10-Q 1 d10q.txt FORM 10-Q (P.E. 03/31/2001) -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 --------------------------------- FORM 10-Q (Mark one) [X] Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 FOR THE QUARTER ENDED MARCH 31, 2001 OR [_] Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 COMMISSION FILE NUMBER 000-24733 ---------------------------------- ENTRUST TECHNOLOGIES INC. (Exact name of registrant as specified in its charter) MARYLAND 62-1670648 (State or other jurisdiction of (IRS employer identification no.) incorporation or organization) ONE PRESTON PARK SOUTH 4975 PRESTON PARK BLVD., SUITE 400 PLANO, TX 75093 (Address of principal executive offices & zip code) Registrant's telephone number, including area code: (972) 943-7300 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 [ ] There were 63,075,050 shares of the registrant's $.01 par value Common stock outstanding as of May 11, 2001. -------------------------------------------------------------------------------- ENTRUST TECHNOLOGIES INC. TABLE OF CONTENTS PART I. FINANCIAL INFORMATION Page ---- Item 1. Financial Statements Condensed Consolidated Balance Sheets........................... 3 Condensed Consolidated Statements of Operations................. 4 Condensed Consolidated Statements of Cash Flows................. 5 Notes to Condensed Consolidated Financial Statements............ 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations........................................... 9 Item 3. Quantitative and Qualitative Disclosures about Market Risk...... 21 PART II. OTHER INFORMATION Item 1. Legal Proceedings............................................... 22 Item 2. Changes in Securities and Use of Proceeds....................... 23 Item 6. Exhibits and Reports on Form 8-K................................ 23 SIGNATURES................................................................. 24 Entrust and getAccess are registered trademarks of Entrust Technologies Inc. or a subsidiary of Entrust Technologies Inc. in certain countries. Entrust.Net is a trademark of Entrust Technologies Inc. or a subsidiary of Entrust Technologies Inc. in certain countries. All other trademarks and service marks used in this quarterly report are the property of their respective owners. 2 PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS ENTRUST TECHNOLOGIES INC. CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited) DECEMBER 31, MARCH 31, ------------ ---------- 2000 2001 ---- ---- (In thousands) ASSETS Current assets: Cash and cash equivalents................... $ 24,241 $ 17,200 Short-term marketable investments........... 203,446 178,351 Accounts receivable, (net of allowance for doubtful accounts of $2,932 at December 31, 2000 and $3,717 at March 31, 2001)..... 46,301 41,167 Prepaid expenses and other.................. 9,603 10,616 --------- --------- Total current assets...................... 283,591 247,334 Property and equipment, net................... 25,168 27,827 Purchased product rights, net................. 19,259 17,882 Goodwill, net................................. 365,127 338,432 Other purchased intangibles, net.............. 22,054 19,849 Long-term investments......................... 16,675 18,110 Other long-term assets, net................... 2,232 3,054 --------- --------- Total assets.............................. $ 734,106 $ 672,488 ========= ========= LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable............................. $ 16,989 $ 17,325 Accrued liabilities.......................... 22,311 9,734 Deferred revenue............................. 19,466 20,710 Due to related party......................... 799 799 --------- --------- Total current liabilities................. 59,565 48,568 Long-term liabilities......................... 477 399 --------- --------- Total liabilities......................... 60,042 48,967 --------- --------- Shareholders' equity: Common stock, par value $0.01 per share; 62,753,738 and 63,067,916 issued and outstanding shares at December 31, 2000 and March 31, 2001, respectively............ 628 631 Additional paid-in capital................... 775,604 777,525 Unearned compensation........................ (316) (260) Accumulated deficit.......................... (101,518) (152,397) Accumulated other comprehensive loss......... (334) (1,978) --------- --------- Total shareholders' equity................ 674,064 623,521 --------- --------- Total liabilities and shareholders' equity................................... $ 734,106 $ 672,488 ========= =========

See accompanying notes to condensed consolidated financial statements 3 ENTRUST TECHNOLOGIES INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited) THREE MONTHS ENDED MARCH 31, -------- 2000 2001 ---- ---- (In thousands, except per share data) Revenues: License.................................................. $20,889 $ 10,559 Services and maintenance................................. 8,173 20,946 ------- -------- Total revenues......................................... 29,062 31,505 ------- -------- Cost of revenues: License.................................................. 937 901 Services and maintenance................................. 4,568 13,346 ------- -------- Total cost of revenues................................. 5,505 14,247 ------- -------- Gross profit............................................... 23,557 17,258 ------- -------- Operating expenses: Sales and marketing...................................... 12,857 26,580 Research and development................................. 4,993 9,487 General and administrative............................... 2,192 4,687 Amortization of purchased product rights................. - 1,377 Amortization of goodwill and other purchased intangibles............................................. 661 28,900 ------- -------- Total operating expenses............................... 20,703 71,031 ------- -------- Income (loss) from operations.............................. 2,854 (53,773) Investment income.......................................... 1,886 3,244 ------- -------- Income (loss) before provision for income taxes............ 4,740 (50,529) Provision for income taxes................................. 1,422 350 ------- -------- Net income (loss).......................................... $ 3,318 $(50,879) ======= ======== Net income (loss) per share: Basic.................................................. $ 0.07 $ (0.81) Diluted................................................ $ 0.06 $ (0.81) Weighted average common shares used in per share computations: Basic.................................................. 49,250 62,911 Diluted................................................ 57,760 62,911

See accompanying notes to condensed consolidated financial statements 4 ENTRUST TECHNOLOGIES INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited) THREE MONTHS ENDED MARCH 31, --------- 2000 2001 ---- ---- (In thousands) CASH FLOWS FROM OPERATING ACTIVITIES: Net income (loss)................................................ $ 3,318 $(50,879) Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Depreciation and amortization.................................. 1,527 32,503 Unearned compensation amortized................................ 58 56 Revenue from non-monetary transaction.......................... -- (353) Changes in operating assets and liabilities, net of effects of acquisitions: (Increase) decrease in accounts receivable..................... (3,080) 4,295 Increase in prepaid expenses and other......................... (149) (764) Increase in accounts payable................................... 1,491 260 Increase (decrease) in accrued liabilities..................... 1,257 (12,873) Increase in deferred revenue................................... 446 950 -------- -------- Net cash provided by (used in) operating activities.......... 4,868 (26,805) -------- -------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchases of marketable investments.............................. (24,140) (47,623) Dispositions of marketable investments........................... 35,187 72,778 Purchases of property and equipment.............................. (1,075) (5,073) Increase in long-term investments................................ (190) (1,496) Increase in other long-term assets............................... -- (1,016) Net cash payments in purchase transactions....................... (15,649) -- -------- -------- Net cash provided by (used in) investing activities.......... (5,867) 17,570 -------- -------- CASH FLOWS FROM FINANCING ACTIVITIES: Repayment of long-term liabilities............................... (3) (72) Proceeds from exercise of stock options and employee stock purchase plan................................................... 4,897 1,924 Proceeds from issuance of common stock, net of issuance costs.... 161,513 -- -------- -------- Net cash provided by financing activities.................... 166,407 1,852 -------- -------- EFFECT OF EXCHANGE RATE CHANGES ON CASH............................ 601 342 -------- -------- NET INCREASE IN CASH AND CASH EQUIVALENTS.......................... 166,009 (7,041) CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD................... 21,877 24,241 -------- -------- CASH AND CASH EQUIVALENTS AT END OF PERIOD......................... $187,886 $ 17,200 ======== ========

See accompanying notes to condensed consolidated financial statements 5 ENTRUST TECHNOLOGIES INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (In thousands, except share and per share data) NOTE 1. BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements have been prepared on the same basis as the audited annual consolidated financial statements and, in the opinion of management, include all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the financial position, results of operations and cash flows. The results of operations for the three months ended March 31, 2001 are not necessarily indicative of the results to be expected for the full year. Certain information and footnote disclosures normally contained in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted. These condensed consolidated financial statements should be read in conjunction with the Notes to Consolidated Financial Statements for the year ended December 31, 2000 contained in Entrust Technologies Inc.'s Form 10-K. NOTE 2. NET INCOME (LOSS) PER SHARE AND SHARES OUTSTANDING Basic net income (loss) per share is computed by dividing the net income (loss) by the weighted average number of shares of Common stock of all classes outstanding during the period. Diluted net income (loss) per share is computed by dividing the net income (loss) by the weighted average number of shares of Common stock and potential Common stock outstanding, and when dilutive, exchangeable Special Voting stock on an as-if exchanged basis, and options to purchase Common stock using the treasury stock method. The dilutive effect of the exchangeable Special Voting stock and the options to purchase Common stock are excluded from the computation of diluted net income (loss) per share if their effect is antidilutive. For the three months ended March 31, 2001, the antidilutive effect excluded from the diluted net loss per share computation due to the options to purchase Common stock was 2,889,126 shares. In the three months ended March 31, 2001, the Company issued 314,178 shares of Common stock related to the exercise of employee stock options and the sale of shares under the employee stock purchase plan. NOTE 3. INVESTMENTS AND EQUITY HEDGING INSTRUMENT The Company maintains marketable investments mainly in a strategic cash management account. This account is invested primarily in highly rated corporate securities, in securities guaranteed by the U.S. government or its agencies and highly rated municipal bonds, with a remaining maturity of not more than 12 months. The Company has the intent and ability to hold all investments until maturity. Therefore, all such investments are classified as held to maturity investments, in current assets, and are stated at amortized cost. At March 31, 2001, the amortized cost of the Company's held to maturity investments approximated fair value. In addition, the Company has invested in an equity instrument of a publicly traded technology company. This investment has been classified as available for sale, in current assets, and is carried at fair value based on quoted market prices. This instrument is considered to be short-term in nature as it is management's intention to dispose of this investment within the year. Realized gains and losses on disposition of available for sale marketable investments are included in investment income in the results of operations. Unrealized gains and losses are included in other comprehensive income, except that the portion designated as being hedged in a fair value hedge is recognized in investment income during the period of the hedge. 6 The Company has a policy that allows for the use of hedges on equity investments in publicly traded companies. The Company had entered into and designated such a hedge on the investment classified as available for sale, in the form of a call option hedge that enables the Company to receive, from the investee, a combination of cash and additional in-kind equity securities equal to any deficiency between the original cost basis of the equity securities and the aggregate of the market values on the dates that the securities are made available for sale on the applicable public equity market. This option is accounted for as a "fair value hedge" in accordance with SFAS No. 133. As of March 31, 2001, the fair value of the call option was $1,776, which is equal to the total of the realized and unrealized losses on the related investment. Effective January 1, 2001, the Company adopted SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities", as amended by SFAS No. 137 and SFAS No. 138, which establishes accounting and reporting standards for derivative financial instruments and hedging activities and requires the recognition of all derivatives as either assets or liabilities on the balance sheet and measurement at fair value. The adoption of SFAS No. 133 did not have a significant impact on the Company's financial position or results of operations because the Company is engaged in limited derivatives use. In implementing SFAS No. 133, the Company reclassified both the unrealized loss on the investment and the offsetting unrealized gain on the related hedge of $1,457 from accumulated other comprehensive income to results of operations with zero net effect on earnings. The Company holds equity securities stated at cost, which represent long- term investments in private companies made for business and strategic alliance purposes. The Company's ownership share in these companies ranges from 1% to 10% of their voting share capital. Consistent with the Company's policies for other long-lived assets, the carrying value of these long-term investments is periodically reviewed for impairment based upon such quantitative measures as undiscounted cash flows as well as qualitative factors. In addition, the Strategic Investment Committee of the Board of Directors monitors and assesses the ongoing operating performance of the underlying companies for evidence of impairment. No loss from impairment had been recorded as of March 31, 2001. The Company recorded revenues representing less than 2% of total revenues for the three months ended March 31, 2001, with respect to arm's-length transactions with companies in which it has made strategic equity investments recorded at cost. NOTE 4. SEGMENT AND GEOGRAPHIC INFORMATION Segment information The Company conducts business in one operating segment: the design, production and sale of software products and related services for encryption, digital signature and authorization. The nature of the Company's products and services is similar and, in general, the type of customers for these products and services is not distinguishable. The Company does, however, prepare information for internal use by the Chief Operating Decision Maker ("CODM"), the President and Chief Executive Officer, on a geographic basis. Accordingly, the Company has included a summary of the segment financial information reported to the CODM as follows in the next section regarding geographic information. Geographic information Revenues are attributed to specific geographical areas based on where the sales order originated. Company assets are identified with operations in the respective geographic areas. 7 The Company operates in three main geographic areas as follows:

(Unaudited) Three Months Ended ------------------ March 31, --------- 2000 2001 ---- ---- Revenues: United States......................................................... $ 17,109 $ 14,212 Canada................................................................ 6,602 5,895 Europe, Asia and Other................................................ 5,351 11,398 -------- -------- Total revenues.................................................... $ 29,062 $ 31,505 ======== ======== Income (loss) before income taxes: United States......................................................... $ 2,063 $(41,903) Canada................................................................ 2,445 (10,020) Europe, Asia and Other................................................ 232 1,394 -------- -------- Total income (loss) before income taxes........................... $ 4,740 $(50,529) ======== ========

(Unaudited) December 31, March 31, 2000 2001 ---- ---- Total assets: United States......................................................... $671,103 $604,687 Canada................................................................ 45,628 50,514 Europe, Asia and Other................................................ 17,375 17,287 -------- -------- Total............................................................. $734,106 $672,488 ======== ========

NOTE 5. COMPREHENSIVE INCOME (LOSS) The components of comprehensive income (loss) are as follows:

(Unaudited) Three Months ------------ Ended March 31, --------------- 2000 2001 ---- ---- Net income (loss).............................................................. $3,318 $(50,879) Translation adjustments........................................................ 601 (1,643) ------ -------- Comprehensive income (loss).................................................... $3,919 $(52,522) ====== ========

NOTE 6. LEGAL PROCEEDINGS On July 7, 2000, an action entitled Frankel v. Entrust Technologies Inc., et al., No. 2-00-CV-119, was filed against the Company and certain of its officers. The action was filed in the U.S. District Court for the Eastern District of Texas. Subsequently, several similar actions were filed in the same court. All of these actions have been consolidated. On January 22, 2001, a consolidated amended complaint was filed. The consolidated amended complaint purports to be a class action lawsuit brought on behalf of persons who purchased or otherwise acquired the Company's common stock during the period from October 19, 1999 through July 3, 2000. The complaint alleges that the defendants misrepresented and failed to disclose certain information about the Company's business and prospects. The complaint asserts claims under the Securities Exchange Act of 1934. The complaint does not specify the amount of damages sought. No trial date or other schedule has been established. The Company believes this class action is without merit and intends to deny all material allegations and to defend itself vigorously. An adverse judgment or settlement in this lawsuit could have a significant adverse impact on the Company's future financial condition or results of operations. The Company is subject to various other legal proceedings and claims, either asserted or unasserted, which arise in the ordinary course of business. While the outcome of these claims cannot be predicted with certainty, management does not believe that the outcome of any of these other legal matters will have a material adverse effect on the Company's consolidated results of operations or consolidated financial position. 8 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This report contains forward-looking statements that involve risks and uncertainties. The statements contained in this report that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including without limitation statements regarding our expectations, beliefs, intentions or strategies regarding the future. All forward-looking statements included in this report are based on information available to us, up to and including, the date of this document, and we assume no obligation to update any such forward-looking statements. Our actual results could differ significantly from those anticipated in these forward-looking statements as a result of certain factors, including those set forth below, under "Overview", "Certain Factors that May Affect Our Business" and elsewhere in this report. We undertake no obligation to update any forward-looking statements. OVERVIEW We are the leading global provider of public-key infrastructure, or PKI, and authorization products and services to e-businesses and other organizations. We are committed to enabling organizations to conduct e-commerce securely, ensuring that they benefit from increased service efficiency, technology cost savings and the confidence associated with trusted e-business technologies. Our products and services enable organizations and their partners to manage trusted, secure electronic transactions and communications over today's advanced networks, including intranets, extranets and the Internet. Since 1994, we have provided our award-winning PKI solution primarily to global enterprises and government entities, as well as small- to mid-sized businesses and individuals. To date, over six million users worldwide have been licensed to use Entrust products. Our quarterly operating results have varied substantially in the past and are likely to vary substantially from quarter to quarter in the future due to a variety of factors. In particular, our period-to-period operating results are significantly dependent upon the completion date of large license agreements. In this regard, the purchase of our products often requires a significant capital investment, which customers may view as a discretionary cost, and, therefore, a purchase that can be deferred or canceled due to budgetary or other business reasons. Estimating future revenues is also difficult because we ship our products soon after an order is received and, therefore, we do not have a significant backlog. Thus, quarterly license revenues are heavily dependent upon orders received and shipped within the same quarter. Moreover, we have generally recorded a significant portion of our total quarterly revenues in the third month of a quarter, with a concentration of these revenues in the last half of that third month. This concentration of revenues is influenced by customers' tendencies to make significant capital expenditures at the end of a fiscal quarter. We expect these revenue patterns to continue for the foreseeable future. In addition, quarterly license revenues are dependent on the timing of revenue recognition, which can be affected by many factors, including the timing of customer installations and acceptance. Accordingly, we have from time to time experienced delays in recognizing revenues with respect to certain orders. In any period a significant portion of our revenue may be derived from large sales to a limited number of customers. Despite the uncertainties in our revenue patterns, our operating expenses are based upon anticipated revenue levels and such expenses are incurred on an approximately ratable basis throughout the quarter. As a result, if expected revenues are delayed or otherwise not realized in a quarter for any reason, our business, operating results and financial condition would be adversely affected in a significant way. See "Certain Factors That May Affect Our Business". 9 RESULTS OF OPERATIONS The following table sets forth certain condensed consolidated statement of operations data expressed as a percentage of total revenues for the periods indicated:

(Unaudited) THREE MONTHS ENDED MARCH 31, --------- 2000 2001 ---- ---- Revenues: License................................................... 71.9% 33.5% Services and maintenance.................................. 28.1 66.5 ------ ------ Total revenues........................................ 100.0 100.0 ------ ------ Cost of revenues: License................................................... 3.2 2.8 Services and maintenance.................................. 15.7 42.4 ------ ------ Total cost of revenues................................ 18.9 45.2 ------ ------ Gross profit................................................ 81.1 54.8 ------ ------ Operating expenses: Sales and marketing....................................... 44.3 84.4 Research and development.................................. 17.2 30.1 General and administrative................................ 7.5 14.9 Amortization of purchased product rights.................. - 4.4 Amortization of goodwill and other purchased intangibles.. 2.3 91.7 ------ ------ Total operating expenses.............................. 71.3 225.5 ------ ------ Income (loss) from operations............................... 9.8 (170.7) Investment income........................................... 6.5 10.3 ------ ------ Income (loss) before provision for income taxes............................................. 16.3 (160.4) Provision for income taxes.................................. 4.9 1.1 ------ ------ Net income (loss)........................................... 11.4% (161.5)% ====== ======

REVENUES We generate revenues from licensing the rights to our software products to end-users and, to a lesser extent, from sublicense fees from resellers. We also generate revenues from consulting, training and post-contract support, or maintenance, performed for customers who license our products. We recognize revenues in accordance with the provisions of the American Institute of Certified Public Accountants' Statement of Position ("SOP") No. 97-2, "Software Revenue Recognition" and SOP No. 98-9, "Modifications of SOP 97-2, Software Revenue Recognition, with Respect to Certain Transactions". 10 Revenues from perpetual software license agreements are recognized as revenue upon receipt of an executed license agreement, or an unconditional order under an existing license agreement, and shipment of the software, if there are no significant remaining vendor obligations, collection of the receivable is probable and payment is due within twelve months. Revenues from maintenance services are recognized ratably over the term of the maintenance period, which is typically one year. If maintenance services are included free of charge or discounted in a license agreement, such amounts are unbundled from the license fee at their fair market value based upon the value established by independent sales of such maintenance to customers. Revenues from the sale of Entrust.Net(TM) Web server certificates are also recognized ratably over the term of the certificate (typically one to two years). Consulting and training revenues are generally recognized as the services are performed. Consulting services are typically performed under separate service agreements and are usually performed on a time and materials basis. Such services primarily consist of implementation services related to the installation and deployment of our products and do not include significant customization or development of the underlying software code. We use the percentage of completion method to account for fixed price custom development contracts. Under this method, we recognize revenue and profit as the work on the contract progresses. Revenues are recognized by applying the percentage of the total cost incurred to date divided by the total estimated contract cost to the total contract value, and any projected loss is recognized immediately. The total project cost estimates are reviewed on a regular basis. Total Revenues Total revenues increased 8% from $29.1 million for the three months ended March 31, 2000 to $31.5 million for the three months ended March 31, 2001. Total revenues derived from North America decreased 15% from $23.7 million for the three months ended March 31, 2000 to $20.1 million for the three months ended March 31, 2001, while total revenues derived from outside of North America increased 111% from $5.4 million for the three months ended March 31, 2000 to $11.4 million for the three months ended March 31, 2001. The majority of the overall growth in total revenues in the first three months of 2001 was experienced outside of North America, which is reflective of the resources invested to focus on those regions in recent quarters. We focused on growing our revenue base internationally, particularly in Europe, Asia and South America, which resulted in a significant increase in non-North American revenues in the three months ended March 31, 2001 compared to the same quarter in 2000. However, the level of non-North American revenues has fluctuated from period to period and this trend is expected to continue for the foreseeable future. In the first quarter of 2001, no single customer accounted for 10% or more of total revenues. License Revenues License revenues decreased 49% from $20.9 million for the three months ended March 31, 2000 to $10.6 million for the three months ended March 31, 2001, representing 72% and 34% of total revenues in the respective periods. The decrease in license revenues in absolute dollars was primarily due to the slowing of the global economy, particularly the economic downturn experienced in North America. The types of license transactions most significantly impacted by the less favorable economic conditions were those license transactions greater than $500,000 in value, which normally represent a substantial deployment to a broad base of users or the addition of new applications to customers' previously installed infrastructure. The rapid global downturn has had a significant impact on information technology projects and, as a result, customers could not make the commitments we were expecting at the end of the first quarter of 2001. License revenues as a percentage of total revenues decreased for the three months ended March 31, 2001 compared to the same period in 2000, partly due to continued strong demand for services and maintenance from our customers and increased professional services revenues from the addition of CygnaCom Solutions, Inc. in March 2000, and enCommerce, Inc. in June 2000, and partly due to decreased license revenues in the first three months of 200l. 11 Services and Maintenance Revenues Services and maintenance revenues increased 155% from $8.2 million for the three months ended March 31, 2000 to $20.9 million for the three months ended March 31, 2001, representing 28% and 66% of total revenues in the respective periods. The increase in services and maintenance revenues in absolute dollars was primarily the result of an increase in demand for consulting services and customer support, the acquisitions of CygnaCom and enCommerce, and increases in maintenance revenues from a larger installed product base and strong customer renewals of annual maintenance agreements. The growth in our customer base resulted in acceleration in the demand from customers to assist them in deploying our solutions, as well as strong demand to outsource our solutions on their behalf. We have invested heavily in additional professional services resources in response to this increased demand from customers. In addition, revenue from our Entrust.Net(TM) certification authority business, which began operating in May 1999, started to contribute significantly to total services and maintenance revenues in the latter part of 2000 and in the first quarter of 2001. The increase in services and maintenance revenues as a percentage of total revenues reflected a continuing shift in mix of revenues from license to service and maintenance revenues in the first quarter of 2001 compared to the same period in 2000. This shift was largely due to the continued growth of our services and maintenance business in response to customer demand, the impact of the professional services revenues of CygnaCom and enCommerce since their respective acquisitions, and the decrease in license revenues in the first quarter of 2001. We continue to focus on developing new service offerings for our customers and also on building our relationships with third-party service providers so that we have adequate resources available to meet the demand of our customers. COST OF REVENUES Cost of License Revenues Cost of license revenues consists primarily of costs associated with product media, documentation, packaging and royalties to third-party software vendors. Amortization of purchased product rights acquired as part of the acquisition of enCommerce has been excluded from cost of license revenues and instead has been included in operating expenses. Cost of license revenues decreased from $937,000 for the three months ended March 31, 2000 to $901,000 for the three months ended March 31, 2001, representing 3% of total revenues in each of the respective periods. The decrease in cost of license revenues in absolute dollars was primarily a result of lower royalty fees paid to third- party software vendors, which reflects the decrease in license revenues in general for the first three months of 2001, compared to the same period in 2000. The mix of third-party products may vary from period to period and, consequently, our gross margins and results of operations could be adversely affected. Cost of Services and Maintenance Revenues Cost of services and maintenance revenues consists primarily of personnel costs associated with customer support, training and consulting services, as well as amounts paid to third-party consulting firms for these services. Cost of services and maintenance revenues increased from $4.6 million for the three months ended March 31, 2000 to $13.3 million for the three months ended March 31, 2001, representing 16% and 42% of total revenues for the respective periods. The increase in absolute dollars during the three months ended March 31, 2001 reflected the increased costs associated with the increased levels of services and maintenance revenues experienced in this period and the increased costs associated with the CygnaCom and enCommerce resources. The increase in the cost of services and maintenance revenues as a percentage of total revenues in the three months ended March 31, 2001 reflected the rapid growth of services and maintenance revenues in comparison to license revenues, and reflected the significant shift in the mix of revenues from license to services and maintenance revenues in the first quarter of 2001 compared to the first quarter of 2000. As the services and maintenance revenues represented the larger proportion of total revenues and grew faster than total revenues, the cost of generating those services and maintenance revenues represented a much larger percentage when compared against total revenues, because significant investment was necessary in order to prepare for current and future growth in this business. Also, we made significant investments in additional customer support personnel to support the growing base of customers with previously installed products. 12 Services and maintenance gross profit as a percentage of services and maintenance revenues was 44% and 36% for the three months ended March 31, 2000 and 2001, respectively. This decrease in the services and maintenance gross profit as a percentage of services and maintenance revenues for the three months ended March 31, 2001, compared to the same period in 2000, reflected the investment we made in the professional services team through the acquisition of CygnaCom late in the first quarter of 2000 and enCommerce at the end of the second quarter of 2000, which represented a slight shift in the mix of overall services revenues toward the lower-margin professional services revenues. Also, the decrease in the services and maintenance gross profit as a percentage of services and maintenance revenues reflected the investment made in additional customer support personnel since the first quarter of 2000, and the continued development and rollout of our new services offerings. OPERATING EXPENSES Sales and Marketing Sales and marketing expenses increased from $12.9 million for the three months ended March 31, 2000 to $26.6 million for the comparable period in 2001. Sales and marketing expenses represented 44% of total revenues for the three months ended March 31, 2000, compared to 84% for the same period in 2001. The increase in absolute dollars in the first quarter of 2001 was primarily the result of costs associated with the expansion of our sales and marketing organization, both domestically and internationally, in order to support the growing revenue base as we continue to penetrate new markets and industry verticals, and as a result of the addition of the enCommerce sales and marketing team. In addition, we continued to make significant investments in marketing to support the launch of new products, services and marketing programs. We have continued our strategy of investing in (a) hiring and training the members of our direct sales organization in anticipation of future market growth, and (b) marketing efforts in support of new product launches. Failure of these investments to generate future revenues could have a significant adverse effect on our operations. The increase in sales and marketing expenses as a percentage of total revenues for the three months ended March 31, 2001, compared to the same period in 2000, was mainly due to the combination of lower than expected license revenues in the first quarter of 2001, and sales and marketing expenses that were largely fixed prior to the beginning of the first quarter of 2001 based on expected license revenues for that period. The increase in sales and marketing expenses as a percentage of total revenues in the first quarter of 2001 also reflected the impact of the integration of the getAccess(TM) sales team of enCommerce into the existing sales organization. We continue to focus on improving the productivity of our sales and marketing organizations. Research and Development Research and development expenses increased from $5.0 million for the three months ended March 31, 2000 to $9.5 million for the comparable period in 2001. Research and development expenses represented 17% of total revenues for the three months ended March 31, 2000, compared to 30% for the same period in 2001. The increase in research and development expenses in absolute dollars in the first quarter of 2001 reflected higher expenses related to increased staffing of software developers. We hired these employees primarily in connection with the continuing expansion, enhancement and globalization of our product offerings, our commitment to quality assurance and testing, and the addition of development employees in connection with the acquisition of enCommerce. Research and development expenses as a percentage of total revenues increased for the three months ended March 31, 2001, compared to the same period in the previous year, due primarily to the lower than expected license revenues, as these costs were largely fixed prior to the start of the quarter, and due to the acquisition of enCommerce and the corresponding addition of the getAccess(TM) development team. However, we believe that we must continue to invest in research and development in order to maintain our technological leadership position and, thus, we expect research and development expenses to continue to increase in absolute dollars as additional experienced security experts and software engineers are hired. 13 General and Administrative General and administrative expenses increased from $2.2 million for the three months ended March 31, 2000 to $4.7 million for the comparable period in 2001. General and administrative expenses represented 8% of total revenues for the three months ended March 31, 2000, compared to 15% for the same period in 2001. The increase in general and administrative expenses in absolute dollars reflected our continued investment in increased staffing and related expenses for the enhancement of the infrastructure necessary to support our growing business, including investor relations programs, improved management information systems and the increased utilization of outside professional service firms. In addition, the increase in general and administrative expenses compared to the first quarter of 2000 was partly due to expenses we incurred in connection with the resignation of a senior executive. General and administrative expenses as a percentage of total revenues increased for the three months ended March 31, 2001, compared to the same period in the previous year, due primarily to the lower than expected license revenues, as these costs were largely fixed prior to the start of the quarter. We continue to look for ways to gain additional efficiencies in our administrative processes. Amortization of Goodwill, Purchased Product Rights and Other Purchased Intangibles On March 14, 2000, we completed the acquisition of CygnaCom, a company based in McLean, Virginia that delivers information technology products and services, with expertise in public key infrastructure, cryptographic technologies, security engineering and systems integration and development. Pursuant to the stock purchase agreement dated March 14, 2000, entered into between us, CygnaCom and the shareholders of CygnaCom, we agreed to acquire all of the outstanding shares of CygnaCom for an aggregate purchase price of $16.6 million, which included cash consideration of $16.0 million. The acquisition was recorded under the purchase method of accounting and, therefore, the results of operations of CygnaCom are included in our financial statements from the acquisition date. Upon consummation of the acquisition, CygnaCom became a wholly owned subsidiary of Entrust. In connection with this acquisition, we recorded goodwill of $16.6 million and goodwill amortization of $460,000 and $1.4 million was expensed in the three months ended March 31, 2000 and 2001, respectively. On June 26, 2000, we completed the acquisition of enCommerce, a company based in Santa Clara, California that provides software and services for managing global e-business relationships at business-to-business and business- to-consumer portals. The acquisition of enCommerce's outstanding capital stock, options and warrants for a total consideration of $505.5 million was accounted for under the purchase method of accounting, which resulted in an allocation of $449.6 million to purchased product rights, goodwill and other purchased intangibles. Also, in connection with this acquisition, an appraisal was done of the intangible assets, resulting in $29.6 million of the purchase price being allocated to in-process research and development that had not yet reached technological feasibility and had no alternative future use. This in-process research and development was expensed in 2000. Amortization of purchased product rights of $1.4 million and amortization of goodwill and other purchased intangibles of $27.3 million were expensed in the three months ended March 31, 2001. Investment Income Investment income increased from $1.9 million for the three months ended March 31, 2000 to $3.2 million for the comparable period in 2001, representing 7% and 10% of total revenues in the respective periods. This increase in investment income reflected the interest earned on the net proceeds of our initial public offering in August 1998, on cash provided by operations in 1999 and 2000, and on the net proceeds of our follow-on offering in February and March 2000. Provision for Income Taxes We recorded an income tax provision of $1.4 million and $350,000 for the three months ended March 31, 2000 and 2001, respectively. We account for income taxes in accordance with Statement of Financial Accounting Standards No. 109. The effective income tax rates differed from statutory rates primarily due to the non-deductible amortization of goodwill, purchased product rights, and other purchased intangible assets, as well as an adjustment of the valuation allowance, that results in the recognition of a portion of the tax benefits from the significant net operating loss and tax credit carry-forwards available. 14 LIQUIDITY AND CAPITAL RESOURCES We used cash of $26.8 million from operating activities during the three months ended March 31, 2001. This cash outflow was primarily a result of a net loss before non-cash charges of $18.7 million, and a decrease in accrued liabilities of $12.9 million, partially offset by cash inflows resulting in a decrease in accounts receivable of $3.5 million during the period. Our average days sales outstanding at March 31, 2001 was 118 days, which represented an increase from the 87 days that we reported at December 31, 2000. The overall increase in days sales outstanding from December 31, 2000 reflected the lower than expected revenues for the quarter, slow collections and longer payment terms for international customers and the shift in revenue mix towards a higher percentage of professional services revenues, which generally remain in accounts receivable longer than license revenues. For purposes of calculating average days sales outstanding, we divide ending accounts receivable by the current quarter's revenues and multiply this amount by 90 days. The level of accounts receivable at each quarter end will be affected by the concentration of revenues in the final weeks of each quarter and may be negatively affected by expanded international revenues in relation to total revenues as licenses to international customers often have longer payment terms. During the three months ended March 31, 2001, we generated $17.6 million of cash from investing activities, primarily due to cash provided by reductions in our marketable investments in the amount of $25.2 million (net of $47.6 million of marketable investment purchases). This was partially offset by $5.1 million invested in property and equipment, $1.4 million invested in a long-term investment and $1.1 million invested in other long-term assets. The property and equipment investments were primarily computer hardware, furniture and leasehold improvements to support our growing organization, largely costs related to the fit-up of our new facility in Santa Clara, California and completion of the fit- up of our new facility in Ottawa, Canada. The long-term investment funded was strategic in nature, represented an investment in less than 10% of the capital stock of a privately held electronic security and technology company, and was accounted for on a cost basis. Equity investments such as this give us better access to various geographic and vertical markets, as well as access to emerging technologies and products. The investment in other long-term assets relates primarily to the purchase of a license for technology to be used in the provision of services to customers. Cash provided by financing activities for the three months ended March 31, 2001 was $1.9 million, primarily from the exercise of employee stock options and the sale of shares under our employee stock purchase plan. As of March 31, 2001, our cash, cash equivalents and short-term investments in the amount of $195.6 million provided our principal sources of liquidity. We believe that cash flows from operations and existing cash, cash equivalents and short-term investments will be sufficient to meet our needs for at least the next twelve months. Certain Factors That May Affect Our Business Our quarterly revenues and operating results are subject to significant fluctuations and such fluctuations may lead to a reduced market price for our stock Our quarterly revenues and operating results have varied in the past and may continue to fluctuate in the future. We believe that period-to-period comparisons of our operating results are not necessarily meaningful, but securities analysts and investors often rely upon these comparisons as indicators of future performance. If our operating results in any future period fall below the expectations of securities analysts and investors, the market price of our securities would likely decline. Factors that have caused our results to fluctuate in the past and which are likely to affect us in the future include the following: . length of sales cycles associated with our product offerings; . the timing, size and nature of our licensing transactions; 15 . market acceptance of new products or product enhancements by us or our competitors; . the relative proportions of revenues derived from licenses and services and maintenance; . the timing of new personnel hires and the rate at which new personnel become productive; . changes in pricing policies by our competitors; . changes in our operating expenses; and . fluctuations in foreign currency exchange rates. Estimating future revenues is difficult, and our failure to do so accurately may lead to a reduced market price for our stock and reduced profitability Estimating future revenues is difficult because we ship our products soon after an order is received and, as such, we do not have a significant backlog. Thus, quarterly license revenues depend heavily upon orders received and shipped within the same quarter. Moreover, we historically have recorded 60% to 80% of our total quarterly revenues in the third month of the quarter, with a concentration of revenues in the second half of that month. We expect that this concentration of revenues, which is attributable in part to the tendency of some customers to make significant capital expenditures at the end of a fiscal quarter and to sales patterns within the software industry, will continue for the foreseeable future. Our expense levels are based, in significant part, upon our expectations as to future revenues and are largely fixed in the short term. We may be unable to adjust spending in a timely manner to compensate for any unexpected shortfall in revenues. Any significant shortfall in revenues in relation to our expectations could have an immediate and significant effect on our profitability for that quarter and may lead to a reduced market price for our stock. Because of the lengthy and unpredictable sales cycle associated with our large PKI transactions, we may not succeed in closing transactions on a timely basis or at all, which would adversely affect our revenues and operating results Transactions for our PKI solution often involve large expenditures, and the sales cycles for these transactions are often lengthy and unpredictable. Factors affecting the sales cycle include: . customers' budgetary constraints; . the timing of customers' budget cycles; and . customers' internal approval processes. We may not succeed in closing such large transactions on a timely basis or at all, which could cause significant variability in our revenues and results of operations for any particular period. If our results of operations and cash flows fall below the expectations of securities analysts, our stock price may decline. A limited number of customers has accounted for a significant percentage of our revenues, which may decline if we cannot keep or replace these customer relationships Historically, a limited number of customers has accounted for a significant percentage of our revenues. In 1999, our three largest customers accounted for 31% of revenues, with the largest customer accounting for 24% of revenues. In 2000, our three largest customers accounted for 12% of revenues. Our three largest customers accounted for 14% of revenues for the three months ended March 31, 2001. We anticipate that our 16 results of operations in any given period will continue to depend to a significant extent upon revenues from a small number of customers. In addition, we anticipate that such customers will continue to vary over time, so that the achievement of our long-term goals will require us to obtain additional significant customers on an ongoing basis. Our failure to enter into a sufficient number of large licensing agreements during a particular period could have a significant adverse effect on our revenues. If the e-business security market does not continue to grow, demand for our products and services will be adversely affected The market for e-business security solutions is at an early stage of development. Continued growth of the e-business security market will depend, in large part, on the following: . the continued expansion of Internet usage and the number of organizations adopting or expanding intranets and extranets; . the ability of network infrastructures to support an increasing number of users and services; . the public recognition of the potential threat posed by computer hackers and other unauthorized users; and . the continued development of new and improved services for implementation across the Internet, intranets and extranets. A decline in the growth of this market could reduce demand for our products, adversely affecting our revenues and results of operations. A breach of security at one of our customers, whether or not due to our products, could harm our reputation and reduce the demand for our products The processes used by computer hackers to access or sabotage networks and intranets are rapidly evolving. A well-publicized actual or perceived breach of network or computer security at one of our customers, regardless of whether such breach is attributable to our products, or any significant advance in techniques for decoding or ''cracking'' encrypted information, could adversely affect the market's perception of us and our products, and could have an adverse effect on our reputation and the demand for our products. If our products contain errors or bugs, sales of our products would likely decline Our products may contain errors, failures or bugs that our existing testing procedures have not detected. The errors may become evident at any time during the life of our products. The discovery of any errors, failures or bugs in any products may result in: . adverse publicity; . product returns; . the loss or delay of market acceptance of our products; and . third-party claims against us. Accordingly, the discovery of any errors, failures or bugs would have a significant adverse effect on the sales of our products. 17 Our revenues may decline if we cannot compete successfully in an intensely competitive market We target our products at the rapidly evolving market for e-business security solutions. Many of our current and potential competitors have longer operating histories, greater name recognition, larger installed bases and significantly greater financial, technical, marketing and sales resources than we do. As a result, they may be able to react more quickly to emerging technologies and changes in customer requirements, or to devote greater resources to the promotion and sale of their products. In addition, certain of our current competitors in particular segments of the security marketplace may in the future broaden or enhance their offerings to provide a more comprehensive solution competing more fully with our functionality. Increased competition, as well as consolidation of competitors, could result in lower prices, reduced margins or the failure of our products and services to achieve or maintain market acceptance, any of which could have a serious adverse effect on our business, financial condition and results of operations. Our business will not be successful if we do not keep up with the rapid changes in our industry The emerging market for e-business security products and related services is characterized by rapid technological developments, frequent new product introductions and evolving industry standards. To be competitive, we have to continually improve the performance, features and reliability of our products and services, particularly in response to competitive offerings, and be first to market with new products and services or enhancements to existing products and services. Our failure to develop and introduce new products and services successfully on a timely basis and to achieve market acceptance for such products and services could have a significant adverse effect on our business, financial condition and results of operations. We may have difficulty managing our expanding operations, which could adversely affect our ability to successfully grow our business The growth in the size and complexity of our business over the past few years has placed a significant strain on our managerial, operational and financial resources. Our ability to manage future growth, if any, will depend upon our ability to: . continue to implement and improve operational, financial and management information systems on a timely basis; and . expand, train, motivate and manage our work force. Our personnel, systems, procedures and controls may not be adequate to support our operations. The geographic dispersal of our operations, including the separation of our headquarters in Plano, Texas, from our research and development facility in Ottawa, Canada and enCommerce's facilities in Santa Clara, California may make it more difficult to manage our growth. If we fail to continue to attract and retain qualified personnel, our business may be harmed Our future success depends upon our ability to continue to attract and retain highly qualified scientific, technical, sales and managerial personnel. Competition for such personnel is intense, particularly in the field of cryptography, and there can be no assurance that we can retain our key scientific, technical, sales and managerial employees or that we can attract, motivate or retain other highly qualified personnel in the future. If we cannot retain or are unable to hire such key personnel, our business, financial condition and results of operations could be significantly adversely affected. Future acquisitions or investments could disrupt our ongoing business, distract our management and employees, increase our expenses and adversely affect our results of operations It is possible, as part of our future growth strategy, that we will from time-to-time acquire or make 18 investments in companies, technologies, product solutions or professional services offerings. With respect to these acquisitions, we would face the difficulties of assimilating personnel and operations from the acquired businesses and the problems of retaining and motivating key personnel from such businesses. In addition, these acquisitions may disrupt our ongoing operations, divert management from day-to-day business, increase our expenses and adversely impact our results of operations. Any future acquisitions would involve certain other risks, including the assumption of additional liabilities, potentially dilutive issuances of equity securities and incurrence of debt. In addition, these types of transactions often result in charges to earnings for such items as amortization of goodwill or in-process research and development expenses. We face risks associated with our international operations and plans for expansion, which, if not managed properly, could have a significant adverse effect on our business, financial condition or results of operations In the future, we may establish additional foreign operations, hire additional personnel and establish relationships with additional partners internationally. This expansion would require significant management attention and financial resources and could have an adverse effect on our business, financial condition and results of operations. Although our international sales currently are primarily denominated in U.S. dollars, we may increasingly denominate sales in foreign currencies in the future. In addition, our international business may be subject to the following risks: . difficulties in collecting international accounts receivable; . difficulties in obtaining U.S. export licenses, especially for products containing encryption technology; . potentially longer payment cycles for customer payments; . increased costs associated with maintaining international marketing efforts; . introduction of non-tariff barriers and higher duty rates; . difficulties in enforcement of contractual obligations and intellectual property rights; . difficulties managing personnel and operations in remote locations; and . increased complexity in global corporate tax structure. Any one of these could significantly and adversely affect our business, financial condition or results of operations. If the laws regarding exports of our products further limit or otherwise restrict our business, we could be prohibited from shipping our products to restricted countries, which would result in a loss of revenues Some of our products are subject to export controls under laws of the U.S., Canada and other countries. The list of products and countries for which exports are restricted, and the relevant regulatory policies, are likely to be revised from time to time. If we cannot obtain required government approvals under these regulations, we may not be able to sell products abroad or make products available for sale internationally via computer networks such as the Internet. Furthermore, U.S. governmental controls on the exportation of encryption products and technology may in the future restrict our ability to freely export some of our products with the most powerful information security encryption technology. We may not be able to protect our intellectual property rights, which could make us less competitive and cause us to lose market share Our future success will depend, in part, upon our intellectual property rights and our ability to protect these rights. We rely on a combination of patent, copyright, trademark and trade secret laws, nondisclosure 19 agreements, shrink-wrap licenses and other contractual provisions to establish, maintain and protect our proprietary rights. Despite our efforts to protect our proprietary rights, unauthorized third parties may: . copy aspects of our products; . obtain and use information that we regard as proprietary; or . infringe upon our patents. Policing piracy and other unauthorized use of our products is difficult, particularly in international markets and as a result of the growing use of the Internet. In addition, third parties might successfully design around our patents or obtain patents that we would need to license or design around. Finally, the protections we have obtained may not be sufficient because: . some courts have held that shrink-wrap licenses, because they are not signed by the licensee, are not enforceable; . our trade secrets, confidentiality agreements and patents may not provide meaningful protection of our proprietary information; and . we may not seek additional patents on our technology or products and such patents, even if obtained, may not be broad enough to protect our technology or products. Our inability or failure to protect our proprietary rights could have a significant adverse effect on our business, financial condition or results of operations. We have been subject to, and may in the future become subject to, intellectual property infringement claims that could be costly and could result in a diversion of management's attention As the number of security products in the industry increases and the functionality of these products further overlaps, software developers and publishers may increasingly become subject to claims of infringement or misappropriation of the intellectual property or proprietary rights of others. We received notice from one of our customers stating that we may be responsible for indemnifying that customer under a product license agreement for infringement of patents assigned to a third party. To date, the customer has not made a formal claim for indemnification from us. In addition, third parties may assert infringement or misappropriation claims against us in the future. Defending or enforcing our intellectual property could be costly and could result in a diversion of management's attention, which could have a significant adverse effect on our business, financial condition or results of operations. A successful claim against us could also have a significant adverse effect on our results of operations for the period in which damages are paid. We may lose access to technology that we license from outside vendors, which loss could adversely affect our ability to sell our products We rely on outside licensors for patent and/or software license rights in technology that is incorporated into and is necessary for the operation of our products. For example, our ability to provide Web server certificates is currently dependent upon a licensing agreement we have with Thawte Consulting (Pty.) of South Africa, which was acquired in January 2000 by Verisign, Inc., one of our primary competitors. Our success will depend in part on our continued ability to have access to such technologies that are or may become important to the functionality of our products. Any inability to continue to procure or use such technology could have a significant adverse effect on our ability to sell some of our products. Our stock price is volatile and may continue to be volatile in the future. The trading price of our common stock has been, and is expected to continue to be, highly volatile and 20 may be significantly and adversely affected by factors such as: . actual or anticipated fluctuations in our operating results; . announcements of technological innovations; . new products or new contracts by us or our competitors; . developments with respect to patents, copyrights or propriety rights; . conditions and trends in the security industry; . changes in financial estimates by securities analysts; and . general market conditions and other factors. Nortel Networks is able to exercise substantial influence over all matters requiring stockholder and board approval and could make decisions about our business that conflict with the Interests of other stockholders. Nortel Networks Corporation, through its subsidiary, Nortel Networks Inc., beneficially owned approximately 25.6% of our outstanding voting stock as of April 30, 2001, and one of our eight directors is a representative of Nortel Networks. Accordingly, Nortel Networks has the ability to exert significant influence over our affairs, including the election of directors and decisions relating to our strategic and operating activities. This concentration of ownership and board representation may have the effect of delaying or preventing a change in control that other stockholders may find favorable. Provisions of our charter and bylaws may delay or prevent transactions that are in your best interests. Our charter and bylaws contain provisions, including a staggered board of directors that may make it more difficult for a third party to acquire us, or may discourage bids to do so. These provisions could limit the price that investors might be willing to pay for shares of our common stock and could make it more difficult for a third party to acquire, or could discourage a third party from acquiring, a majority of our outstanding voting stock. Our board of directors also has the authority to issue up to 5,000,000 shares of preferred stock and to determine the price, rights, preferences, privileges and restrictions, including voting rights, of those shares without any further vote or action by the stockholders. The rights of the holders of common stock will be subject to, and may be adversely affected by, the rights of the holders of any preferred stock that may be issued in the future. The issuance of preferred stock could make it more difficult for a third party to acquire, or may discourage a third party from acquiring, a majority of our outstanding voting stock. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Risk Associated with Interest Rates Our investment policy states that we will invest our cash reserves, including cash, cash equivalents and marketable investments, in investments that are designed to preserve principal, maintain liquidity and maximize return. We actively manage our investments in accordance with these objectives. Some of these investments are subject to interest rate risk, whereby a change in market interest rates will cause the principal amount of the underlying investment to fluctuate. Therefore, depreciation in principal value of an investment is possible in situations where the investment is made at a fixed interest rate and the market interest rate then subsequently increases. We try to manage this risk by maintaining our cash, cash equivalents and marketable investments with high quality financial institutions and investment managers. We also restrict the investments to primarily securities with short-term maturities, such that, at March 31, 2001, the majority of our marketable investments 21 had maturities of less than six months from that date. As a result, we believe that our exposure to market risk related to interest rates is minimal. The following table presents the cash, cash equivalents and marketable investments that we held at March 31, 2001, that would have been subject to interest rate risk, and the related ranges of maturities as of that date:

MATURITY (in thousands) Greater than Within 3 Months 3-6 Months 6 Months --------------- ---------- -------- Investments classified as cash and cash equivalents........... $ 4,862 -- -- Investments classified as marketable investments.............. 132,357 $30,898 $7,197 -------- ------- ------ Total amortized cost........................................ $137,219 $30,898 $7,197 ======== ======= ====== Fair value.................................................... $137,408 $30,942 $7,197 ======== ======= ======

Risk Associated with Exchange Rates We are subject to foreign exchange risk as a result of exposures to changes in currency exchange rates, specifically between the United States and Canada, the United Kingdom, Germany, France, Japan and Switzerland. However, this exposure is considered to be minimal due to the fact that the United Kingdom, German, French, Japanese and Swiss operations are not significant, and the Canadian operations are naturally hedged against exchange rate fluctuations since both revenues and expenses are denominated in Canadian dollars. Therefore, an unfavorable change in the exchange rate for the Canadian subsidiary would result in lower revenues when translated into U.S. dollars, but the expenses would be lowered in a corresponding fashion. As a result, we do not engage in formal hedging activities, but we do periodically review the potential impact of this risk to ensure that the risk of significant potential losses remains minimal. Risk Associated with Equity Investments We hold short-term equity securities of a publicly traded company. It is possible that the market value of these securities could decline significantly in the near future. For example, due to recent stock market volatility, we recorded cumulative unrealized and realized losses of $1.8 million in this investment based on its market value at March 31, 2001. In connection with this investment, we have engaged in a hedging transaction that provides us with the right to receive an amount equal to the difference between the price we paid for these securities and the aggregate of the fair market values on the dates that the securities are made available for sale on the public market. We recorded an unrealized gain of $1.8 million as of March 31, 2001 as a result of this hedging transaction. However, this hedging activity may not sufficiently cover the value of this investment. In addition, we have invested in several privately held companies, most of which are technology companies in the start-up or development stage, or are companies with technologies and products that are targeted at geographically distant markets. If the demand for the technologies and products offered by these privately held companies materializes slowly, to a minimum extent, or not at all in the relevant markets, we could lose all or substantially all of our investments in these companies. To date, we have recorded no loss from impairment in connection with any of these investments. PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS On July 7, 2000, an action entitled Frankel v. Entrust Technologies Inc., et al., No. 2-00-CV-119, was filed against us and certain of our officers. The action was filed in the U.S. District Court for the Eastern District of Texas. Subsequently, several similar actions were filed in the same court. All of these actions have 22 been consolidated. On January 22, 2001, a consolidated amended complaint was filed. The consolidated amended complaint purports to be a class action lawsuit brought on behalf of persons who purchased or otherwise acquired our common stock during the period from October 19, 1999 through July 3, 2000. The complaints allege that the defendants misrepresented and failed to disclose certain information about our business and prospects. The complaint asserts claims under the Securities Exchange Act of 1934. The complaint does not specify the amount of damages sought. No trial date or other schedule has been established. We believe this class action is without merit and intend to deny all material allegations and to defend ourselves vigorously. An adverse judgment or settlement in this lawsuit could have a significant adverse impact on our future financial condition or results of operations. We are subject to various other legal proceedings and claims, either asserted or unasserted, which arise in the ordinary course of business. While the outcome of these claims cannot be predicted with certainty, management does not believe that the outcome of any of these legal matters will have a significant adverse effect on our consolidated results of operations or consolidated financial position. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS (d) Use of Proceeds. On August 21, 1998, we closed an initial public offering of our common stock, $.01 par value. The Registration Statement on Form S-1 (File No. 333- 57275) was declared effective by the Securities and Exchange Commission on August 17, 1998 and we commenced the offering on that date. After deducting the underwriting discounts and commissions and the offering expenses, the net proceeds to us from the offering were approximately $79,097,515. As of March 31, 2001, all of the net proceeds of the offering had been used to fund working capital, expansion of our facilities and our investments in other long-term assets. The entire amount of the net proceeds had been allocated for general corporate purposes and working capital, including product development and the possible acquisition of additional businesses and technologies that are complementary to our current or future business. None of the proceed amounts were paid directly or indirectly to any director, officer, or general partner of us or our associates, persons owning 10 percent or more of any class of equity securities, or an affiliate of us. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K List of Exhibits None Reports on Form 8-K: None 23 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. ENTRUST TECHNOLOGIES INC. ----------------------------------- (Registrant) Dated: May 14, 2001 /s/ David L. Thompson ----------------------------------- David L. Thompson Executive Vice President, Finance and Administration and Chief Financial Officer (Principal Financial and Accounting Officer) 24