10-Q 1 0001.txt FORM 10-Q ________________________________________________________________________________ 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 SEPTEMBER 30, 2000 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 62,619,902 shares of the registrant's $.01 par value Common stock outstanding as of November 10, 2000. ________________________________________________________________________________ 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.......................................................... 10 Item 3. Quantitative and Qualitative Disclosures about Market Risk..................... 23 PART II. OTHER INFORMATION Item 1. Legal Proceedings.............................................................. 24 Item 2. Changes in Securities and Use of Proceeds...................................... 24 Item 6. Exhibits and Reports on Form 8-K............................................... 25 SIGNATURES.................................................................................... 26 EXHIBITS...................................................................................... 27

2 PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS ENTRUST TECHNOLOGIES INC. CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited) DECEMBER 31, SEPTEMBER 30, ------------ ------------- 1999 2000 ---- ---- (In thousands) ASSETS Current assets: Cash and cash equivalents......................................... $ 21,877 $ 59,002 Short-term marketable investments................................. 67,394 183,903 Accounts receivable, net.......................................... 21,817 38,795 Prepaid expenses and other........................................ 4,195 4,212 -------- -------- Total current assets............................................ 115,283 285,912 Long-term marketable investments................................... 2,405 582 Property and equipment, net........................................ 6,904 16,939 Purchased product rights, net...................................... -- 20,633 Goodwill and other purchased intangibles, net...................... 2,948 415,129 Other long-term assets............................................. 2,980 19,274 -------- -------- Total assets.................................................... $130,520 $758,469 ======== ======== LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable.................................................. $ 6,636 $ 19,062 Accrued liabilities............................................... 9,169 20,856 Deferred income................................................... 10,761 16,113 Due to related party.............................................. 799 799 -------- -------- Total current liabilities....................................... 27,365 56,830 Long-term liabilities.............................................. -- 528 -------- -------- Total liabilities............................................... 27,365 57,358 -------- -------- Shareholders' equity: Common and special voting stock and additional paid-in capital....................................... 123,387 775,691 Unearned deferred compensation.................................... (439) (371) Accumulated other comprehensive loss.............................. (535) (551) Accumulated deficit............................................... (19,258) (73,658) -------- -------- Total shareholders' equity...................................... 103,155 701,111 -------- -------- Total liabilities and shareholders' equity...................... $130,520 $758,469 ======== ========

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

(Unaudited) (Unaudited) THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------ ------------ 1999 2000 1999 2000 ---- ---- ---- ---- (In thousands, except per share data) Revenues: License............................................... $16,515 $ 25,451 $42,056 $ 65,120 Services and maintenance.............................. 6,108 16,736 17,147 35,445 ------- -------- ------- -------- Total revenues.................................... 22,623 42,187 59,203 100,565 ------- -------- ------- -------- Cost of revenues: License............................................... 603 787 1,412 2,677 Services and maintenance.............................. 3,385 9,982 9,476 20,614 ------- -------- ------- -------- Total cost of revenues............................ 3,988 10,769 10,888 23,291 ------- -------- ------- -------- Gross profit........................................... 18,635 31,418 48,315 77,274 ------- -------- ------- -------- Operating expenses: Sales and marketing................................... 10,478 21,337 28,857 49,099 Research and development.............................. 4,225 8,454 12,111 19,272 General and administrative............................ 1,993 3,745 5,369 8,659 Acquired in-process research and development.......... - - - 29,614 Amortization of purchased product rights.............. - 1,377 - 1,377 Amortization of goodwill and other purchased intangibles........................................ 178 28,836 534 31,112 ------- -------- ------- -------- Total operating expenses.......................... 16,874 63,749 46,871 139,133 ------- -------- ------- -------- Income (loss) from operations.......................... 1,761 (32,331) 1,444 (61,859) Interest income........................................ 966 3,767 2,733 9,380 ------- -------- ------- -------- Income (loss) before income taxes...................... 2,727 (28,564) 4,177 (52,479) Provision for income taxes............................. 682 212 927 1,921 ------- -------- ------- -------- Net income (loss)...................................... $ 2,045 $(28,776) $ 3,250 $(54,400) ======= ======== ======= ======== Net income (loss) per share: Basic............................................. $ 0.05 $ (0.46) $ 0.07 $ (0.99) Diluted........................................... $ 0.04 $ (0.46) $ 0.06 $ (0.99) Weighted average common shares used in per share computations: Basic............................................. 44,106 62,507 43,504 55,112 Diluted........................................... 54,690 62,507 54,598 55,112

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

(Unaudited) NINE MONTHS ENDED SEPTEMBER 30, ----------------- 1999 2000 ---- ---- (In thousands) CASH FLOWS FROM OPERATING ACTIVITIES: Net income (loss)........................................................... $ 3,250 $ (54,400) Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation and amortization.......................................... 2,229 35,537 Deferred income taxes.................................................. (33) -- Deferred compensation earned........................................... 147 168 Acquired in-process research and development........................... -- 29,614 Changes in operating assets and liabilities: Increase in accounts receivable........................................ (4,141) (12,751) (Increase) decrease in prepaid expenses and other...................... (1,190) 144 Increase (decrease) in accounts payable................................ (1,515) 7,929 Increase in accrued liabilities........................................ 3,542 7,723 Increase in deferred income............................................ 1,907 2,741 Increase due to related party.......................................... 21 -- -------- --------- Net cash provided by operating activities......................... 4,217 16,705 -------- --------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchases of marketable investments......................................... (87,603) (226,761) Dispositions of marketable investments...................................... 97,758 112,075 Purchases of property and equipment......................................... (3,144) (10,418) Increase in other long-term assets.......................................... (1,518) (16,446) Net cash payments in purchase transactions.................................. -- (7,739) -------- --------- Net cash provided by (used in) investing activities............... 5,493 (149,289) -------- --------- CASH FLOWS FROM FINANCING ACTIVITIES: Repayment of long-term liabilities.......................................... (8) (59) Proceeds and tax reduction from exercise of stock options and employee stock purchase plan........................................... 7,028 8,419 Proceeds from issuance of common stock, net of issuance costs............... -- 161,513 -------- --------- Net cash provided by financing activities......................... 7,020 169,873 -------- --------- EFFECT OF EXCHANGE RATE CHANGES ON CASH.......................................... (6) (164) -------- --------- NET INCREASE IN CASH AND CASH EQUIVALENTS........................................ 16,724 37,125 CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD................................. 3,712 21,877 -------- --------- CASH AND CASH EQUIVALENTS AT END OF PERIOD....................................... $ 20,436 $ 59,002 ======== ========= NON-CASH INVESTING AND FINANCING ACTIVITIES: Issuance of common stock, stock options and warrants related to the acquisition of enCommerce, Inc......................................... $ - $ 482,272 ======== =========

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 nine months ended September 30, 2000 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, 1999 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 and nine months ended September 30, 2000, the antidilutive effect excluded from the diluted net loss per share computation due to the exchangeable Special Voting stock outstanding was nil and 859,548 shares, respectively, and due to the options to purchase Common stock was 4,586,607 and 5,071,951 shares, respectively. On August 21, 1998, the Company closed its initial public offering, issuing 5,400,000 shares of its Common stock at an initial public offering price of $16 per share. The net proceeds to the Company from the offering, after deducting underwriting discounts and commissions and offering expenses incurred by the Company, were approximately $79,098. Concurrent with the closing of the initial public offering, the majority shareholder of the Company exercised its option to exchange 2,542,711 shares of the Company's Special Voting stock into the equivalent number of shares of Common stock, among other transactions. After this exchange, the remaining number of issued and outstanding Special Voting shares was 5,157,289. On February 29, 2000 and March 2, 2000, the Company closed its follow-on offering (which included an over-allotment option closing), issuing an aggregate of 2,074,260 shares of its Common stock at an offering price of $82 per share. The net proceeds to the Company from the offering, after deducting underwriting discounts and commissions and offering expenses incurred by the Company, were approximately $161,513. Concurrent with the closing of the follow-on offering, the largest shareholder of the Company exercised its option to exchange 5,157,289 shares of the Company's Special Voting stock into the equivalent number of shares of Common stock. After this exchange, there were no issued and outstanding shares of the Company's Special Voting stock. On June 26, 2000, the Company issued 8,548,177 shares of Common stock in connection with the acquisition of enCommerce, Inc. In addition, 1,616,280 shares of Common stock were issued in the nine months ended September 30, 2000 related to the exercise of employee stock options and the sale of shares under the employee stock purchase plan. Total Common stock issued and outstanding was 45,203,448 shares and 62,599,454 shares at December 31, 1999 and September 30, 2000, respectively. 6 NOTE 3. MARKETABLE INVESTMENTS Marketable investments consist of investments 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, primarily 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 and stated at amortized cost. At September 30, 2000, the amortized cost of the Company's investments approximated fair value. 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 and digital signature. The nature of the Company's products and services is similar and, in general, the type of customers for those 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. The Company operates in three main geographic areas as follows:

(Unaudited) (Unaudited) Three Months Ended Nine Months Ended ------------------ ----------------- September 30, September 30, ------------- ------------- 1999 2000 1999 2000 ------- -------- -------- -------- Revenues: United States................................... $15,294 $ 24,837 $ 41,178 $ 53,336 Canada.......................................... 3,805 3,778 9,538 16,199 Europe, Asia and Other.......................... 3,524 13,572 8,487 31,030 ------- -------- -------- -------- Total revenues............................... $22,623 $ 42,187 $ 59,203 $100,565 ======= ======== ======== ======== Income (loss) before income taxes: United States................................... $ 1,388 $(28,986) $ 2,273 $(56,693) Canada.......................................... 759 (1,082) 580 2,217 Europe, Asia and Other.......................... 580 1,504 1,324 1,997 ------- -------- -------- -------- Total income (loss) before income taxes...... $ 2,727 $(28,564) $ 4,177 $(52,479) ======= ======== ======== ========

7

(Unaudited) December 31, September 30, ----------- ------------ 1999 2000 ---- ---- Total assets: United States.............................. $107,517 $714,760 Canada..................................... 15,216 27,442 Europe, Asia and Other..................... 7,787 16,267 -------- -------- Total.................................. $130,520 $758,469 ======== ========

NOTE 5. ACQUISITION OF CYGNACOM SOLUTIONS, INC. AND ENCOMMERCE, INC. On March 14, 2000 (the "CygnaCom Acquisition Date"), the Company completed the acquisition of all of the outstanding stock of CygnaCom Solutions, Inc. ("CygnaCom"), a Virginia corporation, pursuant to a Stock Purchase Agreement ("Purchase Agreement"), dated as of March 14, 2000, by and among the Company, CygnaCom and the stockholders of CygnaCom. CygnaCom is based in McLean, Virginia and is a high technology company that delivers information technology products and services, with expertise in public key infrastructure, cryptographic technologies, security engineering and systems integration and development. The Company intends to continue CygnaCom's business substantially in the manner conducted by CygnaCom immediately prior to the acquisition. Pursuant to the Purchase Agreement, on the CygnaCom Acquisition Date, all of the outstanding shares of common stock of CygnaCom were exchanged, in the aggregate, for a purchase price of $16,000 in cash and $555 in assumed net liabilities and acquisition expenses, whereupon Cygnacom became a wholly-owned subsidiary of the Company. The Purchase Agreement and the acquisition of CygnaCom were approved by the Board of Directors of the Company, and the Board of Directors and stockholders of CygnaCom. The acquisition was accounted for under the purchase method of accounting, and, accordingly, the purchase price was allocated to the fair value of the assets and liabilities acquired, with the remainder allocated to goodwill. Goodwill of $16,555 was recorded as a result of this acquisition, and $1,380 and $3,220 of goodwill amortization has been recorded in the three and nine months ended September 30, 2000, respectively. In addition, the results of operations of CygnaCom have been included in the Company's financial statements from the CygnaCom Acquisition Date. On June 26, 2000, the Company completed the acquisition of all of the outstanding capital stock, options and warrants of enCommerce, Inc. ("enCommerce"), a global portal infrastructure company and a provider of software and services designed to manage electronic business relationships, based in Santa Clara, California, with subsidiaries in England and Japan, in exchange for an aggregate of 8.548 million shares of the Company's Common stock and options and warrants to purchase 1.702 million shares of Common stock, with an aggregate fair value of $482,272. The Company also incurred approximately $22,355 in acquisition-related expenses. This acquisition was completed in accordance with the Merger Agreement by and among the Company, Enable Acquisition Corp. ("Enable"), a California corporation and a wholly-owned subsidiary of the Company, and enCommerce. Pursuant to the Merger Agreement, Enable merged with and into enCommerce, whereupon enCommerce became a wholly- owned subsidiary of the Company. The acquisition was accounted for under the purchase method of accounting, and, accordingly, the purchase price of approximately $504,627 was allocated to the fair value of the tangible and intangible assets and liabilities acquired, with the remainder allocated to goodwill. Amortization of $28,598 has been recorded in the three and nine months ended September 30, 2000, related to goodwill and other purchased intangible assets arising from this acquisition. In connection with the purchase price allocation, the Company obtained an independent appraisal of the intangible assets, which indicated that approximately $29,614 of the acquired intangible assets consisted of in-process research and development. The development of these products has not reached 8 technological feasibility and the technology has no alternative future use and, accordingly, the $29,614 of in-process research and development has been expensed in the nine months ended September 30, 2000 as a result of this acquisition. The value of purchased in-process research and development was calculated by identifying development projects in areas for which technological feasibility had not been established, estimating the costs to develop the purchased in-process products into commercially viable products, estimating the resulting net cash flows from such products, discounting the net cash flows to present value, and applying the percentage completion of the projects thereto. The discount rate includes a factor that takes into account the uncertainty surrounding the successful deployment of the purchased in-process products. In addition, the results of operations of enCommerce have been included in the Company's financial statements commencing from June 30, 2000, the effective date of the acquisition for accounting purposes. The purchase price of enCommerce has been allocated on a preliminary basis as follows:

Amortization Period (in thousands) (Straight-line) Net tangible assets.......................................................... $ 26,264 -- Purchased product rights, related to the getAccess product suite............. 22,010 4 years Assembled work force......................................................... 3,360 3 years Customer list................................................................ 23,105 3 years Goodwill..................................................................... 400,274 4 years In-process research and development.......................................... 29,614 -- -------- Total purchase price..................................................... $504,627 ========

The following unaudited pro forma data summarize the combined results of operations of Entrust Technologies Inc., CygnaCom and enCommerce for the three and nine months ended September 30, 1999 and 2000, respectively, as if the acquisitions had taken place as of the beginning of the respective periods, and, accordingly, exclude the $29,614 write-off of in-process research and development, a non-recurring charge directly attributable to the acquisition of enCommerce and include a full period's amortization of goodwill and other purchased intangibles in each period shown. Also, the per share data, in each period shown, includes the Common shares of the Company issued in connection with the acquisition of enCommerce, but excludes options and warrants issued as their effect is antidilutive.

(Unaudited) (Unaudited) Three Months Ended Nine Months Ended ------------------ ----------------- September 30, September 30, ------------- ------------- 1999 2000 1999 2000 -------- -------- -------- -------- Revenues............................... $ 27,684 $ 42,187 $ 71,391 $112,163 ======== ======== ======== ======== Net loss............................... (30,989) (28,776) (93,769) (96,736) ======== ======== ======== ======== Basic and diluted net loss per share... (0.59) (0.46) (1.80) (1.59) ======== ======== ======== ========

These pro forma amounts are not necessarily indicative of future results of operations. 9 NOTE 6. COMPREHENSIVE INCOME (LOSS) The components of comprehensive income (loss) are as follows:

(Unaudited) (Unaudited) Three Months Nine Months ------------ ----------- Ended September 30, Ended September 30, ------------------- ------------------- 1999 2000 1999 2000 ------ -------- ------ -------- Net income (loss)...................... $2,045 $(28,776) $3,250 $(54,400) Translation adjustments................ (35) (992) (6) (16) ------ -------- ------ -------- Comprehensive income (loss)............ $2,010 $(29,768) $3,244 $(54,416) ====== ======== ====== ========

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, products and services to e-businesses and other organizations. We are committed to enabling organizations to conduct e-commerce securely, ensuring 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 PKI solution primarily to global enterprises and government entities, as well as small- to mid-sized businesses and individuals. To date, over four 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 customer 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 10 timing of revenue recognition, which can be affected by many factors, including the timing of customer installations and acceptance. In these regards, 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". 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) (Unaudited) THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, -------------------- ------------------- 1999 2000 1999 2000 ----- ------ ----- ------ Revenues: License....................................... 73.0% 60.3% 71.0% 64.8% Services and maintenance...................... 27.0 39.7 29.0 35.2 ----- ------ ----- ------ Total revenues.............................. 100.0 100.0 100.0 100.0 ----- ------ ----- ------ Cost of revenues: License....................................... 2.7 1.8 2.4 2.7 Services and maintenance...................... 14.9 23.7 16.0 20.5 ----- ------ ----- ------ Total cost of revenues...................... 17.6 25.5 18.4 23.2 ----- ------ ----- ------ Gross profit.................................... 82.4 74.5 81.6 76.8 ----- ------ ----- ------ Operating expenses: Sales and marketing........................... 46.3 50.6 48.7 48.8 Research and development...................... 18.7 20.0 20.5 19.2 General and administrative.................... 8.8 8.9 9.1 8.6 Acquired in-process research and development -- -- -- 29.4 Amortization of purchased product rights...... -- 3.3 -- 1.4 Amortization of goodwill and other purchased intangibles............................... 0.8 68.3 0.9 30.9 ----- ------ ----- ------ Total operating expenses.................... 74.6 151.1 79.2 138.3 ----- ------ ----- ------ Income (loss) from operations................... 7.8 (76.6) 2.4 (61.5) Interest income................................. 4.2 8.9 4.6 9.3 ----- ------ ----- ------ Income (loss) before income taxes............... 12.0 (67.7) 7.0 (52.2) Provision for income taxes...................... 3.0 0.5 1.5 1.9 ----- ------ ----- ------ Net income (loss)............................... 9.0% (68.2)% 5.5% (54.1)% ===== ====== ===== ======

11 REVENUES We recognize revenues in accordance with the provisions of the American Institute of Certified Public Accountants' Statement of Position 97-2 "Software Revenue Recognition". We generate revenues primarily 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. Accordingly, revenues from perpetual software license agreements are recognized as revenues 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 services to other customers. Revenues from the sale of Web server certificates by Entrust.net, our certification authority service, are also recognized ratably over the term of the certificate, which is 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 large custom development contracts. Under this method, we recognize revenues 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 project cost estimates in each case are reviewed on a regular basis. Total Revenues Total revenues increased 86% from $22.6 million for the three months ended September 30, 1999 to $42.2 million for the three months ended September 30, 2000. Total revenues increased 70% from $59.2 million for the nine months ended September 30, 1999 to $100.6 million for the nine months ended September 30, 2000. Total revenues derived from North America increased 50% from $19.1 million for the three months ended September 30, 1999 to $28.6 million for the three months ended September 30, 2000, while total revenues derived from outside of North America increased 285% from $3.5 million for the three months ended September 30, 1999 to $13.6 million for the three months ended September 30, 2000. Total revenues derived from North America increased 37% from $50.7 million for the nine months ended September 30, 1999 to $69.5 million for the nine months ended September 30, 2000, while total revenues derived from outside of North America increased 266% from $8.5 million for the nine months ended September 30, 1999 to $31.1 million for the nine months ended September 30, 2000. The majority of the overall growth in total revenues in the first nine months of 2000 has been experienced in Europe, Asia and other international locales, which is reflective of the resources invested to focus on those regions in recent quarters. 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. 12 License Revenues License revenues increased 54% from $16.5 million for the three months ended September 30, 1999 to $25.5 million for the three months ended September 30, 2000, representing 73% and 60% of total revenues in the respective periods. License revenues increased 55% from $42.1 million for the nine months ended September 30, 1999 to $65.1 million for the nine months ended September 30, 2000, representing 71% and 65% of total revenues in the respective periods. The increase in license revenues in absolute dollars was primarily due to increasing market awareness and acceptance of our product offerings, continued enhancement and increasing breadth of our product offerings, expansion of our sales and marketing organization, and sales to new industry verticals and geographic markets. License revenues as a percentage of total revenues have decreased for the three and nine months ended September 30, 2000 compared to the same periods in 1999 due to growing demand for services and maintenance from our customers and stronger professional services revenues from the addition of CygnaCom and enCommerce in the first half of 2000. Services and Maintenance Revenues Services and maintenance revenues increased 174% from $6.1 million for the three months ended September 30, 1999 to $16.7 million for the three months ended September 30, 2000, representing 27% and 40% of total revenues in the respective periods. Services and maintenance revenues increased 107% from $17.1 million for the nine months ended September 30, 1999 to $35.4 million for the nine months ended September 30, 2000, representing 29% and 35% 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 additional professional services resources and revenues due to the acquisitions of CygnaCom and enCommerce, and increases in maintenance revenues from a larger installed product base as well as continued strong customer renewals of annual maintenance agreements. The growing customer base has resulted in an acceleration of demand for consulting services to assist these customers as they deploy our solutions. The increase in services and maintenance revenues as a percentage of total revenues was the result of a continuing shift in mix of revenues from license to service and maintenance revenues in the first three quarters of 2000. This is largely due to the continued growth of our services and maintenance business in response to customer demand, and the incremental impact of CygnaCom and enCommerce professional services revenues since their respective acquisitions in March 2000 and June 2000. We continue to focus on building new service offerings for our customers and also on building our relationships with outside service providers to ensure 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 increased from $603,000 for the three months ended September 30, 1999 to $787,000 for the three months ended September 30, 2000, representing 3% and 2% of total revenues for the respective periods. Cost of license revenues increased from $1.4 million for the nine months ended September 30, 1999 to $2.7 million for the nine months ended September 30, 2000, representing 2% and 3% of total revenues for the respective periods. The increase in cost of license revenues in absolute dollars was primarily a result of higher royalty fees paid to third- party software vendors, in response to the increase in license revenues in general for the first nine months of 2000, compared to the same period of 1999. This also was the primary contributor to the increase in cost of license revenues as a percentage of total revenues for the nine months ended September 30, 2000, compared to the same nine-month period in 1999. The decrease in cost of license revenues as a percentage of total revenues in the third quarter of 2000 compared to the same quarter in 1999 was primarily the result of the acquisition of enCommerce, which eliminated our requirement to pay royalties to third-party vendors related to the sale of authentication/privilege management software when bundled with our PKI product sales. The mix of 13 third-party products may vary from period to period and our gross margins and, consequently, our 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 those services. Cost of services and maintenance revenues increased from $3.4 million for the three months ended September 30, 1999 to $10.0 million for the three months ended September 30, 2000, representing 15% and 24% of total revenues for the respective periods. Cost of services and maintenance revenues increased from $9.5 million for the nine months ended September 30, 1999 to $20.6 million for the nine months ended September 30, 2000, representing 16% and 21% of total revenues for the respective periods. The increase in absolute dollars during the three and nine months ended September 30, 2000 reflected the increased costs associated with the increased levels of services and maintenance revenues experienced during these periods 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 and nine months ended September 30, 2000 reflects slightly lower productivity and utilization of available services resources compared to the same periods of the previous year due to an additional investment made in new professional service personnel in the first three quarters of 2000. The new personnel require training time before they reach target utilization, but such investment is necessary in order to prepare for future growth in the business. Also, we made significant investments in added customer support personnel to support the growing installed base of customers. Further, the increase as a percentage of total revenues is indicative of the fact that services and maintenance revenues grew more rapidly than license revenues in the third quarter of 2000. Services and maintenance gross profit as a percentage of services and maintenance revenues was 45% and 40% for the three months ended September 30, 1999 and 2000, respectively. Services and maintenance gross profit as a percentage of services and maintenance revenues was 45% and 42% for the nine months ended September 30, 1999 and 2000, respectively. This decrease in the services and maintenance gross profit as a percentage of services and maintenance revenues for the three and nine months ended September 30, 2000, compared to the same periods in 1999, reflects the investment we made in the professional services team through the acquisition of CygnaCom during the first quarter of 2000 and enCommerce at the end of the second quarter of 2000, which represents a slight shift in the mix of overall services revenue toward the lower-margin professional services revenues. Also, the decrease in the service and maintenance gross profit as a percentage of services and maintenance revenues reflects the investment made in additional customer support personnel in the first three quarters of 2000. OPERATING EXPENSES Sales and Marketing Sales and marketing expenses increased from $10.5 million and $28.9 million for the three and nine months ended September 30, 1999 to $21.3 million and $49.1 million for the comparable periods in 2000. Sales and marketing expenses represented 46% and 49% of total revenues for the three and nine months ended September 30, 1999, compared to 51% and 49% for the comparable periods in 2000. The increase in absolute dollars 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. In addition, we continue to make significant investments in marketing to support the launch of new products, services and marketing programs. We have continued our strategy of (a) investing in hiring and training our direct sales organization in anticipation of future market growth, and (b) investing in 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 September 30, 2000, compared to the same period in 1999, reflects the impact of the integration of the getAccess sales team from enCommerce into the existing sales organization. Overall, the sales and marketing expenses as a percentage of total revenues for the first three quarters of 2000 has been consistent with the same period of the previous year. We continue to 14 focus on improving the productivity of our sales and marketing organizations and on gaining efficiencies in the related processes. Research and Development Research and development expenses increased from $4.2 million and $12.1 million for the three and nine months ended September 30, 1999 to $8.5 million and $19.3 million for the comparable periods in 2000. Research and development expenses represented 19% and 21% of total revenues for the three and nine months ended September 30, 1999, compared to 20% and 19% for the comparable periods in 2000. The increased investment in research and development expenses in absolute dollars reflects higher expenses related to increased staffing of software developers. These employees were added primarily in connection with the continuing expansion and enhancement of our product offerings and our commitment to quality assurance and testing, and globalization of these product offerings, and due to the integration of enCommerce. Research and development expenses as a percentage of total revenues increased for the three months ended September 30, 2000, compared to the previous year, due to the acquisition of enCommerce and the corresponding addition of the getAccess development team. The investment in research and development as a percentage of total revenues decreased for the nine months ended September 30, 2000, compared to the same period in 1999, as a result of the growth of revenues outpacing the expansion of the development team between those periods. However, we believe that we must continue to invest in research and development in order to maintain our technological leadership position and, thus, expect research and development expenses to continue to increase in absolute dollars as we hire additional experienced security experts and software engineers. General and Administrative General and administrative expenses increased from $2.0 million and $5.4 million for the three and nine months ended September 30, 1999 to $3.7 million and $8.7 million for the comparable periods in 2000. General and administrative expenses represented 9% of total revenues for each of the three and nine month periods ended September 30, 1999 and 2000. The increase in general and administrative expenses in absolute dollars reflects 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. We continue to look for ways to gain efficiencies throughout our administrative processes as we grow as a company. Acquired In-process Research and Development and Amortization of Goodwill and Other Purchased Intangibles On June 8, 1998, we completed the acquisition of r3 Security Engineering AG, a company based in Zurich, Switzerland, which provides consulting, applied research and product development services related to commercial security and encryption solutions. We have recorded $178,000 and $235,000 of amortization with respect to the goodwill that arose as a result of this acquisition in the three months ended September 30, 1999 and 2000, respectively, with total amortization of $534,000 and $671,000 for the nine months ended September 30, 1999 and 2000, respectively. 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 15 wholly owned subsidiary. In connection with this acquisition, we recorded goodwill of $16.6 million and, accordingly, goodwill amortization of $1.4 million has been expensed for the three months ended September 30, 2000, with total amortization of $3.2 million for the nine months ended September 30, 2000. On June 26, 2000, we completed the acquisition of enCommerce, a company based in Santa Clara, California, which is a provider of 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 of $504.6 million was accounted for under the purchase method of accounting, which resulted in an allocation of $448.7 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 has not yet reached technological feasibility and has no alternative future use. This in-process research and development was expensed in the nine months ended September 30, 2000. Amortization of purchased product rights of $1.4 million has been expensed for the three and nine months ended September 30, 2000, and amortization of goodwill and other purchased intangibles of $27.2 million have been expensed for those same periods of 2000. Interest Income Interest income increased from $966,000 and $2.7 million for the three and nine months ended September 30, 1999, respectively, to $3.8 million and $9.4 million for the comparable periods in 2000. Interest income represented 4% and 5% of total revenues for the three and nine months ended September 30, 1999, compared to 9% for both periods in 2000. This increase in investment income reflects 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 2000. Provision for Income Taxes We recorded an income tax provision of $212,000 and $1.9 million for the three and nine months ended September 30, 2000, respectively, compared with an income tax provision of $682,000 and $927,000 for the same periods of 1999. 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 in-process research and development write- off and the amortization of goodwill 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. LIQUIDITY AND CAPITAL RESOURCES We generated cash of $16.7 million from operating activities during the nine months ended September 30, 2000. This cash inflow was primarily a result of net income before non-cash charges of $10.9 million, an increase in accounts payable, accrued liabilities and deferred income during the period. These inflows were partially offset by cash outflows relating to an increase in accounts receivable. Our average days sales outstanding at September 30, 2000 was 83 days, which represents a decrease over the 87 days that we reported at June 30, 2000. The overall decrease in days sales outstanding from June 30, 2000 reflects the focus on reducing the length of payment terms to international customers and the slight shift in revenues in the last quarter towards a greater percentage from North America, which generally require shorter payment terms. 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 nine months ended September 30, 2000, we used $149.3 million of cash in investing activities, primarily due to the $15.6 million we invested in the acquisition of CygnaCom, and our $10.0 million 16 investment in the PaymentWave, LLC joint venture, which represented a 50% equity interest in a startup business focused on delivering secured, guaranteed payments via the Internet for B2B and B2C e-markets. In September 2000, PaymentWave was renamed SurePay, LLC. Subsequent to September 30, 2000, our ownership interest in SurePay decreased to 17% as a result of a return of equity originally invested of $7.0 million, combined with additional investment from other investors. Also, we invested cash in marketable investments in the amount of $114.7 million (net of $112.1 million of marketable investment maturities). This was partially offset by the net cash assumed of $7.9 million in connection with the acquisition of enCommerce. We also invested $10.4 million in property and equipment and an additional $6.4 million in other long-term assets which include strategic investments in the capital stock of privately-held electronic security and technology companies, accounted for on a cost basis. 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 Ottawa, Canada. Cash provided by financing activities for the nine months ended September 30, 2000 was $169.9 million, primarily due to the net proceeds of $161.5 million from the issuance of common stock in the follow-on offering in February 2000, and $8.4 million from the exercise of employee stock options and the sale of shares under our employee stock purchase plan. In connection with the acquisition of enCommerce, we assumed long-term capital lease obligations totaling approximately $590,000, with $263,000 due within the next 12 months, which has been included in accrued liabilities, and $327,000 due in monthly payments over the period from October 2001 to January 2003 which has been included in long-term liabilities. As of September 30, 2000, our cash, cash equivalents and short-term investments in the amount of $242.9 million comprised our principal sources of liquidity. It is our belief that cash flows from operations and existing cash and 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; . 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 17 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 have 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 have accounted for a significant percentage of our revenues. In 1997, three customers accounted for 19%, 12% and 11% of revenues, respectively. In 1998, our three largest customers accounted for 23% of revenues. In 1999, our three largest customers accounted for 31% of revenues, with the largest customer accounting for 24% of revenues. Our three largest customers accounted for only 13% of revenues for the nine months ended September 30, 2000. We anticipate that our 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; 18 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. 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 19 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 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: 20 . 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 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. 21 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. Surety Technologies, Inc. asserted an unsuccessful patent infringement claim against us in February 1999, and 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 encryption 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 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 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. As of November 10, 2000, Nortel Networks Corporation, through its subsidiary, Nortel Networks Inc., beneficially owned approximately 27% of our outstanding voting stock and two of our nine directors were representatives of Nortel Networks. Accordingly, Nortel Networks has the ability to exert significant influence 22 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. YEAR 2000 IMPACT We have not experienced any problems with our computer systems relating to such systems being unable to recognize appropriate dates related to the year 2000. We are also not aware of any material problems with our clients or vendors. Accordingly, we do not anticipate incurring material expenses or experiencing any material operational disruptions as a result of any Year 2000 issues. 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, a 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 September 30, 2000, the majority of our marketable investments 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 September 30, 2000, that would have been subject to interest rate risk, and the related ranges of maturities as of that date:

MATURITY (in thousands) Within 3 Months 3-6 Months > 6 Months --------------------- ----------------- ----------------- Investments classified as cash and cash equivalents........... $ 47,444 -- -- Investments classified as marketable investments.............. $103,464 $43,222 $37,798 -------- ------- ------- Total amortized cost........................................ $150,908 $43,222 $37,798 ======== ======= ======= Fair value.................................................... $150,908 $43,222 $37,900 ======== ======= =======

23 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. PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS We are subject to various 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. 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. These actions have been consolidated. The actions purport to be class action lawsuits brought on behalf of persons who purchased or otherwise acquired our common stock during the period from April 19, 2000 through July 3, 2000. The complaints allege that the defendants misrepresented and failed to disclose certain information about our business and prospects. The complaints assert claims under the Securities Exchange Act of 1934. The complaints do not specify the amount of damages sought. No trial date or other schedule has been established. We believe these class action lawsuits are without merit. We intend to deny all material allegations and to defend ourselves vigorously. An adverse judgment or settlement in these lawsuits could have a significant adverse effect on our financial condition or results of operations. 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. 24 As of September 30, 2000, approximately $60.5 million 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 remaining net proceeds are invested in short-term, interest-bearing, investment grade securities. The entire amount of the net proceeds has 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 27 Financial Data Schedule Reports on Form 8-K: On July 10, 2000, we filed a Current Report on Form 8-K, dated June 26, 2000, to report under Item 2 (Acquisition or Disposition of Assets) our acquisition of enCommerce, Inc. On August 10, 2000, we filed an Amendment No. 1 to Current Report on Form 8-K/A to file under Item 7 (Financial Statements, Pro Forma Financial Information and Exhibits) historical financial statements of enCommerce, Inc. and pro forma financial information reflecting the acquisition of enCommerce, Inc. 25 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: November 14, 2000 /s/ David L. Thompson ------------------------- David L. Thompson Chief Financial Officer and Senior Vice President of Finance (Principal Financial and Accounting Officer) 26 ENTRUST TECHNOLOGIES INC. INDEX TO EXHIBITS EXHIBIT DESCRIPTION ------- ----------- 27 Financial Data Schedule 27