Kendall square research

Harvard Business School 9-194-068 Rev. November 10, 1998

Professor William J. Bruns, Jr., prepared this case as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation..

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Kendall Square Research Corporation (A)

Kendall Square Research Corporation (KSR) was founded in 1986 by Henry Burkhardt III and Steve Frank, another computer designer. KSR was the third computer company co-founded by Burkhardt—the first two having been Data General Corporation and Encore Computer Corporation. At KSR, Burkhardt chose a radical design for a supercomputer that would make the machines attractive for both government and university laboratories and for commercial users. The company delivered its first machine to the Oak Ridge National Laboratory in the fall of 1991, and Kendall Square Research reported that it reached break-even volume before the end of 1992.

From its beginning KSR funded its development and the design of its products through private placements of its equity and debt securities and an initial public stock offering in April 1992. A subsequent stock offering in April 1993 brought the total financing of the start-up to about $150 million—more than $80 million of which had come in two offerings of stock to the public. Shares in the first of the public offerings had more than doubled in price in less than 18 months. By October 1993, the market capitalization of the shares was about five times estimated 1993 sales and 45 times estimated 1993 earnings.1

From the time of its first sale, some critics questioned the criteria used by KSR to determine when revenue would be recognized. The company recognized revenue on product sales upon written customer acceptance of the product. Acceptance often occurred before the configuration of a particular system was finalized or any payment had been received from a customer. Kendall Square Research fully disclosed its policy on revenue recognition in its financial reports to shareholders. (See Exhibit 1 for excerpts from the 1992 Kendall Square Research Corporation Annual Report to Shareholders.)

Kendall Square Research and Supercomputing

Kendall Square Research2 recognized at its founding that a key to its success would be its ability to deliver more computing power at lower cost per computation than its competitors. Its

1John R. Dorfman and William M. Bulkeley, "Heard on the Street: Supercomputer Maker Kendall Square's Effort to Crack Business Markets Has Some Skeptics," The Wall Street Journal, October 11, 1993, p. C2. 2This section is based on information take from the 1992 Annual Report of Kendall Square Research Corporation.

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194-068 Kendall Square Research Corporation (A)

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approach was based on linking many low-cost minicomputers and dividing the computer task among them, rather than building larger mainframe computers or trying to improve programming and software to wring more performance from the computer architectures that were available. The concept of massively parallel processing had first surfaced in the 1980s, and several competitors felt that it had tremendous potential.

A large-scale parallel computer was potentially faster and less expensive than traditional mainframes or available supercomputers. In addition to lower cost per computation or transaction, large-scale parallel computers were theoretically scaleable; bigger and more powerful machines could be assembled merely by adding processors and the memory and input and output devices to support them. However, as processors were added, programming became more difficult and cumbersome.

Kendall Square’s founders believed that a highly successful parallel computer could succeed only if it could take advantage of the library of applications and languages that were already standard in the mainframe and supercomputer worlds. Their goal was to develop a standards-based multi-user system that could run multiple applications simultaneously, so that a sufficiently powerful system could serve an entire technical or business enterprise. Their ideal system would even be able to run scientific and business applications at the same time.

The technology that was needed to develop such a computer did not exist in 1986 when KSR was founded. For six years Kendall Square scientists and engineers invested in chip development technology that they hoped would turn their insight into a working computer. By 1992 they were sure they had succeeded. They had developed a large scale parallel computer which combined the power of massively parallel, distributed memory machines with the familiar shared-memory programming environment of conventional mainframes. The KSR1 family of computers was designed for high performance computing requirements typical of scientific environments, for decision support and complex database query applications, and for on-line transaction-intensive environments such as automatic teller machines or airline reservation systems.

The KSR1 family of systems scaled from 16 to 1088 processors. A $975,000 model with 16 processors could handle 1,200 transactions per second, a measure of commercial computer speed. Scalability allowed users to add computer resources in incremental and cost-effective steps without changes in software and without performance degradation. Therefore, a customer could add to an installation at a later date without the need to replace all software or to reprogram operating systems. While the scaling up of processors in massive parallel processing computer systems was not fully reliable, reports from users of KSR machines seemed to support the company’s contention that they scale up more effectively than those of some other competitors.

In 1993 supercomputers with massively parallel processing were more commonly found in scientific applications than in commercial applications. One reason for this was the tendency for supercomputers to crash as users pushed their limits. In scientific applications, users were often willing to sacrifice reliability for performance, but most commercial applications required computers to work reliably for months at a time. The business market for supercomputers had been estimated to be about $31 billion—far larger than the scientific and research market, which had been estimated to be about $4 billion.3 In 1992, Kendall Square signed contracts with Neodata, a direct-mail company working with Electronic Data Systems (EDS), and AMR, the parent company of American Airlines, to work together to develop systems using KSR computers.

3Dorfman and Bulkeley, loc. cit.

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Kendall Square Research Corporation (A) 194-068

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Revenue Recognition at Kendall Square Research Corp.

Critics of the revenue recognition practices used by KSR claimed that the company was far too liberal in what it called a sale of a machine or system. They cited cases in which laboratories had ordered or received equipment which was subsequently accepted but for which there was no prospective funding, or for which research grants had been requested but not yet granted. In such cases there was no assurance that the research grant would be received and, even if it was, there could be significant delays before the customer would pay KSR.

Other analysts thought that the liberal accounting practices used by KSR were not uncommon in the computer industry, but such practices were less visible in the financial statements of more mature companies such as IBM or Digital Equipment Corporation. These analysts pointed out that terms requiring payment in six or nine months after a customer had received a grant from a government agency—often very slow payers—were not unusual. Such terms might be appropriate for the typical university or research laboratory that were the base of early KSR users.

Terms of Kendall’s supercomputer deliveries were often extremely attractive to researchers. For example, Edward Lazowska, chairman of the department of computer science at the University of Washington, said that it has two KSR1 computers with a total of 60 processors. He said, “We paid $1 million for half of it, and the rest was a loan of equipment against future grants.” Kendall . . . treated the entire shipment as a sale.

William Goddard, a physicist at the California Institute of Technology, said he paid for 32 processors in September 1992 using a National Science Foundation grant. He liked it so much that last spring he wanted to double the size of the system and applied for more grant money. Kendall shipped him the computer immediately, but he and Kendall are still waiting for the grant award. “I’m committed to buying it,” he said. “I am applying for two very large grants.”4

Other contracts included one for $1.5 million that could be canceled if the second of two phases was not completed. Still others involved distributors that had the right to cancel the contract if a customer could not be found.

A second sales practice added to the concerns of critics of KSR’s accounting policies. Some users purchased machines with fewer processors than were eventually thought to be needed. In these cases the processors purchased were booked as revenue and accounts receivable, but KSR had delivered additional processors to the customer for installation and use by the customer. The additional processors remained on KSR’s balance sheet as inventory pending the customer’s decision to keep the processors, apply for grants to buy them, or to otherwise make arrangements to pay for the loaned processors.

As a result of these practices, revenues recognized had exceeded cash collected from customers by significant amounts. Some critics thought this indicated that revenue was being recognized too early. Other observers thought this was normal for a new, growing company in the process of ramping up sales.

Of additional concern was the practice of KSR giving research grants to some users of its systems. Such grants had been reported to range between $5,000 and $50,000 or more. Henry

4William M. Bulkeley, "Kendall Square . . . " The Wall Street Journal, December 2, 1993, p. A3.

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194-068 Kendall Square Research Corporation (A)

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Burkhardt was reported to have agreed that grants “. . . sometimes do run into substantial amounts, but are legitimate expenses to foster software development, not disguised sales incentives. . . .”5

Kendall Square Research in 1993

In August 1993, The Wall Street Journal reported:

WALTHAM, Mass Kendall Square Research Inc. is “quite comfortable” with analysts’ estimates that it will earn 45 cents to 50 cents a share for the year, President Henry Burkhardt said.

Mr. Burkhardt also said he is comfortable with estimates that revenue for the year will top $60 million, up from $20.7 million. And he said he is comfortable with third- quarter earnings estimates of 9 cents to 13 cents a share. For the year-earlier quarter, Kendall Square reported a net loss of 29 cents a share on revenue of $5.3 million.6

Questions

1. Evaluate the revenue recognition policies used by Kendall Square Research.

Do they conform to generally accepted accounting principles with respect to

a. the timing of revenue recognition?

b. the amount of revenue recognized?

c. the matching of costs and expenses to revenue?

2. The rapid growth in sales expected by Kendall Square Research managers will strain the company’s ability to finance its expansion. How, if at all, should this fact affect the ways in which management chooses accounting principles and a reporting strategy?

5Ibid. 6"Kendall Square Agrees with Profit Estimates for Quarter and Year," The Wall Street Journal, August 13, 1993, p. B5A.

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Kendall Square Research Corporation (A) 194-068

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Exhibit 1 Excerpts from 1992 Annual Report of Kendall Square Research Corporation

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Introduction

The Company was incorporated in February 1986 and sold its first computer system in September 1991. As of December 26, 1992, the Company had sold 22 systems, of which 11 were sold to customers in the United States and 11 to customers in Europe. Several of these customers have enlarged the size of their system configuration since initial installation. The Company’s revenue for the fiscal year ended December 26, 1992, was $20.7 million. The Company has not been profitable on an annual basis since its inception and no assurance can be given that the Company will be able to operate on a profitable basis. As of December 26, 1992, the Company’s accumulated deficit was approximately $69.7 million.

The Company’s future operating results will depend on many factors, including the demand for the Company’s products for both technical and commercial applications, the level of competition faced by the Company and the ability of the Company to develop and market new products and control costs. The Company’s sales and marketing strategy contemplates sales of its computer systems for both technical and commercial applications. To date, however, all of the computer systems have been sold for technical applications.

Results of Operations

Years Ended December 28, 1991, and December 26, 1992

The Company does not believe that the year-to-year comparison of various items of expense as a percentage of revenue is meaningful due to the significant growth in the Company’s revenue from 1991 to 1992.

Revenue

Revenue increased from $904,000 to $20,729,000. The Company shipped its first computer system in September 1991 and recorded its first revenue in the third quarter of 1991. The Company recorded revenue growth in each of the four quarters in 1992 as it increased the number of systems shipped. There can be no assurance that the Company will continue to achieve quarterly revenue growth in future periods. See “Quarterly Results.” Sales to customers in Europe accounted for approximately 44% of revenue in 1992.

Cost of Revenue

Cost of revenue increased from $332,000 to $9,189,000, or from 37% to 44% of revenue. These expenses include actual material, labor, and indirect costs associated with the manufacture of systems for which revenue has been recognized. The Company does not believe that the year-to-year comparison is meaningful due to the low level of revenues in fiscal 1991 as well as the allocation of certain start-up manufacturing costs in 1991 to other operating costs.

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194-068 Kendall Square Research Corporation (A)

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Research and Development

Research and development expenses decreased by 11% from $15,786,000 to $14,113,000. Additionally, in 1992 the Company capitalized $3,506,000 of costs attributable to software license fees and software development. No such costs were capitalized in 1991. The Company increased research and development staffing levels from 79 to 115 persons from 1991 to 1992. In order to establish a competitive position and to develop new and enhanced products, the Company intends to continue to devote substantial resources to research and development. The Company expects that research and development expenses will fluctuate from quarter to quarter but will generally increase over time.

Selling, General and Administrative

Selling, general and administrative expenses increased by 63% from $6,441,000 to $10,475,000. These expenses were comprised primarily of selling and marketing expenses, reflecting significant increases in sales, marketing, and support staffing levels from 49 to 66 persons from 1991 to 1992. These expenses are expected to continue to increase as the Company expands its selling and marketing efforts.

Other Operating Costs and Expenses

Other operating costs in 1991 of $850,000 resulted from costs incurred in the establishment of the Company’s manufacturing facilities and procedures and other initial manufacturing costs, including depreciation of test equipment. The manufacturing facilities and procedures became operational during the fourth quarter of 1991. There were no such costs incurred in 1992.

Other Income (Expense), Net

The Company recorded other income of $326,000 in 1992, compared to other expense of $2,000 in 1991. Interest income increased by 104% from $380,000 to $775,000 which was partially offset by an 18% increase in interest expense from $382,000 to $449,000. The Company’s average cash and investments balances were higher in 1992 than in 1991 as a result of the receipt of proceeds from convertible debt financings and the Company’s initial public offering. All of the convertible debt was converted into shares of common stock upon the closing of the Company’s initial public offering on April 3, 1992.

To date, inflation has not had a material impact on the Company’s revenue or results of operations.

Years Ended December 29, 1990, and December 28, 1991

Revenue

Revenue for the year ended December 28, 1991, of $904,000 resulted from the Company’s first shipment and customer acceptance of one KSR1-20 system. There were no shipments in the year ended December 29, 1990.

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Kendall Square Research Corporation (A) 194-068

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Cost of Revenue

Cost of revenue of $332,000 includes actual material, labor, and indirect costs associated with the manufacture of systems for which revenue was recognized.

Research and Development

Research and development expenses increased by 49% from $10,575,000 to $15,786,000. This increase resulted primarily from materials and other costs incurred in the design and development of product prototypes, as well as an increase in research and development staffing levels from 77 to 79 persons from 1990 to 1991.

Selling, General and Administrative

Selling, general and administrative expenses increased by 108% from $3,099,000 to $6,441,000. These expenses were comprised primarily of selling and marketing expenses, reflecting an increase in sales, marketing and support staffing level from 24 to 49 persons from 1990 to 1991. These expenses were incurred as part of the Company’s strategy to market its computer systems concurrently with its development efforts.

Other Operating Costs and Expenses

Other operating costs increased by 134% from $363,000 to $850,000. This increase resulted from costs incurred in the establishment of the Company’s manufacturing facilities and procedures and other initial manufacturing costs, including depreciation of test equipment.

Other Income (Expense), Net

The Company recorded other expense of $2,000 in 1991 compared to other income of $687,000 in 1990. The Company had more proceeds from private equity and convertible subordinated debt financings in 1990 available for investment than in 1991 and earned higher average interest rates thereon. Additionally, interest expense was higher in 1991 as a result of higher capital lease obligations and the issuance in 1991 of $12,820,000 in convertible subordinated notes.

Quarterly Results

The following table presents unaudited quarterly financial information for the four fiscal quarters ended December 26, 1992. This information has been prepared by the Company on a basis consistent with the Company’s audited consolidated financial statements and includes all adjustments (consisting only of normal recurring adjustments) which management considers necessary for a fair presentation of the results for such periods. The operating results for any quarter are not necessarily indicative of the results for any future period.

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194-068 Kendall Square Research Corporation (A)

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3 Months Ended

(In thousands) March 28,

1992 June 27,

1992 September 26,

1992 December 26,

1992

Revenue $ 1,954 $ 2,297 $ 5,310 $11,168 Cost of revenue 896 1,058 2,466 4,769

Gross profit 1,058 1,239 2,844 6,399

Cost and expenses: Research and development 3,407 4,312 3,444 2,950 Selling, general and administrative 1,890 2,160 2,859 3,566

5,297 6,472 6,303 6,516

Loss from operations (4,239) (5,233) (3,459) (117)

Other income (expense): Interest income 30 348 249 148 Interest expense (323) (61) (40) (25)

(293) 287 209 123

Net income (loss) $(4,532) $(4,946) $(3,250) $ 6

Revenue in the first full year of shipments demonstrated successive quarterly growth, highlighted by fourth quarter revenue of $11,168,000 from the sale of systems to 13 new customers. The Company sold systems to eight new customers during the first three quarters of the year. Gross profit was approximately 54% of revenue throughout the first three quarters and improved to approximately 57% in the fourth quarter as revenues increased more rapidly than fixed costs. Research and development expenses increased in the second quarter primarily due to the shifting of development efforts to new products. The reduction in fourth quarter expenses was attributable to the capitalization of certain patents and trademarks and to increased capitalization of software development costs. Selling, general and administrative expenses reflect the increasing investment in the expansion of sales offices in Europe and the United States, staffing increases in sales, marketing and support staffing level and marketing programs. Interest income increased in the second quarter as a result of the investment of the proceeds from the Company’s initial public offering. Interest expense in the first quarter was primarily attributable to the outstanding convertible debt, which was converted into shares of common stock early in the second quarter. The balance of the year reflects the interest expense on capital leases.

Selected Consolidated Financial Data

The following data has been derived from financial statements audited by Price Waterhouse, independent accountants. The consolidated balance sheet at December 28, 1991 and December 26, 1992 and the related consolidated statements of operations, of stockholders’ equity and of cash flows for the three years ended December 26, 1992 and the notes thereto appear elsewhere in this Annual Report.

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Kendall Square Research Corporation (A) 194-068

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Year Ended (In thousands except per share data)

December 31, 1988

December 30, 1989

December 29, 1990

December 28, 1991

December 26, 1992

Statement of Operations Data:

Revenue $ 904 $ 20,729 Cost of revenue $ 332 $ 9,189 Gross profit 572 11,540

Costs and expenses: Research and development $ 6,348 8,253 10,575 15,786 14,113 Selling, general and

administrative 902 2,494 3,099 6,441 10,475 Other operating costs and

expenses 363 850

7,250 10,747 14,037 23,077 24,588

Loss from operations (7,250) (10,747) (14,037) (22,505) (13,048) Other income (expense), net 499 425 687 (2) 326 Net loss (6,751) (10,322) (13,350) (22,507) (12,722)

Pro forma net loss per sharea (2.31) (2.92) (2.77) (3.90) (1.22) Weighted average shares

outstandinga 2,925 3,531 4,814 5,712 10,171

Year Ended

(in thousands) December 31,

1988 December 30,

1989 December 29,

1990 December 28,

1991 December 26,

1992

Balance Sheet Data:

Working capital $7,112 $5,471 $10,674 $4,463 $33,473 Total assets 10,298 9,226 15,959 13,129 48,733 Long-term capital lease

obligations 114 942 892 599 Stockholders’ equitya 9,316 7,523 12,812 6,408 40,427

aAssumes the conversion of all outstanding shares of all series of convertible preferred stock and convertible subordinated notes outstanding prior to the closing of the Company’s initial public offering on April 3, 1992 into common stock. See Notes 1 and 4 of Notes to Consolidated Financial Statements.

Price Range of Common Stock

The Company’s common stock is traded in the Over-the-Counter market on the National Association of Securities Dealers, Inc. Automated Quotation (“NASDAQ”) National Market System under the symbol “KSRC.” The following table sets forth the range of high and low sale prices for the common stock for the periods indicated, as reported on the NASDAQ National Market System. Quotations represent prices between dealers and do not reflect retail mark-ups, markdowns or

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194-068 Kendall Square Research Corporation (A)

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commissions. There was no market for the Company’s common stock prior to its initial public offering effective on March 27, 1992.

Price Range of Common Stock

High Low

First quarter $12 $11 Second quarter 13¼ 7½ Third quarter 11½ 7½ Fourth quarter 19½ 5½

As of February 10, 1993, there were approximately 1,500 individual participants in security position listings for the Company’s common stock.

Report of Independent Accountants

To the Board of Directors and Stockholders of Kendall Square Research Corporation

In our opinion, the accompanying consolidated balance sheet and the related consolidated statements of operations, of stockholders’ equity and of cash flow present fairly, in all material respects, the financial position of Kendall Square Research Corporation and its subsidiaries at December 26, 1992 and December 28, 1991, and the results of their operations and their cash flows for each of the three years in the period ended December 26, 1992, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company’s management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above.

Price Waterhouse Boston, Massachusetts February 8, 1993, except as to Note 4, which is as of April 1, 1993

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Kendall Square Research Corporation (A) 194-068

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Consolidated Balance Sheet

(In thousands, except per share data) December 28, 1991 December 26, 1992

Assets

Current assets: Cash and cash equivalents $ 4,035 $ 7,392 Short-term investments 10,372 Accounts receivable 804 13,328 Inventories 4,316 8,939 Prepaid expenses and other current assets 1,137 1,149

Total current assets 10,292 41,180

Fixed assets, net 2,635 3,108 Software development cost, net 3,451 Other assets, net 202 994

$13,129 $48,733

Liabilities and Stockholders’ Equity

Current liabilities: Accounts payable $ 2,885 $ 3,001 Accrued payroll costs 1,019 1,575 Other accrued expenses 612 2,047 Deferred revenue 428 196 Current portion of long-term capital lease

obligations 885 888 Total current liabilities 5,829 7,707

Long-term capital lease obligations 892 599

Stockholders equity: Convertible preferred stock 50,098 Convertible subordinated notes, converted into

common stock upon the closing of the initial public offering 13,029

Common stock. $.01 par value; 35,000,000 shares authorized; 375,578 and 11,356,517 shares issued at December 28, 1991 and December 16, 1992, respectively 4 114

Additional paid-in capital 215 109,987 Accumulated deficit (56,938) (69,660)

6,408 40,441 Less 1,263 shares of common stock held in

treasury, at cost (14)

Total stockholders’ equity 6,408 40,427

Commitments $13,129 $48,733

The accompanying notes are an integral part of the financial statements.

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194-068 Kendall Square Research Corporation (A)

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Consolidated Statement of Operations

Year Ended (In thousands, except per share data)

December 29, 1990

December 28, 1991

December 26, 1992

Revenue $ 904 $ 20,729 Cost of revenue 332 9,189 Gross profit 572 11,540

Costs and expenses: Research and development 10,575 15,786 $ 14,113 Selling, general and administrative 3,099 6,441 10,475 Other operating costs and expenses 363 850 -

14,037 23,077 24,588

Loss from operations (14,037) (22,505) (13,048)

Other income (expense): Interest income 755 380 775 Interest expense (68) (382) (449)

687 (2) 326

Net losses $(13,350) $(22,507) $(12,722)

Unaudited proforma net loss per share assuming conversion of convertible preferred stock and convertible subordinated notes (Note 1) $ (2.77) $ (3.90) $ (1.22)

Weighted average shares outstanding 4,814 5,712 10,171

The accompanying notes are an integral part of the financial statements.

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Kendall Square Research Corporation (A) 194-068

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Consolidated Statement of Cash Flows Increase (decrease) in Cash and Cash Equivalents

Year Ended (In thousands, except per share data)

December 29, 1990

December 28, 1991

December 26, 1992

Cash flows from operating activities: Cash received from customer $ 527 $ 8,533 Cash paid to suppliers and employees (13,538) (23,192) (36,231) Interest received 636 530 681 Interest paid (68) (173) (177)

Net cash used for operating activities (12,970) (22,308) (27,194)

Cash flows from investing activities: (Purchase) sale of short-term investments (2,888) 2,888 (10,372) Payment for capitalized software

development costs (3,506)

Purchase of fixed assets (1,561) (710) (879) Proceeds from sale of fixed assets 242

Net cash provided for (used for) investing activities (4,207) 2,178 (14,757)

Cash flows from financing activities: Proceeds from sale and leaseback of

equipment 961 Principal payments on capital lease

obligations (325) (666) (1,156) Issuance of convertible subordinated

notes 12,820 6,451 Debt issuance costs (288) Issuance of convertible preferred stock 18,817 3,059 Convertible preferred stock issuance

costs (195) (47)

Initial public offering of common stock 44,000 Initial public offering issuance costs (3,964) Proceeds from exercise of common stock

options, warrants, and employee stock purchases 17 64 279

Repurchase of common stock (14) Net cash provided by financing

activities 19,275 15,230 45,308

Net increase (decrease) in cash and cash equivalents 2,098 (4,900) 3,357

Cash and cash equivalents, beginning of period 6,837 8,935 4,035

Cash and cash equivalents, end of period $ 8,935 $ 4,035 $ 7,392

The accompanying notes are an integral part of the financial statements.

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194-068 Kendall Square Research Corporation (A)

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Consolidated Statement of Cash Flows (continued)—Reconciliation of Net Loss to Net Cash Used for Operating Activities

Year Ended

(In thousands) December 29,

1990 December 28,

1991 December 26,

1992

Net loss $(13,350) $(22,507) $(12,722) Adjustments to reconcile net loss to cash used

for operating activities: Depreciation and amortization 1,526 1,786 2,115 Gain on sale of fixed assets (114) Interest accrued on convertible subordinated

notes 209 277 Change in assets and liabilities:

Increase in accounts receivable (804) (12,524) Increase in inventories (4,316) (5,411) Increase in prepaid expenses and other

current assets (860) (81) (12) (Increase) decrease in other assets (183) 10 (792) Increase (decrease) in accounts payable (161) 2,190 116 Increase in accrued payroll costs 107 509 556 Increase in other accrued expenses 65 268 1,435 Increase (decrease) in deferred revenue 428 (232)

Net cash used for operating activities $(12,970) $(22,308) $(27,194)

The accompanying notes are an integral part of the financial statements.

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Kendall Square Research Corporation (A) 194-068

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Notes to Consolidated Financial Statements

Note 1: Nature of Business and Summary of Significant Accounting Policies

Kendall Square Research Corporation (the “Company”) was incorporated on February 4, 1986. The Company develops, manufactures, markets, and supports a family of high performance, general purpose parallel computer systems for a broad range of mainstream applications, including numerically intensive computation, on-line transaction processing and database management and inquiry.

Principles of consolidation The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany transactions are eliminated in consolidation.

Fiscal year The Company’s fiscal year ends on the last Saturday of December.

Cash equivalents and short-term investments The Company considers all highly liquid debt instruments purchased with original maturities of three months or less to be cash equivalents. Short- term investments, which include treasury bills with original maturities of greater than three months, are recorded at cost which approximates market.

Revenue recognition The Company recognizes revenue from product sales upon written customer acceptance. Warranty costs are accrued as product sales revenue is recognized.

Inventories Inventories are stated at the lower of cost or market. Cost is determined by the first-in, first-out (FIFO) method.

Fixed assets Fixed assets are recorded at cost and depreciated by use of the straight-line method over their estimated useful lives. Repair and maintenance costs are expensed as incurred.

Software development costs Certain software development costs incurred subsequent to the establishment of technological feasibility are capitalized and amortized under straight-line and units- shipped methods over the lesser of the estimated economic life of the products or three years commencing when the products are available for general release. Amortization of software development costs is included in cost of revenue and in 1992 totaled $55,000.

Note 2: Inventories

Inventories consist of the following (in thousands):

December 28, 1991

December 26, 1992

Raw materials and manufactured assemblies $1,337 $4,808 Work in process 1,906 1,272 Finished goods 1,073 2,859

$4,316 $8,939

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194-068 Kendall Square Research Corporation (A)

16

Deposits on inventory purchases at December 28, 1991 and December 26, 1992 totaled $543,000 and $164, respectively and are included in prepaid expenses and other current assets.

Note 3: Fixed Assets

Fixed assets consist of the following (in thousands):

Useful Life in Years

December 28, 1991

December 26, 1992

Computer equipment and purchased software 3 $ 7,151 $ 8,916 Office furniture and equipment 3-5 778 1,274

Lease term 345 617 Leasehold improvements 8,274 10,807

Less accumulated depreciation and amortization (5,639) (7,699) $2,635 $3,108

The Company incurred capital lease obligations of $1,757,000, $844,000 and $866,000 in 1990, 1991, and 1992, respectively. Accumulated depreciation on equipment under capital leases totaled $1,229,000 and $2,219,000 at the end of 1991 and 1992, respectively.

In 1992, inventories totaling $788,000 were transferred to fixed assets.

The Company has a $2,600,000 lease line with a commercial lender for the leasing of fixed assets. At December 26, 1992, the Company has $1,734,000 available under the lease line.

Note 4: Stock Option and Purchase Plans

During 1991, the board of directors adopted the 1991 Stock Option Plan (the “Plan”) under which it may issue both incentive and nonqualified stock options. The exercise price of incentive stock options will be no less than the fair market value of the common stock on the date of grant. The Plan allows for a maximum of 1,211,250 common shares to be granted under options over a ten- year period expiring in 2001. The options generally vest between three to five years. Options for the purchase of 210,625 common shares vest in seven years, however, the vesting may be accelerated based on the Company achieving certain revenue levels. All options to date have been issued at fair market value. At December 26, 1992, options for 181,492 shares were available for future grants. On February 8, 1993, the board of directors, subject to stockholder approval, authorized an increase of an additional 1,500,000 shares issuable under the Plan.

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Kendall Square Research Corporation (A) 194-068

17

A summary of activity in the Plan is as follows:

Incentive Stock Options Nonqualified Stock Options

Incentive Stock Options Number of

Shares Option Price

Number of Shares

Option Price

Balance at December 30, 1989 320,421 $.16-$1.60 48,750 1.60 Granted 50,656 1.60- 4.00 Exercised (22,646) .16- 1.60 Canceled (32,031) .80- 1.60

Balance at December 29, 1990 316,400 .80- 4.00 48,750 1.60 Granted 91,500 4.00- 9.00 23,125 4.00 Exercised (42,916) .80- 4.00 Canceled (77,772) .80- 4.00

Balance at December 28, 1991 287,212 .80-9.00 71,875 1.60-4.00 Granted 432,099 9.00-11.00 Exercised (26,986) .80-4.00 (4,125) 1.60 Canceled (22,946) 1.60-11.00 -

Balance at December 26, 1992 669,379 .80-11.00 67,750 1.60-4.00

At December 26, 1992, options for the purchase of 149,384 shares were exercisable.

On December 14, 1991, the Company’s board of directors adopted the 1991 Employee Stock Purchase Plan (the “Purchase Plan”) which provides for the issuance of up to 262,500 shares of common stock to participating employees of the Company through a series of four six-month offerings, beginning May 1, 1992. The Purchase Plan covers substantially all employees, subject to certain limitations. Each employee may elect to have up to 11% of base pay withheld and applied toward the purchase of shares in such offering. The price at which the shares of common stock may be purchased in an offering is 85% of the fair market value of the common stock on the date such offering commences or the date such offering terminates, whichever is lower. In 1992, 33,395 shares were purchased under the Purchase Plan.

The Company has reserved 1,412,892 shares of common stock for issuance upon the exercise of warrants (Note 4) and for use in the Plan and Purchase Plan.

Note 6: Income Taxes

Certain items of expense, primarily research and development, are recognized for income taxes in different periods than for financial reporting purposes. Certain research and development costs are capitalized for tax reporting purposes. Beginning in 1992, the Company is amortizing these costs over a period of 60 months. At December 26, 1992, unamortized research and development costs totaled $34,100,000.

At December 26, 1992, the Company has net operating loss carryforwards of approximately $64,100,000 and $26,500,000 for financial and tax reporting purposes, respectively. The net operating loss carryforwards expire through 2007. In addition, the Company has research and development tax credit carryforwards which expire through 2007 of approximately $2,900,000 available to offset future regular income tax liabilities. Under the Internal Revenue Code, certain substantial changes in the Company’s ownership could result in an annual limitation on the amount of the carryforwards which could be utilized.

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194-068 Kendall Square Research Corporation (A)

18

Note 8: Major Customers and Export Sales

Sales to one and three major customers accounted for $904,000 and $7,763,000, or 100% and 37% of revenue, for 1991 and 1992, respectively. In 1992, revenue from European customers totaled $9,173,000.

Note 10: Line of Credit

The Company has a bank line-of-credit which provides for borrowings of up to $2,500,000. Borrowings under the line-of-credit bear interest at the bank’s base rate plus 2%. In the event that the Company’s quarterly net income exceeds $250,000, borrowings under the line of credit may increase to $5,000,000 and the interest will decrease to the bank’s base rate plus ¾%. All borrowings are secured by accounts receivable and inventories. At December 26, 1992, there were no borrowings outstanding under the line of credit.

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