| BSQUARE CORP /WA Item 1A Risk Factors |
| The following risk factors and other information included in this Annual Report on Form 10-K should be carefully considered |
| The risks and uncertainties described below are not the only ones we face |
| Additional risks and uncertainties not presently known to us, or that we currently deem immaterial, may also impair our business operations |
| If any of the following risks occur, our business, financial condition, operating results and cash flows could be materially adversely affected |
| If we do not maintain our OEM Distribution Agreement with Microsoft, our revenue would decrease and our business would be adversely affected |
| We have an OEM Distribution Agreement (ODA) with Microsoft, which enables us to resell Microsoft Windows Embedded operating systems to our customers in North America, including Mexico and the Dominican Republic |
| Software sales under this agreement constituted over 63prca of our revenue in 2005 |
| If the ODA was terminated, our software revenue would decrease significantly and our operating results would be impacted accordingly |
| Moreover, if the ODA with Microsoft is renewed on less favorable terms, our revenue could decrease, and/or our gross profit from these transactions, which is relatively low, could further decline |
| Microsoft offers us, and our competitors, largely volume-based rebates under the ODA and its related programs which have the effect of increasing our software gross profit |
| If Microsoft were to reduce, or eliminate, these rebate programs, which can contribute 2-3prca of our gross profit from sales of Microsoft Embedded operating systems on a quarterly basis, our gross profit and operating results would be negatively impacted |
| The ODA is renewable annually, and there is no automatic renewal provision in the agreement |
| The ODA was last renewed in October 2005 and will expire on September 30, 2006, unless terminated earlier under the provisions of the ODA Microsoft has audited our records under our OEM Distribution Agreement in the past and may do so again in the future, and any future audit could result in additional charges |
| There are provisions in the Microsoft ODA that require us to maintain certain internal records and processes for royalty auditing and other reasons |
| Non-compliance with these and other requirements could result in the termination of the ODA We underwent an audit under the ODA with Microsoft which began in the fourth quarter of 2003 and concluded in the second quarter of 2004 |
| The audit covered a period of five years |
| Microsoft determined that we had correctly reported royalties during the audit period but that we could not account for all license inventory that we had received from Microsoft’s authorized replicators |
| While we believe that the unaccounted-for license inventory related to undocumented inventory returns and disagreed with the audit findings, we ultimately chose to settle the dispute |
| Total settlement costs of 14 _________________________________________________________________ [68]Table of Contents dlra310cmam000 were recognized in the second quarter of 2004, which included audit costs of dlra140cmam000 |
| It is possible that future audits could result in additional charges |
| The market for the resale of Microsoft Embedded operating systems licenses is highly competitive and the profit margin for such resales is relatively low |
| If the profit margins in this business erode or we lose customers to competitors, our results will be negatively impacted |
| There are three competitors that also resell Embedded Windows licenses to substantially the same customer base as we do in North America, which can lead to intense competition |
| For example, on March 4, 2005, we were notified by Cardinal, our largest customer of Microsoft Embedded operating systems at the time, that it would begin purchasing from one of our competitors and discontinue purchasing from us at the beginning of the second quarter of 2005 |
| Additionally, this competition can create additional downward pressure on gross profit margins |
| The gross profit margin on sales of Microsoft Embedded Windows licenses is relatively low, recently about 13 to 14prca on average |
| Our gross profit margin on the sale of Microsoft Embedded operating systems and tools has remained relatively flat, but there can be no assurance that gross profit on future sales will not decline given these competitive pressures |
| If we do not maintain our favorable relationship with Microsoft, we will have difficulty marketing and selling our software and services and may not receive developer releases of Windows Embedded operating systems and Windows Mobile targeted platforms |
| We maintain a strategic marketing relationship with Microsoft |
| In the event that our relationship with Microsoft were to deteriorate, our efforts to market and sell our software and services to OEMs and others could be adversely affected and our business could be harmed |
| Microsoft has significant influence over the development plans and buying decisions of OEMs and others utilizing Windows Embedded operating systems and Windows Mobile targeted platforms for smart devices and these targeted platforms are a significant focus for us |
| Microsoft provides customers referrals to us |
| Moreover, Microsoft controls the marketing campaigns related to its operating systems |
| Microsoft’s marketing activities, including trade shows, direct mail campaigns and print advertising, are important to the continued promotion and market acceptance of Windows Embedded operating systems and Windows Mobile targeted platforms and, consequently, to our sale of Windows-based embedded software and services |
| We must maintain a favorable relationship with Microsoft to continue to participate in joint marketing activities with them, which includes participating in “partner pavilions” at trade shows, listing our services on Microsoft’s website, and receiving customer referrals |
| In the event that we are unable to continue our joint marketing efforts with Microsoft, or fail to receive referrals from them, we would be required to devote significant additional resources and incur additional expenses to market software products and services directly to potential customers |
| In addition, we depend on Microsoft for developer releases of new versions of, and upgrades to, Windows Embedded and Windows Mobile software in order to facilitate timely development and delivery of our own software and services |
| If we are unable to maintain our favorable relationship with Microsoft, our revenue could decline and/or our costs could increase |
| Unexpected delays or announcement of delays by Microsoft of Windows Embedded operating systems and Windows Mobile targeted platforms product releases could adversely affect our revenue |
| Unexpected delays or announcement of delays in Microsoft’s delivery schedule for new versions of its Windows Embedded operating systems and Windows Mobile targeted platforms could cause us to delay our product introductions or impede our ability to sell our products and services and/or to complete customer projects on a timely basis |
| These delays, or announcements of delays by Microsoft could also cause our customers to delay or cancel their project development activities or product introductions, which may have a negative impact on our revenue and operating results |
| 15 _________________________________________________________________ [69]Table of Contents Our marketplace is extremely competitive, which may result in price reductions, lower gross profit margins and loss of market share |
| The market for Windows-based embedded software and services is extremely competitive |
| Increased competition may result in price reductions, lower gross profit margins and loss of customers and market share, which would harm our business |
| We face competition from: • Our current and potential customers’ internal research and development departments, which may seek to develop their own proprietary products and solutions that compete with both our proprietary software products and our engineering services; • North American engineering service firms such as Intrinsyc, CalAmp, Vanteon and Teleca; • Off-shore development companies, particularly those focused on the North American marketplace; • ODMs particularly those in Taiwan who are adding software development capabilities to their offerings; • Contract manufacturers who are adding software development capabilities to their offerings; and • Microsoft Embedded operating system distributors such as Arrow, Avnet and Bell Microsystems |
| Larger customers of Microsoft Embedded operating systems are typically knowledgeable of the competing distributors in the North American market and, consequently, will often put large orders out to bid amongst the distributors, which can create margin pressure and make it difficult to maintain long-term relationships with customers who purchase only Microsoft Embedded operating systems from us |
| As we develop new products, particularly products focused on specific industries, we may begin competing with companies with which we have not previously competed |
| It is also possible that new competitors will enter the market or that our competitors will form alliances, including alliances with Microsoft, that may enable them to rapidly increase their market share |
| We have observed, for example, that at least one large contract manufacturer, Flextronics, has been acquiring embedded software expertise in order to enhance their manufacturing services offerings |
| Microsoft has not agreed to any exclusive arrangement with us, nor has it agreed not to compete with us |
| Microsoft may decide to bring more of the core embedded development services and expertise that we provide in-house, possibly resulting in reduced product and service revenue opportunities for us |
| The barrier to entering the market as a provider of Windows-based smart device software and services is low |
| In addition, Microsoft has created marketing programs to encourage systems integrators to work on Windows Embedded operating system products and services |
| These systems integrators are given substantially the same access by Microsoft to the Windows technology as we are |
| New competitors may have lower overhead than we do and may be able to undercut our pricing |
| We expect that competition will increase as other established and emerging companies enter the Windows-based smart device market, and as new products and technologies are introduced |
| Microsoft has released Windows CE version 5dtta0 and its next generation of Windows Mobile Smartphone and PocketPC which contains basic SDIO Now! |
| functionality |
| Current and potential customers may decide that the functionality they receive directly from Microsoft is sufficient to complete their device development and may therefore choose not to purchase our SDIO Now! |
| Our agreement with Microsoft required us to deliver to Microsoft our SDIO Now! |
| 1dtta0 source code for inclusion into Windows CE 5dtta0 and recent release of Windows Mobile Smartphone and PocketPC operating systems |
| Since that source code was delivered to Microsoft, we have continued to develop our SDIO Now! |
| product line, introducing SDIO Now! |
| 2dtta2, with new features and performance improvements that we believe are important to customers |
| Additionally, we plan further enhancements to our SDIO Now! |
| However, there can be no assurance that our next-generation SDIO Now! |
| product offerings will continue to be competitive in the marketplace or that customers will not decide to use the basic functionality they receive from Microsoft |
| comprised 5prca of our software revenue for 2005 and 6prca for 2004 |
| Sales of SDIO Now! |
| carry much higher gross profit margin than the third-party software products we sell to our customers |
| were to decline, our proprietary software revenue and operating results would be adversely impacted and our business would suffer |
| If Microsoft adds features to its Windows operating system or develops products that directly compete with products and services we provide, our revenue could be reduced and our profits could suffer |
| As the developer of Windows, Windows XP Embedded, Windows CE, Windows Mobile for Smartphone and Windows Mobile for PocketPC, Microsoft could add features to its operating systems or could develop products that directly compete with the products and services we provide to our customers |
| Such features could include, for example, software that competes with our own proprietary software products, driver development tools, hardware-support packages and quality-assurance tools |
| The ability of our customers, or potential customers, to obtain products and services directly from Microsoft that compete with our products and services could negatively affect our revenue and operating results |
| Even if the standard features of future Microsoft operating system software were more limited than our offerings, a significant number of our customers, and potential customers, might elect to accept more limited functionality in lieu of purchasing additional software from us |
| Moreover, the resulting competitive pressures could lead to price reductions for our products and reduce our revenue and gross profit margin accordingly |
| Our ability to maintain or grow the portion of our software revenue attributable to sales of our proprietary software products is contingent on our ability to bring to market competitive, unique offerings that keep pace with technological changes and needs |
| Proprietary software products provide us with much higher gross profit margins than we typically receive from third-party software products and our engineering service offerings |
| Increasing the number and amount of proprietary products we sell is an important part of our growth strategy |
| Our ability to maintain and increase the revenue contribution from proprietary software products is contingent on our ability to enhance the features and functionality of our current proprietary products as well as to devise, develop and introduce new products |
| There can be no assurance that we will be able to maintain and expand the number of proprietary products that we sell, and our failure to do so could negatively impact revenue and our operating results |
| We may experience delays in our efforts to develop new products, and these delays could cause us to miss product market opportunities which could negatively impact our revenue and operating results |
| The market for Windows-based embedded software and services is very competitive |
| As a result, the life cycles of our products and services are difficult to estimate |
| To be successful, we believe we must continue to enhance our current offerings and provide new software product and service offerings with attractive features, prices and terms that appeal to our customers with attractive features, prices and terms |
| We have experienced delays in enhancements and new product release dates in the past and may be unable to introduce enhancements or new products successfully or in a timely manner in the future |
| Our revenue and operating results may be negatively impacted if we delay releases of our products and product enhancements, or if we fail to accurately anticipate our customers’ needs or technical trends and are unable to introduce new products and service offerings into the market successfully |
| In addition, our customers may defer or forego purchases of our products if we, Microsoft, our competitors or major hardware, systems or software vendors introduce or announce new products |
| The market for smart devices is still emerging and the potential size of this market and the timing of its development are not known |
| As a result, our profit potential is uncertain and our revenue may not 17 _________________________________________________________________ [71]Table of Contents develop as anticipated, if at all |
| We are dependent upon the broad acceptance by businesses and consumers of a wide variety of smart devices, which will depend on many factors, including: • The development of content and applications for smart devices; • The willingness of large numbers of businesses and consumers to use devices such as smartphones, PDAs and handheld industrial data collectors to perform functions currently carried out manually, or by traditional PCs, including inputting and sharing data, communicating among users and connecting to the Internet; and • The evolution of industry standards or the necessary infrastructure that facilitate the distribution of content over the Internet to these devices via wired and wireless telecommunications systems, satellite or cable |
| If the market for Windows Embedded operating systems and Windows Mobile targeted platforms fails to develop further, develops more slowly than expected, or declines, our business and operating results may be materially harmed |
| Because a significant portion of our revenue to date has been generated by software products and engineering services targeted at the Windows Embedded operating systems and Windows Mobile platforms, if the market for these systems or platforms fails to develop further or develops more slowly than expected, or declines, our business and operating results may be negatively impacted |
| Market acceptance of Windows Embedded and Windows Mobile will depend on many factors, including: • Microsoft’s development and support of the Windows Embedded and Windows Mobile markets |
| As the developer and primary promoter of Windows CE, Windows XP Embedded, Windows Mobile for Smartphone and Windows Mobile for PocketPC, if Microsoft were to decide to discontinue or lessen its support of these operating systems and platforms, potential customers could select competing operating systems, which could reduce the demand for our Windows Embedded and Windows Mobile software products and engineering services; • The ability of the Microsoft Windows Embedded operating systems and Windows Mobile software to compete against existing and emerging operating systems for the smart device market, including: VxWorks and pSOS from WindRiver Systems Inc |
| ; Symbian and Palm OS from PalmSource, Inc |
| ; JavaOS from Sun Microsystems, Inc |
| ; and other proprietary operating systems |
| In particular, in the market for handheld devices, Windows Mobile software for Pocket PC and Windows CE face intense competition from the Linux operating system |
| In the market for converged devices, Windows Mobile for Pocket PC Phone Edition and for Smartphone face intense competition from the EPOC operating system from Symbian |
| Windows Embedded operating systems and the Windows Mobile for Smartphone may be unsuccessful in capturing a significant share of these two segments of the smart device market, or in maintaining its market share therein; • The acceptance by OEMs and consumers of the mix of features and functions offered by Windows Embedded operating systems and Windows Mobile targeted platforms; and • The willingness of software developers to continue to develop and expand the applications that run on Windows Embedded operating systems and Windows Mobile targeted platforms |
| To the extent that software developers write applications for competing operating systems that are more attractive to smart device users than those available on Windows Embedded operating systems and Windows Mobile targeted platforms, potential purchasers could select competing operating systems over Windows Embedded operating systems and Windows Mobile targeted platforms |
| 18 _________________________________________________________________ [72]Table of Contents The success and profitability of our engineering service offerings are contingent on our ability to differentiate our offerings adequately in the marketplace, which is, in turn, contingent on our ability to retain our engineering personnel and defend our billing rate structures against those of our competitors, including those using lower-cost offshore resources |
| If we are unable to do so successfully, our business could be harmed |
| We are a leader in providing engineering services to smart device customers |
| Our market differentiation is created through several factors, including our experience with a variety of smart device platforms and applications |
| Our differentiation is contingent, in part, on our ability to attract and retain employees with this expertise, significantly all of whom currently are based in the United States |
| To the extent we are unable to retain critical engineering services talent and/or our competition is able to deliver the same services by using lower-cost offshore resources, our service revenue and operating results could be negatively impacted |
| The success and profitability of our service engagements are contingent upon our ability to scope and bid engagements and deliver our services profitably |
| If we are unable to do so, our service revenue service gross profit margin may be significantly impacted |
| Various factors may cause the total cost of service projects to exceed the original estimate provided to the customer or the contractual maximum in the case of fixed price contracts, including specification changes, customer deliverable delays, inadequate scoping and inefficient service delivery |
| If we are unable to adequately scope, bid and deliver on service engagements successfully, our service revenue and operating results could be negatively impacted |
| In addition, depending on the cause of an overrun for a given customer, we may also decide to provide pricing concessions to that customer which could negatively impact our service revenue and operating results |
| We have entered into service agreements that involve reducing up front service revenue in exchange for royalties as our customers devices are sold in the market |
| There is no guarantee that these arrangements will culminate as anticipated |
| We have entered into two service contracts that involve reducing up-front engineering service fees in return for a per-device royalty as our customers ship their devices, and we may enter into more such agreements in the future |
| These contracts call for guaranteed royalty payments by our customers |
| Because we are delaying revenue past the point where our services are performed, there is a risk that our customers may cancel their device projects, or that their devices may not be successful in the market, and these customers may choose not to pay us all royalties owed, which could negatively impact our revenue and operating results |
| If we are unable to license key software from third parties, our business could be harmed |
| We sometimes integrate third-party software with our proprietary software and engineering service offerings or sell such third-party software offerings on a standalone basis (eg Embedded operating systems under our ODA with Microsoft) |
| If our relationships with these third-party software vendors were to deteriorate, or be eliminated in their entirety, we might be unable to obtain licenses on commercially reasonable terms, if at all |
| In the event that we are unable to obtain these third-party software offerings, we would be required to develop this technology internally, assuming it was economically or technically feasible, or seek similar software offerings from other third parties, which could delay or limit our ability to introduce enhancements or new products, or to continue to sell existing products and engineering services, and our revenue and operating results could be negatively impacted |
| Our revenue may flatten or decline and we may not be able to regain and sustain profitability in accordance with our current plans |
| We have generated net losses in every year since 2001 |
| If our revenue remains flat or declines and/or our expenses increase or cannot be maintained proportionately, we will experience additional losses and 19 _________________________________________________________________ [73]Table of Contents will be required to use our existing cash to fund operations |
| We expect that our expenses will continue to be substantial in the foreseeable future, including potential compliance costs associated with the Sarbanes-Oxley Act of 2002, and may prove higher than we currently anticipate |
| Further, we may not succeed in increasing our revenue sufficiently to offset unanticipated expense increases |
| Unexpected fluctuations in our operating results could cause our stock price to decline |
| If our operating results fall below the expectations of analysts and investors, the price of our common stock may fall |
| Factors that have in the past and may continue in the future to cause our operating results to fluctuate include those described in this “Risk Factors” section |
| In addition, our stock price may fluctuate due to conditions unrelated to our operating performance, including general economic conditions in the technology industry, our Nasdaq listing status and the market for technology stocks |
| A continued decline in our shareholders’ equity or a decline in our stock price could cause our common stock to be delisted from the Nasdaq National Market |
| As of December 31, 2005, our shareholders’ equity was dlra11dtta5 million |
| The minimum continued listing requirement for the Nasdaq National Market is dlra10 million |
| We have incurred significant net losses since 2001 and may incur additional losses in the future |
| If our shareholders’ equity decreases below dlra10 million, we will be notified by the Nasdaq Listing Qualifications Department that we are not in compliance with the minimum dlra10 million shareholders’ equity requirement of Nasdaq Marketplace Rule 4450(a)(3) |
| In addition, during the last three years, our common stock has traded at times near or below the dlra1dtta00 Nasdaq National Market minimum bid price |
| On April 5, 2005, we received notification from The Nasdaq Stock Market that for the previous 30 consecutive business days, the bid price of our common stock had closed below the minimum dlra1dtta00 per share requirement for continued inclusion under Nasdaq Marketplace Rule 4450(a)(5) |
| Therefore, in accordance with Nasdaq Marketplace Rule 4450(e)(2), we were provided 180 calendar days, or until October 3, 2005, to regain compliance with the minimum bid price listing requirement |
| On October 5, 2005, our board of directors approved an amendment to our articles of incorporation to reduce our number of authorized shares of common stock from 150cmam000cmam000 to 37cmam500cmam000 and also approved a one-for-four reverse stock split of our common stock |
| The reverse stock split was effective with respect to shareholders of record at the close of trading on October 6, 2005, and our common stock began trading on a split-adjusted basis on October 7, 2005 |
| On October 24, 2005, we received notification from the Nasdaq Listing Qualifications Staff that we had regained compliance with Marketplace Rule 4450(a)(5) and that the Staff would give this matter no further consideration |
| There can be no assurance that we will continue to meet the dlra1dtta00 minimum bid requirement |
| If our common stock is delisted from trading on the Nasdaq National Market as a result of listing requirement violations and is neither relisted thereon nor listed for trading on the Nasdaq Capital Market, trading in our common stock may continue to be conducted on the OTC Bulletin Board or in a non-Nasdaq over-the-counter market, such as the “pink sheets |
| ” Delisting of our common stock from trading on the Nasdaq National or Capital Market would adversely affect the price and liquidity of our common stock and could adversely affect our ability to issue additional securities or to secure additional financing |
| In that event our common stock could also be deemed to be a “penny stock” under the Securities Enforcement and Penny Stock Reform Act of 1990, which would require additional disclosure in connection with trades in the common stock, including the delivery of a disclosure schedule explaining the nature and risks of the penny stock market |
| Such requirements could further adversely affect the liquidity of our common stock |
| Non-compliance with certain agreements could have a material adverse impact on our financial position |
| In addition to our Microsoft OEM Distribution Agreement described previously, we entered into a lease in February 2004 for our new corporate headquarters and, at the same time, an amendment to the 20 _________________________________________________________________ [74]Table of Contents lease for our former corporate headquarters |
| Both of these agreements were entered into with the same landlord |
| However, if we default under our new corporate headquarters lease, the landlord has the ability to demand cash payments forgiven in 2004 under the former headquarters lease |
| The amount of the forgiven payments for which the landlord has the ability to demand repayment, in the event of default, decreases on the straight-line basis over the length of our new ten-year headquarters lease |
| The total amount of cash payments forgiven for which the landlord has the ability to demand repayment was dlra2dtta1 million at December 31, 2005 |
| Any breach of or non-compliance with these lease agreements or our OEM Distribution Agreement with Microsoft could have a material adverse impact on our business |
| The long sales cycle of our products and services makes our revenue susceptible to fluctuations |
| Our sales cycle is typically three to nine months because the expense and complexity of the software and engineering service offerings we sell generally require a lengthy customer approval process and may be subject to a number of significant risks over which we have little or no control, including: • Customers’ budgetary constraints and internal acceptance review procedures; • The timing of budget cycles; and • The timing of customers’ competitive evaluation processes |
| In addition, to successfully sell software and engineering service offerings, we must frequently educate our potential customers about the full benefits of these software and services, which can require significant time |
| If our sales cycle further lengthens unexpectedly, it could adversely affect the timing of our revenue which could cause our quarterly results to fluctuate |
| Erosion of the financial condition of our customers could adversely affect our business |
| Our business could be adversely affected should the financial condition of our customers erode, given that such erosion could reduce demand from those customers for our software and engineering services or even cause them to terminate their relationships with us, and also could increase the credit risk of those customers |
| If the global information technology market weakens, the likelihood of the erosion of the financial condition of our customers increases, which could adversely affect the demand for our software and services |
| Additionally, while we believe that our allowance for doubtful accounts is adequate, those allowances may not cover actual losses, which could adversely affect our business and operating results |
| Continued erosion of our financial condition would adversely affect our business |
| If our financial condition continues to erode, particularly if we continue to generate operating losses and our cash balance declines, our customers and potential customers may decide that our financial condition is not sufficient to do business with us, particularly those that have implemented new vendor requirements as part of their Sarbanes-Oxley compliance, and may choose to engage with one of our competitors |
| This would adversely affect our business and operating results |
| Our software and service offerings could infringe the intellectual property rights of third parties, which could expose us to additional costs and litigation and could adversely affect our ability to sell our products and services or cause shipment delays or stoppages |
| It is difficult to determine whether our products and engineering services infringe third-party intellectual property rights, particularly in a rapidly evolving technological environment in which technologies often overlap and where there may be numerous patent applications pending, many of which are confidential when filed |
| If we were to discover that one of our products, or a product based on one of our reference designs, violated a third-party’s proprietary rights, we may not be able to obtain a license on commercially reasonable terms, or at all, to continue offering that product or service |
| Similarly, third parties may claim that our current or future products and services infringe their proprietary rights, regardless of whether such claims have merit |
| Any such claims could increase our costs and negatively 21 _________________________________________________________________ [75]Table of Contents impact our business and operating results |
| In certain cases, we have been unable to obtain indemnification against claims that our products and services infringe the proprietary rights of others |
| Even if we receive broad third-party indemnification, these entities may not have the financial capability to indemnify us in the event of infringement |
| In addition, in some circumstances we could be required to indemnify our customers for claims made against them that are based on our products or services |
| There can be no assurance that infringement or invalidity claims related to the products and services we provide, or arising from the incorporation by us of third-party technology, and claims for indemnification from our customers resulting from such claims, will not be asserted or prosecuted against us |
| Some of our competitors have, or are affiliated, with companies with substantially greater resources than we have, and these competitors may be able to sustain the costs of complex intellectual property litigation to a greater degree and for longer periods of time than we could |
| In addition, we expect that software developers will be increasingly subject to infringement claims as the number of products and competitors in the software industry grows, and as the functionality of products in different industry segments increasingly overlap |
| Such claims, even if not meritorious, could result in the expenditure of significant financial and managerial resources in addition to potential product redevelopment costs and delays |
| Furthermore, if we were unsuccessful in resolving a patent or other intellectual property infringement action claim against us, we may be prohibited from developing or commercializing certain of our technologies and products, or delivering services based on the infringing technology, unless we obtain a license from the holder of the patent or other intellectual property rights |
| There can be no assurance that we would be able to obtain any such license on commercially favorable terms, or at all |
| If such license is not obtained, we would be required to cease these related business operations, which could have a material adverse effect on our business, revenue and operating results |
| If we fail to adequately protect our intellectual property rights, competitors may be able to use our technology or trademarks, which could weaken our competitive position, reduce our revenue and increase our costs |
| If we fail to adequately protect our intellectual property, our competitive position could be weakened and our revenue adversely affected |
| We rely primarily on a combination of patent, copyright, trade secret and trademark laws, as well as confidentiality procedures and contractual provisions, to protect our intellectual property |
| These laws and procedures provide only limited protection |
| We have applied for a number of patents relating to our engineering work although we do not rely on patents as our primary defensive measure in protecting our intellectual property |
| These patents, both issued and pending, may not provide sufficiently broad protection, or they may not prove to be enforceable, against alleged infringers |
| There can be no assurance that any of our pending patents will be granted |
| Even if granted, these patents may be circumvented or challenged and, if challenged, may be invalidated |
| Any patents obtained may provide limited or no competitive advantage to us |
| It is also possible that another party could obtain patents that block our use of some, or all, of our products and services |
| If that occurred, we would need to obtain a license from the patent holder or design around those patents |
| The patent holder may or may not choose to make a license available to us at all or on acceptable terms |
| Similarly, it may not be possible to design around a blocking patent |
| In general, there can be no assurance that our efforts to protect our intellectual property rights through patent, copyright, trade secret and trademark laws will be effective to prevent misappropriation of our technology, or to prevent the development and design by others of products or technologies similar to or competitive with those developed by us |
| We frequently license the source code of our products and the source code results of our services to customers |
| There can be no assurance that customers with access to our source code will comply with the license terms or that we will discover any violations of the license terms or, in the event of discovery of violations, that we will be able to successfully enforce the license terms and/or recover the economic value lost from such violations |
| To license some of our software products, we rely in part on “shrinkwrap” and “clickwrap” licenses that are not signed by the end user and, therefore, may be unenforceable under the laws of certain jurisdictions |
| As with other software, our products are susceptible to unauthorized copying and uses that may go undetected, and policing such unauthorized use is difficult |
| A significant portion of 22 _________________________________________________________________ [76]Table of Contents our marks include the word “BSQUARE” or the preface “b |
| ” Other companies use forms of “BSQUARE” or the preface “b” in their marks alone, or in combination with other words, and we cannot prevent all such third-party uses |
| We license certain trademark rights to third parties |
| Such licensees may not abide by our compliance and quality control guidelines with respect to such trademark rights and may take actions that would harm our business |
| The computer software market is characterized by frequent and substantial intellectual property litigation, which is often complex and expensive, and involves a significant diversion of resources and uncertainty of outcome |
| Litigation may be necessary in the future to enforce our intellectual property or to defend against a claim of infringement or invalidity |
| Litigation could result in substantial costs and the diversion of resources and could negatively impact our business and operating results |
| We may be subject to product liability claims that could result in significant costs |
| Our license, warranty and service agreements with our customers typically contain provisions designed to limit our exposure to potential product liability claims |
| It is possible, however, that these provisions may be ineffective under the laws of certain jurisdictions |
| Although we have not experienced any product liability claims to date, the sale and support of our products and services, particularly our now-discontinued Power Handheld hardware product, entail the risk of such claims, and we may be subject to such claims in the future |
| In addition, to the extent we develop and sell increasingly comprehensive, customized turnkey solutions for our customers, we may be increasingly subject to risks of product liability claims |
| There is a risk that any such claims or liabilities may exceed, or fall outside, the scope of our insurance coverage, and we may be unable to retain adequate liability insurance in the future |
| A product liability claim brought against us, whether successful or not, could harm our business and operating results |
| Our software or hardware products or the third-party hardware or software integrated with our products may suffer from defects or errors that could impair our ability to sell our products and services |
| Software and hardware components as complex as those needed for smart devices frequently contain errors or defects, especially when first introduced or when new versions are released |
| We have had to delay commercial release of certain versions of our products until problems were corrected and, in some cases, have provided product enhancements to correct errors in released products |
| In addition, it is possible that by the time defects are fixed, the market opportunity may decline which may result in lost revenue |
| Moreover, to the extent that we provide increasingly comprehensive products and services, particularly those focused on hardware, and rely on third-party manufacturers and suppliers to manufacture our and our customers’ products, including those related to Power Handheld devices distributed prior to discontinuance, we will be dependent on the ability of third-party manufacturers to correct, identify and prevent manufacturing errors |
| Errors that are discovered after commercial release could result in loss of revenue or delay in market acceptance, diversion of development resources, damage to our reputation and increased service and warranty costs, all of which could negatively affect our business and operating results |
| As we increase the amount of software development conducted in non-US locations, potential delays and quality issues may impact our ability to timely deliver our software and services, potentially impacting our revenue and profitability |
| We conduct development activities in non-US locations, primarily India and Taiwan, to take advantage of the high-quality, low-cost software development resources found in these countries |
| Additionally, we have plans to increase development activity both in our Taiwan operation and other non-US locations as engineering demands necessitate the need for additional engineering personnel |
| To date, we have limited experience in managing large scale software development done in non-US locations |
| Moving portions of our software development to these locations inherently increases the complexity of managing these programs and may result in delays in introducing new products to market, or delays in completing service projects for our customers, which in turn may adversely impact the revenue we 23 _________________________________________________________________ [77]Table of Contents recognize from related products and services and could also adversely impact the profitability of service engagements employing off-shore resources |
| We have initiated litigation against a former customer to recover fees due for engineering services provided by us in the first half of 2005, and there can be no assurance as to the outcome of this proceeding |
| We filed a complaint for breach of contract and misappropriation of intellectual property against a former customer on December 22, 2005 in Federal district court in Delaware |
| We have petitioned for an award of damages of approximately dlra475cmam000, plus interest and attorneys fees and related costs, and we have reserved the right to request an injunction against the customer for misappropriation of intellectual property |
| On January 27, 2006, the former customer filed an answer and counterclaim against us, denying our claims and alleging breach of contract, tortious interference with the customer’s business and fraud in the inducement of the underlying contract |
| The former customer has asked for an award of damages that includes a refund of all payments made by them prior to the customer’s breach for non-payment (approximately dlra280cmam000), lost profits, costs incurred by the customer to complete the project, any reduction in the value of goodwill, and attorneys’ fees and costs |
| We filed our reply to the counterclaim on February 16, 2006 |
| We believe that we have fulfilled all of our contractual obligations under the services contract, that we will be able to successfully defend the counterclaims against us, and that we are entitled to collect all amounts due under the contract, plus attorneys’ fees and costs |
| However, there can be no assurance that the court will ultimately rule in our favor, and it may, in fact, rule in favor of the former customer |
| Further, the legal proceedings could result in the incurrence of significant legal and related expenses, which may not be recoverable depending on the outcome of the litigation |
| An award by the court in favor of the customer and/or the incurrence of significant legal fees which are not recoverable could adversely impact our operating results |
| Past acquisitions have proven difficult to integrate, and future acquisitions, if any, could disrupt our business, dilute shareholder value and adversely affect our operating results |
| We have acquired the technologies, assets and/or operations of other companies in the past and may acquire or make investments in companies, products, services and technologies in the future as part of our growth strategy |
| for dlra500cmam000 in cash and the assumption of certain liabilities and obligations |
| If we fail to properly evaluate, integrate and execute on our acquisitions and investments, our business and prospects may be seriously harmed |
| In some cases, we have implemented reductions in workforce and office closures in connection with an acquisition, which has resulted in significant costs to us |
| To successfully complete an acquisition, we must properly evaluate the technology, accurately forecast the financial impact of the transaction, including accounting charges and transaction expenses, integrate and retain personnel, combine potentially different corporate cultures and effectively integrate products and research and development, sales, marketing and support operations |
| If we fail to do any of these, we may suffer losses and impair relationships with our employees, customers and strategic partners |
| Additionally, management may be distracted from day-to-day operations |
| We also may be unable to maintain uniform standards, controls, procedures and policies, which are especially critical in light of the new Sarbanes-Oxley compliance requirements, and significant demands may be placed on our management and our operations, information services and financial, legal and marketing resources |
| Finally, acquired businesses sometimes result in unexpected liabilities and contingencies, which could be significant |
| It might be difficult for a third-party to acquire us even if doing so would be beneficial to our shareholders |
| Certain provisions of our articles of incorporation, bylaws and Washington law may discourage, delay or prevent a change in the control of us or a change in our management, even if doing so would be beneficial to our shareholders |
| Our Board of Directors has the authority under our amended and restated articles of incorporation to issue preferred stock with rights superior to the rights of the holders of common 24 _________________________________________________________________ [78]Table of Contents stock |
| As a result, preferred stock could be issued quickly and easily with terms calculated to delay or prevent a change in control of our company or make removal of our management more difficult |
| In addition, our Board of Directors is divided into three classes |
| The directors in each class serve for three-year terms, one class being elected each year by our shareholders |
| This system of electing and removing directors may discourage a third-party from making a tender offer or otherwise attempting to obtain control of our company because it generally makes it more difficult for shareholders to replace a majority of our directors |
| In addition, Chapter 19 of the Washington Business Corporation Act generally prohibits a “target corporation” from engaging in certain significant business transactions with a defined “acquiring person” for a period of five years after the acquisition, unless the transaction or acquisition of shares is approved by a majority of the members of the target corporation’s Board of Directors prior to the time of acquisition |
| This provision may have the effect of delaying, deterring or preventing a change in control of our company |
| The existence of these anti-takeover provisions could limit the price that investors might be willing to pay in the future for shares of our common stock |
| We likely will incur substantial costs to comply with the requirements of the Sarbanes-Oxley Act of 2002 |
| The Sarbanes-Oxley Act of 2002 (the Act) introduced new requirements regarding corporate governance and financial reporting |
| Among the many requirements is the requirement under Section 404 of the Act for management to report on our internal control over financial reporting and for our registered public accountant to attest to this report |
| The SEC has modified the effective date of Section 404 implementation for non-accelerated filers, such as us, twice within 2005 such that management will now have to report on our internal control over financial reporting as of December 31, 2007 |
| In April 2006, the SEC Advisory Committee on Smaller Public Companies is expected to make final recommendations to the SEC regarding the internal control requirements of smaller public companies |
| Pending the final rules, we may be required to dedicate significant time and resources during fiscal 2006 and 2007 to ensure compliance |
| The costs to comply with these requirements will likely be significant and adversely affect our operating results |
| In addition, there can be no assurance that we will be successful in our efforts to comply with Section 404 |
| Failure to do so could result in penalties and additional expenditures to meet the requirements, which could affect the ability of our auditors to issue an unqualified report which, in turn, may further adversely affect our business |
| Decreased effectiveness of equity compensation could adversely affect our ability to attract and retain employees, and required changes in accounting for equity compensation could adversely affect earnings |
| We have historically used stock options and other forms of equity-related compensation as key components of our overall employee compensation program in order to align employees’ interests with the interests of our shareholders, encourage employee retention, and provide competitive compensation packages |
| In recent periods, many of our employee stock options have had exercise prices in excess of our stock price, which reduces their value to employees and could affect our ability to retain or attract present and prospective employees |
| Moreover, applicable stock exchange listing standards relating to obtaining shareholder approval of equity compensation plans could make it more difficult or expensive for us to grant options to employees in the future |
| As a result, we may incur increased compensation costs, change our equity compensation strategy or find it difficult to attract, retain and motivate employees, any of which could materially adversely affect our business |
| Our international operations expose us to greater intellectual property, management, collections, regulatory and other risks |
| Foreign operations generated approximately 3prca of our total revenue for 2005 and 4prca in 2004 |
| Our international operations expose us to a number of risks, including the following: • Greater difficulty in protecting intellectual property due to less stringent foreign intellectual property laws and enforcement policies; 25 _________________________________________________________________ [79]Table of Contents • Loss or reduction of withholding tax exemptions; • Longer collection cycles than we typically experience in the US; • Unfavorable changes in regulatory practices and tariffs; • Complex and/or adverse tax laws and/or changes thereto |
| Additionally, we may be subject to income, withholding and other taxes for which we may realize no current benefit despite the existence of significant net operating losses and tax credits in the US; • The impact of fluctuating exchange rates between the US dollar and foreign currencies; and • General economic and political conditions in international markets which may differ from those in the US These risks could have a material adverse effect on the financial and managerial resources required to operate our foreign offices, as well as on our future international revenue, which could harm our business and operating results |
| We currently have international operations in Taipei, Taiwan and Tokyo, Japan |
| In February 2006, we established a subsidiary in Vancouver, Canada and have hired four employees there to support our professional engineering services |