareholders' equity .................................................... 1,437 2,457
--------- ---------
$ 2,984 $ 6,883
========= =========
* - reclassified to conform to current year presentation
The accompanying notes are an integral part of these consolidated financial statements.
F-2
COMMTOUCH SOFTWARE LTD.
CONSOLIDATED STATEMENTS OF OPERATIONS
(USD in thousands, except share and per share data)
Year ended
December 31,
------------------------------------------
2001 2002 2003
-------- -------- --------
Revenues:
Email services ............................................................. $ 13,318 $ 3,238 $ 329
Software licenses .......................................................... 270 200 --
-------- -------- --------
Total revenues ............................................................. 13,588 3,438 329
Cost of revenues ................................................................ 13,962 1,675 581
-------- -------- --------
Gross profit (loss) ............................................................. (374) 1,763 (252)
-------- -------- --------
Operating expenses:
Research and development, net .............................................. 5,884 2,246 1,476
Sales and marketing ........................................................ 12,894 1,176 1,875
General and administrative ................................................. 10,337 2,588 1,308
Amortization of stock-based employee deferred compensation (1) ............. 2,204 551 247
Write-off of property and equipment and other .............................. 10,166 750 --
-------- -------- --------
Total operating expenses ................................................... 41,485 7,311 4,906
-------- -------- --------
Operating loss .................................................................. (41,859) (5,548) (5,158)
Interest and other income (expense), net ................................... 583 (60) (1,967)
Equity in earnings (losses) of affiliate ................................... -- (56) 291
Write-off of impaired long-term investments ................................ (2,000) -- --
Minority interest .......................................................... 285 74 --
-------- -------- --------
Loss from continuing operations ................................................. (42,991) (5,590) (6,834)
-------- -------- --------
Discontinued operations
Gain from disposal of Wingra ............................................... -- 1,014 --
Discontinued operations - Wingra ........................................... (18,016) (335) --
-------- -------- --------
Income (Loss) from discontinued operations ...................................... (18,016) 679 --
-------- -------- --------
Net loss ........................................................................ $(61,007) $ (4,911) $ (6,834)
======== ======== ========
Basic and diluted net loss per share
Loss from continuing operations ............................................ $ (2.51) $ (0.27) $ (0.28)
Income (Loss) from discontinued operations ................................. (1.05) $ 0.03 $ --
-------- -------- --------
Net loss ........................................................................ $ (3.56) $ (0.24) $ (0.28)
======== ======== ========
Weighted average number of shares used in computing
basic and diluted net loss per share ....................................... 17,152 20,854 24,573
======== ======== ========
Year ended
December 31,
------------------------------------------
2001 2002 2003
-------- -------- --------
(1) Stock-based Employee Compensation Relates to the following:
Cost of revenues ........................................................... $ 82 $ 20 $ 9
Research and development, net .............................................. 226 56 25
Sales and marketing ........................................................ 554 139 62
General and administrative ................................................. 1,342 336 151
-------- -------- --------
Total ...................................................................... $ 2,204 $ 551 $ 247
======== ======== ========
The accompanying notes are an integral part of these consolidated financial statements.
F-3
COMMTOUCH SOFTWARE LTD.
STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY
(USD in thousands, except share and per share data)
Stock-based
employee
Ordinary share Ordinary Additional deferred
Shares share Amount paid-in capital compensation
---------- ---------- --------------- ------------
Balance as of January 1, 2001 ................................. 16,925,022 $ 236 $ 150,994 (2,729)
Issuance of shares, net .................................... 315,789 2 256 --
Issuance of shares upon exercise of options ................ 256,008 1 116 --
Stock based compensation related to warrants
granted to a service provider ............................ -- -- 53 --
Amortization of deferred stock compensation ................ -- -- -- 2,204
Deferred stock based compensation .......................... -- -- 303 (303)
Repayment of notes receivable .............................. -- -- -- --
Forgiveness of notes receivable ............................ -- -- -- --
Other comprehensive income-unrealized
holding losses on marketable securities .................. -- -- -- --
Issuance of shares to minority interest in
Japan - Note 2j .......................................... -- -- 440 --
Net loss ................................................... -- -- -- --
---------- ---------- ---------- ----------
Total comprehensive loss ................................... -- -- -- --
Balance as of December 31, 2001 ............................... 17,496,819 239 152,162 (828)
Issuance of shares, net .................................... 4,434,932 48 1,295 --
Issuance of shares upon exercise of options ................ 287,945 3 3 --
Amortization of deferred stock based
compensation ............................................. -- -- -- 551
Repayment of notes receivable .............................. -- -- -- --
Valuation allowance for notes receivable ................... -- -- -- --
Net loss ................................................... -- -- -- --
---------- ---------- ---------- ----------
Total comprehensive loss ................................... -- -- -- --
Balance as of December 31, 2002 ............................... 22,219,696 290 153,460 (277)
Issuance of shares, net .................................... 5,546,667 60 2,949 --
Issuance of shares upon exercise of options ................ 287,087 3 33 --
Issuance of shares due to conversion of
convertible loan ......................................... 5,693,142 64 1,836 --
Issuance of shares to shareholders upon
exercise of warrants ..................................... 3,151,126 36 1,230 --
Issuance of shares to consultants upon
exercise of warrants ..................................... 206,897 3 -- --
Beneficial conversion feature of notes and
fair value of warrants ................................... -- -- 1,084 --
Amortization of deferred stock based
compensation ............................................. -- -- -- 247
Repayment of notes receivable .............................. -- -- -- --
Forgiveness of notes receivable ............................ -- -- -- --
Valuation allowance for notes receivable ................... -- -- -- --
Accumulated other comprehensive income
-Foreign currency translation adjustment ................. -- -- -- --
Net loss ................................................... -- -- -- --
Total comprehensive loss ................................... -- -- -- --
---------- ---------- ---------- ----------
Balance as of December 31, 2003 ............................... 37,104,615 $ 456 $ 160,592 $ (30)
========== ========== ========== ==========
The accompanying notes are an integral part of these consolidated financial statements.
F-4
COMMTOUCH SOFTWARE LTD.
Notes Accumulated
receivable other Total
from comprehensive Accumulated Comprehensive
shareholders income deficit Loss Total
--------- --------- --------- --------- ---------
Balance as of January 1, 2001 ................................ (1,041) 21 (85,753) -- 61,728
Issuance of shares, net ................................... -- -- -- -- 258
Issuance of shares upon exercise of options ............... -- -- -- -- 117
Stock based compensation related to warrants
granted to a service provider ........................... -- -- -- -- 53
Amortization of deferred stock based compensation ......... -- -- -- -- 2,204
Deferred stock compensation ............................... -- -- -- -- --
Repayment of notes receivable ............................. 144 -- -- -- 144
Forgiveness of notes receivable ........................... 143 -- -- -- 143
Other comprehensive income--unrealized
holding losses on marketable securities ................. -- (21) -- (21) (21)
Issuance of shares to minority interest in
Japan-Note 2j ........................................... -- -- -- -- 440
Net loss .................................................. -- -- (61,007) (61,007) (61,007)
--------- --------- --------- ========= ---------
Total comprehensive loss .................................. -- -- -- (61,028)
=========
Balance as of December 31, 2001 .............................. (754) -- (146,760) -- 4,059
Issuance of shares, net ................................... -- -- -- -- 1,343
Issuance of shares upon exercise of options ............... -- -- -- -- 6
Amortization of deferred stock based compensation ......... -- -- -- -- 551
Repayment of notes receivable ............................. 4 -- -- -- 4
Valuation allowance for notes receivable .................. 385 -- -- -- 385
Net loss .................................................. -- -- (4,911) (4,911) (4,911)
--------- --------- --------- ========= ---------
Total comprehensive loss .................................. -- -- -- (4,911)
=========
Balance as of December 31, 2002 .............................. (365) -- (151,671) -- 1,437
Issuance of shares, net ................................... -- -- -- -- 3,009
Issuance of shares upon exercise of options ............... -- -- -- -- 36
Issuance of shares due to conversion of convertible ....... -- -- -- -- 1,900
loan
Issuance of shares to shareholders upon exercise
of warrants ............................................ -- -- -- -- 1,266
Issuance of shares to consultants upon
exercise of warrants .................................. -- -- -- -- 3
Beneficial conversion feature of notes and
fair value of warrants ................................. -- -- -- -- 1,084
Amortization of deferred stock based compensation ......... -- -- -- -- 247
Repayment of notes receivable ............................. 581 -- -- -- 581
Forgiveness of notes receivable ........................... 67 -- -- -- 67
Valuation allowance for notes receivable .................. (385) -- -- -- (385)
Accumulated other comprehensive income -
Foreign currency translation adjustment ................... -- -- -- 46 46
Net loss .................................................. -- -- (6,834) (6,834) (6,834)
--------- --------- --------- ========= ---------
Total comprehensive loss .................................. -- -- -- (6,788)
=========
Balance as of December 31, 2003 .............................. $ (102) $ -- $(158,505) -- $ 2,457
========= ========= ========= ========== =========
The accompanying notes are an integral part of these consolidated financial statements.
F-5
COMMTOUCH SOFTWARE LTD.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(USD in thousands)
Year Ended
December 31,
--------------------------------------
2001 2002 2003
-------- -------- --------
Cash flows from operating activities:
Net loss ........................................................................... $(61,007) $ (4,911) $ (6,834)
Less loss for the period from discontinued operations .............................. 18,016 335 --
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization ...................................................... 7,432 1,988 608
Amortization of deferred stock-based compensation and warrants
issued for services received ....................................................... 2,204 551 247
Amortization of convertible loan discount, beneficial conversion
feature and fair value of warrants ................................................. -- -- 1,084
Inducement relating to early conversion of convertible loan ........................ -- -- 752
Write-off of impaired long-term investments ........................................ 2,000 -- --
Write-off of property, equipment and other ......................................... 10,166 750 --
Loss from sale of property and equipment ........................................... 751 247 --
Gain from sale of discontinued operations .......................................... -- (1,014) --
Loss from sale of shares in consolidated subsidiary ................................ -- 153 --
Equity in earnings (losses) of affiliate ........................................... -- (56) (291)
Changes in assets and liabilities:
Trade receivables, net ............................................................. 3,712 114 (28)
Prepaid expenses and other accounts receivable ..................................... 2,932 379 60
Accounts payable ................................................................... (3,052) (981) 141
Employee and payroll accruals, accrued expenses and other liabilities .............. (5,164) (496) (137)
Deferred revenues .................................................................. (739) (445) 222
Accrued severance pay, net ......................................................... 216 (91) 20
Valuation allowance of notes receivable ............................................ -- 385 (385)
Forgiveness of notes receivable .................................................... 143 -- 67
Minority interest in losses of a consolidated subsidiary ........................... (285) (74) --
Other .............................................................................. (1,969) 366 7
-------- -------- --------
Net cash used in operating activities ................................................. (24,644) (2,800) (4,467)
-------- -------- --------
Cash flows from investing activities:
Proceeds from sales of marketable securities ....................................... 8,586 -- --
Long-term lease deposits ........................................................... 202 100 --
Proceeds from sale of Wingra ....................................................... -- (193) --
Proceeds from sale of consolidated subsidiary ...................................... -- 1 --
Proceeds from sale of property and equipment ....................................... 160 719 --
Purchase of property and equipment ................................................. (3,265) -- (31)
-------- -------- --------
Net cash (used) provided in investing activities ...................................... 5,683 627 (31)
-------- -------- --------
Cash flows from financing activities:
Repayment of note receivable by shareholder ........................................ 144 4 581
Repayment of bank loans and notes payable .......................................... (946) (40) --
Principal payment of capital lease ................................................. (24) -- --
Proceeds from issuance of shares, net .............................................. 428 1,349 3,273
Proceeds from issuance of convertible loan ......................................... -- -- 2,500
Proceeds from conversion of loan, net .............................................. -- -- 1,234
Deferred expenses regarding convertible loan ....................................... -- -- (353)
Proceeds from minority interest in consolidated subsidiary ......................... 440 -- --
Contribution from minority interest of consolidated subsidiary ..................... 336 -- --
-------- -------- --------
Net cash provided by financing activities ............................................. 378 1,313 7,235
-------- -------- --------
Decrease in cash and cash equivalents ................................................. (18,583) (860) 2,737
Cash and cash equivalents at the beginning of the year ................................ 20,831 2,248 1,388
-------- -------- --------
Cash and cash equivalents at the end of the year ...................................... $ 2,248 $ 1,388 $ 4,125
======== ======== ========
The accompanying notes are an integral part of these consolidated financial statements.
F-6
COMMTOUCH SOFTWARE LTD.
Supplemental disclosure of cash flows activity:
Cash paid during the year:
Interest ........................................................................... $ 161 $ 3 $--
Non-cash transaction
Receivables on account of shares ...................................................... $-- $-- $ 955
Discount due to fair value of warrants ................................................ $-- $-- $ 366
Conversion of loan .................................................................... $-- $-- $ 1,234
The proceeds from the sale of Wingra, for year ended December 31, 2002 were as
follows:
Tangible assets sold .............................................. $ 314
Liabilities transferred ........................................... (1,521)
-------
Net liabilities transferred: ...................................... (1,207)
Cash transferred: ................................................. 193
-------
Gain from sale of Wingra .......................................... $(1,014)
The proceeds from the sale of shares in consolidated subsidiary (Commtouch K.K
(Japan), now known as Imatrix), for year ended December 31, 2002 were as
follows:
Tangible assets ................................................... $ 421
Liabilities ....................................................... (267)
-------
Net assets transferred: ........................................... 154
Cash received: .................................................... 1
-------
Loss from sale of consolidated subsidiary ......................... $ 153
The accompanying notes are an integral part of these
consolidated financial statements.
F-7
Commtouch Software Ltd.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share and per share data)
NOTE 1: GENERAL
a. Commtouch Software Ltd. ("Commtouch", "the Company") was incorporated under
the laws of Israel in 1991. The Company and its subsidiary (Commtouch Inc.)
develop and provide email anti-spam solutions to enterprises. During 2002, the
Company's main business was providing outsourced integrated Web-based email and
messaging solutions to a few businesses that remained as customers following the
transfer of theconsumer outsource web-based email business and sale of the
Hosted Exchange email business during late 2001 and early 2002. During early
2002, concurrent with the divestiture of the Company's above-stated businesses,
the Company began marketing to service providers its messaging software platform
("CMP"), which had been in development by the Company prior to that time.
Following a concerted effort to penetrate the email server market and a
determination that the continuing unfavorable economic conditions would hamper
potential sales of CMP, and given the Company's inherent knowledge of anti-spam
solutions based on its many years as an ASP in the outsourced email market and
the growing worldwide attention was directed to the problem of spam, the Company
transitioned its focus to the anti-spam market in mid-2002. While no uniform
definition of spam exists, the Company generally defines "spam" as the sending
of unsolicited bulk email for commercial and non-commercial purposes. During
2003, approximately 70% of the revenues were derived from three customers (33%
from customer A, 25% from customer B, and 12% from customer C). During 2002,
approximately 57% of the revenues were derived from two customers (39% from
customer D and 18% from customer E). During 2001, no single customer accounted
for more than 10% of the revenues.
The Company expects that it will continue to be dependent upon resellers for a
significant portion of its revenues, which will derived from sales of the
Company's anti-spam solutions. Also, the Company is still developing its
distribution channels and is currently dependent on a relatively small number of
its global resellers/channel partners to generate the majority of sales
transactions. If anticipated orders from these resellers fail to materialize, or
one of the key resellers/distribution channels ceases the promotion of the
Company's business, operating results and financial condition will be materially
adversely affected.
b. Discontinued operations
In November 2000, the Company acquired Wingra, Inc. ("Wingra"), a provider of
messaging integration and migration solutions for large enterprises.
In February 2002, the Company sold off its migration service business, Wingra,
to Wingra's senior management. The operations of Wingra were eliminated from the
operations of the entity as a result of this transaction. The Company has no
intent to continue its activity in the migration service. The results of
operations, including revenue, operating expenses and other income and expense
of Wingra for 2001 and 2002, have been reclassified in the accompanying
statements of operations as discontinued operations.
The proceeds from the sale of Wingra for the year ended December 31, 2002 were
as follows:
Tangible assets: .......................................... $ 314
Liabilities transferred ................................... (1,521)
-------
Net liabilities transferred: .............................. (1,207)
Cash transferred: ......................................... 193
-------
Gain from sale of Wingra .................................. $(1,014)
=======
F-8
Commtouch Software Ltd.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share and per share data)
Summary operating results from the discontinued operation for the years ended
December 31, 2001 and 2002 are as follows:
Year Ended
December 31,
-----------------------
2001 2002
-------- --------
Revenues ........................................... $ 1,730 $ 157
Cost of revenues ................................... 643 76
-------- --------
Gross profit ....................................... 1,087 81
Operating expenses ................................. 3,029 416
Amortization and impairment of goodwill and
other intangible assets .......................... 16,074 --
-------- --------
Operating loss ..................................... $(18,016) $ (335)
======== ========
NOTE 2: SIGNIFICANT ACCOUNTING POLICIES
The consolidated financial statements have been prepared in accordance with
accounting principles generally accepted in the United States ("U.S. GAAP").
a. Use of Estimates:
The preparation of consolidated financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the amounts reported in the consolidated financial
statements and accompanying notes. Actual results could differ from those
estimates.
b. Financial Statements in U. S. Dollars:
A majority of the revenues of the Company and its subsidiaries is made in United
States dollars ("dollars"). In addition, a substantial portion of their costs is
incurred or determined in dollars. The Company's management believes that the
dollar is the primary currency of the economic environment in which the Company
and its subsidiary operates. Thus the dollar is their functional and reporting
currency. Accordingly, monetary accounts maintained in currencies other than the
dollar are remeasured into U.S. dollars, in accordance with Statement of
Financial Accounting Standard No. 52 "Foreign Currency Translation" ("SFAS No.
52"). All transaction gains and losses of the remeasured monetary balance sheet
items are reflected in the statements of operations as financial income or
expenses, as appropriate.
The financial statements of the Company's affiliate, Imatrix ("Imatrix"),
reported using the equity method of accounting, whose functional currency is not
the dollar, have been translated into dollars, in accordance with SFAS No. 52.
All balance sheet accounts have been translated using the exchange rates in
effect at the balance sheet date. Statement of income amounts have been
translated using the average exchange rate for the year. The resulting aggregate
translation adjustments are reported as Foreign currency translation adjustment
under accumulated other comprehensive income in shareholders' equity.
c. Principles of Consolidation:
The consolidated financial statements include the accounts of the Company, its
wholly-owned subsidiary and majority-owned subsidiary. All inter-company
balances and transactions have been eliminated in consolidation.
d. Cash and Cash Equivalents:
Cash equivalents are short-term highly liquid investments that are readily
convertible to cash with original maturities of three months or less.
e. Investment in affiliate:
For the purposes of these financial statements, an affiliated company is a
company held to the extent of 20% or more, or a company less than 20% held,
which the Company can exercise significant influence over operating and
financial policy of the affiliate. The investment in an affiliated company is
accounted for under the equity method. Profits on inter-company sales not
realized outside the group were eliminated.
F-9
Commtouch Software Ltd.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share and per share data)
The Company's investment is reviewed for impairment whenever events or changes
in circumstances indicate that the carrying amount of investment may not be
recoverable. During 2003, the Company recognized $291 as "Equity in earnings
(losses) of affiliate."
As of December 31, 2003, no impairment losses have been identified.
f. Property and Equipment:
Property and equipment are stated at cost net of accumulated depreciation.
Depreciation is calculated using the straight line method over the estimated
useful lives of the assets at the following annual rates:
%
---------------------------------------
Computers and peripheral equipment 33.33
Office furniture and equipment 7 - 20
Motor vehicles 15 - 25
Leasehold improvements Over the term of the lease or the
life of the assets, by the shorter of
The Company and its subsidiary's long-lived assets are reviewed for impairment
in accordance with Statement of Financial Accounting Standard No.144 "Accounting
for the Impairment or Disposal of Long-Lived Assets" ("SFAS No.144") whenever
events or changes in circumstances indicate that the carrying amount of an asset
may not be recoverable. Recoverability of assets to be held and used is measured
by a comparison of the carrying amount of an asset to the future undiscounted
cash flows expected to be generated by the assets. If such assets are considered
to be impaired, the impairment to be recognized is measured by the amount by
which the carrying amount of the assets exceeds the fair value of the assets.
Assets to be disposed of are reported at the lower of the carrying amount or
fair value less costs to sell. For the year ended December 31, 2002 the Company
had impairment losses totaling $ 750, which were recorded as operating expenses.
No impairment losses were recorded in 2003.
During 2001, due to the economic slowdown, the reduction of the employee
headcount and the transfer into new facilities, the Company assesses the
recoverability of the carrying amount of property and equipment and provides for
any possible impairment loss based upon the difference between the carrying
amount and fair value of such assets in accordance with Statement of Financial
Accounting Standard No. 121 "Accounting for the Impairment of Long-Lived Assets
and for Long-Lived Assets to be Disposed Of". As a result of the evaluation, the
Company recordedimpairment losses totaling $10,166, which were recorded as
operating expenses.
g. Investments in other companies:
The investment in other companies is stated at lower of cost or estimated fair
value according to Accounting Principle Board Opinion No. 18 "The Equity Method
of Accounting for Investments in Common Stocks", since the Company does not have
the ability to exercise significant influence over operating and financial
policies of the investee. The Company's investments in other companies are
reviewed for impairment whenever events or changes in circumstances indicate
that the carrying amount of such investments may not be recoverable.
Measurements of an impairment loss for investments in other companies that
management expects to hold are based on the fair value of the investment.
The Company invested $7,000 in the first nine months of 2000 in three Internet
centric companies in which the Company believed it had a significant ongoing
strategic interest.
Due to the economic slowdown and the significant decline in capital available to
and in valuations of its investment in privately funded Internet centric
companies, the Company believes all of these investments are impaired. During
2000 and 2001, based on a comprehensive review of the Company's investments, the
Company recorded a non-cash charge of $5,000 and $1,700, respectively, to
write-down the recorded investment values.
h. Revenue Recognition:
During 2001 and through the first half of 2003, the Company derived its revenues
from providing hosted email services, royalties for the sale of its hosted Email
services and from software license agreements.
F-10
Commtouch Software Ltd.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share and per share data)
During the second half of 2003, the Company launched its first anti-spam
solution and began generating revenues therefrom.
Revenues from anti-spam and email services were recognized in accordance with
Staff Accounting Bulletin No. 104 "Revenue Recognition in Financial Statements"
("SAB No. 104") when delivery occurred, persuasive evidence of an agreement
existed, the vendor's fee was fixed and determinable and collectibility was
probable. Revenues from contracts that were not dependent upon the number of
mailboxes and provided non-refundable fixed payments were recognized ratably
over the contract term. Revenues from contracts specifying a contractual rate
per mailbox per month were recognized on a monthly basis for mailboxes covered
by the respective contracts. Revenues from contracts based on a share of
advertising revenues earned by business partners were recognized when such
revenues were earned. Deferred revenue includes unearned amounts received under
anti-spam and email service contracts, and amounts received by customers but not
recognized as revenues.
Royalties for the sale of the hosted email services were recognized when
persuasive evidence of an arrangement existed, services were provided, no
significant obligation with regard to the implementation remained, the fee was
fixed and determinable and collectibility was probable.
The Company accounts for software license revenue in accordance with Statement
of Position 97-2, "Software Revenue Recognition", as amended ("SOP 97-2"). SOP
97-2 generally requires revenue earned on software arrangements involving
multiple elements to be allocated to each element based on the relative fair
value of the elements. The Company has also adopted SOP 98-9, "Modification of
SOP 97-2, Software Revenue Recognition with Respect to Certain Transactions"
("SOP 98-9"), for all multiple elements transactions entered into after January
1, 2000. SOP 98-9 requires that revenue be recognized under the "Residual
Method" when "Vendor Specific Objective Evidence" ("VSOE") of fair value exists
for all undelivered elements and no VSOE exists for the delivered elements.
Revenue from software licenses fees to end users are recognized when persuasive
evidence of an arrangement exists, delivery of the software has occurred, no
significant obligation with regard to the implementation remains, the fee is
fixed and determinable and collectibility is probable.
i. Research and Development Costs:
Research and development costs are charged to the statement of operations as
incurred. Statement of Financial Accounting Standards No. 86 "Accounting for the
Costs of Computer Software to be Sold, Leased or Otherwise Marketed" requires
capitalization of certain software development costs subsequent to the
establishment of technological feasibility.
Based on the Company's product development process, technological feasibility is
established upon completion of a working model. The Company did not incur any
material costs between the completion of its working models and the points at
which its products were ready for general release. Therefore, through December
31, 2003, the Company charged all software development costs to research and
development expense in the period incurred.
j. Minority Interest:
Minority interest represents other shareholders' proportionate ownership of
Commtouch, K.K. (Japan) (now known as Imatrix). At December 31, 2001 the Company
owned 70.6%, and at December 31, 2002 and 2003, the Company owned 32% of the
equity and voting rights of Commtouch, K.K. (Japan).
During 2001, the Company's strategic partner in Japan, CSK, invested
approximately $800 in Commtouch, K.K. (Japan). According to Staff Accounting
Bulletin No. 84 "Accounting for Sales of Stock by a Subsidiary", the Company did
not recognize gains from this issuance of shares since it was considered to be
an early stage company and thus classified the issuance to the Shareholders'
Equity section of the balance sheet under Additional paid-in capital. In April
2002, as part of the Company's focus change, the Japanese subsidiary's employees
purchased 38% of Commtouch, K.K. (Japan) shares from the Company for the par
value of the shares. Consequently the Company's holdings decreased from 70% to
approximately 32%. The sale of the shares resulted in a loss of $153 that was
recorded as part of the equity in losses of an affiliate.
k. Concentrations of Credit Risk:
SFAS No. 105, "Disclosure of Information About Financial Instruments with
off-Balance-Sheet Risk and Financial Instruments with Concentration of Credit
Risk" requires disclosure of any significant off-balance-sheet and credit risk
F-11
Commtouch Software Ltd.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share and per share data)
concentrations. The Company and its subsidiaries have no significant
off-balance-sheet concentration of credit risk such as foreign exchange
contracts, option contracts or other foreign hedging arrangements.
Financial instruments that potentially subject the Company to concentrations of
credit risk consist principally of trade receivables, receivables on account of
shares and cash and cash equivalents. The majority of the Company's cash and
cash equivalents are invested in dollar and dollars linked investments and are
deposited in major banks in the United States and Israel. Such investments in
the United States may be in excess of insured limits and are not insured in
other jurisdictions. Management believes that the financial institutions that
hold the Company's investments are financially sound and, accordingly, minimal
credit risk exists with respect to these investments.
The trade receivables of the Company are derived from transactions with
companies located primarily in North America, Europe, Israel and the Far East.
An allowance for doubtful accounts is determined with respect to those amounts
that the Company and its subsidiaries have determined to be doubtful of
collection. The allowance for doubtful accounts is composed of specific debts
that are doubtful of collection amounting to $41 and $0 at December 31, 2002 and
2003, respectively. Bad debt expense (recovery) for the years-ended December 31,
2001, 2002 and 2003 was $260, $(40) and zero, respectively.
l. Accounting for Stock-Based Compensation:
The Company has elected to follow Accounting Principles Board Opinion No. 25
("APB 25") "Accounting for Stock Issued to Employees" and FASB Interpretation
No. 44 "Accounting for Certain Transactions Involving Stock Compensation," ("FIN
44") in accounting for its employee stock option plans. Under APB 25, when the
exercise price of the Company's stock options equals or is above the market
value of the underlying stock on the date of grant, no compensation expense is
recognized.
The Company has adopted the disclosure provisions of Financial Accounting
Standards Board Statement no. 148, "Accounting for Stock Based Compensation
Transition and Disclosure" ("SFAS 148") which amended certain provisions of SFAS
123 to provide alternative methods of translation for an entity that voluntarily
changes to the fair value based method of accounting for stock-based employee
compensation, effective as the beginning of the year. The Company continues to
apply the provisions of APB No. 25, in accounting for stock based compensation.
Pro forma information regarding the Company's net loss and net loss per share is
required by SFAS No. 123 and has been determined as if the Company has accounted
for its employee stock options under the fair value method prescribed by SFAS
No. 123.
Pro forma information under SFAS 123 is as follows:
2001 2002 2003
-------- -------- --------
Net loss as reported ......................................................... $(61,007) $ (4,911) $ (6,834)
Add - stock-based employee compensation - intrinsic value ................. 2,204 551 247
Deduct - stock-based employee compensation - fair value ................... (6,931) (4,267) (4,172)
-------- -------- --------
Pro forma net loss ........................................................... $(65,734) $ (8,627) $(10,759)
======== ======== ========
Basic and diluted net loss per share - as reported ........................... $ (3.56) $ (0.24) $ (0.28)
======== ======== ========
Basic and diluted net loss per share - pro forma ............................. $ (3.83) $ (0.41) $ (0.44)
-------- -------- --------
The Company applies SFAS 123 and Emerging Issues Task Force 96-18 "Accounting
for Equity Instruments that are Issued to Other than Employees for Acquiring, or
in Conjunction with Selling, Goods or Services" ("EITF 96-18") with respect to
options issued to non-employees. SFAS 123 requires use of an option valuation
model to measure the fair value of these options at the grant date. In
accounting for warrants granted to those other than employees, the Company
applied the provisions of SFAS No. 123, and EITF 96-18. The fair value of these
warrants was estimated at the grant date, using the Black-Scholes option-pricing
model.
F-12
Commtouch Software Ltd.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share and per share data)
m. Royalty-bearing Grants;
Royalty-bearing grants from the Government of Israel for funding approved
research and development projects are recognized at the time the Company is
entitled to such grants, on the basis of the costs incurred and such grants are
included as a deduction of research and development costs. Research and
development grants amounted to $600, $200 and zero in 2001, 2002 and 2003,
respectively.
n. Basic and Diluted Net Loss Per Share:
Basic and diluted net loss per share is presented in accordance with Statement
of Financial Accounting Standard No. 128, "Earnings per Share", for all periods
presented.
Basic net loss per share has been computed using the weighted-average number of
ordinary shares outstanding during the year. Diluted net loss per share is
computed based on the weighted average number of ordinary shares outstanding
during each year, plus the weighted average number of dilutive potential
ordinary shares considered outstanding during the year.
All outstanding stock options and warrants have been excluded from the
calculation of the diluted loss per share because all such securities are
anti-dilutive for all periods presented. The total number of shares related to
outstanding options and warrants excluded from the calculations of diluted net
loss per share were 4,990,673, 8,525,460 and 12,266,874 for 2001, 2002 and 2003,
respectively.
o. Severance Pay:
The Company's liability for severance pay in Israel is calculated pursuant to
Israeli severance pay law based on the most recent salary of the employees
multiplied by the number of years of employment as of the balance sheet date.
Employees are entitled to one month's salary for each year of employment or a
portion thereof. The Company's liability for all of its Israeli employees is
fully provided by monthly deposits with severance pay fund's insurance policies
and by an accrual. The value of those funds and policies is recorded as an asset
in the Company's balance sheet.
The deposited funds include profits accumulated up to the balance sheet date.
The deposited funds may be withdrawn only upon the fulfillment of the obligation
pursuant to Israeli severance pay law or labor agreements. The value of the
deposited funds is based on the cash surrender value of these policies, and
includes immaterial profits.
Severance expenses for 2001, 2002 and 2003 were approximately $754, $58 and $20,
respectively.
p. Fair Value of Financial Instruments:
The carrying amounts of cash and cash equivalents, trade receivables,
receivables on account of shares, prepaid expenses, other accounts receivable
and accounts payable, approximate their fair values due to the short-term
maturities of financial instruments.
The carrying amount of the Company's convertible loan approximates its fair
value. The fair value was estimated using discounted cash flow analysis based on
the current interest rate of similar terms and maturities.
q. Reclassification:
Certain amounts from prior years have been reclassified to conform to the 2003
presentation. The reclassification had no effect on previously reported net
loss, shareholder's equity or cash flows.
r. Recently Issued Accounting Pronouncements:
In January 2003, the FASB issued FASB Interpretation No. 46, "Consolidation of
Variable Interest Entities" (FIN 46). This interpretation of Accounting Research
Bulletin No. 51, "Consolidated Financial Statements", addresses consolidation of
variable interest entities. FIN 46 requires certain variable interest entities
("VIE's") to be consolidated by the primary beneficiary if the entity does not
effectively disperse risks among the parties involved. The provisions of FIN 46
are effective immediately for those variable interest entities created after
January 31, 2003. The provisions, as amended, are effective for the first
interim or annual period ending after March 15, 2004 for those variable
interests held prior to February 1, 2003. While the Company believes this
Interpretation will not have a material effect on its financial position or
results of operations, it is continuing to evaluate the effect of adoption of
this Interpretation. The effective date for SPE is December 31, 2003.
F-13
Commtouch Software Ltd.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share and per share data)
In May 2003, the FASB issued SFAS No. 150 "Accounting for Certain Financial
Instruments which Characteristics as both Liabilities and Equity" which
establishes standards for how an issuer of financial instruments classifies and
measures certain financial instruments with characteristics of both liabilities
and equity. It requires that an issuer classify a financial instrument that is
within its scope as a liability (or an asset in some circumstances) if, at
inception, the monetary value of the obligation is based solely or predominantly
on a fixed monetary amount known at inception, variation in something other than
the fair value of the issuer's equity shares or variations inversely related to
changes in the fair value of the issuer's equity shares. This statement is
effective for financial instruments entered into or modified after May 31, 2003,
and otherwise is effective at the beginning of the first interim period
beginning after June 30, 2003. The adoption of SFAS No. 150 is not expected to
have a material impact on the Company's financial position of results of
operations.
NOTE 3: RECEIVABLES ON ACCOUNT OF SHARES
According to EITF 85-1 "Classifying Notes Received for Capital Stock" ("EITF
85-1"), in the event that an enterprise receives a note, rather than cash, as a
contribution to its equity, such note may be recorded as an asset if collected
in cash prior to issuance of the financial statements.
As of December 31, 2003, in accordance with EITF 85-1, the Company recorded
receivables on account shares, which were classified as an asset, at a total
amount of $955 related to the exercise of the warrants (see note 7a), due to the
fact the amount has not yet been received as of December 31, 2003. The Company
received the total amount in January 2004.
NOTE 4: DEFERRED EXPENSES
During the last quarter of 2003, the Company paid issuance costs relating to
Convertible Notes (see note 7b), at a total amount of $353, consisting mainly of
legal costs. In Accordance with APB 21, these costs were recorded as deferred
expenses and are recognized over 36 months, the contractual term of the Notes.
NOTE 5: PROPERTY AND EQUIPMENT, NET
December 31,
-----------------------
2002 2003
------- -------
Cost:
Computers and peripheral equipment ............. $ 5,222 $ 5,243
Office furniture and equipment ................. 477 477
Motor vehicles ................................. 88 88
Leasehold improvements ......................... 694 704
------- -------
6,481 6,512
Less accumulated depreciation .................. (5,452) (6,060)
------- -------
Property and equipment, net .................... $ 1,029 $ 452
======= =======
Depreciation expenses amounted to approximately $7,432, $1,988 and $608 for
2001, 2002 and 2003, respectively.
See Note 2 f for impairment charges during 2001 and 2002.
NOTE 6: COMMITMENTS AND CONTINGENCIES
a. Operating Leases:
The Company leases its facility in Israel under an operating lease agreement
expiring on November 30, 2004. 2004 minimum lease payments under this
non-cancelable lease are $147.
The Company leases its facility in the US under operating lease agreement
expiring on October 31, 2004. 2004 minimum lease payments under this
non-cancelable lease are $38.
F-14
Commtouch Software Ltd.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share and per share data)
Rent expenses for 2001, 2002 and 2003 were approximately $2,800, $400 and $199,
respectively. The above rent expense is net of sub-lease rental income from the
Company's unused premises totaling approximately $54, $700, and $100 in 2003,
2002 and 2001, respectively.
b. Royalties:
The Company is committed to pay royalties of 3% to 5% to the government of
Israel on proceeds from sales of products resulting from the government funded
research and development projects, up to an amount equal to 100% of the grants
received by the Company, linked to the dollar and bearing interest at an annual
rate of LIBOR. As of December 31, 2003, the Company had a contingent liability
to pay royalties of approximately $800.
c. November 2003 Notes Agreement
Under the November Notes Agreement (see note 7b), the occurrence of certain
defined events of default, may result, among other things, in the acceleration
of repayment of the $3,000 loan (plus accrued interest), penalties to be paid in
cash, and the lenders will be entitled to exercise their first priority secured
rights in assets of the Company.
According to the Nasdaq Listing Qualification Staff, the Company is required to
comply with certain minimum terms in order to remain as a listed security in the
Nasdaq SmallCap Market. Should the Company's securities be de-listed, the
effectiveness of all registered shares would become null. According to the
November Notes Agreement, the Company is required to maintain the effectiveness
of the registered shares for the forthcoming periods. Not maintaining the
effectiveness, can cause the occurrence of an event of default and consequently
redemption of the notes by the lenders, and/or penalties to be paid in cash.
d. Class Action Litigation
Following the restatement of revenues for the first three quarters of 2000,
several class action lawsuits were filed in the United States District Court for
the Northern District of California against the Company and certain of its
officers and a director, alleging violations of the antifraud provisions of the
Securities Exchange Act of 1934 arising from the Company's financial statements.
These lawsuits were consolidated into one action in late 2001. Thereafter, the
Company filed a Motion to Dismiss, which was granted. The plaintiffs then filed
a second amended and consolidated complaint, and the Company's second motion to
dismiss was only partially accepted, with the end result being that the
plaintiff's filed a third amended and consolidated complaint.
In May 2003, Commtouch settled the shareholder class action lawsuit filed on
behalf of shareholders against the company in early 2001. The litigation was
initiated against the company and two members of management in response to the
company's announcement that it had decided to restate unaudited earnings for the
first three quarters of 2000, alleging violations of the antifraud provisions of
the Securities Exchange Act of 1934.
The settlement is being fully funded by the Company's Directors and Officers
insurance policy.
NOTE 7: CONVERTIBLE LOAN
a. On January 29, 2003, Commtouch entered into a Convertible Loan Agreement
("the January 2003 Loan"), with certain lenders. The Company received the total
loan amount of $1,250 from the lenders, which bore interest at a rate of ten
percent per annum, and convertible into ordinary shares of the Company at the
price of $0.25 per share. In connection with the January Loan, the Company also
issued warrants (the "January 2003 warrants") exercisable for purchase of up to
5,000,000 of the Company's ordinary shares, each one-third of the warrants
exercisable within five years at prices per ordinary share of $0.25, $0.33 and
$0.50 respectively.
In accordance with APB No. 14 "Accounting for Convertible Debt and Debt Issued
with Stock Purchase Warrants" ("APB 14"), the Company allocated a portion of the
proceeds to the warrants, based on their applicable fair values. Amounts
allocated to the warrants totaling $1,045, were recorded as additional paid in
capital.
The fair value of the warrants was estimated at the grant date using a
Black-Scholes option pricing model with the following assumptions: risk-free
interest rate of 3.7%, dividend yield of 0%, volatility factors of the expected
market price of the Commtouch ordinary shares of 1.384 and an expected life of
five years.
F-15
Commtouch Software Ltd.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share and per share data)
In accordance with EITF 98-5, "Accounting for Convertible Securities with
Beneficial Conversion Features or Contingent Adjustable Conversion Rations"
("EITF 98-5"), the Company recorded as additional paid in capital $39 as the
beneficial conversation feature of the January 2003 Loan. Amounts reflecting the
fair value of the warrants and the beneficial conversion feature of the Loan
have been recorded as discounts on the Loan. The discount related to the
warrants and the beneficial conversion feature are amortized as financial
expenses over the term of the January 2003 Loan.
In November 2003, the Company signed a new agreement (the "New Agreement") with
the lenders of the January 2003 Loan, to early convert their loan into equity of
the Company, and to exercise half of the related warrants previously granted.
According the New Agreement, the Company granted an inducement to the lenders,
of an additional 375,000 shares and 375,000 warrants.
On December 26, 2003, the lenders converted the loan and accrued interest into
5,652,216 Ordinary Shares of the Company and, in accordance with the New
Agreement, exercised warrants to purchase 187,518 shares, in consideration for
approximately $1,017, received in full by January 2004.
The Company treats the modification and exchange of its debt as an inducement of
conversion in accordance with Statement of Financial Accounting Standard 84
"Induced Conversions of Convertible Debt, an amendment of APB Opinion No. 26"
("FAS 84"). As such, the Company recognized expenses in a total amount of $526,
upon conversion of an amount equal to the fair value of all securities and other
consideration transferred in the transaction in excess of the fair value of
securities issuable pursuant to the original conversion terms.
In accordance with EITF 00-27, upon conversion of the January Loan and the
exercise of January warrants into Ordinary shares of the Company, the beneficial
conversion features and the discount related to the fair value of the warrants
measured upon issuance and amortized through the maturity of the loan, were
fully amortized and are recorded as financial expenses totaling $1,084.
b. On November 26, 2003, the Company signed an agreement (the "November 2003
Notes Agreement") for a private placement of $3,000 in senior convertible notes
(the "November 2003 Notes") and related warrants (the "November 2003 Warrants")
with a group of institutional investors. The notes mature in three years and
bear interest at a rate of 8% per annum. The notes are convertible at any time,
at the lenders' option, into the Company's ordinary shares at a fixed conversion
price of $1.153. The lenders also received warrants to purchase 600,000 shares
of the Company, exercisable within three year at an exercise price of $1.153 per
share. The issuance of the November 2003 Notes was contingent on the conversion
of the January 2003 Loan and the exercise of the January 2003 warrants into
equity. The total amount was received in full by January 2004.
According to the New Agreement, any delay in registration and/or effectiveness
of the November 2003 Notes according to the registration requirements, can cause
the occurrence of an event of default and redemption of the notes by the
lenders, and/or penalties to be paid in cash. The Company classified the
warrants fair value as liabilities according to EITF 00-19 "Accounting for
Derivative Financial Instruments Indexed to, and Potentially Settled in, a
Company's Own Stock" ("EITF 00-19").
NOTE 8: RESTRUCTURING CHARGES
During 2002, the Company continued implementing strategic initiatives intended
to further reduce costs. In connection with the strategic initiatives, and in
accordance with SFAS 121, "Accounting for the Impairment of Long-Lived Assets
and for Long-Lived Assets To Be Disposed Of", SAB 100 "Restructuring and
Impairment Charges" and EITF 94-3, "Liability Recognition for Certain Employee
Termination Benefits and Other Costs to Exit an Activity (Including Certain
Costs in a Restructuring)" (EITF 94-3), the Company recorded restructuring and
other non-recurring charges of approximately $1,125. The restructure included
curtailing expenses and reducing the number of employees. The following table
summarizes the restructuring accruals status as of December 31, 2002:
Utilized Balance at
Restructuring ---------------------------- December 31,
charge Cash Non-cash 2002
------------- -------- --------- ------------
Lease deposits and termination fees ........................... $ 128 $ 128 $ -- $--
Impairment of property and equipment .......................... 750 -- 750 --
Loss on sale of assets ........................................ 247 -- 247 --
------ ------ ------ ---
$1,125 $ 128 $ 997 $--
====== ====== ====== ===
F-16
Commtouch Software Ltd.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share and per share data)
NOTE 9: INCOME TAXES
Israeli Income Tax:
The Company's production facilities in Israel have been granted "Approved
Enterprise" status for three separate investment programs in 1992, 1996 and 2000
by the Israeli Investment Center under the Law for Encouragement of Capital
Investments, 1959 ("the Law"). The Company's first program was approved in 1995.
The Company's second and third programs (which were later cancelled) received a
letter of approval in April 1996 and in December 2000, respectively.
During 2001, the "Approved Enterprise" status for the 1996 investment program
was cancelled. During 2002, the "Approved Enterprise" status for the 2000
investment program was cancelled.
The law and regulations prescribing the benefits provide for an expiration date
for the grant of new benefits. The expiration date has been extended several
times in the past. The expiration date currently in effect is June 30, 2004
(which may be extended by ministerial decision until December 31, 2004), and no
new benefits will be granted after that date unless the expiration date is
extended. We cannot be assured that new benefits will be available after June
30, 2004 or that benefits will continue in the future at their current levels or
at all. Undistributed Israeli income derived from each of its "Approved
Enterprise" programs entitle the Company to a tax-exemption for a period of two
years commencing with the first year it will earn taxable income (which has yet
to occur) and to a reduced tax rate of 10%-25% for an additional period of five
to eight years (depending on the level of foreign investment in the Company).
These tax benefits cannot continue beyond the earlier of twelve years from
commencement of operations, or fourteen years from receipt of approval.
Thereafter, the Company's income will be subject to the regular income tax rate
of 36%. Income that is not derived from "Approved Enterprise" during the
benefits period is taxed at the regular rate of 36%. As currently only a part of
the Company's capital investments are approved (a "Mixed Enterprise"), its
effective corporate tax rate (once it earns taxable income) will be determined
by the weighted combination of the various applicable rates.
As of December 31, 2003, the tax benefits period for the outstanding valid
program had not yet commenced.
The tax exempt income attributable to the "Approved Enterprise" can be
distributed to shareholders without subjecting the Company to taxes only upon
the complete liquidation of the Company.
Distribution of cash dividends from income that was tax exempt due to the
"Approved Enterprise" status is subject to corporate tax at the rate that would
have been applicable to the income of the Company had the Company not been tax
exempt. In addition, these dividends will generally be subject to a 15%
withholding tax.
Distribution of cash dividends from income that was not derived from "Approved
Enterprise" generally is subject to 25% withholding tax.
The entitlement to the above benefits is conditional upon the Company's
fulfilling the conditions stipulated by the above law, regulations published
thereunder and the instruments of approval for the specific investments in
"Approved Enterprises". In the event of failure to comply with these conditions,
the benefits may be canceled and the Company may be required to refund the
amount of the benefits, in whole or in part, including interest.
The Company is currently viewed as qualifying as an "industrial company" under
the Law for the Encouragement of Industry (Taxation), 1969 and as such is
entitled to certain tax benefits, mainly accelerated rates of depreciation and
the right to deduct public issuance expenses.
Results for tax purposes are measured in terms of earnings in NIS after certain
adjustments for increases in the Israeli Consumer Price Index "CPI". As
explained in Note 2b, the financial statements are measured in U.S. dollars. The
difference between the annual change in the Israeli CPI and in the NIS/dollar
exchange rate causes a further difference between taxable income and the income
before taxes shown in the financial statements. In accordance with paragraph
9(f) of SFAS No. 109, the Company has not provided deferred income taxes on the
difference between the functional currency and the tax bases of assets and
liabilities.
F-17
Commtouch Software Ltd.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share and per share data)
On January 1, 2003, a comprehensive tax reform took effect in Israel. Pursuant
to the reform, resident companies are subject to Israeli tax on income accrued
or derived in Israel or abroad. In addition, the concept of "controlled foreign
corporation" was introduced, according to which an Israeli company may become
subject to Israeli taxes on certain income of a non-Israeli subsidiary if the
subsidiary's primary source of income is passive income (such as interest,
dividends, royalties, rental income or capital gains). The tax reform also
substantially changed the system of taxation of capital gains.
As of December 31, 2003, Israeli net operating loss and capital losses
carry-forwards amounted to $31,525. Such net operating loss may be carried
forward indefinitely and offset against future taxable income. The Company
expects that during the period these tax losses are utilized its income will be
substantially tax exempted. Accordingly, there will be no tax benefit from such
losses and no deferred income taxes have been included in these financial
statements.
U.S. Income Tax:
Commtouch Inc. is taxed based upon tax laws in the U.S.
As of December 31, 2003, Commtouch Inc. had U.S. federal net operating loss
carry-forwards.. The net operating loss expires in various amounts between the
years 2009 and 2024. Utilization of U.S. net operating losses may be subject to
the substantial annual limitation due to the "change in ownership" provisions of
the Internal Revenue Code of 1986 and similar state provisions. The annual
limitation may result in the expiration of net operating losses before
utilization.
Deferred Income Taxes:
Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. Significant components of
the Company's deferred tax liabilities and assets are as follows:
December 31,
---------------------
2002 2003
-------- --------
Deferred tax assets are as follows:
U.S. operating loss carry-forwards ................... $ 27,699 $ 28,589
Reserves and allowances not currently deductible ..... 496 1,320
-------- --------
Net deferred tax asset before valuation allowance .... 28,195 29,909
Valuation allowance .................................. (28,195) (29,909)
-------- --------
Net deferred tax asset ............................... $-- $--
======== ========
As of December 31, 2003, the Company has provided a 100% valuation allowance
with respect to deferred tax assets resulting from tax loss carry-forwards.
Management currently believes that since the Company and Commtouch Inc. have a
history of losses it is more likely than not that the deferred tax regarding the
loss carry-forwards and other temporary differences will not be realized in the
foreseeable future.
Pretax loss:
Pretax losses from continuing operations are as follows:
2001 2002 2003
------- ------- -------
Israel ..................... $26,951 $ 4,320 $ 4,214
U.S. ....................... 15,403 2,619 2,620
Other ...................... 637 (1,349) --
------- ------- -------
$42,991 $ 5,590 $ 6,834
======= ======= =======
NOTE 10: SHAREHOLDERS' EQUITY
The ordinary shares of the Company have been traded on the NASDAQ National
Market and SmallCap Market, since July 1999 and 2002, respectively.
F-18
Commtouch Software Ltd.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share and per share data)
As of December 31, 2003, Commtouch outstanding warrants issued to various
parties, were as follows:
Warrants for Exercise
Issuance ordinary price Warrants
Date shares per share exercisable Exercisable through
------------------ -------------- ------------ ------------ ------------------
July 1999 1,136,000 $ 12.80* 1,136,000 July 2004
December 2001 175,000 $ 0.26 175,000 December 2006
January 2002 200,000 $ 0.29 200,000 January 2007
October 2002 26,754 $ 0.01 26,754 October 2007
February 2002 2,660,955 $ 0.37 - $2.00 2,335,955 April 2007
January 2003 5,652,216 $ 0.25 - $0.50 2,826,126 January 2008
July 2003 1,440,000 $ 0.50 1,115,000 August 2008
July 2003 1,600,000 $ 0.65 1,600,000 August 2008
December 2003 600,000 $ 1.153 600,000 December 2006
---------- ----------
Total 13,490,925 10,014,835
========== ==========
* Subject to adjustments (see "Warrants Issued to Strategic Partners and
Consultants" below).
Warrants to Private Placement Investors and lenders.
On February 27, 2002, Commtouch entered into a private placement agreement,
whereby Commtouch issued approximately 4,400,000 ordinary shares against the
investment of approximately $1,343 in a private placement to private investors.
The purchasers in the private placement also received five-year warrants to
purchase up to an additional 2,660,955 ordinary shares. The exercise price for
one-third of the warrants is $0.37 per share, the exercise price for an
additional one-third of the warrants is $1.00 per share and the exercise price
for the final one-third of the warrants is $2.00 per share. These warrants
remain exercisable and expire on April 15, 2007.
For January 29, 2003 details refer to Note 7a herein.
On July 10, 2003, Commtouch entered into an ordinary shares and Warrants
Purchase Agreement with certain investors. Under this agreement, the Company
received an investment of $1,440, and issued to the investors 2,880,000 ordinary
shares and warrants to purchase within five years 1,440,000 ordinary shares at
an exercise price of $0.50. Warrants totaling 325,000 shares were exercised in
2003, leaving 1,115,000 warrants outstanding as at December 31, 2003. These
warrants remain exercisable and expire on August 11, 2008.
On July 29, 2003, Commtouch entered into two identical ordinary shares and
Warrants Purchase Agreements with certain investors. Under these agreements, the
company received investments totaling $1,600, and issued to the investors
2,666,667 ordinary shares and warrants to purchase within five years 1,600,000
ordinary shares at an exercise price of $0.65. These warrants remain exercisable
and expire on August 11, 2008.
For November 26, 2003 details refer to Note 7b herein.
Warrants Issued to Strategic Partners and Consultants.
Concurrent with the closing of the IPO, the Company entered into a customary
commercial email service agreement with InfoSpace (Formerly, Go2Net), a related
party. Under this agreement, the Company provided email services to the end
users of InfoSpace's various email properties. In connection with this
agreement, the Company issued a warrant expiring in July 2004 to purchase
1,136,000 ordinary shares at an exercise price of $12.80 per share (subject to
adjustment as described below). As of December 31, 2003, this warrant had not
been exercised. The warrant is non-forfeitable, fully vested and immediately
exercisable, and will expire five years from the date of the original email
service agreement (July 16, 2004). If Infospace does not exercise this warrant
and continue to hold an amount of warrant shares representing twenty-five
percent of its and Vulcan Ventures original shareholdings purchased in 1999,
they will lose the right to appoint one director to the Board of the Company. At
InfoSpace's option, the warrant is exercisable pursuant to a cashless exercise
based on the average closing price of the ordinary shares for the five days
preceding the exercise. The holder of the warrant is required to avoid becoming
a 10% or greater shareholder of the Company as a result of any exercise of the
warrant. The holder of the warrant is given the opportunity to profit from a
F-19
rise in the market price of the ordinary shares and the warrant. The warrant
includes provisions which adjust the exercise price upon the occurrence of
certain events which might otherwise dilute the value of the warrant, and the
Company believes that following certain of the Company's recent and upcoming
financing activities, the exercise price is projected to be approximately $4.91.
At the grant date, the fair value of this warrant was estimated as $5,800 and
was amortized to operating expenses over the minimum term of the contract
(twelve months through July 2000).
Warrants to service providers in connection with Settlement Agreements.
As part of the settlement of significant outstanding and future lease
obligations to Commtouch Inc.'s Mountain View facility lessor, Equity Office
Properties ("EOP"), as well as Commtouch Inc.'s equipment vendor, Compaq
Financial Services, the Company issued warrants to these services providers. The
EOP fully vested warrant was issued in December 2001 and allows for purchase of
up to 175,000 ordinary shares at a price of $0.26, and the Compaq fully vested
warrant was issued in January 2002 and allows for purchase of up to 200,000
ordinary shares at a price of $0.29 per share. These warrants expire in December
2006 and January 2007, respectively.
The fair value for the EOP and Compaq warrants were estimated at the date of
grant using a Black-Scholes Option Pricing Model with the following
weighted-average assumptions: risk-free interest rates of 4.0%, dividend yields
of 0%, volatility factors of the expected market price of the Company's ordinary
shares of 1.482 and a contractual life of the warrant of 5 years after the
warrant is vested. Accordingly, the Company recorded approximately $113 as
compensation expense and included the amount in operating expenses.
Warrants to AxcessNet Resources LLC.
As consideration for consulting services, on September 1, 2002 the Company
issued a fully vested warrant to AxcessNet Resources LLC for purchase of up to
206,897 of the Company's ordinary shares at a price of $0.01 per share. The
warrant was exercised in 2003.
The fair value for the warrant was estimated at the date of grant using a
Black-Scholes Option Pricing Model with the following weighted-average
assumptions: risk-free interest rates of 3.7%, dividend yields of 0%, volatility
factors of the expected market price of the Company's ordinary shares of 1.482
and a contractual life of the warrant of 5 years. The fair value of the warrant
was immaterial.
Warrants to service provider.
As consideration for consulting services, on October 1, 2002 the Company issued
a fully vested warrant to a service provider to purchase of up to 26,754 of the
Company's ordinary shares at a price of $0.01 per share. The warrant expires on
October 1, 2007.
The fair value for the warrant was estimated at the date of grant using a
Black-Scholes Option Pricing Model with the following weighted-average
assumptions: risk-free interest rates of 3.7%, dividend yields of 0%, volatility
factors of the expected market price of the Company's ordinary shares of 1.482
and a contractual life of the warrant of 5 years. The fair value of the warrant
was immaterial.
c. Issuance of Ordinary Shares Against Promissory Notes:
During 1999, several employees and officers early exercised 670,180 options
previously granted to them by Commtouch. In consideration for the ordinary
shares purchased pursuant to the early exercise of the options, they provided
Commtouch with full recourse promissory notes in the original principal amount
of approximately $1,060. The promissory notes bear interest at 4.83%, with
interest payment due at the end of each calendar year, with the principal due on
the fourth anniversary of the date of the promissory notes.
During 2001, the Company had forgiven a promissory notes of $143 for one of its
employees and demanded the then current value of the shares ($7 relating to the
7,500 shares) and the full interest on the original note. Both interest and the
adjusted note were repaid in March 2001. The Company accounted for this note in
accordance with EITF 00-23 "Issues Related to the Accounting for Stock
Compensation under APB 25 and FASB Interpretation No. 44" and EITF 95-16
"Accounting for Stock Compensation Arrangements with Employer Loan Features
under APB Opinion No. 25". During 2001, a note for $137 was repaid by another
employee for 94,560 shares.
F-20
Commtouch Software Ltd.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share and per share data)
As of December 31, 2003, only one note pertaining to a current executive officer
remains outstanding. Under this note, $263 was repaid in 2003, and the Company
believes that the loan will be fully repaid during 2004. During 2003, the
Company collected additional $318 from two former employees covering most of the
principal amounts due under the applicable notes, and the balance of $67 was
forgiven. Consequently based on the collection of the notes, the Company
reversed the valuation allowance originally recorded in 2002 at an amount of
$385. Accordingly, the Company recorded a recovery in the statement of
operations for $318.
d. Employee Stock Purchase Plan:
Commtouch reserved a total of 1,229,156 shares for issuance under the plan.
Eligible employees were able to purchase ordinary shares at 85% of the lower of
the market value of the Company's Ordinary shares on the first day of the
applicable offering period or the last day of the applicable purchase period.
The total shares issued under the plan in 2001 were 136,782. This Plan was
terminated in late 2001.
e. Repricing
On April 30, 2001, the Company's Board of Directors approved the "repricing" of
options previously granted to employees according to the criteria stated below.
Accordingly, the Company filed a Tender Offer, which expired on September 14,
2001, and Commtouch accepted for exchange options to purchase 1,273,513 Ordinary
Shares. Previously granted options were cancelled and new options were issued
with an exercise price equal to the par value of the shares. In order to enjoy
the repricing mechanism, previously granted stock options were required to meet
the following conditions:
o The exercise price of the original options exceeds $10
o The option is issued but not exercised
The repriced stock options vest over three years with 1/3 vesting on February
15, 2002 and the remaining 2/3 vesting every six months for the following two
years. In connection with this repricing, the Company charged approximately $300
as compensation expense in 2001 and approximately $234 as compensation expense
in 2002 and 2003, respectively.
During October 2001, the Company decided that 1/3 of the options granted on
September 14, 2001 to employees dismissed during October 2001 will not expire
upon termination of employment. The Company decided that this portion of the
options will vest according to the original grant terms on February 15, 2002 and
will be exercisable until August 15, 2002. This modification of the terms of
vesting was accounted for under APB 25 and FIN 44 and had no effect on the
Company's statement of operations.
f. Stock Options:
In 1996, the Company adopted the 1996 CI Stock Option Plan for granting options
to its U.S. employees and consultants to purchase ordinary shares of the
Company. Until 1999, the Company issued options to purchase ordinary shares to
its Israeli employees pursuant to individual agreements. In 1999 the Company
approved the 1999 Section 3(i) Share Option Plan for its Israeli employees and
consultants, which was amended in 2001 to include Section 102 applicability (the
sections relate to code sections under the Israel tax law). This plan was
further amended in 2003 to take advantage of changes made by the Israeli
legislature under Section 102 of the Israeli tax code.
The Company has reserved 11,460,000 ordinary shares for issuance under employee
stock option plans and agreements. As of December 31, 2003, an aggregate of
5,110,633 ordinary shares of the Company are still available for future grant.
Options granted under such plans and agreements expire generally after 10 years
from the date of grant and terminate upon termination of the optionee's
employment or other relationship with the Company. The options generally vest
ratably over a 4-year period. Certain repriced stock options offered to
employees in a Tender Offer Statement of July 20, 2001, as amended, vest over a
three year period. The exercise price of the options granted under the
individual agreements may not be less than the nominal value of the shares into
which such options are exercisable. Any options that are canceled or not
exercised within the options period become available for future grant.
F-21
Commtouch Software Ltd.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share and per share data)
A summary of the Company's share option activity under the plans is as follows:
Weighted Average
Number of Shares Exercise Price
--------------------------------------------- -----------------------------------
2001 2002 2003 2001 2002 2003
---------- ---------- ---------- --------- -------- --------
Outstanding at beginning of period ...... 2,650,455 2,915,689 2,733,545 $ 19.91 $ 0.46 $ 0.17
Granted ................................. 3,009,388* 2,058,521 2,093,948 0.2 0.16 0.39
Exercised ............................... (119,268) (261,490) (253,605) 0.39 0.02 0.14
Canceled ................................ (2,624,886) (1,979,175) (203,380) 19.68 0.60 0.15
---------- ---------- ---------- --------- -------- --------
Outstanding at end of period ............ 2,915,689 2,733,545 4,370,508 $ 0.46 $ 0.17 $ 0.29
========== ========== ========== ========= ======== ========
Exercisable at end of period ............ 281,830 716,407 1,675,734 $ 2.70 $ 0.21 $ 0.18
========== ========== ========== ========= ======== ========
* - Includes 1,273,513 options repriced to par value during 2001.
The options outstanding as of December 31, 2003, have been separated into ranges
of exercise price, as follows:
Weighted
Options Average Weighted Options Weighted Average
Outstanding as of Remaining Average Exercisable as of Price of
December 31, Contractual Life Exercise December 31, Exercisable
Exercise Price 2003 (years) Price 2003 Options
-------------- ----------------- ---------------- -------- ------------------ --------------
$0.01-$0.11 1,688,423 7.80 $ 0.06 1,080,922 $ 0.06
$0.12-$1.45 2,681,085 8.08 $ 0.42 593,937 $ 0.34
$35 1,000 6.48 $ 35 875 $ 35.00
--------- ---- ------ --------- -------
$ 0.01-$35 4,370,508 7.92 $ 0.29 1,675,734 $ 0.18
========= ==== ====== ========= =======
Weighted average fair values and weighted average exercise prices of options
whose exercise price is less or equals market price of the shares at date of
grant are as follows:
For exercise prices on the date of grant that:
--------------------------------------------------------------------
Equals market price Are less than market price
Year ended December 31, Year ended December 31,
-------------------------------- --------------------------------
2001 2002 2003 2001 2002 2003
-------- -------- -------- -------- -------- --------
Weighted average exercise prices ........................ $ 0.27 $ 0.16 $ 0.40 $ 0.01 $ 0.01 $ 0.19
Weighted average fair values on date of grant ........... $ 0.10 $ 0.16 $ 0.40 $ 0.44 $ 0.16 $ 0.40
Under SFAS 123, pro forma information regarding net income (loss) and earnings
(loss) per share is required and has been determined as if the Company had
accounted for its employee stock options under the fair value method of that
Statement. The fair value for these options was estimated at the date of grant
using a Black-Scholes option valuation model with the following weighted-average
assumptions for 2001, 2002 and 2003: risk-free interest rates of 4.0% for 2001,
3.7% for 2002, and 3.7% for 2003, dividend yields of 0%, volatility factors of
the expected market price of the Company's ordinary shares of 1.482 for 2001,
1.416 for 2002, and 1.384 for 2003 and a contractual life of the option of 6
months after the option is vested for 2001, 2002 and 2003.
The Company recorded deferred compensation representing the difference between
the exercise price and the deemed fair value of the Company's ordinary shares at
the date of grant. Such amount is being amortized using the sum-of-digits or the
straight-line method over the vesting period of the options, generally four
years.
Deferred stock based compensation is as follows:
Balance as of January 1, 2003..................................... $ 277
Less amortization of deferred stock based compensation............ (247)
-----
Balance as of December 31, 2003................................... $ 30
=====
g. Amended and Restated Non-Employee Directors Stock Option Plan:
The Company adopted the 1999 Non-Employee Directors Stock Option Plan. The
original allotment of shares in this plan was in the amount of 180,000 ordinary
shares. The Company, with shareholder approval, has amended this allotment over
the past few years as follows:
F-22
Commtouch Software Ltd.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share and per share data)
a. In 2001, an increase was approved bringing the plan's total allotment
to 750,000 ordinary shares;
b. In 2002, two increases were approved bringing the plan's total
allotment to 1,450,000; and
c. In 2002, two increases were approved bringing the plan's total
allotment to 1,450,000.
d. In 2003, an increase was approved bringing the plan's total allotment
to 2,290,000.
Prior to August 2001, directors who were reelected at each annual meeting of
shareholders were generally entitled to additional grants of 10,000 shares.
However, this amount has been increased over the past few years pursuant to
shareholder approvals, such that:
a. Directors reelected at the August 22, 2001 annual meeting of
shareholders were entitled to a grant of 33,750;
b. Directors in office immediately after the extraordinary general
meeting of shareholders on February 25, 2002 were granted a one-time
option grant of 150,000 ordinary shares; and
c. Directors in office immediately after the annual meeting of
shareholders on November 18, 2002 were granted a one-time option grant
of 50,000 ordinary shares.
d. Directors reelected at the annual general meeting in 2003 and
thereafter are entitled to an option grant of 50,000 ordinary shares.
As from the annual meeting of shareholders in 2003, new directors joining the
board are entitled to an option grant of 150,000 ordinary shares.
Also, in addition to the grant of shares for her reelection as a director in
August 2001, Carolyn Chin, on behalf of her activities as Chairman of the Board,
received an additional grant of 221,250 ordinary shares.
Each option granted under the Non-Employee Directors Plan originally was to have
become exercisable with respect to one-fourth of the number of shares covered by
such option three months after the date of grant and with respect to one-third
of the remaining shares subject to the option every three months thereafter;
however, this changed pursuant to an amendment to the plan approved by
shareholders at the August 10, 2000 annual meeting of shareholders, such that
options under subsequent grants become exercisable at a rate of 1/16th of the
shares every three months. Each option has an exercise price equal to the fair
market value of the ordinary shares on the grant date of such option. However,
certain options outstanding and unexercised at the time of the effective date of
the Tender Offer Statement of July 20, 2001, as amended, were repriced in
accordance with the terms of the Tender Offer Statement, as amended. Each option
has a maximum term of ten years, but will terminate earlier if the optionee
ceases to be a member of the Board of Directors.
During 2003, the Company granted 425,000 options to non-employee directors at a
weighted average exercise price of $0.82 per share. As of December 31, 2003,
636,249 options were vested and 1,769,850 were outstanding under the Amended and
Restated 1999 Non-Employee Directors Stock Option Plan.
Due to changes in the Israeli tax code, grants to Israeli resident directors as
from the annual general meeting of shareholders will be made pursuant to the
Amended and Restated Israeli Share Option Plan, though the grant amounts and
vesting schedule will remain in accordance with the Non-Employee Directors Plan.
NOTE 10: GEOGRAPHIC INFORMATION
The Company conducts its business on the basis of one reportable segment (see
Note 1 for brief description of the Company's business). The Company has adopted
Statement of Financial Accounting Standard No. 131, "Disclosures About Segments
of an Enterprise and Related Information".
F-23
Commtouch Software Ltd.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share and per share data)
Revenues from external customers:
Revenues
---------------------------
2001 2002 2003
------- ------- -------
Israel ........................................... $ 451 $ 416 $ 27
U.S.A ............................................ 5,806 1,207 275
Europe ........................................... 2,500 1,436 --
Japan ............................................ 656 356 27
Latin America .................................... 2,910 23 --
Other ............................................ 1,265 -- --
------- ------- -------
$13,588 $ 3,438 $ 329
======= ======= =======
The Company's long-lived assets are as follows:
2002 2003
------- -------
Israel ........................................... $ 441 $ 294
U.S.A ............................................ 588 158
------- -------
$ 1,029 $ 452
======= =======
NOTE 11: SUBSEQUENT EVENT (Unaudited)
On May 18, 2004, the Company entered into a definitive agreement for the private
placement of 5,131,580 ordinary shares of the Company at a purchase price of
$0.76 per share to existing institutional investors for gross proceeds to the
Company of approximately $3.9 million.
The investors also received five year warrants to purchase up to an additional
2,565,790 ordinary shares, with an exercise price of $0.83 per share. In
addition, the Company had granted the investors additional investment rights to
purchase up to an additional 5,131,580 ordinary shares at $0.83 per share,
together with additional warrants to purchase up to an additional 2,565,790
ordinary shares with an exercise price of $0.83 per share, for a period of one
year following the effectiveness of the registration statement covering the
resale of the ordinary shares underlying these rights.
The Company agreed to reduce the conversion and exercise prices of the notes and
warrants issued to the investors in the November 26, 2003 transaction between
those investors and the Company. The conversion price previously set at $1.153
shall be reduced so that the initial notes in the aggregate amount of $3,000,000
shall have a conversion price of $0.83 and the initial warrants issued in that
transaction shall have an exercise price of $0.83 per share. The conversion
price of the additional notes and exercise price of the additional warrants
issuable in connection with that transaction [if and when the investors' option
to loan additional funds is exercised] shall be reduced to $0.90. In addition,
the exercise period for the additional loan shall be extended for a period 18
months from the effectiveness of the registration statement (January 20, 2004)
covering the resale of the ordinary shares relating to the initial loan under
the November 2003 transaction.
The closing of the financing is subject to certain closing conditions, including
receipt of shareholder approval of an increase in the authorized share capital
of the Company and the terms of this transaction. The Company is scheduled to
hold an extraordinary meeting of its shareholders on June 28, 2004.
F-24
SIGNATURES
The registrant hereby certifies that it meets all of the requirements for filing
on Form 20-F and that it has duly caused and authorized the undersigned to sign
this annual report on its behalf.
COMMTOUCH SOFTWARE LTD.
By: /s/ Devyani Patel
-------------------------------------
Devyani Patel
V.P. Finance
June 18, 2004
COMMTOUCH SOFTWARE LTD.
SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
U.S. Dollars in thousands
Balance at
the Charged to Balance at
beginning of cost and end of the
the period expenses Deductions period
---------- -------- ---------- ------
Year ended December 31, 2001:
Bad debt ......................................... $ 862 $ 259 $(551) $ 570
===== ===== ===== =====
Year ended December 31, 2002:
Bad debt ......................................... $ 570 $ 40 $(569) $ 41
===== ===== ===== =====
Year ended December 31, 2003:
Bad debt ......................................... $ 41 $-- $ (41) $--
===== ===== ===== =====
Item 19. Exhibits
Exhibit Number Description of Document
-------------- -----------------------
1.1 Memorandum of Association of the Company.(1)
1.2 Amended and Restated Articles of Association of the Company,
as amended on December 26, 2003.
2.1 Specimen Certificate of Ordinary Shares.(1)
2.2 Amended and Restated Registration Rights Agreement dated as of
April 19, 1999.(1)
2.2.1 Amendment No. 1 to Amended and Restated Registration Rights
Agreement dated as of December 29, 1999.(4)
2.2.2 Amendment No. 2 to Amended and Restated Registration Rights
Agreement dated as of March 10, 2000.(5)
2.3 Reserved.
2.4 Form of Drag-Along Letter dated as of April 15, 1999. (1)
2.5 Reserved.
2.6 Reserved.
2.7 Company hereby agrees to furnish the Securities and Exchange
Commission, upon request, with the instruments defining the
rights of holders of long-term debt of the registrant with
respect to which the total amount of securities authorized
does not exceed 10% of the total consolidated assets of the
Company.
2.8 Ordinary Shares and Warrants Purchase Agreement dated as of
February 27, 2002 by and between Commtouch Software Ltd., and
the Investors Listed on Exhibit A Thereto. (31)
2.9 Text of Report on Form 6-K filed by the Registrant for the
month of April 2003. (21)
2.9.1 Convertible Loan Agreement dated January 29, 2003, inclusive
of Exhibits "A" through "D" thereto.(22)
2.9.2 Exhibit "F" to Convertible Loan Agreement dated January 29,
2003 - Form of Guaranty. (23)
2.9.3 Exhibit "G" to Convertible Loan Agreement dated January 29,
2003- Form of U.S. Subsidiary Security Agreement. (24)
2.9.4 Exhibit "H" to Convertible Loan Agreement dated January 29,
2003 - Form of Company Security Agreement. (25)
2.9.5 Exhibit "I" to Convertible Loan Agreement dated January 29,
2003 - Form of Collateral Agency Agreement. (26)
2.9.6 Exhibit "J" to Convertible Loan Agreement dated January 29,
2003 - Form of Patent and Trademark Security Agreement. (27)
2.9.7 Exhibit "K" to Convertible Loan Agreement dated January 29,
2003 - Opinion of Israeli Counsel to the Company. (28)
2.9.8 Exhibit "L" to Convertible Loan Agreement dated January 29,
2003 - Opinion of US Counsel to the Company.(29)
2.9.9 Addendum 1 to Convertible Loan Agreement.(30)
2.9.10 Addendum 2 to Convertible Loan Agreement.(11)
2.9.11 Addendum 3 to Convertible Loan Agreement.
2.10 Text of Report on Form 6-K filed by the Registrant for the
month of November 2003.(34)
2.10.1 Securities Purchase Agreement dated November 26, 2003.(35)
2.10.2 Exhibit "D" to Securities Purchase Agreement dated November
26, 2003 - Form of Registration Rights Agreement.(36)
2.10.3 Exhibit "A" to Securities Purchase Agreement dated November
26, 2003 - Form of Convertible Note.(37)
2.10.4 Exhibit "C" to Securities Purchase Agreement dated November
26, 2003 - Form of Warrant.(38)
2.10.5 Exhibit "K" to Securities Purchase Agreement dated November
26, 2003 - Form of Voting Agreement.(39)
2.10.6 Exhibit "E" to Securities Purchase Agreement dated November
26, 2003- Form of Security Agreement.(40)
2.10.7 Exhibit "F" to Securities Purchase Agreement dated November
26, 2003 - Form of Guarantee.(41)
4.1 Company's 1996 CSI Stock Option Plan and forms of agreements
thereunder.(1)
4.2 Company's form of Stock Option Agreement for Israeli
Employees.(1)
4.3 Commtouch Software Ltd. 1999 Section 3(i) Share Option
Plan.(8)
4.4 Amended and Restated 1996 CSI Stock Option Plan.(18)
4.5 Amended and Restated 1999 Section 3(i) Share Option Plan and
form of option agreement thereunder.(19)
4.6 Amended and Restated 1999 Non-Employee Directors Stock Option
Plan.(20)
4.7 Amended and Restated 1999 Israeli Share Option Plan [fka 1999
Section 3(i) Share Option Plan].(9)
4.8 Form of Share Warrant for Go2Net, Inc. to purchase ordinary
shares of the Registrant.(3)
4.9 Form of Share Purchase Agreement by and among the Registrant,
Go2Net, Inc. and Vulcan Ventures Incorporated.(3)
4.9.1 Form of Registration Rights Agreement by and among the
Registrant, Go2Net, Inc. and Vulcan Ventures Incorporated.(3)
4.10 Text of Report on Form 6-K filed by the Registrant for the
month of July 2003.(13)
4.10.1 Ordinary Shares and Warrants Purchase Agreement dated July 10,
2003, inclusive of Exhibits "A" and "B" thereto.(14)
4.11 Text of Report on Form 6-K filed by the Registrant for the
month of August 2003.(15)
4.11.1 Ordinary Shares and Warrants Purchase Agreement dated July 29,
2003, inclusive of Exhibits "A" and "B" thereto.(16)
4.11.2 Ordinary Shares and Warrants Purchase Agreement dated July 29,
2003, inclusive of Exhibits "A" and "B" thereto.(17)
4.12 Lease Termination Agreement between Young Woo & Assoc., LLC
and Commtouch Inc. and Commtouch Software Ltd. (as guarantor)
dated September 6, 2002.(6)
4.13 Surrender Agreement between Omni South Beach, L.P. and
Commtouch Latin America Inc. dated August 31, 2002.(7)
4.14 Agreement of September 1, 2002 between AxcessNet Ltd. and
Commtouch Software Ltd. plus Warrant for purchase of
Registrant's ordinary shares.(32)
4.15 Agreement of September 1, 2002 between AxcessNet Ltd. and
Commtouch Software Ltd., plus Amendment 1 thereto.(33)
8 Subsidiaries of the Company (1. Commtouch Inc., a California
corporation)
12.1 Certification of Company's Principal Executive Officer
Pursuant to Exchange Act Rule 13a-14a or 15d-14a
12.2 Certification of Company's Principal Financial Officer
Pursuant to Exchange Act Rule 13a-14a or 15d-14a
13 Certification of Company's Principal Executive Officer and
Principal Financial Officer Pursuant to 18 U.S.C. 1350.
14.1 Consent of Kost, Forer, Gabbay & Kasierer, independent
auditors.
14.2 Memorandum of Understanding between the Registrant, Go2Net,
Inc. and Vulcan Ventures Incorporated, dated July 7, 1999.(2)
-----------------
(1) Incorporated by reference to exhibits in Amendment No. 1 to
Registration Statement on Form F-1 of Commtouch Software Ltd., File No.
333-78531.
(2) Incorporated by reference to exhibits in Amendment No. 4 to
Registration Statement on Form F-1 of Commtouch Software Ltd., File No.
333-78531.
(3) Incorporated by reference to exhibits in Amendment No. 5 to
Registration Statement on Form F-1 of Commtouch Software Ltd., File No.
333-78531.
(4) Incorporated by reference to exhibit in Amendment No. 1 to Registration
Statement on Form F-1 of Commtouch Software Ltd., File No. 333-89773.
(5) Incorporated by reference to exhibits in Amendment No. 2 to
Registration Statement on Form F-1 of Commtouch Software Ltd., File No.
333-89773, filed March 28, 2000.
(6) Incorporated by reference to Exhibit 4.22 to Annual Report on Form 20-F
for the year ended December 31, 2002.
(7) Incorporated by reference to Exhibit 4.23 to Annual Report on Form 20-F
for the year ended December 31, 2002.
(8) Incorporated by reference to Exhibit 10.2 to Registration Statement on
Form S-8 No. 333-94995.
(9) Incorporated by reference to Exhibit 10.5 to Registration Statement on
Form S-8 No. _____________.
(10) Reserved.
(11) Incorporated by reference to Exhibit 2.9.10 to Annual Report on Form
20-F for the year ended December 31, 2002.
(12) Incorporated by reference to Exhibit 1 to Report on Form 6-K for the
month of May 2001, filed June 1, 2001.
(13) Incorporated by reference to Report on Form 6-K for the month of July
2003, filed July 28, 2003.
(14) Incorporated by reference to Exhibit 2 to Report on Form 6-K for the
month of July 2003, filed July 28, 2003.
(15) Incorporated by reference to Report on Form 6-K for the month of August
2003, filed August 15, 2003.
(16) Incorporated by reference to Exhibit 2 to Report on Form 6-K for the
month of August 2003, filed August 15, 2003.
(17) Incorporated by reference to Exhibit 3 to Report on Form 6-K for the
month of August 2003, filed August 15, 2003.
(18) Incorporated by reference to Exhibit 10.4 to Registration Statement on
Form S-8 No. _____________.
(19) Incorporated by reference to Exhibit 5 to Schedule TO, filed July 20,
2001.
(20) Incorporated by reference to Exhibit 10.3 to Registration Statement on
Form S-8 No. _____________.
(21) Incorporated by reference to Report on Form 6-K for the month of April
2003, filed April 2, 2003.
(22) Incorporated by reference to Exhibit 1 to Report on Form 6-K for the
month of April 2003, filed April 2, 2003.
(23) Incorporated by reference to Exhibit 2 to Report on Form 6-K for the
month of April 2003, filed April 2, 2003.
(24) Incorporated by reference to Exhibit 3 to Report on Form 6-K for the
month of April 2003, filed April 2, 2003.
(25) Incorporated by reference to Exhibit 4 to Report on Form 6-K for the
month of April 2003, filed April 2, 2003.
(26) Incorporated by reference to Exhibit 5 to Report on Form 6-K for the
month of April 2003, filed April 2, 2003.
(27) Incorporated by reference to Exhibit 6 to Report on Form 6-K for the
month of April 2003, filed April 2, 2003.
(28) Incorporated by reference to Exhibit 7 to Report on Form 6-K for the
month of April 2003, filed April 2, 2003.
(29) Incorporated by reference to Exhibit 8 to Report on Form 6-K for the
month of April 2003, filed April 2, 2003.
(30) Incorporated by reference to Exhibit 9 to Report on Form 6-K for the
month of April 2003, filed April 2, 2003.
(31) Incorporated by reference to Exhibit 2.8 to Annual Report on Form 20-F
for the year ended December 31, 2001.
(32) Incorporated by reference to Exhibit 4.24 to Annual Report on Form 20-F
for the year ended December 31, 2002.
(33) Incorporated by reference to Exhibit 4.25 to Annual Report on Form 20-F
for the year ended December 31, 2002.
(34) Incorporated by reference to Report on Form 6-K for the month of
November 2003, filed December 2, 2003.
(35) Incorporated by reference to Exhibit 1 to Report on Form 6-K for the
month of November 2003, filed December 2, 2003.
(36) Incorporated by reference to Exhibit 2 to Report on Form 6-K for the
month of November 2003, filed December 2, 2003.
(37) Incorporated by reference to Exhibit 3 to Report on Form 6-K for the
month of November 2003, filed December 2, 2003.
(38) Incorporated by reference to Exhibit 4 to Report on Form 6-K for the
month of November 2003, filed December 2, 2003.
(39) Incorporated by reference to Exhibit 5 to Report on Form 6-K for the
month of November 2003, filed December 2, 2003.
(40) Incorporated by reference to Exhibit 6 to Report on Form 6-K for the
month of November 2003, filed December 2, 2003.
(41) Incorporated by reference to Exhibit 7 to Report on Form 6-K for the
month of November 2003, filed December 2, 2003.