10-Q 1 0001.txt FORM 10-Q ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ________________ FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2000 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission file number 333-96217 ________________ NUANCE COMMUNICATIONS, INC. (Exact name of registrant as specified in its charter)

Delaware 94-3208477 (State of incorporation) (IRS Employer Identification Number)

1005 Hamilton Avenue Menlo Park, California 94025 (650) 847-0000 (Address and telephone number of principal executive offices) ________________ Indicate by check mark whether 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, and (2) has been subject to such filing requirements for the past 90 days. YES [X] NO [ ] 31,955,297 shares of the registrant's common stock, $0.01 par value, were outstanding as of November 13, 2000. ================================================================================ NUANCE COMMUNICATIONS, INC. & SUBSIDIARIES FORM 10-Q, September 30, 2000 ________________ CONTENTS

Item Number Page ----------- ---- PART I: FINANCIAL INFORMATION Item 1. Financial Statements Condensed Consolidated Statements of Operations: Three and nine months ended September 30, 2000 and 1999........ 3 Condensed Consolidated Balance Sheets: September 30, 2000 and December 31, 1999....................... 4 Condensed Consolidated Statements of Cash Flows: Nine months ended September 30, 2000 and 1999.................. 5 Notes to Condensed Consolidated Financial Statements............. 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations......................................... 8 Item 3. Quantitative and Qualitative Disclosures about Market Risk........ 19 PART II: OTHER INFORMATION Item 1. Legal Proceedings................................................. 21 Item 2. Changes in Securities............................................. 21 Item 6. Exhibits and Reports on Form 8-K.................................. 21 SIGNATURES................................................................ 22 EXHIBIT INDEX............................................................. 23

2 NUANCE COMMUNICATIONS, INC. & SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) (in thousands, except per share data)

Three Months Ended Nine Months Ended September 30, September 30, ------------------ -------------------- 2000 1999 2000 1999 ------- ------- -------- -------- Revenue: License.............................................. $10,465 $ 2,678 $ 25,185 $ 9,610 Service.............................................. 3,995 1,684 9,219 4,258 ------- ------- -------- -------- Total revenue........................................ 14,460 4,362 34,404 13,868 ------- ------- -------- -------- Cost of revenue: License.............................................. 40 - 53 - Service.............................................. 3,055 1,259 6,780 3,831 ------- ------- -------- -------- Total cost of revenue................................ 3,095 1,259 6,833 3,831 ------- ------- -------- -------- Gross profit.......................................... 11,365 3,103 27,571 10,037 ------- ------- -------- -------- Operating expenses: Sales and marketing, net of $243 and $703 of noncash compensation expense for the three and nine months ended September 30, 2000, respectively... 8,493 4,902 23,332 11,221 Research and development, net of $523 and $1,513 of noncash compensation expense for the three and nine months ended September 30, 2000, respectively... 5,283 3,077 14,406 7,753 General and administrative, net of $372 and $1,076 of noncash compensation expense for the three and nine months ended September 30, 2000, respectively... 2,502 859 6,800 2,389 Noncash compensation expense.......................... 1,138 - 3,292 - ------- ------- -------- -------- Total operating expenses............................. 17,416 8,838 47,830 21,363 ------- ------- -------- -------- Loss from operations.................................. (6,051) (5,735) (20,259) (11,326) Interest and other income, net........................ 1,529 70 3,007 337 ------- ------- -------- -------- Loss before provision for income taxes................ (4,522) (5,665) (17,252) (10,989) Provision for income taxes............................ 85 - 231 - ------- ------- -------- -------- Net loss............................................. $(4,607) $(5,665) $(17,483) $(10,989) ======= ======= ======== ======== Basic and diluted net loss per share.................. $ (0.15) $ (1.90) $ (0.88) $ (3.85) ======= ======= ======== ======== Shares used to compute basic and diluted net loss per share............................................. 29,797 2,978 19,799 2,854 ======= ======= ======== ======== Pro forma basic and diluted net loss per share........ $ (0.15) $ (0.31) $ (0.64) $ (0.61) ======= ======= ======== ======== Shares used to compute pro forma basic and diluted net loss per share.................................... 29,797 18,204 27,357 18,080 ======= ======= ======== ========

The accompanying notes to condensed consolidated financial statements are an integral part of these financial statements. 3 NUANCE COMMUNICATIONS, INC. & SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (in thousands, except share amounts)

September 30, December 31, ------------- ------------ 2000 1999 -------- -------- (unaudited) Assets Current assets: Cash and cash equivalents.......................... $ 81,454 $18,073 Short-term investments............................. 12,116 23,353 Accounts receivable, net of allowance for doubtful accounts of $958 and $571, respectively...................................... 12,555 5,349 Receivable from underwriter........................ 144,091 - Prepaid expenses and other current assets.......... 4,389 3,027 -------- ------- Total current assets.............................. 254,605 49,802 Property and equipment, net........................ 8,946 4,276 Other assets....................................... 11,975 101 -------- ------- Total assets...................................... $275,526 $54,179 ======== ======= Liabilities and Stockholders' Equity Current liabilities: Current portion of debt............................ $ 278 $ 1,043 Accounts payable................................... 2,512 3,024 Accrued liabilities................................ 12,554 7,034 Deferred revenue................................... 7,073 4,794 -------- ------- Total current liabilities......................... 22,417 15,895 Long-term debt, less current portion............... - 1,333 -------- ------- Total liabilities................................. 22,417 17,228 -------- ------- Commitments Stockholders' Equity: Convertible preferred stock, $.001 par value, 5,000,000 shares authorized; none and 19,725,986 shares issued and outstanding, respectively......................... - 20 Common stock, $.001 par value, 250,000,000 shares authorized; 31,742,050 and 3,240,349 shares issued and outstanding, respectively..................... 32 3 Additional paid-in capital......................... 307,771 76,415 Deferred stock compensation........................ (3,338) (5,614) Accumulated deficit................................ (51,356) (33,873) -------- -------- Total stockholders' equity........................ 253,109 36,951 -------- -------- Total liabilities and stockholders' equity........................................... $275,526 $ 54,179 ======== ========

The accompanying notes to condensed consolidated financial statements are an integral part of these financial statements. 4 NUANCE COMMUNICATIONS, INC. & SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (in thousands)

Nine Months Ended September 30, ---------------------- 2000 1999 -------- -------- Cash flows from operating activities: Net loss................................................ $(17,483) $(10,989) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization.......................... 1,762 775 Noncash compensation expense........................... 3,292 -- Provision for doubtful accounts........................ 387 161 Fair value of common stock options and warrants.............................................. -- 167 Changes in operating assets and liabilities: Accounts receivable................................... (7,593) (2,434) Prepaid expenses and other assets..................... (2,814) (383) Accounts payable...................................... (512) 549 Accrued liabilities................................... 5,520 2,021 Deferred revenue...................................... 2,279 1,008 -------- -------- Net cash used in operating activities................. (15,162) (9,125) -------- -------- Cash flows from investing activities: Purchase of marketable securities....................... (19,485) (18,286) Purchase of long-term investment........................ (11,273) -- Maturities of marketable securities..................... 30,722 28,121 Purchases of property and equipment..................... (6,432) (2,185) -------- -------- Net cash (used in) provided by investing activities... (6,468) 7,650 -------- -------- Cash flows from financing activities: Proceeds from issuance of common stock.................. 80,341 -- Proceeds from exercise of stock options................. 5,813 160 Proceeds from exercise of Series D warrant.............. 1,000 -- Repurchase of common stock.............................. (8) -- Proceeds from borrowings................................ - 1,295 Repayment of borrowings................................. (2,098) -- -------- -------- Net cash provided by financing activities............. 85,048 1,455 -------- -------- Effect of exchange rate fluctuations.................... (37) -- Net increase (decrease)in cash and cash equivalents..... 63,381 (20) Cash and cash equivalents, beginning of period.......... 18,073 1,642 -------- -------- Cash and cash equivalents, end of period................ $ 81,454 $ 1,622 ======== ========

The accompanying notes to condensed consolidated financial statements are an integral part of these financial statements. 5 NUANCE COMMUNICATIONS, INC. & SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 1. Basis of Presentation The unaudited condensed consolidated financial statements have been prepared by the Company in accordance with instructions to Form 10-Q and Article 10 of Regulation S-X. The condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All intercompany accounts and transactions have been eliminated. In the opinion of management, all adjustments, consisting only of normal recurring adjustments considered necessary for a fair presentation, have been included. The results of operations for the three and nine month periods ended September 30, 2000 are not necessarily indicative of the results to be expected for the full year or for any future periods. The accompanying condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements contained in the Company's Prospectus on Form S-1 filed with the Securities and Exchange Commission on September 26, 2000. Certain reclassifications have been made to the prior period balances to conform to the current year presentation. 2. Revenue Recognition The Company's revenue is derived from two sources, licenses and services. Services include consulting, software maintenance and support, and training. The Company's license revenue consists of license fees for its voice interface software products. This license fee is calculated using two variables: the computation power required to run the Company's platform and the maximum number of simultaneous end-user connections to an application running on the platform. License revenue is recognized when: . evidence of an arrangement exists; . delivery has occurred; . the fee is fixed and determinable; and . collection is probable. The timing of license revenue recognition is affected by whether the Company performs consulting services in the arrangement and the nature of those services. In the majority of cases, the Company either performs no consulting services at all or performs standard implementation services that are not essential to the functionality of the software. In these cases, the Company recognizes license revenue either upon issuance of the permanent software license key (which enables the software to be operated) or on system acceptance, if the customer has established acceptance criteria (which occurs only in a small minority of cases). In those contracts having acceptance criteria, criteria typically consist of a demonstration to the customer that, upon implementation, the software performs in accordance with specified system parameters, such as recognition accuracy or call completion rates. When the Company performs consulting services that are essential to the functionality of the software, both license and consulting revenue are recognized over time based on the percentage of the consulting services that have been completed. Invoicing for license fees is triggered by the issuance of the permanent license key and the Company's standard payment terms are net 30 days from invoicing. License revenue from value-added resellers and original equipment manufacturers is recognized when product has been solid through to an end user and such sell-through has been reported to the Company. Service revenue consists of revenue from providing consulting, training, maintenance updates and technical support. Training service revenue is recognized as services are performed. Consulting service contracts are bid either on a fixed-fee or a time and materials basis. For a fixed-fee contract, the Company recognizes service revenue on a percentage of completion basis in accordance with Statement of Position ("SOP") 81-1 "Accounting for Performance of Construction-Type and Certain Production-Type Contracts." For time and materials contracts, the Company recognizes service revenue as services are performed in accordance with SOP 81-1. Losses on service contracts, if any, are recognized as soon as such losses become known. Revenue from maintenance updates and technical support is recognized ratably over the term of the applicable agreement. In December 1998, the AICPA issued SOP 98-9, "Modification of SOP No. 97-2, Software Revenue Recognition, With Respect to Certain Transactions." SOP No. 98-9 amends SOP 97-2 to require an entity to recognize revenue for multiple element arrangements by means of the "residual method" when: . vendor-specific evidence of fair value exists for all of the undelivered elements that are not accounted for by means of long-term contract accounting; . vendor-specific evidence of fair value does not exist for one or more of the delivered elements; and . all revenue recognition criteria of SOP No. 97-2, other than the requirement for vendor-specific evidence of the fair value of each delivered element, are satisfied. The adoption of SOP 98-9 in fiscal 1999 did not have a significant effect on the Company's financial position or results of operations. Many of the Company's arrangements include multiple elements. The Company follows the residual method when accounting for multiple element arrangements. The Company has established vendor-specific objective evidence of fair value for all undelivered elements, including consulting services and maintenance updates and technical support, based on vendor-specific objective evidence of fair value as determined by the price charged for the individual elements when they are sold separately. However, vendor-specific objective evidence of fair value has not been established for the license component (i.e. the delivered element). Revenue for the undelivered elements of a contract are allocated based on the vendor-specific objective evidence of fair value. To the extent that a discount exists on any of the elements, the Company follows the residual method and attributes that discount entirely to the delivered elements. Cost of license revenue consists primarily of license fees payable on third-party software products. Cost of service revenue consists of compensation and related overhead costs for employees engaged in consulting, training and maintenance for our customers. 3. Recent Accounting Pronouncements In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 133 requires certain accounting and reporting standards for derivative financial instruments and hedging activities. In June 1999, the FASB issued SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activities--Deferral of the Effective Date of FASB Statement No. 133," which amends SFAS No. 133 to be effective for all fiscal quarters of all fiscal years beginning after June 15, 2000. The Statement will be effective for the Company on January 1, 2001. Because the Company does not currently hold any derivative instruments and does not engage in hedging activities, management does not believe that the adoption of these statements will have a material impact on the Company's financial position or results of operations. In December 1999, the Securities and Exchange Commission ("SEC") issued Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements" ("SAB 101") and amended it in March and June 2000 with respect to the effective date. The Company will adopt SAB 101 in the fourth quarter of 2000 and does not believe there will be any material impact. 4. Net Loss Per Share Historical net loss per share has been calculated under SFAS No. 128, "Earnings Per Share." Basic net loss per share on a historical basis is computed using the weighted average number of shares of common stock outstanding, which includes shares of common stock issued upon the conversion of convertible preferred stock following the closing of the Company's initial public offering. Diluted net loss per share is equal to basic net loss per share for all periods presented since potential common shares from conversion of the convertible preferred stock, stock options and warrants are antidilutive. The total number of shares excluded from diluted net loss per share was 5,857,000 for the three months ended September 30, 2000 and 11,892,000 for the nine months ended September 30, 2000. The total number of shares excluded from diluted net loss per share was 19,287,000 for the three months ended September 30, 1999 and 16,734,000 for the nine months ended September 30, 1999. Pro forma basic net loss per share has been calculated assuming the conversion of convertible preferred stock into an equivalent number of common shares, as if the shares had converted on the dates of their issuance. The following table presents the calculation of basic and pro forma basic net loss per share (in thousands, except per share data): 6

Three Months Ended Nine Months Ended September 30, September 30, ------------------- --------------------- 2000 1999 2000 1999 --------- ------- --------- --------- Net loss........................................... $(4,607) $(5,665) $(17,483) $(10,989) ======= ======= ======== ======== Basic: Weighted average shares of common stock outstanding....................................... 30,554 2,981 20,353 2,900 Less: Weighted average shares of common stock subject to repurchase............................. (757) (2) (554) (46) ------- ------- -------- -------- Weighted average shares used in computing basic and diluted net loss per share.................... 29,797 2,979 19,799 2,854 ======= ======= ======== ======== Basic and diluted net loss per share............... $ (0.15) $ (1.90) $ (0.88) $ (3.85) ======= ======= ======== ======== Net loss........................................... $(4,607) $(5,665) $(17,483) $(10,989) ======= ======= ======== ======== Pro forma: Shares used above.................................. 29,797 2,979 19,799 2,854 Pro forma adjustment to reflect weighted average effect of assumed conversion of convertible preferred stock.................................. - 15,225 7,558 15,226 ------- ------- -------- -------- Weighted average shares used in computing pro forma basic and diluted net loss per share....... 29,797 18,204 27,357 18,080 ======= ======= ======== ======== Pro forma basic and diluted net loss per share..... $ (0.15) $ (0.31) $ (0.64) $ (0.61) ======= ======= ======== ========

5. Deferred Stock Compensation In connection with the grant of certain stock options to employees through March 31, 2000, the Company recorded deferred stock compensation within stockholders' equity of $8.7 million, representing the difference between the estimated fair value of the common stock for accounting purposes and the option exercise price of these options at the date of grant. Such amount is presented as a reduction of stockholders' equity and is being amortized over the vesting period of the applicable options using an accelerated method of amortization. Under the accelerated method, each vested tranche of options is accounted for as a separate option grant awarded for past services. Accordingly, the compensation expense is recognized over the period during which the services will be provided; however, the method results in a front-loading of the compensation expense. The Company recorded amortization of deferred compensation for the three and nine months ended September 30, 2000 of $1.1 million and $3.3 million, respectively. This deferred compensation related to 3,152,000 options with a weighted average exercise price of $8.58 granted through March 31, 2000. 6. Segment Reporting The Company has two operating segments: licenses and services. Revenue and cost of revenue for the segments are identical to those presented on the accompanying condensed consolidated statements of operations. The Company does not track operating expenses nor derive net profit or loss based on these segments. Sales of licenses and services through September 30, 2000 occurred through partners and direct sales representatives located in the Company's headquarters in Menlo Park, California, and in other locations. These sales were supported through the Menlo Park location. The Company does not separately report costs by region internally. Additionally, long-lived assets in locations other than Menlo Park are not significant. International revenues are based on the country in which the end-user is located. The following is a summary of license and service revenue by geographic region for the three and nine month periods ended September 30, 2000 and 1999:

Three Months Ended Nine Months Ended September 30, September 30, --------------------- --------------------- 2000 1999 2000 1999 --------- --------- --------- --------- License revenue Americas $ 5,776.4 $ 2,317.2 $16,239.3 $ 8,848.2 Europe 1,742.9 202.1 4,916.3 567.2 Asia 2,945.7 158.7 4,029.4 194.6 --------- --------- ---------- --------- Total $10,465 $ 2,678 $25,185 $ 9,610 ========= ========= ========== ========= Service revenue Americas $ 2,460.6 $ 1,330.0 $ 6,465.7 $ 3,364.0 Europe 911.1 210.0 1,715.7 537.0 Asia 623.3 144.0 1,037.6 357.0 --------- --------- ---------- --------- Total $ 3,995 $ 1,684 $ 9,219 $ 4,258 ========= ========= ========== =========

7. Public Offerings On April 13, 2000, the Company commenced its initial public offering of 5.2 million shares of common stock. The offering raised approximately $80 million, net of offering expenses, for the Company. Upon the closing of the offering, 19,925,986 shares of preferred stock were converted into common stock. On September 27, 2000, in a secondary offering, the Company sold 1,256,793 shares and selling shareholders sold 1,743,207 shares of our common stock. The offering raised approximately $144.1 million for the Company, net of offering costs, and is intended to be used for general corporate purposes, including working capital and capital expenditures, and 7 strategic investments. The proceeds from this offering were not received until October 2, 2000 and therefore have been recorded as a receivable from underwriter in the accompanying balance sheet. 8. Subsequent Event On November 10, 2000, the Company acquired Speechfront, a privately-held Canadian company, for total consideration of $10.5 million cash and shares of Nuance stock. Speechfront is a developer of voice instant messaging systems. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with the condensed consolidated financial statements and related notes included elsewhere in this report. The results shown herein are not necessarily indicative of the results to be expected for the full year or any future periods. This Report on Form 10-Q contains forward-looking statements, within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act, including but not limited to our expectations for results over the balance of the year, regarding expense trends, cash positions and our outlook for the Company, as well as our expectations, beliefs, intentions or strategies regarding the future. All forward-looking statements included in this Report on Form 10-Q are based on information available to us on the date hereof, and we assume no obligation to update any such forward-looking statements. These statements involve risks and uncertainties and actual results could differ materially from those anticipated in these forward-looking statements as a result of a number of factors, including, but not limited to, those set forth in "Factors that affect future results" and elsewhere in this Report on Form 10-Q. Results of Operations: The following table sets forth, for the periods indicated, the percentage of net revenue represented by certain items in our statements of operations for the three and nine months ended September 30, 2000 and 1999. Overview: We develop, market and support a voice interface software platform that makes the content and services of enterprises, telecommunications networks and the Internet accessible from any telephone. We were incorporated in July 1994 and began operations in October 1994. Prior to 1996, our revenue was derived from technical consulting services. In 1996, we deployed the first version of our voice interface software platform and began to generate software license revenue. Today, we offer a range of voice interface software products. To support the sale, deployment and operation of our products, we also provide a number of services that include consulting, training, maintenance updates and technical support. Our license revenue consists of license fees for our voice interface software products. Historically, this license fee has been calculated using the two variables: the computation power required to run our platform and the maximum number of simultaneous end-user connections to an application running on our platform. During the quarter ending September 30, 2000, we began implementing a new pricing model for the license fees for our software platform. Under this new pricing model, the license fee is calculated using two variables, one of which is the maximum number of simultaneous end-user connections to an application running on the platform, consistent with our prior method. However, the second variable of the license fee is now based on the value attributed to the functional use of the software. A pricing reserve was established during the second quarter associated with the implementation of this new pricing model to the Company's value-added resellers. This new pricing model for value-added resellers was resolved during the third quarter. License revenue is recognized when: . evidence of an arrangement exists; . delivery has occurred; . the fee is fixed and determinable; and . collection is probable. The timing of license revenue recognition is affected by whether we perform consulting services in the arrangement, and the nature of those services. In the majority of cases, we either perform no consulting services or we perform standard implementation services that are not essential to the functionality of the software. In these cases, we recognize license revenue either upon issuance of the permanent software license key (which enables the software to be operated) or on system acceptance, if the customer has established acceptance criteria (which occurs only in a small minority of cases). In those contracts having acceptance criteria, criteria typically consist of a demonstration to the customer that, upon implementation, the software performs in accordance with specified system parameters, such as recognition accuracy or call completion rates. When we perform consulting services that are essential to the functionality of the software, we recognize both license and consulting revenue over time based on the percentage of the consulting services that have been completed. Service revenue consists of revenue from providing consulting, training, maintenance updates and technical support. Our consulting service contracts are bid either on a fixed-fee basis or on a time-and-materials basis. For a fixed-fee contract, we recognize revenue using the percentage of completion method. For time-and-materials contracts, we recognize revenue as services are performed. Training service revenue is recognized as services are performed. Losses on consulting and training service contracts, if any, are recognized as soon as such losses become known. Revenue from maintenance updates and technical support is recognized ratably over the terms of the applicable agreement.

Three Months Nine Months Ended September 30, Ended September 30, ------------------- ------------------ 2000 1999 2000 1999 ---- ----- ---- ---- Revenue: License................................. 72% 61% 73% 69% Service................................. 28 39 27 31 ---- ----- ---- ---- Total revenue.......................... 100 100 100 100 Cost of revenue: License................................. - - - - Service................................. 21 29 20 28 ---- ----- ---- ---- Total cost of revenue.................. 21 29 20 28 ---- ----- ---- ---- Gross Margin............................. 79 71 80 72 Operating expenses:...................... Sales and marketing..................... 59 112 68 81 Research and development................ 37 71 42 56 General and administrative.............. 17 20 20 17 Noncash compensation expense............ 8 - 9 - ---- ----- ---- ---- Total operating expenses 121 203 139 154 ---- ----- ---- ---- Loss from operations (42) (132) (59) (82) Interest and other income, net 11 2 9 3 ---- ----- ---- ---- Loss before provision for income taxes (31) (130) (50) (79) Provision for income taxes............... 1 - 1 - ---- ----- ---- ---- Net loss.............................. (32)% (130)% (51)% (79)% ==== ===== ==== ====

8 Comparison of the Three and Nine Months Ended September 30, 2000 and 1999 Revenue Total revenue increased from $4.4 million in the three months ended September 30, 1999 to $14.5 million in the three months ended September 30, 2000, an increase of 231%. Total revenue increased from $13.9 million in the nine months ended September 30, 1999 to $34.4 million in the nine months ended September 30, 2000, an increase of 148%. License revenue increased from $2.7 million in the three months ended September 30, 1999 to $10.5 million in the three months ended September 30, 2000, an increase of 291%, and from $9.6 million in the nine months ended September 30, 1999 to $25.2 million in the nine months ended September 30, 2000, an increase of 162%. This increase in license revenue was due to an increased acceptance of our products in the marketplace. License revenue represented 61% and 69% of total revenue for the three and nine months ended September 30, 1999, respectively, and 72% and 73% of total revenue for the three and nine months ended September 30, 2000, respectively. Service revenue increased from $1.7 million for the three months ended September 30, 1999 to $4.0 million in the three months ended September 30, 2000, an increase of 137%, and from $4.3 million for the nine months ended September 30, 1999 to $9.2 million in the nine months ended September 30, 2000, an increase of 117%. This increase in service revenue was due primarily to growth in license revenue, the installed base of our voice interface software platform and related system design, support and training activities. In addition, approximately $360,000 of our service revenue increase during the quarter was the result of subcontract work done by one of our European partners. Service revenue represented 39% and 31% of total revenue for the three and nine months ended September 30, 1999, respectively, and 28% and 27% of total revenue for the three and nine months ended September 30, 2000, respectively. Cost of Revenue Cost of service revenue increased from $1.3 million in the three months ended September 30, 1999 to $3.1 million in the three months ended September 30, 2000, an increase of 143%, and from $3.8 million in the nine months ended September 30, 1999 to $6.8 million in the nine months ended September 30, 2000, an increase of 77%. This increase was due to hiring additional personnel in the professional services, technical support and training groups. In addition, approximately $400,000 of our service revenue increase during the quarter was the result of subcontract work done by one of our European partners. Cost of service revenue as a percentage of service revenue was 75% and 90% for the three and nine months ended September 30, 1999, respectively, and 76% and 74% for the three and nine months ended September 30, 2000, respectively. We anticipate that cost of service revenue will increase in absolute dollars, although cost of service revenue will vary as a percentage of service and total revenue from period to period. Operating Expenses Sales and Marketing. Sales and marketing expenses consist of compensation and related costs for sales and marketing personnel and promotional expenditures, including public relations, advertising, trade shows and marketing materials. Sales and marketing expenses increased from $4.9 million in the three months ended September 30, 1999, to $8.5 million in the three months ended September 30, 2000, an increase of 73%. Sales and marketing expenses increased from $11.2 million in the nine months ended September 30, 1999 to $23.3 million in the nine months ended September 30, 2000, an increase of 108%. This increase was attributable to the addition of approximately 40 sales and marketing personnel which added approximately $8.7 million in expense, an increase in sales commissions associated with the growth in revenue which added approximately $2.7 million to expenses and higher marketing costs due to expanded promotional activities which added approximately $700,000 in expenses. As a percentage of total revenue, sales and marketing expenses were 112% and 81% in the three and nine months ended September 30, 1999, respectively, and 59% and 68% in the three and nine months ended September 30, 2000, respectively. We expect to continue to increase our marketing and promotional efforts and hire additional sales 9 personnel. Accordingly, we anticipate that sales and marketing expenses will increase in absolute dollars, but will vary as a percentage of total revenue from period to period. Research and Development. Research and development expenses consist of compensation and related costs for research and development personnel and contractors. Research and development expenses increased from $3.1 million in the three months ended September 30, 1999, to $5.3 million in the three months ended September 30, 2000, an increase of 72%. Research and development expenses increased from $7.8 million in the nine months ended September 30, 1999 to $14.4 million in the nine months ended September 30, 2000, an increase of 86%. This increase was attributable to the addition of approximately 40 personnel associated with product development activities, which added approximately $5.7 million in expenses, and the costs of technical contractors, which added approximately $900,000 in expenses. As a percentage of total revenue, research and development expenses were 71% and 56% in the three and nine months ended September 30, 1999, respectively, and 37% and 42% in the three and nine months ended September 30, 2000, respectively. We expect to continue to make substantial investments in research and development and anticipate that research and development expenses will continue to increase in absolute dollars, but will vary as a percentage of total revenue from period to period. General and Administrative. General and administrative expenses consist of compensation and related costs for administrative personnel, legal services, accounting services and other general corporate expenses. General and administrative expenses increased from $859,000 in the three months ended September 30, 1999, to $2.5 million in the three months ended September 30, 2000, an increase of 191%. General and administrative expenses increased from $2.4 million in the nine months ended September 30, 1999 to $6.8 million in the nine months ended September 30, 2000, an increase of 185%. The increase was due to the addition of approximately 30 administrative personnel, which added approximately $3.0 million in expenses, increased facility costs, which added approximately $700,000 in expenses, and costs associated with our new status as a public company, including insurance, accounting and legal fees, which added approximately $700,000 in expenses. As a percentage of total revenue, general and administrative expenses were 20% and 17% in the three and nine months ended September 30, 1999, respectively, and 17% and 20% in the three and nine months ended September 30, 2000, respectively. We expect that general and administrative expenses will increase in absolute dollars as we continue to add personnel and incur additional costs related to the anticipated growth of our business. However, we expect that these expenses will vary as a percentage of total revenue from period to period. Non-cash compensation. Non-cash compensation expenses consist of compensation charges related to stock options granted to employees between September 1999 and February 2000. The compensation expense was $1.1 million in the three months ended September 30, 2000 and $3.3 million in the nine months ended September 30, 2000. This expense is being recognized over the vesting period of the stock options. Interest and Other Income, Net Interest and other income, net, consists of interest earned on cash and short-term investments, offset by interest expense related to a note payable. Interest and other income, net was $70,000 in the three months ended September 30, 1999 and $1.5 million in the three months ended September 30, 2000. Interest and other income, net, was $337,000 in the nine months ended September 30, 1999 and $3.0 million in the nine months ended September 30, 2000. The increase was due to interest income earned on higher average cash balances, primarily the result of cash proceeds raised in the Company's initial public offering in April 2000. Provision for Income Taxes. Our provision for income taxes of $85,000 and $231,000 for the three and nine months ended September 30, 2000, respectively, relates to income tax liabilities in certain foreign jurisdictions. Liquidity and Capital Resources From inception through March 31, 2000, we financed our operations primarily from private sales of convertible preferred stock totaling $70.0 million and, to a lesser extent, from bank financing. In April 2000, we raised approximately $80 million through the completion of our initial public offering of common stock. As of September 30, 2000, we had cash and cash equivalents aggregating $81.5 million and short-term investments totaling $12.1 million. On October 2, 2000, we received cash proceeds, net of the offering costs, of approximately $144.1 million upon the closing of our secondary public offering. 10 Our operating activities used cash of $15.2 million for the nine months ended September 30, 2000, and $9.1 million during the nine months ended September 30, 1999. This negative operating cash flow in the nine months ended September 30, 2000 resulted principally from our net losses as we invested in all areas of our business. The cash flow during the period was also impacted by increases in accounts receivable and prepaid expenses and other assets. These factors were partially offset by increases in accrued liabilities and deferred revenue. The negative operating cash flow for the nine months ended September 30, 1999, was primarily caused by our net loss and an increase in accounts receivable, partially offset by an increase in accrued liabilities and deferred revenue. Investing activities used cash of $6.5 million during the nine months ended September 30, 2000, and provided cash of $7.7 million during the nine months ended September 30, 1999. The use of cash during the nine-month period ended September 30, 2000, was due to the Company investing $11.3 million in long-term time deposits held by a major bank as security for letters of credit on newly signed facility leases and additions to fixed assets. These factors were partially offset by net proceeds received from marketable securities. Our financing activities generated cash of $85.0 during the nine months ended September 30, 2000, and $1.5 million for the nine months ended September 30, 1999. The cash provided by financing activities for the nine months ended September 30, 2000 was primarily the result of proceeds from the Company's initial public offering and the exercise of employee stock options. This amount was slightly offset by the repayment of the Company's term loan with Silicon Valley Bank. The cash generated by financing activities for the nine months ended September 30, 1999 was a result of proceeds received from the Company's term loan with Silicon Valley bank and the exercise of stock options. Our Canadian subsidiary carries a revolving line of credit under which it can borrow up to $600,000 in Canadian dollars. The revolving line of credit, secured by a letter of credit from our primary bank, bears interest at the lender's prime rate plus .5% per annum (8.0% at September 30, 2000). The line of credit remains in effect as long as the underlying letter of credit remains in place. As of September 30, 2000, there was a $278,000 U.S. dollar balance outstanding against this line of credit and $122,000 U.S. dollar was available for borrowing under this line. On November 10, 2000, the Company acquired Speechfront, a privately-held Canadian company, for total consideration of $10.5 million in both cash and shares of Nuance stock. Speechfront is a developer of voice instant messaging systems. Our capital requirements depend on numerous factors. We expect to devote substantial resources to continue our research and development efforts, expand our sales, support, marketing and product development organizations, establish additional facilities worldwide and build the infrastructure necessary to support our growth. We have experienced substantial increases in our expenditures since our inception consistent with growth in our operations and personnel, and we anticipate that our expenditures will continue to increase in the future. We believe that the proceeds from our initial and secondary public offerings, together with our current cash and cash equivalents and our borrowing capacity, will be sufficient to fund our activities for at least the next 24 months. In addition, we will continue to evaluate acquisitions of other businesses, products or technologies. We may also consider additional equity or debt financing, which could be dilutive to existing investors. FACTORS THAT AFFECT FUTURE RESULTS We have a history of losses. We expect to continue to incur losses and we may not achieve or maintain profitability. We have incurred losses since our inception, including a loss of approximately $17.5 million in the nine months ended September 30, 2000. As of September 30, 2000, we have an accumulated deficit of approximately $51.4 million. We expect to have net losses and negative cash flow for at least the next 15 months. We expect to spend significant amounts to enhance our products and technologies, expand international sales and operations and fund research and development. As a result, we will need to generate significant additional revenue to achieve profitability. Even if we achieve profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis. Information that we may provide to investors from time to time is accurate only as of the date we disseminate it and we undertake no obligation to update the information. From time to time we may publicly disseminate forward-looking information or guidance in compliance with Regulation FD promulgated by the Securities and Exchange Commission. This information or guidance represents our outlook only as of the date that we disseminated it, and we undertake no obligation 11 to provide updates to this information or guidance in our filings with the Securities and Exchange Commission or otherwise. Voice interface software may not achieve widespread acceptance by businesses and telecommunications carriers, which could limit our ability to grow our business. The market for voice interface software is relatively new and rapidly evolving. Our ability to increase revenue in the future depends on the acceptance by both our customers and their end users of voice interface software. The adoption of voice interface software could be hindered by the perceived costs of this new technology, as well as the reluctance of enterprises that have invested substantial resources in existing call centers or touch-tone-based systems to replace their current systems with this new technology. Accordingly, in order to achieve commercial acceptance, we will have to educate prospective customers, including large, established telecommunications companies, about the uses and benefits of voice interface software in general and our products in particular. If these efforts fail, or if voice interface software platforms do not achieve commercial acceptance, our business could be harmed. The continued development of the market for our products also will depend upon the: . widespread deployment of voice interface applications by third parties, which is driven by consumer demand for services having a voice user interface; . demand for new uses and applications of voice interface technology, including adoption of voice user interfaces by companies that operate web sites; . adoption of industry standards for voice interface and related technologies; and . continuing improvements in hardware technology that may reduce the costs of voice interface software solutions. Our ability to accurately forecast our quarterly sales is limited, our costs are relatively fixed in the short term and we expect our business to be affected by seasonality. As a result, our quarterly operating results may fluctuate. Our quarterly operating results have varied significantly in the past and we expect that they will vary significantly from quarter to quarter in the future. These quarterly variations are caused by a number of factors, including: . delays in customer orders due to the complex nature of large telephony systems and the associated implementation projects; . timing of product deployments and completion of project phases, particularly for large orders; . delays in recognition of software license revenue in accordance with applicable accounting principles; . our ability to develop, introduce, ship and support new and enhanced products, such as our voice browser and new versions of our software platform, that respond to changing technology trends in a timely manner and our ability to manage product transitions; . the amount and timing of increases in expenses associated with our growth; and . the utilization rate of our professional services personnel. Due to these factors, and because the market for our voice interface software platform is new and rapidly evolving, our ability to accurately forecast our quarterly sales is limited. In addition, most of our costs are for personnel 12 and facilities, which are relatively fixed in the short term. If we have a shortfall in revenue in relation to our expenses, we may be unable to reduce our expenses quickly enough to avoid lower quarterly operating results. We do not know whether our business will grow rapidly enough to absorb the costs of these employees and facilities. As a result, our quarterly operating results could fluctuate significantly and unexpectedly from quarter to quarter. In addition, we expect to experience seasonality in the sales of our products. For example, we anticipate that sales may be lower in the first quarter of each year due to patterns in the capital budgeting and purchasing cycles of our current and prospective customers. We also expect that sales may decline during summer months. These seasonal variations in our sales may lead to fluctuations in our quarterly operating results. Because we have limited operating results, it is difficult for us to evaluate the degree to which this seasonality may affect our business. Our products can have a long sales and implementation cycle and, as a result, our quarterly operating results may fluctuate. The sales cycles for our products have typically ranged from three to twelve months, depending on the size and complexity of the order, the amount of services to be provided by us and whether the sale is made directly by us or indirectly through a value added reseller or systems integrator. Purchase of our products requires a significant expenditure by a customer. Accordingly, the decision to purchase our products typically requires significant pre-purchase evaluation. We may spend significant time educating and providing information to prospective customers regarding the use and benefits of our products. During this evaluation period, we may expend substantial sales, marketing and management resources. In addition, during any quarter we may receive a number of orders that are large relative to our total revenues for that quarter or subsequent quarters. After purchase, it may take substantial time and resources to implement our software and to integrate it with our customers' existing systems. If we are performing significant professional services in connection with the implementation, we do not recognize software revenue until after system acceptance or deployment. In cases where the contract specifies milestones or acceptance criteria, we may not be able to recognize services revenue until these conditions are met. We have in the past and may in the future experience unexpected delays in recognizing revenue. Consequently, the length of our sales and implementation cycles and the varying order amounts for our products make it difficult to predict the quarter in which revenue recognition may occur and may cause license and services revenue and operating results to vary significantly from period to period. Our failure to respond to rapid change in the market for voice interface software could cause us to lose revenue and harm our business. The voice interface software industry is relatively new and rapidly evolving. Our success will depend substantially upon our ability to enhance our existing products and to develop and introduce, on a timely and cost-effective basis, new products and features that meet changing end-user requirements and incorporate technological advancements. If we are unable to develop new products and enhanced functionalities or technologies to adapt to these changes, or if we cannot offset a decline in revenue from existing products with sales of new products, our business would suffer. Commercial acceptance of our products and technologies will depend, among other things, on: . the ability of our products and technologies to meet and adapt to the needs of our target markets; . the performance and price of our products and our competitors' products; and 13 . our ability to deliver customer service directly and through our resellers. Our products are not 100% accurate at recognizing speech and we could be subject to claims related to the performance of our products. Any claims, whether successful or unsuccessful, could result in significant costs and could damage our reputation. Speech recognition, natural language understanding and authentication technologies, including our own, are not 100% accurate. Our customers, including several financial institutions, use our products to provide important services to their customers, including transferring funds to accounts and buying and selling securities. Any misrecognition of voice commands or incorrect authentication of a user's voice in connection with these financial or other transactions could result in claims against us or our customers for losses incurred. Although our contracts typically contain provisions designed to limit our exposure to liability claims, a claim brought against us for misrecognition or incorrect authentication, even if unsuccessful, could be time-consuming, divert management's attention, result in costly litigation and harm our reputation. Moreover, existing or future laws or unfavorable judicial decisions could limit the enforceability of the limitation of liability, disclaimer of warranty or other protective provisions contained in our contracts. Any software defects in our products could harm our business and result in litigation. Complex software products such as ours may contain errors, defects and bugs. With the planned release of any product, we may discover these errors, defects and bugs and, as a result, our products may take longer than expected to develop. In addition, we may discover that remedies for errors or bugs may be technologically unfeasible. Delivery of products with undetected production defects or reliability, quality, or compatibility problems could damage our reputation. Errors, defects or bugs could also cause interruptions, delays or a cessation of sales to our customers. We could be required to expend significant capital and other resources to remedy these problems. In addition, customers whose businesses are disrupted by these errors, defects and bugs could bring claims against us which, even if unsuccessful, would likely be time-consuming and could result in costly litigation and payment of damages. Our current and potential competitors, some of whom have greater resources and experience than we do, may develop products and technologies that may cause demand for, and the prices of, our products to decline. A number of companies have developed, or are expected to develop, products that compete with our products. Competitors in the voice interface software market include IBM, ITT Industries, Lernout and Hauspie Speech Products, Locus Dialog, Lucent Technologies, Microsoft, Philips Electronics, SpeechWorks International and T-NETIX. We expect additional competition from other companies such as Microsoft, who has recently made investments in, and acquired, voice interface technology companies. Furthermore, our competitors may combine with each other, and other companies may enter our markets by acquiring or entering into strategic relationships with our competitors. Current and potential competitors have established, or may establish, cooperative relationships among themselves or with third parties to increase the abilities of their advanced speech and language technology products to address the needs of our prospective customers. Many of our current and potential competitors have longer operating histories, significantly greater financial, technical, product development and marketing resources, greater name recognition and larger customer bases than we do. Our present or future competitors may be able to develop products comparable or superior to those we offer, adapt more quickly than we do to new technologies, evolving industry trends and standards or customer requirements, or devote greater resources to the development, promotion and sale of their products than we do. Accordingly, we may not be able to compete effectively in our markets, competition may intensify and future competition may harm our business. 14 We depend on resellers for a significant portion of our sales. The loss of a key reseller would limit our ability to sustain and grow our revenue. In 1998, 31% of our revenue was achieved by indirect sales through resellers. The percentage of revenue through indirect sales increased to 56% in 1999 and to 68% for the nine months ended September 30, 2000. We intend to continue to rely on resellers for a substantial portion of our sales in the future. As a result, we are dependent upon the continued viability and financial stability of our resellers, as well as upon their continued interest and success in selling our products. The loss of a key reseller or our failure to develop new and viable reseller relationships could limit our ability to sustain and grow our revenue. Significant expansion of our internal sales force to replace the loss of a key reseller would require increased management attention and higher expenditures. Our contracts with resellers generally do not require a reseller to purchase our products. We cannot guarantee that any of our resellers will continue to market our products or devote significant resources to doing so. In addition, we may, from time to time, terminate some of our relationships with resellers. Any termination could have a negative impact on our business and result in threatened or actual litigation. Finally, these resellers possess confidential information concerning our products, product release schedules and sales, marketing and reseller operations. Although we have nondisclosure agreements with our resellers, we cannot guarantee that any reseller would not use our confidential information in competition with us or otherwise. If our resellers do not successfully market and sell our products for these or any other reasons, our sales could be adversely affected and our revenue could decline. We depend on a limited number of customer orders for a substantial portion of our revenue during any given period. Loss of, or delays in, a key order could substantially reduce our revenue in any given period and harm our business. We derive a significant portion of our revenue in each quarter from a limited number of customers. For example, in the three months ended September 30, 2000, five customers made up 50% of our total revenue, and one of those customers exceeded 10% of our total revenue. We expect that a limited number of customers and customer orders will continue to account for a substantial portion of our revenue in a given period. Generally, customers who make large purchases from us are not expected to make subsequent, equally large purchases in the short term. As a result, if we do not acquire a major customer, if a contract is delayed, cancelled or deferred, or if an anticipated sale is not made, our revenue could be adversely affected. Sales to customers outside the United States account for a significant portion of our revenue, which exposes us to risks inherent in international operations. International sales represented approximately 18% of our revenue in 1998, 21% in 1999 and 48% in the nine months ended September 30, 2000. We are subject to a variety of ris ks associated with conducting business internationally, any of which could harm our business. These risks include: . difficulties and costs of staffing and managing foreign operations; . the difficulty in establishing and maintaining an effective international reseller network; . the burden of complying with a wide variety of foreign laws, particularly with respect to intellectual property and license requirements; . political and economic instability outside the United States; . import or export licensing and product certification requirements; . tariffs, duties, price controls or other restrictions on foreign currencies or trade barriers imposed by foreign countries; 15 . potential adverse tax consequences, including higher marginal rates; . unfavorable fluctuations in currency exchange rates; and . limited ability to enforce agreements, intellectual property rights and other rights in some foreign countries. In order to increase our international sales, we must develop localized versions of our products. If we are unable to do so, we may be unable to grow our revenue and execute our business strategy. We intend to expand our international sales, which requires us to invest significant resources to create and refine different language models for each particular language or dialect. These language models are required to create versions of our products that allow end users to speak the local language or dialect and be understood and authenticated. If we fail to develop localized versions of our products, our ability to address international market opportunities and to grow our business will be limited. If the standards we have selected to support are not adopted as the standards for voice interface software, businesses might not use our voice interface software platform for delivery of applications and services. The market for voice interface software is new and emerging and industry standards have not been established yet. We may not be competitive unless our products support changing industry standards. The emergence of industry standards, whether through adoption by official standards committees or widespread usage, could require costly and time consuming redesign of our products. If these standards become widespread and our products do not support them, our customers and potential customers may not purchase our products. Multiple standards in the marketplace could also make it difficult for us to insure that our products will support all applicable standards, which could in turn result in decreased sales of our products. We may encounter difficulties in managing our growth, which could prevent us from executing our business strategy. Our rapid growth has placed, and continues to place, a significant strain on our resources. To accommodate this growth, we must implement or upgrade a variety of operational and financial systems, procedures and controls, including the improvement of our accounting and other internal management systems. We have had to hire additional employees to accommodate this growth in business and product development activity. This has resulted in increased responsibilities for our management. Our systems, procedures and controls may not be adequate to support our operations. If we fail to improve our operational, financial and management information systems, or to hire, train, motivate or manage our employees, our business could be harmed. Any inability to adequately protect our proprietary technology could harm our ability to compete. Our future success and ability to compete depends in part upon our proprietary technology and our trademarks, which we attempt to protect with a combination of patent, copyright, trademark and trade secret laws, as well as with our confidentiality procedures and contractual provisions. These legal protections afford only limited protection and may be time-consuming and expensive to obtain and/or maintain. Further, despite our efforts, we may be unable to prevent third parties from infringing upon or misappropriating our intellectual property. Although we have filed multiple U.S. patent applications, we have currently only been issued one patent. There is no guarantee that more patents will be issued with respect to our current or future patent applications. Any patents that are issued to us could be invalidated, circumvented or challenged. If challenged, our patents might not be upheld or their claims could be narrowed. Our intellectual property may not be adequate to provide us with competitive advantage or to prevent competitors from entering the markets for our products. 16 Additionally, our competitors could independently develop non-infringing technologies that are competitive with, equivalent to, and/or superior to our technology. Monitoring infringement and/or misappropriation of intellectual property can be difficult, and there is no guarantee that we would detect any infringement or misappropriation of our proprietary rights. Even if we do detect infringement or misappropriation of our proprietary rights, litigation to enforce these rights could cause us to divert financial and other resources away from our business operations. Further, we license our products internationally, and the laws of some foreign countries do not protect our proprietary rights to the same extent as do the laws of the United States. Third parties could obtain licenses from SRI International relating to voice interface technologies and develop technologies to compete with our products, which could cause our sales to decline. Upon our incorporation in 1994, we received a license from SRI International to a number of patents and other proprietary rights, including rights in software, relating to voice interface technologies developed by SRI International. This license was exclusive until December 1999, when we chose to allow the exclusivity to lapse. As a result, SRI International may license these patents and proprietary rights to our competitors. If a license from SRI International were to enable third parties to enter the markets for our products and services or to compete more effectively, we could lose market share and our business could suffer. Our products may infringe the intellectual property rights of others, and resulting claims against us could be costly and require us to enter into disadvantageous license or royalty arrangements. The software industry is characterized by the existence of a large number of patents and frequent litigation based on allegations of patent infringement and the violation of intellectual property rights. Although we attempt to avoid infringing known proprietary rights of third parties we may be subject to legal proceedings and claims for alleged infringement by us or our licensees of third-party proprietary rights, such as patents, trade secrets, trademarks or copyrights, from time to time in the ordinary course of business. Any claims relating to the infringement of third-party proprietary rights, even if not successful or meritorious, could result in costly litigation, divert resources and management's attention or require us to enter into royalty or license agreements which are not advantageous to us. In addition, parties making these claims may be able to obtain injunctions, which could prevent us from selling our products. Furthermore, former employers of our employees may assert that these employees have improperly disclosed confidential or proprietary information to us. Any of these results could harm our business. We may be increasingly subject to infringement claims as the number of, and number of features of, our products grow. If we are unable to hire and retain technical, sales and marketing and operational personnel, our business could be harmed. We intend to continue to hire a significant number of additional personnel, including software engineers, sales and marketing personnel and operational personnel. Competition for these individuals is intense, especially in the San Francisco Bay Area where we are headquartered, and we may not be able to attract, assimilate, or retain additional highly qualified personnel in the future. The failure to attract, integrate, motivate and retain these employees could harm our business. We rely on the services of our key personnel, whose knowledge of our business and technical expertise would be difficult to replace. We rely upon the continued service and performance of a relatively small number of key technical and senior management personnel. Our future success depends on our retention of these key employees, such as Ronald Croen, our Chief Executive Officer. None of our key technical or senior management personnel are bound by employment agreements, and, as a result, any of these employees could leave with little or no prior notice. If we lose any of our key technical and senior management personnel, our business could be harmed. We do 17 not have key person life insurance policies covering any of our employees. Our stock price is extremely volatile. Since our initial public offering on April 13, 2000, our stock price has been extremely volatile. During that time, the stock market in general, and The Nasdaq National Market and the securities of technology companies in particular, has experienced extreme price and trading volume fluctuations. These fluctuations have often been unrelated or disproportionate to the operating performance of individual companies. These broad market fluctuations may materially adversely affect our stock price, regardless of our operating results. Certain stockholders may disagree with how Nuance uses the proceeds from its public offerings. Management will retain broad discretion over the use of proceeds from the Company's April 2000 initial public offering and September 2000 secondary public offering. Stockholders may not deem these uses desirable and our use of the proceeds may not yield a significant return or any return at all. Because of the number and variability of factors that determine our use of the net proceeds from the offering, we cannot guarantee that these uses will not vary substantially from our currently planned uses. Some of our existing stockholders can exert control over Nuance and may not make decisions that are in the best interests of all stockholders. Since our secondary public offering on September 27, 2000, our executive officers and directors, their affiliates and other current principal stockholders together control approximately 42% of our outstanding common stock. As a result, these stockholders, if they act together, are able to exert a significant degree of influence over our management and affairs and over matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions. In addition, this concentration of ownership may delay or prevent a change in control of Nuance, even when a change in control may be in the best interests of other stockholders. Moreover, the interests of this concentration of ownership may not always coincide with our interests or the interests of other stockholders and, accordingly, these controlling stockholders could cause us to enter into transactions or agreements which we would not otherwise consider. Our charter and bylaws and Delaware law contain provisions which may delay or prevent a change of control of Nuance. Provisions of our charter and bylaws may make it more difficult for a third party to acquire, or discourage a third party from attempting to acquire, control of Nuance. These provisions could limit the price that investors might be willing to pay in the future for shares of our common stock. These provisions include: . the division of the board of directors into three separate classes; . the elimination of cumulative voting in the election of directors; . prohibitions on our stockholders from acting by written consent and calling special meetings; . procedures for advance notification of stockholder nominations and proposals; and . the ability of the board of directors to alter our bylaws without stockholder approval. In addition, our board of directors 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 issuance of preferred stock, while providing flexibility in connection with possible financings or acquisitions or other corporate purposes, could have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock. 18 Since the completion of our initial public offering on April 13, 2000, we have been subject to the antitakeover provisions of the Delaware General Corporation Law, including Section 203, which may deter potential acquisition bids for our company. Under Delaware law, a corporation may opt out of Section 203. We do not intend to opt out of the provisions of Section 203. We may incur a variety of costs to engage in future acquisitions of companies, products or technologies, and the anticipated benefits of those acquisitions may never be realized. As a part of our business strategy, we may make acquisitions of, or significant investments in, complementary companies, products or technologies. Any future acquisitions would be accompanied by risks such as: . difficulties in assimilating the operations and personnel of acquired companies; . diversion of our management's attention from ongoing business concerns; . our potential inability to maximize our financial and strategic position through the successful incorporation of acquired technology and rights into our products and services; . additional expense associated with amortization of acquired assets; . maintenance of uniform standards, controls, procedures and policies; and . impairment of existing relationships with employees, suppliers and customers as a result of the integration of new management personnel. We cannot guarantee that we will be able to successfully integrate any business, products, technologies or personnel that we might acquire in the future, and our failure to do so could harm our business. Future sales of our common stock could cause the price of our shares to decline. Our common stock began trading on the Nasdaq National Market on April 13, 2000. However, to date there have been a limited number of shares trading in the public market. Some of our current stockholders own restricted securities which will become available for sale in the future. 188,889 shares will be available for sale in the public market beginning on December 14, 2000 and 19,413,438 shares will be available for sale beginning on December 26, 2000. Sales of a substantial number of shares of our common stock could cause our stock price to fall. In addition, the sale of shares by our stockholders could impair our ability to raise capital through the sale of additional stock. Our facilities are located near known earthquake fault zones, and the occurrence of an earthquake or other natural disaster could cause damage to our facilities and equipment which could require us to curtail or cease operations. Our facilities are located in the San Francisco Bay Area near known earthquake fault zones and are vulnerable to damage from earthquakes. In October 1989, a major earthquake that caused significant property damage and a number of fatalities struck this area. We are also vulnerable to damage from other types of disasters, including fire, floods, power loss, communications failures and similar events. If any disaster were to occur, our ability to operate our business at our facilities could be seriously, or potentially completely, impaired. The insurance we maintain may not be adequate to cover our losses resulting from disasters or other business interruptions. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK MARKET RISK The following discusses our exposure to market risk related to changes in interest rates, equity prices and foreign currency exchange rates. This 19 discussion contains forward-looking statements that are subject to risks and uncertainties. Actual results could vary materially as a result of a number of factors including those set forth in the risk factors section of this Quarterly Report on Form 10-Q. Foreign Currency Exchange Rate Risk To date, all of our recognized revenues have been denominated in U.S. dollars and primarily from customers in the United States, and our exposure to foreign currency exchange rate changes has been immaterial. We expect, however, that future product license and services revenues may also be derived from international markets and may be denominated in the currency of the applicable market. As a result, our operating results may become subject to significant fluctuations based upon changes in the exchange rates of certain currencies in relation to the U.S. dollar. Furthermore, to the extent that we engage in international sales denominated in U.S. dollars, an increase in the value of the U.S. dollar relative to foreign currencies could make our products less competitive in international markets. Although we will continue to monitor our exposure to currency fluctuations, and when appropriate, may use financial hedging techniques to minimize the effect of these fluctuations, we cannot assure you that exchange rate fluctuations will not adversely affect our financial results in the future. Interest Rate Risk As of September 30, 2000, we had cash and cash equivalents of $81.5 million which consisted of cash and highly liquid short-term investments. Any decline in interest rates over time would reduce our interest income from our short-term investments. Based upon our balance of cash and cash equivalents, a decrease in interest rates of 0.5% would cause a corresponding decrease in our annual interest income by approximately $0.3 million. As of September 30, 2000, we had short-term debt outstanding in the amount of $278,000 at an interest rate of 8.0%. 20 NUANCE COMMUNICATIONS INC. & SUBSIDIARIES FORM 10-Q, September 30, 2000 PART II: OTHER INFORMATION Item 1. Legal Proceedings: We are not currently a party to any legal proceedings. Item 2. Changes in Securities: The effective date of our registration statement on Form S-1 filed under the Securities Act of 1933 (No. 333-45128) relating to a public offering of our common stock, was September 26, 2000. A total of 1,256,793 shares of our common stock were sold by us to an underwriting syndicate led by Goldman, Sachs & Co., Credit Suisse First Boston, Thomas Weisel Partners LLC and Wit Soundview. The offering commenced on September 27, 2000 and closed on October 2, 2000. On October 27, 2000, the Registrant issued 31,021 shares of common stock at a per share price of $0.96 to Phoenix Leasing Incorporated, upon the net exercise of an outstanding warrant. Item 3. Defaults Upon Senior Securities None Item 4. Submission of Matters to a Vote of Security Holders None Item 5. Other Information None Item 6. Exhibits and Reports on Form 8-K: (a) Exhibits. The exhibits listed in the accompanying Exhibit Index are filed or incorporated by reference as part of this Report. (b) No reports on Form 8-K were filed during the quarter. 21 SIGNATURES Pursuant to the requirements of the Securities Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Nuance Communications /s/ Graham Smith Date: November 13, 2000 By: _________________________________ Graham Smith Vice President and Chief Financial Officer 22 EXHIBIT INDEX Exhibit Number Exhibit Title 3.1 Amended and Restated Articles of Incorporation of Registrant, as currently in effect.(1) 3.2 Form of Certificate of Incorporation of Registrant, to be in effect upon the reincorporation of Registrant into Delaware.(1) 4.1 Form of Registrant's Common Stock Certificate.(1) 4.2 Amended and Restated Investors' Rights Agreement, dated as of October 1, 1999, among the Registrant and the parties named therein.(1) 27.1 Financial Data Schedule. -------------------------------------------------------------------------------- (1) Incorporated by reference from the Registrant's Registration Statement on Form S-1 filed with the Commission on February 4, 2000. 23