| SCO GROUP INC Item 1A Risk Factors Because of the following factors, as well as other variables affecting our operating results, past financial performance may not be a reliable indicator of future performance, and historical trends should not be used to anticipate results or trends in future periods |
| We do not have a history of profitable operations |
| Our profitability for the year ended October 31, 2003 resulted primarily from our SCOsource 9 ______________________________________________________________________ business |
| For the years ended October 31, 2005 and 2004, we incurred net losses to common stockholders of dlra10cmam726cmam000 and dlra16cmam227cmam000, respectively, and our accumulated deficit as of October 31, 2005 was dlra234cmam942cmam000 |
| If our revenue from the sale of our UNIX products and services continues to decline, we will need to further reduce operating expenses to generate positive cash flow |
| We may not be able to further reduce operating expenses without damaging our ability to support our existing UNIX business |
| Additionally, we may not be able to achieve profitability through additional cost-cutting actions |
| Our UNIX products and services revenue has declined over the last several years primarily as a result of continued competition from alternative operating systems, particularly Linux |
| In our results of operations, we recognize revenue from agreements for support and maintenance contracts and other long-term contracts that have been previously invoiced and are included in deferred revenue |
| Our future UNIX revenue may be adversely impacted and may continue to decline if we are unable to replenish these deferred revenue balances with long-term maintenance and support contracts or replace them with other sustainable revenue streams |
| If we are unable to generate positive cash flow and profitable operations, our business will be adversely impacted |
| We may not prevail in our SCO Litigation, which may adversely affect our ability to continue in business |
| We continue to pursue the SCO Litigation and believe in the merits of our cases |
| In our action against IBM, we seek damages for claims generally relating to our allegation that IBM has inappropriately used and distributed our UNIX source code and derivative works in connection with its efforts to promote the Linux operating system |
| IBM has responded to our claims and brought counterclaims against us asserting generally that we do not have the right to assert claims based on our ownership of UNIX intellectual property against IBM or others in the Linux market |
| Discovery is continuing in the case |
| If we do not prevail in our action against IBM, or if IBM is successful in its counterclaims against us, our business and results of operations would be materially harmed and we may not be able to continue in business |
| The litigation with IBM and others will be costly, and our costs for legal fees and related expenses have been and will continue to be substantial and may exceed our capital resources |
| Additionally, the market price of our common stock may be negatively affected as a result of developments in our legal action against IBM that may be, or may be perceived to be, adverse to us |
| As a result of the SCO Litigation, participants in the Linux marketplace and others affiliated with IBM or sympathetic to the Linux movement have taken actions attempting to negatively affect our business and our SCOsource efforts |
| Linux proponents have taken a broad range of actions against us, including, for example, attempting to influence participants in the markets in which we sell our products to reduce or eliminate the amount of our products and services they purchase from us |
| We expect that similar efforts likely will continue |
| There is a risk that additional participants in our marketplace will negatively view the SCO Litigation, and we may lose support from such participants |
| Any of the foregoing could adversely affect our position in the marketplace, our results of operations and our stock price and our ability to stay in business |
| As a response to our claim that our UNIX source code and derivative works have inappropriately been included in Linux, Novell has publicly asserted its belief that it owns certain copyrights in our UNIX source code, and it has filed 15 copyright applications with the United States Copyright Office related to UNIX Novell has claimed to have retained rights related to UNIX source code licenses, including the license with IBM Novell asserts it has the right to take action on behalf of SCO in connection with such licenses, including termination rights |
| Novell has purported to veto our termination of the IBM, Sequent and SGI licenses |
| We have asserted that we obtained the UNIX business, source code, claims and copyrights when we acquired the assets and operations of the server and professional services groups from The Santa Cruz Operation in May 2001, which had previously acquired all such assets and rights from Novell in 1995 pursuant to an asset purchase agreement, as amended |
| In January 2004, in response 10 ______________________________________________________________________ to Novell’s actions, we brought suit against Novell for slander of title seeking relief for Novell’s alleged bad faith effort to interfere with our rights related to our UNIX source code and derivative works and our UnixWare products |
| Novell twice unsuccessfully sought to have the case dismissed |
| On July 29, 2005, Novell filed its Answer and Counterclaims against us, asserting counterclaims for our alleged breaches of the Asset Purchase Agreement between Novell and our predecessor-in-interest, The Santa Cruz Operation, Inc, for slander of title, restitution/unjust enrichment, and accounting, and for declaratory relief regarding Novell’s alleged rights under the Asset Purchase Agreement |
| On or about December 30, 2005, we filed a motion for leave to amend our complaint to assert additional claims against Novell, including copyright infringement, unfair competition and a breach of Novell’s limited license to use our UNIX source code |
| Notwithstanding our assertions of full ownership of critical UNIX-related intellectual property rights, as set forth above, including copyrights, and even if we are successful in our legal action against Novell and end users such as AutoZone and DaimlerChrysler, the efforts of Novell and the other Linux proponents described above may cause further damage to our business including our ability to monetize our UNIX assets |
| These efforts of Linux proponents also may increase the negative view some participants in our marketplace have regarding our SCO Litigation and may contribute to creating confusion in the marketplace about the validity of our claim that the unauthorized use of our UNIX source code and derivative works in Linux violates our contracts and copyrights |
| Increased negative perception and potential confusion about our claims in our marketplace could impede our continued pursuit of the SCO Litigation and negatively impact our business |
| For example, we believe that our decrease in SCOsource revenue for the years ended October 31, 2005 and 2004 was in part attributable to Novell’s claim of UNIX copyright ownership, which may have caused potential customers to delay or forego licensing until an outcome in this legal matter has been reached |
| We operate in a highly competitive market and face significant competition from a variety of current and potential sources; many of our current and potential competitors have greater financial and technical resources than we do; thus, we may fail to compete effectively |
| In the operating system market, our competitors include IBM, Red Hat, Novell, HP, Sun, Microsoft and other Linux distributors |
| These and other competitors are aggressively pursuing the current UNIX operating system market |
| Many of these competitors have access to substantially greater resources than we do |
| The major competitive alternative to our UNIX products is Linux |
| The expansion of our competitors’ offerings may restrict the overall market available for our UNIX products, including some markets where we have been successful in the past |
| Our future success may depend in part on our ability to continue to meet the increasing needs of our customers by supporting existing and emerging technologies |
| If we do not enhance our products to meet these evolving needs, we may not remain competitive and be able to sustain or grow our business |
| Additionally, because technological advancement in the UNIX operating system market and alternative operating system markets is progressing at an advanced pace, we will have to develop and introduce enhancements to our existing products and any new products on a timely basis to keep pace with these developments, evolving industry standards and changing customer requirements |
| Our failure to meet any of these and other competitive pressures may render our existing products and services obsolete, which would have an adverse impact on our revenue and operations |
| The success of our UNIX business will depend on the level of commitment and certification we receive from industry partners and developers |
| In recent years, we have seen hardware and software vendors as well as software developers turn their certification and application development efforts toward Linux and elect not to continue to support or certify to our UNIX operating system products |
| If this trend continues, our competitive position will be adversely impacted and our future revenue from 11 ______________________________________________________________________ our UNIX business will decline |
| The decline in our UNIX business may be accelerated if industry partners withdraw their support from us for any reason, including our SCO Litigation |
| If the market for UNIX continues to contract, our business will be harmed |
| Our revenue from the sale of UNIX products has declined over the last several years |
| This decrease in revenue has been attributable primarily to increased competition from other operating systems, particularly Linux |
| Our sales of UNIX products and services are primarily to existing customers |
| If the demand for UNIX products continues to decline, and we are unable to develop UNIX products and services that successfully address a market demand, our UNIX revenue will continue to decline, industry participants may not certify to our operating system and products, we may not be able to attract new customers or retain existing customers and our business and results of operations will be adversely affected |
| Because of the long adoption cycle for operating system purchases and the long sales cycle of our operating system products, we may not be able to reverse these revenue declines quickly |
| We may lose the support of industry partners leading to an accelerated decline in our UNIX products and services revenue |
| The decline in our UNIX business and our SCO Litigation may cause industry partners, developers and hardware and software vendors to choose not to support or certify to our UNIX operating system products |
| This would lead to an accelerated decline in our UNIX products and services revenue and would adversely impact our results of operations and liquidity |
| Our claims relating to our UNIX intellectual property may subject us to additional legal proceedings |
| In August 2003, Red Hat brought a lawsuit against us asserting that the Linux operating system does not infringe on our UNIX intellectual property rights and seeking a declaratory judgment for non-infringement of copyrights and no misappropriation of trade secrets |
| In addition, Red Hat claims we have engaged in false advertising in violation of the Lanham Act, deceptive trade practices, unfair competition, tortious interference with prospective business opportunities, and trade libel and disparagement |
| Although this case is currently stayed pending the resolution of our suit against IBM, we intend to vigorously defend this action |
| However, if Red Hat is successful in its claim against us, our business and results of operations could be materially harmed |
| In addition, regulators or others in the Linux market and some foreign regulators have initiated or in the future may initiate legal actions against us, all of which may negatively impact our operations and future operating performance |
| We rely on our indirect sales channel for distribution of our products, and any disruption of our channel at any level could adversely affect the sales of our products |
| The relationships we have developed with resellers allow us to offer our products and services to a much larger customer base than we would otherwise be able to reach through our own direct sales and marketing efforts |
| Some solution providers also purchase solutions through our resellers, and we anticipate they will continue to do so |
| Because we usually sell indirectly through resellers, we cannot control the relationships through which resellers, solution providers or equipment integrators purchase our products |
| In turn, we do not control the presentation of our products to end users |
| Therefore, our sales could be affected by disruptions in the relationships between us and our resellers, between our resellers and solution providers, or between solution providers and end users |
| Also, resellers and solution providers may choose not to emphasize our products to their customers |
| Any of these occurrences could diminish the effectiveness of our distribution channel and lead to decreased sales |
| 12 ______________________________________________________________________ Our future SCOsource licensing revenue is uncertain |
| We initiated the SCOsource licensing effort in the year ended October 31, 2003 to review the status of UNIX licensing and sublicensing agreements |
| This effort resulted in the execution of two significant vendor license agreements and generated dlra25cmam846cmam000 in revenue during the year ended October 31, 2003 |
| During the year ended October 31, 2004, our SCOsource licensing revenue declined significantly to only dlra829cmam000 and during the year ended October 31, 2005, our SCOsource licensing revenue declined further to dlra166cmam000 |
| Because of a lack of historical experience and the uncertainties related to SCOsource licensing revenue, we are unable to estimate the amount and timing of future SCOsource licensing revenue, if any |
| If we do receive revenue from this source, it may be sporadic and fluctuate from quarter to quarter |
| Additionally, the success of these initiatives may depend on the strength of our intellectual property rights and contractual claims regarding UNIX, including the strength of our claim that unauthorized UNIX source code and derivative works are prevalent in Linux |
| Fluctuations in our operating results or the failure of our operating results to meet the expectations of public market analysts and investors may negatively impact our stock price |
| Fluctuations in our operating results or our failure to meet the expectations of analysts or investors, even in the short-term, could cause our stock price to decline significantly |
| Because of the potential for significant fluctuations in our SCOsource licensing revenue in any particular period, you should not rely on comparisons of our results of operations as an indication of future performance |
| Factors that may affect our results include: • ability to successfully negotiate and complete licensing and other agreements related to our intellectual property; • the interest level of resellers in recommending our UNIX business solutions to end users and the introduction, development, timing, competitive pricing and market acceptance of our products and services and those of our competitors; • the activities of short sellers; • changes in general economic conditions, such as recessions, that could affect capital expenditures in the software industry; • results of, or developments in, our SCO Litigation; • changes in business attitudes toward UNIX as a viable operating system compared to other competing systems, especially Linux; • the contingency and other legal fees we may pay to the law firms representing us in our efforts to establish our intellectual property rights; and • changes in attitudes of customers and partners due to the decline in our UNIX business and our aggressive position against the inclusion of our UNIX code and derivative works in Linux |
| We also experience fluctuations in operating results in interim periods in Europe and the Asia Pacific regions due to seasonal slowdowns and economic conditions in these areas |
| Seasonal slowdowns in these regions typically occur during the summer months |
| As a result of the factors listed above and elsewhere, it is possible that our results of operations may be below the expectations of public market analysts and investors in any particular period |
| If revenue falls below our expectations, and we are unable to 13 ______________________________________________________________________ quickly reduce our spending in response, our operating results will be lower than expected |
| Our stock price may fall in response to these events |
| Our foreign-based operations and sales create special problems, including the imposition of governmental controls and taxes and fluctuations in currency exchange rates that could hurt our results |
| We have foreign operations, including development facilities, sales personnel and customer support operations in Europe, Latin America and Asia |
| These foreign operations are subject to certain inherent risks, including: • potential loss of developed technology through piracy, misappropriation, or more lenient laws regarding intellectual property protection; • imposition of governmental controls, including trade restrictions and other tax requirements; • fluctuations in currency exchange rates and economic instability; • longer payment cycles for sales in foreign countries; and • seasonal reductions in business activity |
| In addition, certain of our operating expenses are denominated in local currencies, creating risk of foreign currency translation losses that could harm our financial results and cash flows |
| When we generate profits in foreign countries, our effective income tax rate is increased |
| During the three months ended April 30, 2004, our Indian office was given a withholding tax assessment from the Government of India Income Tax Department |
| The Tax Department assessed a 15 percent withholding tax on certain revenue transactions in India that the Tax Department deemed royalty revenue under the Income Tax Act |
| We have filed an appeal with the Tax Department and believe that revenue from our packaged software does not qualify for royalty treatment and therefore would not be subject to withholding tax |
| However, we may be unsuccessful in our appeal against the Tax Department and be obligated to pay the assessed taxable amounts |
| Because of our international operations, we may be subject to additional withholding or taxes from other international jurisdictions |
| If we are unable to retain key personnel in an intensely competitive environment, our operations could be adversely affected |
| We need to retain our key management, technical and support personnel |
| Competition for qualified professionals in the software industry is intense, and departures of existing personnel could be disruptive to our business and might result in the departure of other employees |
| The loss or departure of any officers or key employees could harm our ability to implement our business plan and could adversely affect our operations |
| Our future success depends to a significant extent on the continued service and coordination of our management team, particularly Darl C McBride, our President and Chief Executive Officer |
| Our Engagement Agreement with the law firms representing us in the SCO Litigation requires us to pay for expert, consulting and other costs, which could harm our liquidity position if these costs are higher than anticipated |
| As of October 31, 2005, we had a total of dlra10cmam437cmam000 in cash and cash equivalents and available-for-sale securities and an additional dlra2cmam875cmam000 of restricted cash to be used in our operations and pursue the SCO Litigation |
| Since October 31, 2004, we have spent dlra2cmam125cmam000 for expert, consulting and other costs as agreed in the Engagement Agreement with our legal counsel in the SCO Litigation |
| As we continue with discovery and other trial preparations during the year ending October 31, 2006, we believe 14 ______________________________________________________________________ that we will spend the dlra2cmam875cmam000 remaining in escrow and we may be required to place additional amounts into the escrow account, which could harm our liquidity position |
| We have issued options under our equity compensation plans without complying with registration or qualification requirements under the securities laws of California, Georgia and possibly other states, and, as a result, we may incur rescission liability for such options and may face additional potential claims under state securities laws |
| In addition to the shares issued under the ESPP, we have granted options under our 1999 Omnibus Stock Incentive Plan and 2002 Omnibus Stock Incentive Plan without complying with the registration or qualification requirements under the securities laws of California, Georgia and possibly other states |
| We may face rescission liability to plan participants holding unexercised stock options in these states |
| Additionally, regulatory authorities may require us to pay fines or they may impose other sanctions upon us, and we may face other claims by plan participants other than rescission claims |
| The trading price for our common stock has been volatile during the last several years and our share price has changed dramatically over short periods |
| We believe that changes in our stock price are affected by the factors mentioned above under the caption entitled “Fluctuations in our operating results or the failure of our operating results to meet the expectations of public market analysts and investors may negatively impact our stock price” as well as from changing public perceptions concerning the strength of our intellectual property claims and other factors beyond our control |
| Public perception can change quickly and without any change or development in our underlying business or litigation position |
| An investment in our stock is subject to such volatility and, consequently, is subject to significant risk |
| There are risks associated with the potential exercise of our outstanding options |
| As of December 31, 2005, we have issued and outstanding options to purchase up to approximately 3cmam811cmam000 shares of common stock with an average exercise price of dlra4dtta17 per share |
| The existence of such rights to acquire common stock at fixed prices may prove a hindrance to our efforts to raise future equity and debt funding, and the exercise of such rights will dilute the percentage ownership interest of our stockholders and may dilute the value of their ownership |
| The possible future sale of shares issuable on the exercise of outstanding options could adversely affect the prevailing market price for our common stock |
| Further, the holders of the outstanding stock options may exercise them at a time when we would otherwise be able to obtain additional equity capital on terms more favorable to us |
| Common stock available for resale may depress the market price of our common stock |
| We have filed a registration statement with the Securities and Exchange Commission (“SEC”), which has been declared effective, covering the potential resale by one of our shareholders of up to 2cmam105cmam163 shares of common stock, or 10dtta0prca of our outstanding common stock |
| In addition, we have filed a registration statement with the SEC, which has not been declared effective, covering the potential resale by some of our shareholders of up to 2cmam852cmam449 shares of our common stock, or 13dtta6prca of our outstanding common stock |
| The existence of a substantial number of shares of common stock subject to immediate resale could depress the market price for our common stock and impair our ability to raise needed capital |
| Our stock price could decline further because of the activities of short sellers |
| Our stock has attracted significant interest from short sellers |
| The activities of short sellers could further reduce the price of our stock or inhibit increases in our stock price |
| 15 ______________________________________________________________________ The right of our Board of Directors to authorize additional shares of preferred stock could adversely impact the rights of holders of our common stock |
| Our Board of Directors currently has the right, with respect to the 5cmam000cmam000 shares of our preferred stock, to authorize the issuance of one or more additional series of our preferred stock with such voting, dividend and other rights as our directors determine |
| The Board of Directors can designate new series of preferred stock without the approval of the holders of our common stock |
| The rights of holders of our common stock may be adversely affected by the rights of any holders of additional shares of preferred stock that may be issued in the future, including without limitation, further dilution of the equity ownership percentage of our holders of common stock and their voting power if we issue preferred stock with voting rights |
| Additionally, the issuance of preferred stock could make it more difficult for a third party to acquire a majority of our outstanding voting stock |
| Our stockholder rights plan could make it more difficult for a hostile bid for our company or a change of control transaction to succeed at current market prices for our stock |
| We have adopted a stockholder rights plan |
| The power given to the Board of Directors by the stockholder rights plan may make it more difficult for a change of control of our company to occur or for our company to be acquired when the acquisition is opposed by our Board of Directors |