CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS
This Annual Report on Form 10-K contains "forward-looking statements" within the meaning of the safe-harbor provisions of the U.S. Private Securities Litigation Reform Act of 1995. Forward-looking statements can often be identified by words such as: "expect," "believe," "estimate," "plan," "strategy," "future," "potential," "continue," "may," "should," "will," and similar references to future periods. Examples include, among others, statements about: expected future growth and operating results, such as revenue and earnings; anticipated levels of capital and other expenditures; future market demand, opportunities and conditions; our belief that we have sufficient liquidity to fund our business operations for at least the next 12 months; expectations of the effect on our financial condition of claims, litigation, contingent liabilities and supplier audits; and strategies for customer retention, growth, new product and service developments, and market position.
Forward-looking statements are neither historical facts nor assurances about future performance. Instead, they are only predictions, based on current beliefs, expectations and assumptions about the future of our business and other future conditions. Forward-looking statements are subject to known and unknown risks, uncertainties and changes in circumstances that are difficult to predict and many of which are outside of our control. Actual events and results may differ materially. Therefore, you should not rely on any of these forward-looking statements.
Any forward-looking statement made by us in this report is based only on information available to us on the date of this report. Except as may be required by law, we undertake no obligation to publicly update any forward-looking statement, whether as a result of new information, future developments or otherwise.
Our forward-looking statements can be affected by inaccurate assumptions we might make or by known or unknown risks, uncertainties and other factors. We discuss many of these risks, uncertainties and other factors in this Annual Report on Form 10-K in greater detail under the Item 1A—“Risk Factors.” We caution readers that our business and financial performance are subject to substantial risks and uncertainties.
BUSINESS
Overview
As used in this Annual Report on Form 10-K, “we,” “us”, “our”, “the Company” and “BSQUARE” refer to BSQUARE Corporation.
Since our inception, our business has largely been focused on providing software solutions (historically, including reselling software from Microsoft Corporation (“Microsoft”)) and related engineering services to businesses that develop, market and sell dedicated-purpose standalone intelligent systems. Examples of dedicated-purpose standalone intelligent systems include smart, connected computing devices such as smart phones, set-top boxes, point-of-sale terminals, kiosks, tablets and handheld data collection devices, as well as smart vending machines, ATM machines, digital signs and in-vehicle telematics and entertainment devices. We focus on systems that utilize various Microsoft Windows Embedded operating systems as well as devices running other popular operating systems such as Android, Linux, and QNX, and that are usually connected to a network via a wired or wireless connection. Our customers include world-class original equipment manufacturers (“OEMs”), original design manufacturers (“ODMs”), corporate enterprises (“Enterprises”), silicon vendors (“SVs”) and peripheral vendors. A significant portion of our business historically has also been focused on reselling software from Microsoft, from which a majority of our revenue currently continues to be derived.
Beginning in early 2014, we initiated development efforts focused on new proprietary software products addressing the Industrial Internet of Things (“IIoT”) market, by interconnecting of uniquely identifiable devices, extracting data from those devices and applying advanced analytics and machine learning to the data in order to derive meaningful and actionable insights. While IIoT is a relatively new market, we believe the work we have engaged in since our inception—namely adding intelligence and connectivity to discrete standalone devices and systems—embodies much of what is central to the core functionality of IIoT. These software development efforts have driven a new business initiative for BSQUARE, which we refer to as DataV™. Our DataV solution includes software products, applications and services that are designed to turn raw IIoT device data into meaningful and actionable data for our customers.
We launched DataV late in the first quarter of 2016 and announced our first three major customer bookings later that year. These bookings comprised software licensing, software maintenance and related systems integration services and are, we believe, indicative of the potential customer demand for DataV. During 2017 we began selling data analytics services and DataV application pilots to major industrial customers primarily in the transportation, oil and gas and manufacturing vertical markets, and signed four pilots in the first six months of 2017 and another fifteen pilots in the second half of 2017, the majority of which are still ongoing.
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We believe that DataV presents high growth opportunit
ies in a large, expanding addressable market, at substantially higher gross margins as compared to our traditional business. Developing, selling and implementing DataV has become our primary focus, as approximately 65% of our non-administrative employees a
re now working solely on DataV, representing a transition away from dependence on resale software and professional engineering services toward increased reliance on our own proprietary software and related systems integration services. We intend to continu
e to run our legacy software resale business to maximize cash flow for the foreseeable future. Our legacy professional engineering services business is now managed as a part of our overall services business, which increasingly serves DataV customers and pr
ospects.
We were incorporated in the State of Washington in July 1994. Our principal office is located at 110 110th Avenue NE, Suite 300, Bellevue, Washington 98004, and our telephone number is (425) 519-5900.
Industry Background
The IIoT market is still emerging, but we believe it will present a large market opportunity for us. This market includes consumer, business, government and industrial segments. It encompasses software, hardware, connectivity and cloud providers as well as systems integrators. While larger research firms do not yet widely track the size of the IIoT market, available research indicates to us that over time, the deployment of hundreds of billions of connected devices may generate trillions of dollars of economic value.
The IIoT marketplace is currently being influenced by the following factors:
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Development of machine learning and data analytics software that advances the understanding of complex systems but lacks the capability to effectively process the proliferation of resulting data. This provides an opportunity for solutions such as DataV to develop models of complex mechanical equipment that can be used for predictive reasoning;
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Nearly ubiquitous wireless connectivity, including near-field communications (“NFC”), Bluetooth, Wi-Fi and cellular, allowing connectivity and data exchange with large populations of small, remote, and frequently mobile devices;
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Increasing competitive pressures that are forcing a wide array of businesses to invest in automation as a way to improve productivity, reduce costs, and enhance the value of their own offerings; and
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The increasing availability of inexpensive cloud computing and storage capabilities able to scale to the extent likely to be demanded by IIoT.
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Sources of Revenue
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Year Ended December 31,
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(In thousands, except percentages)
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2017
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2016
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Software revenue:
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Third-party software
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$
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65,755
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$
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80,231
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Proprietary software
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4,646
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1,939
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Professional engineering service revenue
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10,410
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15,271
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Total revenue
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$
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80,811
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$
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97,441
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As a percentage of total revenue:
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Third-party software revenue
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81
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%
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82
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%
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Proprietary software revenue
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6
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%
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2
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%
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Professional engineering service revenue
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13
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%
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16
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%
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Software
DataV Software
DataV is BSQUARE’s proprietary comprehensive software solution which addresses a variety of business use cases specific to IIoT applications, including:
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Predictive Failure: By employing machine learning and advanced data analytics, DataV can predict, with varying levels of accuracy, future operational conditions for equipment or devices that are part of the overall IIoT system. For many industrial concerns, the operational condition of greatest interest is a failure state. By being able to predict failures before they occur, DataV customers can take steps to remediate the condition more quickly, less expensively and with less operational disruption. DataV can also develop maintenance schedules from actual equipment usage and environmental data, reducing overall service costs and improving asset longevity.
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Adaptive Diagnostics: For equipment that has already failed, DataV can dynamically proscribe diagnostic and repair steps that have the highest probability of quickly and more cost-effectively resolving the problem. DataV employs machine learning, data analytics, and historical repair data to help customers identify underperforming assets and proscribe remediation steps to optimize performance.
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IIoT Device Management: The spread of data-generating devices in IIoT systems introduces a new set of operational problems for industrial concerns. DataV can facilitate IIoT device management, including software and configuration updates, over large-scale populations of connected devices.
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Asset Utilization: DataV can assist customers in tracking how their products are used in the field. This can help ensure that equipment is used as intended, an important requirement for customers such as heavy equipment rental firms. It can also provide product designers with feedback that can help improve product performance and differentiation.
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Our DataV solution is designed to be implemented in a wide variety of industrial sectors and vertical markets, including commercial transportation, oil and gas extraction, manufacturing, water and power and other vertical markets. These industrial sectors share common operational characteristics, such as the dependence on complex capital equipment where the cost of failure or sub-optimal performance is relatively high. In other cases, our customers are seeking new revenue-generating products or services to enhance operating profitability. In the future, we will be making DataV available through a software as a service (“SaaS“) revenue model. We currently provide DataV software through hosted subscription or perpetual licensing models.
We officially launched DataV as a commercially available product in March 2016. We secured our first order in May 2016 from PACCAR, Inc., a heavy-duty truck manufacturer, to employ adaptive diagnostics in order to more rapidly service and repair trucks. This order, valued at $4.3 million, included a perpetual license to use DataV for that specific application on certain engine types in North America, as well as custom systems integration services and annual software maintenance fees. We delivered the software and custom services in the first quarter of 2017, resulting in our first major DataV revenue.
In November 2016, we secured our second DataV order from Itron, Inc., a large global manufacturer of electric, water, and gas meters for utilities as well as smart city solutions targeting IIoT device management. This order, valued at $4.8 million, included $1.9 million for the first year and a $2.9 million four-year extension option, and included a subscription license to use DataV in addition to maintenance and systems integration services. In November 2017, Itron renewed its subscription exercising its extension option. We are in the final stages of completing our hosted software delivery and expect Itron to accept delivery in early 2018.
In December 2016, we secured an order from a global provider of candy and beverages to help fulfill their smart vending initiative that adds intelligence to existing fleets of vending machines, better tracks real-time sales data and, in the future, better predicts equipment failures within these machines. We expect this solution to be rolled out in phases beginning in the first quarter of 2018, providing expansion opportunities with increasing machine volumes and geographic territories.
In March 2017, we announced a series of applications, or apps, offering solutions addressing an array of business use cases. These apps are designed to be platform agnostic and to be deployed on Amazon Web Services (“AWS”) or Microsoft Azure. We entered into four customer pilot agreements in the second quarter of 2017, seven pilot agreements in the third quarter and eight pilot agreements in the fourth quarter, for a total of 19 new customer pilot agreements in 2017. Most of these pilots are still ongoing.
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Other Proprietary Software
Apart from DataV, we currently offer the following proprietary software products:
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HTML5 Rendering Engine—Our HTML5 Rendering Engine is based on the open-source WebKit platform that is maintained by a number of leading internet and device companies. Using WebKit, device makers can create portable applications and user interfaces for their devices using the industry-standard HTML5 markup language; and
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TestQuest
TM
10—TestQuest 10 is our testing automation tool that provides customers with a complete test solution that brings together everything necessary to test connected devices, including tools to create and manage test cases, a platform that allows teams to collaborate on test development, and a reporting tool that allows customers to analyze test results.
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By the end of 2016, we had reduced our research and development efforts on these products as our focus has shifted to our DataV solution.
Third-Party Software
We have distribution agreements with multiple third-party software vendors. Our ability to resell these third-party software products, whether as stand-alone products or in conjunction with our own proprietary software and engineering service offerings, provides our customers with a comprehensive solution source for their device project needs. Our primary third-party software offerings include the following:
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For 19 years, we have been a Microsoft authorized Value-Added Provider (“VAP”) of Windows Embedded operating systems and toolkits for the complete line of Windows Embedded products, including major product families such as Windows Embedded Compact, Windows Embedded Standard and Windows Embedded Server. We are authorized to sell Windows Embedded operating systems in the United States, Canada, Mexico, Argentina, Brazil, Chile, Columbia, Peru, Puerto Rico, the Caribbean (excluding Cuba), the European Union (“E.U.”), the European Free Trade Association, Turkey and Africa. Of our total revenue, 70% in 2017 and 72% in 2016 resulted from the sale of Windows Embedded operating systems. Our current distribution agreements related to Windows Embedded operating systems expire on June 30, 2018 and are typically renewed annually or bi-annually;
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We have been a Microsoft authorized VAP of Windows Mobile operating systems since November 2009. Along with Windows Mobile operating systems, we also sell Microsoft’s Office Mobile product. We are currently authorized to sell Windows Mobile operating systems and related products in North America, South America, and Central America (excluding Cuba) (the “Americas”), Japan, Taiwan, and the region comprised of Europe, the Middle East, and Africa (“EMEA”). Of our total revenue in 2017, 10% was generated through the sale of Windows Mobile operating systems, compared to 9% in 2016. Our current distribution agreements related to Windows Mobile operating systems expire on June 30, 2018 and are typically renewed annually or bi-annually;
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We are an authorized distributor for Adobe Flash technologies and Adobe Reader. We have the right to distribute Adobe Flash Lite licenses on a worldwide basis; and
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We are an authorized distributor of Intel Corporation’s Embedded Security product in North America.
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The sale of Microsoft operating systems has accounted for substantially all of our third-party software revenue historically, including approximately 98% of third-party software revenue in both 2017 and 2016.
Professional Engineering Services
DataV Services
In order to operate efficiently, DataV software must be integrated with a variety of customer systems, devices and databases, requiring a significant service component. We anticipate future DataV contracts could include a service component ranging from 10% to 30% of total contract value. Services offered in this context include the following:
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Integration with enterprise databases;
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Integration with internal enterprise systems;
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Integration with external public or third-party data sources;
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Custom application development on our DataV platform;
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Software integration on remote devices;
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Management of customer cloud deployments hosting DataV software.
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Other Service Offerings
Customers engage us for engineering services due to our extensive experience in the areas of device software development and testing, as well as embedded and mobile operating systems. We believe that engaging us on a new device design typically results in shorter development cycles and reduced time-to-market, lower overall costs to complete projects, and enhanced product robustness and features, which a customer may otherwise have been unable to achieve. The engineering services that we offer to our customers include:
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Architectural and system design;
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Software design and development;
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Platform development systems integration;
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Application, middleware and multimedia software development;
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Quality assurance and testing;
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Device solution strategy consulting;
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Test automation engineering and consulting services.
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Revenue from professional engineering services derived from our engagement with The Coca-Cola Company was $3.7 million, or 36%, of total revenue from these services in 2017, and $3.4 million, or 23%, of total professional engineering services revenue in 2016.
Revenue derived from our engagement with Google was $2.9 million, or 28%, of our total revenue from professional engineering services in 2017, and $5.2 million, or 34%, of such revenue in 2016.
Strategy
Our strategy is to invest in growing our DataV solution and applications, while continuing to operate our third-party software and ongoing engineering services business as efficiently as possible. Toward that end, we invest the cash generated by our third-party software and ongoing professional engineering services business, together with cash on hand, in our DataV solution. In 2017 we:
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Focused all research and development efforts on development of our DataV solution and related business applications. We made significant investments in software development, quality assurance, and data scientists;
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Focused all marketing efforts on launching our DataV solution and building our IIoT business solutions brand. We also expanded the size of our marketing team and the array of marketing programs in which we engage;
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Focused a substantial majority of our sales organization on DataV and expanded the DataV sales group with new hires;
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Maintained our third-party software sales group capabilities from prior years and will manage this group to maximize cash flow opportunities; and
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Continued to enhance our customer solutions group, which is focused on building enterprise-scale customer support, cloud hosting, and DataV services capabilities. This group also includes our professional engineering services organization.
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It is our intention that these steps, collectively, will help us to execute on a higher-margin proprietary software business enabled by related systems integration services, while reducing our dependency on our legacy lower-margin software and related services business.
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Relationship with Microsoft
We have a long-standing relationship with Microsoft and this relationship is important to the continuing success of our business. Our credentials as a Microsoft partner include:
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We have been one of Microsoft’s largest distributors of Windows Embedded operating systems for over 19 years;
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We have been a distributor of Microsoft’s Windows Mobile operating systems since November 2009;
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We are a Windows Embedded Gold-level Systems Integrator;
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We were the OED Americas Channel Sales & Marketing Award recipient for Distributor Sales Excellence in 2013;
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We were the Microsoft Embedded Distributor of the Year for 2011;
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We received a Microsoft Technical Excellence Award for our delivery of highest quality technical solutions on the latest Windows Embedded technologies in the European region in 2011;
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Our HTML5 Rendering Engine won a Microsoft Technical Excellence Award in 2012;
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We are a developer and provider of Microsoft Official Curriculum Training for Windows Embedded Compact and Windows Embedded Standard;
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We are a Preferred Provider of Visual Tools for Microsoft;
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We are a Gold-level member of Microsoft’s Third-Party Tools Provider Program;
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We are a Silver Data Analytics partner;
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We are a Silver Data Platform partner;
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We are a Silver Cloud Platform partner;
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We are a U.S.-Managed and Co-Sell Ready ISV Partner for Microsoft; and
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Microsoft has engaged us from time to time on various engineering service engagements.
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We work closely with Microsoft executives, developers, product managers and sales personnel. We leverage these relationships in a variety of ways, including:
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We gain early access to new Microsoft embedded software and other technologies;
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We are able to leverage co-marketing resources, content and strategies from Microsoft, including market development funds, to support our own marketing and sales efforts;
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We participate in Microsoft-sponsored trade shows, seminars, and other events;
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We receive sales leads from Microsoft; and
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We receive rebates from Microsoft based upon the achievement of predefined sales objectives.
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See Item 1A, “Risk Factors,” for more information regarding our relationship with Microsoft.
Sales and Marketing
We market our products and professional engineering services utilizing a direct sales model. We have sales personnel throughout the United States and in the United Kingdom. Historically, we have not made significant use of resellers, channel partners, representative agents or other indirect channels. We are investigating alternative ways to leverage existing relationships with AWS and Microsoft Azure, as well as developing new relationships with technology partners alongside our direct sales force to enhance our DataV sales efforts and initiatives.
Key elements of our sales and marketing strategy include direct marketing, content marketing, trade shows, event marketing, public relations, analyst relations, social media properties, customer and strategic alliance partner co-marketing programs and a comprehensive website.
Research and Development
During 2017, substantially all of our research and development personnel were dedicated to the design, development and release of DataV, and we expect this to continue to be the case for the foreseeable future. Members of our research and development staff work closely with our sales and marketing departments, as well as with our customers and potential customers,
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to better understand IIoT market n
eeds and requirements. We perform our research and development primarily utilizing engineering staff located in the United States. Research and development expense was $6.6 million and $2.9 million in 2017 and 2016, respectively.
Customers
Targeted customers for DataV include large industrial concerns that either manufacture capital assets, such as a heavy-duty commercial truck manufacturer, or rely on the widespread deployment of capital assets in the operation of their businesses, such as a large for-hire fleet operator. DataV customers may also include manufacturers incorporating DataV within their own offerings in order to enhance capabilities, such as an electric meter manufacturer developing smart grid technology for power utilities.
Customers purchasing third-party software and our other proprietary software solutions and professional engineering services include leading OEMs, ODMs, Enterprises, SVs and peripheral vendors. Representative customers include Hewlett Packard, Google, Coca-Cola, Elo Touch Solutions, Honeywell International, Inc., IGT, Microsoft, Mitsubishi Electric Corporation, Panasonic, Oracle, Omnicell, Elektrobit and several industrial handset companies.
Competition
The IIoT market is still emerging but is already becoming increasingly competitive. Our competitors in this space include, or we anticipate could include, the following:
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Large, established enterprise software and solution providers such as IBM, SAS, Oracle and SAP;
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Cloud IIoT providers such as AWS, Microsoft Azure, and General Electric (“GE”) Predix. Although we are closely partnered with AWS and Microsoft, there are elements of their solutions with which we compete directly;
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Mid-sized companies engaged in business transitions similar to our own, including PTC ThingWorx; and
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Startups funded to enter the IIoT market, including C3IOT and others.
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In addition, we anticipate that we will encounter increasing competition in the growing IIoT market from a number of additional software and service providers as we continue to expand our focus on this market in 2018 and beyond.
The market for device software and engineering services is extremely competitive. We face competition from the following:
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Our current and potential customers’ internal research and development departments, which may seek to develop their own software solutions which could compete with our proprietary software products and engineering services;
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Engineering service firms, including off-shore development companies, such as Adeneo, SymphonyTeleca and Wipro;
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ODMs, particularly those in Taiwan and China, with their own software development capabilities;
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Contract manufacturers with their own software development capabilities;
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Mobile and embedded test automation providers including Perfecto Mobile, mVerify, JAMO Solutions, SmartBear Software (AutomatedQA), TestPlant (eggPlant) and Keynote, as well as our customers’ and potential customers’ internally created tools and manual testing capabilities;
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Microsoft Windows Embedded and Windows Mobile operating system distributors such as Arrow Electronics, Inc. Avnet, Inc. and Synnex Corporation; and
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Marketing agencies and specialized vendors who provide mobile application services.
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Some of our competitors focus on only one aspect of our business or offer complementary products that can be integrated with our products. As we develop and bring to market new software products and service offerings, we may begin competing with companies with which we have not previously competed. Further, as we expand the geographic markets into which we sell our software solutions and related services, or increase our penetration therein, we may expect to increasingly compete with companies with which we have not previously competed. It is also likely that new competitors will enter the market or that our competitors will form alliances, including alliances with Microsoft or Amazon, that may enable them to rapidly increase their market share. New competitors may have lower overhead than we do and may be able to undercut our pricing. We expect that competition will increase as other established and emerging companies enter the connected device market, and as new products and technologies are introduced.
Neither Microsoft nor Amazon has agreed to any exclusive arrangement with us, nor has either agreed not to compete with us. Amazon may decide to focus on providing products or services that compete directly with our products and services or partnering with other solution providers that compete with us. Microsoft may decide to bring more of the core embedded development
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services and expertise that we provide in-house, possibly resulting in reduced software and service revenue opportunit
ies for us. The barrier to entering the market as a provider of Microsoft-based smart connected systems software and services is low. In addition, Microsoft has created marketing programs to encourage systems integrators to work on Windows Embedded and Win
dows Mobile operating system software and services. These systems integrators are given substantially the same access by Microsoft to Microsoft technology as we are.
International Operations
Our international operations outside of North America consist principally of engineering services operations in Taipei, Taiwan and Trowbridge, England. We have also maintained a sales and sales support office in Tokyo, Japan. Because our OEM Distribution Agreement with Microsoft for the sale of Microsoft Windows Embedded operating systems (e.g. Windows Embedded Compact) has previously been restricted to North America, the majority of our revenue continues to be generated from North America. In 2017, revenue generated from customers located outside of North America was 6% of total revenue, compared to 5% in 2016.
See Item 1A, “Risk Factors,” and Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” for more information regarding our international operations.
Personnel
Our headcount by area was as follows:
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December 31,
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2017
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2016
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Professional engineering services
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51
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78
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Sales, marketing and administrative
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78
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70
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Research and product development
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63
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21
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Total employees
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192
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169
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Contractors (primarily professional engineering services)
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6
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3
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Total headcount
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198
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172
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Of the total headcount at December 31, 2017, 147 were located in North America, 22 in Taiwan, 28 in the United Kingdom and one in Japan. As conditions necessitate, professional engineering service employees perform research and development activities and vice versa.
Intellectual Property and Other Proprietary Rights
In general, we strive to protect our intellectual property rights through patent, copyright, trademark and trade secret laws and through contractual arrangements. However, we cannot be certain that our efforts will be effective to prevent the misappropriation of our intellectual property, or to prevent the development and design by others of products or technologies similar to, or competitive with, those developed by us.
Additionally, because a significant portion of our revenue relates to the sale of third-party software products, we also rely on our partners, particularly Microsoft, to appropriately protect their own intellectual property.
As of January 31, 2018, we had fourteen pending United States (“US”) patent applications related to DataV, in addition to nine issued US patents related to other products and services. We also have a number of registered trademarks in various jurisdictions. We will continue to pursue appropriate protections for our intellectual property.
See Item 1A, “Risk Factors,” for more information regarding our intellectual property and other proprietary rights.
Available Information
We electronically file with or furnish to the Securities and Exchange Commission (“SEC”) our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. We make available on our website at www.bsquare.com, free of charge, copies of these reports, as soon as reasonably practicable after electronically filing such reports with, or furnishing them to the SEC. The information contained in, or that can be accessed through, our website is not part of, and is not incorporated into, this Annual Report on Form 10-K or any of our other reports filed with or furnished to the SEC.
As discussed under Item 1 of Part I, “Business—Cautionary Note Regarding Forward-Looking Statements,” our actual results could differ materially from those expressed in our forward-looking statements. Factors that might cause or contribute to such differences include, but are not limited to, those discussed below. Additional risks and uncertainties not presently known to us, or
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that we currently deem immaterial but later emerge as
material, may also impair our business operations. If any of the following risks occur, our business, financial condition, operating results, cash flows and the trading price of our common stock could be materially adversely affected.
DataV-Related Risk Factors
Beginning in early 2014, we initiated development efforts focused on new proprietary software products addressing the Industrial Internet of Things (IIoT) market. We launched our DataV solution, which includes software products, applications and services that are designed to render raw IIoT device data into meaningful and actionable data for our customers, late in the first quarter of 2016. Developing, selling and implementing DataV has become our primary focus, representing a transition away from dependence on resale software and professional engineering services toward increased reliance on our own proprietary software and related systems integration services. The following DataV-related risks may negatively impact our business and operating results.
Our ability to maintain and grow our proprietary software revenue is contingent on the success of DataV, our proprietary business-focused IIoT solution. If DataV fails to gain or maintain traction with potential customers, or if we are not otherwise successful in developing competitive, unique product and service offerings that keep pace with technological changes and needs, our business would be negatively impacted.
Proprietary software product revenue provides us with much higher gross profit margins than we typically receive from either our third-party software products or our engineering service offerings, and provides other advantages as well. During 2017 and 2016, we invested significant resources in developing and marketing our DataV proprietary IIoT solution, which includes software products, applications and services designed to render raw device data into meaningful and actionable data. Our DataV customer engagements typically commence with an initial proof-of-concept (POC) or pilot project, after which it is anticipated that customers will convert to a fully paid license of DataV products and services. However, as a relatively new solution, DataV may gain customer traction more slowly than anticipated, or not at all. We may be unsuccessful in converting customers from POCs and pilots to fully paid licenses, and our revenue and profit potential is uncertain. We expect to continue to make significant investments in the development and marketing of DataV, and this will increase our operating expenses. There can be no assurance that there will be sufficient revenue generated by sales of DataV, or that it will achieve customer adoption quickly, or at all. Its failure would materially and adversely impact our revenue and operating results.
The IIoT is an emerging market, and there can be no assurance that the IIoT market will evolve as we expect, or that we will be successful in capitalizing on opportunities in this market.
We are currently devoting significant effort and resources to develop and launch our DataV solution to customers within the IIoT market. IIoT is an emerging and evolving market with many potential industry participants and customers, as well as undefined market opportunities and risks. This market may not materialize as we anticipate, and our efforts to capitalize on these opportunities may not be successful in the near term, or at all. If the IIoT market does not materialize as we anticipate, or if our products and services do not achieve market acceptance, our business, financial condition, and operating results would be adversely affect, any of which would likely cause our stock price to decline.
Transitioning our primary business from reselling software and professional engineering services to developing, marketing and selling our own proprietary DataV software and related systems integration services represents a significant shift of corporate focus and resources, and the failure to make this transition successfully would significantly harm our business and operating results.
The ongoing transition of our business to developing, marketing and selling our own proprietary DataV solution is subject to a number of significant risks, including:
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The significant investment of time and financial and other corporate resources;
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The uncertainty and lack of predictability of a new and evolving market;
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The relative experience of our management team with different market strategies and expertise of our employees with new technologies; and
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Customer acceptance of our proprietary solutions.
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Our failure to address these and other risks during this transition would have a material adverse effect on our business and results of operations.
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The long sales cycl
e of our products and services makes our revenue susceptible to fluctuations.
Our sales cycle can run six to eighteen months because the expense and complexity of the software and service offerings we sell generally require a lengthy customer approval process and may be subject to a number of significant risks over which we have little or no control, including:
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Customers’ budgetary constraints and internal acceptance review procedures;
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The effects of economic uncertainties;
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The timing of budget cycles; and
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The timing of customers’ competitive evaluation processes.
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In addition, to successfully sell our software and engineering service offerings, we must frequently educate our potential customers about the full benefits of our software and services, including through the implementation of POCs or pilot programs, all of which can require significant time and expense. This is particularly true given the early stage of the IIoT market. If our sales cycle further lengthens unexpectedly, or if we are unsuccessful in converting customers from POCs and pilots to fully paid licenses, it could adversely affect the timing of our revenue, which could cause our quarterly results to fluctuate.
Our DataV operating results fluctuate, and if we fail to meet the expectations of analysts or investors, our stock price could decline substantially.
Our DataV operating results fluctuate and are expected to continue to fluctuate. Some of the important factors that may cause our DataV operating results to fluctuate include the following:
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The uncertainty and lack of predictability of the new and evolving IIoT market;
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The extent of customer acceptance of our DataV solution;
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The degree of conversion of customers from POCs and pilots to fully paid DataV licenses; and
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The timing of recognition of DataV product and services revenue.
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These and other factors make it difficult to forecast our quarterly and annual financial results. Many of these factors are not within our control, and the occurrence of one or more of them might cause our operating results to fluctuate and vary widely from our financial forecasts. As such, we believe that quarter-to-quarter comparisons of our operating results may not be meaningful and should not be relied upon as an indication of future performance. Moreover, we may also fail to meet or exceed the expectations of securities analysts or investors, and the market price of our common stock could decline.
If our security measures or those of third-party data center hosting facilities, cloud computing platform providers, or other service partners are breached or unauthorized access is otherwise obtained to our customers’ data, our data or our information technology (“IT”) systems, our or our customers’ confidential or personal information may be compromised or misappropriated, our products and services offerings may be perceived as not being secure, customers may curtail or stop using our products and services, and we may incur significant legal and financial liability.
Our products and services involve the storage and transmission of customers’ proprietary data and personal information, and security breaches could result in a risk of loss of this data or information, litigation and possible liability. While we have security measures in place, they may be breached as a result of third-party action, including intentional misconduct by computer hackers, employee error, malfeasance or otherwise and result in someone obtaining unauthorized access to our IT systems, our customers’ data or our data, including our intellectual property and other confidential business information. Additionally, third parties may attempt to fraudulently induce employees or customers into disclosing sensitive personal information such as user names, passwords or other information in order to gain access to our customers’ data, our data or our IT systems. Because the techniques used to obtain unauthorized access, or to sabotage systems, change frequently and generally are not recognized until launched against a target, we may be unable to anticipate these techniques or to implement adequate preventative measures. In addition, our customers may authorize third-party technology providers to access their customer data, and some of our customers may not have adequate security measures in place to protect their data. Because we do not control the IT security of our customers or third-party technology providers, or of the processing of such data by third-party technology providers, we cannot ensure the integrity or security of such transmissions or processing. Malicious third parties may also conduct attacks designed to temporarily deny customers access to our products and services. Any security breach could result in a loss of confidence in the security of our products and services, damage our reputation, negatively impact our future sales, disrupt our business and lead to legal liability.
Interruptions or delays in services from third-party data center hosting facilities or cloud computing platform providers could impair the delivery and availability of our products and services and harm our business.
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We currently serve certain of our customers through third-party data center hosting facilities and cloud computing platform providers located in the United States and other countries. Any da
mage to, or failure of, these systems generally could result in interruptions in the availability of our products and services. We have from time to time experienced, and may continue to experience, such interruptions, which could cause us to issue credits
or pay penalties, cause customers to terminate their subscriptions, and adversely affect our customer attrition rates and our ability to attract new customers, all of which would reduce our revenue. Our business would also be harmed if our customers and p
otential customers believe our product and services offerings are unreliable.
Despite contract provisions to protect us, customers may look to us to support and provide warranties for these third-party systems, which may expose us to potential claims, liab
ilities and obligations for technology or services we did not develop or sell, all of which could harm our business. Further, third-party software and cloud platforms that we currently or may in the future utilize may not continue to be available at reason
able prices, on commercially reasonable terms, or may become unavailable. Any of these outcomes could significantly increase our expenses and result in delays in the provisioning of our products and services until we are able to procure alternative solutio
ns, either by developing equivalent technology or, if available, obtaining such technology through purchase or license from other third parties.
We do not control the operation or security of any of these hosting facilities or cloud computing platforms, and they may be vulnerable to damage or interruption from earthquakes, floods, fires, power loss, telecommunications failures and similar events. They may also be subject to break-ins, sabotage, intentional acts of vandalism and similar misconduct, as well as local administrative actions, changes to legal or permitting requirements and litigation to stop, limit or delay operation. Despite precautions taken by providers of these facilities and platforms, the occurrence of a natural disaster or an act of terrorism, a decision to close the facilities or platforms without adequate notice or other unanticipated problems at these facilities or platforms could result in lengthy interruptions in or cessation of our services.
Privacy concerns and laws, evolving regulation of cloud computing, cross-border data transfer restrictions and other domestic or foreign regulations may limit the use and adoption of our products and services and adversely affect our business.
Regulation related to the provision of services on the internet is evolving and increasing, as federal, state and foreign governments continue to adopt new laws and regulations addressing data privacy and the collection, processing, storage and use of personal information, such as the E.U.’s Data Protection Directive and General Data Protection Regulation (“GDPR”). Further, laws and regulations are increasingly aimed at the use of personal information for marketing purposes, such as the E.U.’s ePrivacy Directive and ePrivacy Regulation. Country-specific laws and regulations are subject to new and differing interpretations and may be inconsistent among jurisdictions. Existing laws and regulations, as well as future requirements, could reduce demand for our products and services or restrict our ability to store and process data or, in some cases, impact our ability to offer our products and services in certain locations or our customers' ability to deploy our solutions globally. The costs of compliance with and other burdens imposed by laws, regulations and standards such as GDPR may also limit the use and adoption of our products and services, reduce overall demand for our products and services, lead to significant fines, penalties or liabilities for noncompliance, or slow the pace at which we close sales transactions, any of which could harm our business. Furthermore, concerns regarding data privacy may cause our customers’ customers to resist providing the data necessary to allow our customers to use our products and services effectively. Even the perception that the privacy of personal information is not satisfactorily protected or does not meet regulatory requirements could inhibit sales of our products and services, and could limit adoption of our cloud-based solutions.
Microsoft-Related Risk Factors
Because we provide software and services to customers building devices utilizing Microsoft’s Windows Embedded and Windows Mobile operating systems, as well as the fact that a significant portion of our revenue is derived from the sale of Microsoft Windows Embedded and Windows Mobile operating systems, Microsoft has a significant direct and indirect influence on our business. The following Microsoft-related risks may negatively impact our business and operating results.
If we do not maintain our OEM Distribution Agreements with Microsoft or if Microsoft de-emphasizes or divests itself from these areas of its business, our revenue would decrease and our business would be adversely affected.
We have OEM Distribution Agreements (“ODAs”) for Software Products for Embedded Systems with Microsoft, which enable us to sell various Microsoft Windows Embedded operating systems to our customers in the United States, Canada, the Caribbean (excluding Cuba), Mexico, the E.U. and the European Free Trade Association. These ODAs are effective through June 30, 2018 and are typically renewed annually or bi-annually. We have also entered into ODAs with Microsoft pursuant to which we are licensed to sell Microsoft Windows Mobile operating systems to customers in North America, South America, Central America (excluding Cuba), Japan, Taiwan, Europe, the Middle East, and Africa. The ODAs to sell Windows Mobile operating systems are effective through June 30, 2018 and are typically renewed annually or bi-annually.
We generated $64.4 million and $78.8 million of revenue in 2017 and 2016, respectively, through our sales of Microsoft operating systems and expect this revenue stream to continue in 2018. If any of the ODAs are terminated by Microsoft (which
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Microsoft can do unilaterally) or not ren
ewed, or if Microsoft decides to no longer invest in or to divest itself from these areas of its business, our third-party software revenue and resulting gross profit could decrease significantly and our operating results would be negatively impacted. Futu
re renewals by Microsoft, if any, could be on less favorable terms, which could also negatively impact our business and operating results.
Microsoft can change pricing under the ODAs at any time, and unless we are able to pass through price increases to our customers, our revenue, gross profit and operating results would be negatively impacted. Further, Microsoft currently offers a rebate program in conjunction with our ODA activities in which we earn money for achieving certain predefined objectives. If Microsoft were to eliminate or negatively modify the rebate program, our gross profit and operating results would be negatively impacted. We qualified for rebate credits from Microsoft of $1.7 million and $1.2 million in 2017 and 2016, respectively, a portion of which is accounted for as a reduction in cost of sales and a portion as a reduction in marketing expense if and when qualified expenditures are made.
Our business and results of operations could be negatively impacted by changes Microsoft implements in its pricing of its operating systems.
Microsoft implemented significant pricing changes for its operating systems products, including ending its design registration pricing discounts, terminating its OEM Volume Royalty Program (“OVRP”) and changing the aggregate volume price structure and product royalties for existing Windows Embedded products effective January 1, 2016, and Microsoft could make further pricing changes in the future. These changes have altered the competitive dynamics because the same pricing discounts are available to all distributors of these Microsoft products. As a distributor of Microsoft products, this impacts both the sales prices we charge our customers and the cost of goods sold we incur for many of the Microsoft products we sell. The amount and impact of these changes to our revenue and gross profit are not determinable; however, they may negatively impact our operating results in future reporting periods. The sale of Microsoft operating systems represented approximately 80% and 81% of our total revenue and approximately 54% and 74% of our total gross margin for the years ended December 31, 2017 and 2016, respectively.
Microsoft has audited our records under the ODAs in the past and may audit our records again in the future, and any negative audit results could result in additional charges and/or the termination of the ODAs.
There are provisions in the ODAs that require us to maintain certain internal records and processes for auditing purposes. Non-compliance with these or other contractual requirements could result in the termination of the ODAs. Microsoft concluded audits of our records pertaining to the ODAs in 2009 and 2006, neither of which had material findings. It is possible that future audits could result in charges due to any material findings that are found. The ODA provisions also include terms that may make us contractually liable for payment of royalties to Microsoft in the event that certificates of authenticity are lost, damaged or stolen.
Our business and results of operations would be adversely impacted if Microsoft decided to provide Windows Embedded or Windows Mobile operating systems free of charge to customers.
Microsoft offers certain consumer Windows phone and tablet-based operating systems to customers free of charge, subject to certain limitations. While we do not distribute these operating systems today under our ODAs with Microsoft, if Microsoft were to offer, free of charge, operating systems that we do distribute, our business and results of operations would be adversely impacted.
If the markets for Windows Embedded and/or Windows Mobile operating systems decline, our business and operating results would be materially harmed.
Because a significant portion of our revenue to date has been generated by software and services targeted at customers and devices running various Microsoft Windows Embedded and Windows Mobile operating systems, if the markets for these systems decline, our business and operating results would be negatively impacted. Continued market acceptance of Microsoft Windows Embedded and Windows Mobile operating systems will depend on many factors, including:
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Microsoft’s development and support of various Windows Embedded and Windows Mobile markets. As the developer and primary promoter of Windows Embedded and Windows Mobile operating systems, if Microsoft were to decide to discontinue or lessen its support of these operating systems, potential customers could select competing operating systems, which could reduce the demand for our Microsoft Windows Embedded and Windows Mobile software products and engineering services, from which a significant portion of our revenue continues to be generated;
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The ability of the Microsoft Windows Embedded and Windows Mobile operating systems to compete against existing and emerging operating systems for the smart connected systems market, including: iOS from Apple, Inc., VxWorks and Linux from WindRiver Systems Inc.; Android from Google Inc.; QNX from BlackBerry Limited; and other proprietary operating systems. Microsoft Windows Embedded and Windows Mobile operating systems may be unsuccessful in capturing or retaining a significant share of the smart connected systems market in the future;
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The acceptance by customers of the mix of features and functions offered by Microsoft Windows Embedded and Windows Mobile operating systems; and
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The willingness of software developers to continue to develop and expand the applications running on Microsoft Windows Embedded and Windows Mobile operating systems. To the extent that software developers write applications for competing operating systems that are more attractive to users than those available on Microsoft Windows Embedded and Windows Mobile operating systems, this could cause potential customers to select competing operating systems.
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General Business-Related Risk Factors
Our marketplace is extremely competitive, which may result in price reductions, lower gross profit margins and loss of market share.
The IIoT market is still emerging but is already becoming increasingly competitive. Our competitors in this space include, or we anticipate could include, the following:
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Large, established enterprise software and solution providers such as IBM, SAS, Oracle and SAP;
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Cloud IIoT providers such as AWS, Microsoft Azure, and GE Predix. Although we are closely partnered with AWS and Microsoft, there are elements of their solutions with which we compete directly;
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Mid-sized companies engaged in business transitions similar to our own, including PTC ThingWorx; and
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Startups funded to enter the IIoT market, including C3IoT and others.
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In addition, we anticipate that we will encounter increasing competition in the growing IIoT market from a number of additional software and service providers as we continue to expand our focus on this market in 2018 and beyond.
The market for device software and engineering services is extremely competitive. We face competition from the following:
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Our current and potential customers’ internal research and development departments, which may seek to develop their own software solutions which could compete with our proprietary software products and engineering services;
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Engineering service firms, including off-shore development companies, such as Adeneo, SymphonyTeleca and Wipro;
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ODMs, particularly those in Taiwan and China, with their own software development capabilities;
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Contract manufacturers with their own software development capabilities;
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Mobile and embedded test automation providers including Perfecto Mobile, mVerify, JAMO Solutions, SmartBear Software (AutomatedQA), TestPlant (eggPlant) and Keynote, as well as our customers’ and potential customers’ internally created tools and manual testing capabilities;
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Microsoft Windows Embedded and Windows Mobile operating system distributors such as Arrow Electronics, Inc. Avnet, Inc. and Synnex Corporation; and
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Marketing agencies and specialized vendors who provide mobile application services.
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Some of our competitors focus on only one aspect of our business or offer complementary products that can be integrated with our products. As we develop and bring to market new software products and service offerings, we may begin competing with companies with which we have not previously competed. Further, as we expand the geographic markets into which we sell our software solutions and related services, or increase our penetration therein, we may expect to increasingly compete with companies with which we have not previously competed. It is also likely that new competitors will enter the market or that our competitors will form alliances, including alliances with Microsoft or Amazon, that may enable them to rapidly increase their market share. New competitors may have lower overhead than we do and may be able to undercut our pricing. We expect that competition will increase as other established and emerging companies enter the connected device market, and as new products and technologies are introduced.
Neither Microsoft nor Amazon has agreed to any exclusive arrangement with us, nor has either agreed not to compete with us. Amazon may decide to focus on providing products or services that compete directly with our products and services or partnering with other solution providers that compete with us. Microsoft may decide to bring more of the core embedded development services and expertise that we provide in-house, possibly resulting in reduced software and service revenue opportunities for us. The barrier to entering the market as a provider of Microsoft-based smart connected system software and services is low. In addition, Microsoft has created marketing programs to encourage systems integrators to work on Windows Embedded and Windows Mobile
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operating system software and services. These systems integrators are given substantially the same access by Microsoft to Microsoft technology as we are.
Management turnover creates uncertainties and could harm our business.
We have had significant changes in executive leadership in the past and more could occur. Changes to strategic or operating goals, which can often occur with the appointment of new executives, can create uncertainty, may negatively impact our ability to execute quickly and effectively, and may ultimately be unsuccessful. In addition, executive leadership transition periods are often difficult as the new executives gain detailed knowledge of our operations, and friction can result from changes in strategy and management style. Management turnover inherently causes some loss of institutional knowledge, which can negatively affect strategy and execution. Until we integrate new personnel, and unless they are able to succeed in their positions, we may be unable to successfully manage and grow our business, and our financial condition and profitability may suffer.
Further, to the extent we experience additional management turnover, competition for top management is high and it may take months to find a candidate that meets our requirements. If we are unable to attract and retain qualified management personnel, our business could suffer.
Because competition for technology industry employees is intense, we may not be able to attract and retain the highly skilled employees we need to support our operations and grow our business.
In the technology industry generally, and in the greater Seattle area in particular, there is intense competition for software engineers, as well as for technology sales and operations personnel. We may not be successful in attracting or retaining such qualified personnel. If we fail to attract new personnel or to retain and motivate our current personnel, our business would be harmed.
We depend on our direct sales force to achieve planned revenue growth in the future, and if our sales force is not successful, our financial condition will be harmed.
We sell our solutions primarily through our direct sales force. Our ability to achieve planned revenue growth in the future will depend upon the success of our direct sales force and our ability to adapt our sales efforts to address the evolving markets for our solutions. If our direct sales force does not perform as expected, our business, financial condition, and operating results could be adversely affected.
Our operating results may be adversely affected by changing economic and market conditions and the uncertain geopolitical environment.
Uncertain economic and political conditions in the U.S. and worldwide have from time to time contributed, and may continue to contribute, to volatility in the technology industries at large, particularly in an emerging market such as IIoT. These factors could potentially result in reduced demand for our products and services as a result of constraints on IT-related capital spending by our customers; purchasing delays; payment delays adversely affecting our cash flow and revenue; and difficulty in accurate budgeting and planning. If global economic and market conditions, or economic conditions in key markets, remain uncertain or deteriorate, we may experience material impacts on our business, operating results and financial condition.
Our business and operations would be adversely impacted in the event of a failure or interruption of our IT infrastructure.
The proper functioning of our own IT infrastructure is critical to the efficient operation and management of our business. Our IT is vulnerable to cyberattacks, computer viruses, worms and other malicious software programs, physical and electronic break-ins, sabotage and similar disruptions from unauthorized tampering with our computer systems. We believe that we have adopted appropriate measures to mitigate potential risks to our technology infrastructure and our operations from these IT-related and other potential disruptions. However, given the unpredictability of the timing, nature and scope of such disruptions, we could potentially be subject to downtimes, operational delays, other detrimental impacts on our operations or ability to provide products and services to our customers, the compromising of confidential or personal information, destruction or corruption of data, security breaches, other manipulation or improper use of our systems and networks, financial losses from remedial actions, loss of business or potential liability, and/or damage to our reputation, any of which could have a material adverse effect on our cash flows, competitive position, financial condition or results of operations.
We may be subject to product liability, infringement or other legal claims that could result in significant costs.
Our software license and service agreements with our customers typically contain provisions designed to limit our exposure to potential product liability, infringement and other legal claims. It is possible, however, that these provisions may be ineffective under the laws of certain jurisdictions or that our customers may not agree to these limitations. Although we have not experienced any product liability or infringement claims to date, as our business focus continues to transition to the sale of our own proprietary products, the sale and support of our products and services may be subject to such claims in the future. There is a risk that any such
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claims or liabilities may exceed, or fall outside
, the scope of our insurance coverage, and we may be unable to obtain adequate liability insurance in the future. A product liability, infringement or other legal claim brought against us, whether successful or not, could negatively impact our business and
operating results.
Our business and results of operations would be adversely impacted in the event that we incur business losses that are not covered by or exceed our existing business insurance coverage.
We are insured against certain business risks and liabilities under our corporate insurance policies. However, to the extent that we incur losses in connection with our business that are not covered by our existing insurance policies or that exceed our existing policy coverage, our business and results of operations would be adversely impacted.
Negative business conditions, changes in useful lives, and other factors may negatively affect the carrying value of the intangible assets and goodwill we have acquired.
We evaluate goodwill and intangible assets for impairment on an annual basis or more frequently when an event occurs or circumstances change that indicate that the carrying value may not be recoverable. Reductions in operating cash flows or projected cash flows of our reporting units could result in an impairment charge that would negatively impact our operating results. Further, business conditions and other factors may also require us to reassess the useful lives associated with intangible assets.
Past acquisitions have proven difficult to integrate, and future acquisitions, if any, could disrupt our business, dilute shareholder value and negatively affect our operating results and may not accrete to our revenue or other operating results or to our business generally.
We have acquired the technologies, assets and/or operations of other companies in the past and may acquire or make investments in companies, products, services and technologies in the future as part of our growth strategy. If we fail to properly evaluate, integrate and execute on our acquisitions and investments, our business and prospects may be seriously harmed. In addition, acquisitions may not be as accretive to our revenue or other operating results as expected. To successfully complete an acquisition, we must properly evaluate the business, technology, market and management team of the acquisition target, accurately forecast the financial impact of the transaction, including accounting charges and transaction expenses, integrate and retain personnel, combine potentially different corporate cultures and effectively integrate products, research and development, sales, marketing and support operations. If we fail to do any of these, we may suffer losses and impair relationships with our employees, customers and strategic partners. Additionally, acquisition activities may distract management from day-to-day operations. We also may be unable to maintain consistently uniform standards, controls, procedures and policies across our entire business as a result, and significant additional demands may be placed on our management and our operations, information services and financial, legal and marketing resources. Finally, acquired businesses may result in unexpected liabilities and contingencies, which may involve compliance with foreign laws, payment of taxes, labor negotiations or other unknown costs and expenses, which could be significant.
We may not be able to access our existing credit facility or raise additional capital if required to support our business, and the issuance of additional equity or convertible debt securities would result in the dilution of our existing shareholders.
Our continuing investment in our DataV business has resulted in a decrease in our cash, cash equivalents and investments from approximately $33.2 million at December 31, 2016 to approximately $24.8 million at December 31, 2017, and we expect to continue making ongoing investments in our DataV business for the foreseeable future. In addition, Honeywell International, Inc. had accounts receivable balances of approximately $7.1 million at December 31, 2016 and $8.7 million at December 31, 2017 with net 270-day payment terms, which limits our ability to access these funds on a more current basis. If we need to raise additional operating capital, it may be difficult and costly to access the public equity and debt capital markets. In the past, our stock has traded at low volumes and overall investor confidence in the stock market could falter. This could make it difficult or impossible to sell additional shares of our stock in the public market. In addition, we may not be able to access our existing credit facility if we are not in compliance with certain financial and other covenants, and it may be difficult and costly to obtain additional commercial debt financing and we may be unable to borrow additional funds at acceptable cost, or at all, should the need arise. If we are unable to raise capital as necessary, it may adversely affect our ability to invest in products or fund operations, which would materially harm our business and negatively affect operating results. If we decide to raise additional funds by issuing equity or convertible debt securities, the ownership percentages of our existing shareholders would be reduced.
Our common stock has experienced and may continue to experience price and volume fluctuations, which could lead to costly litigation for us and make an investment in us less appealing.
Stock markets are subject to significant price and volume fluctuations that may be unrelated to the operating performance of particular companies and the market price of our common stock may therefore frequently change as a result. In addition, the market price of our common stock has fluctuated and may continue to fluctuate substantially due to a variety of other factors,
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including quarterly fluctuations in our results of operations (including as a result of fluctuations in our revenue recognition), announcements about technological innovations or new products or services by us or our competitors, market acceptance o
f new products and services offered by us, developments in the IIoT market, changes in our relationships with our suppliers or customers, our ability to meet analysts’ expectations, changes in the information technology environment, changes in earnings est
imates by analysts, sales of our common stock by existing holders and the loss of key personnel. In the past, following periods of volatility in the market price of a company’s stock, class action securities litigation has often been instituted against suc
h companies. Such litigation, if instituted against us, could result in substantial costs and diversion of management’s attention and resources, which would materially adversely affect our business, financial condition and operating results.
We could become subject to taxation in jurisdictions in which we do not believe we currently have tax nexus, which could expose us to additional tax liability that we have not been subject to in the past.
We make sales in many jurisdictions across the United States. We believe we do not have nexus in most of these jurisdictions and, therefore, we believe we are not subject to sales, franchise, income and other state and local taxes in such jurisdictions. However, if we are determined to have tax nexus in other jurisdictions (as a result of more aggressive interpretations of nexus by taxing jurisdictions or otherwise) and we are unable to pass through this cost to our customers, our tax expense will increase which will negatively affect our results of operations. Further, because state and local tax laws are becoming increasingly complex, we anticipate that our cost to monitor our state and local tax compliance will increase which will negatively affect our results of operations. Additionally, there can be no assurance that we do not currently have unknown tax exposure in a state or local tax jurisdiction because of recent tax law changes of which we are unaware and the resulting liability could be significant and would negatively affect our results of operations.
There may be restrictions on the use of our net operating loss and tax credit carryforwards due to a tax law “ownership change.”
Sections 382 and 383 of the U.S. Internal Revenue Code restrict the ability of a corporation that undergoes an ownership change to use net operating loss and tax credit carryforwards. At December 31, 2017, we had approximately $61.6 million of federal and $4.4 million of state net operating loss carryforwards and $3.0 million of tax credit carryforwards. Of the federal net operating loss carryforwards, an aggregate of $36.3 million will expire in 2022 and 2023. Under the applicable tax rules, an ownership change occurs if greater than five percent shareholders of an issuer’s outstanding common stock collectively increase their ownership percentage by more than 50 percentage points over a rolling three-year period. We have performed analyses of possible ownership changes which included consideration of a third-party study, and do not believe that an ownership change as defined by Section 382 has occurred. However, if a tax law ownership change has occurred of which we are not aware, or if a tax law ownership change occurs in the future, we may have to adjust the valuation of our deferred tax assets, and could be at risk of having to pay income taxes notwithstanding the existence of our sizable carryforwards. Further, to the extent that we have utilized our carryforwards from prior years, the existence of a previous tax law ownership change that we did not account for could result in liability for back taxes, interest, and penalties. If we are unable to utilize our carryforwards and/or if we previously utilized carryforwards to which we were not entitled, it would negatively impact our business, financial condition and operating results.
Changes in our effective tax rate may impact our results of operations.
We are subject to taxes in the U.S. and other jurisdictions. Tax rates in these jurisdictions may be subject to significant change due to economic and/or political conditions. A number of other factors may also impact our future effective tax rate including:
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the jurisdictions in which profits are determined to be earned and taxed;
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the resolution of issues arising from tax audits with various tax authorities;
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changes in valuation of our deferred tax assets and liabilities;
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increases in expenses not deductible for tax purposes, including write-offs of acquired intangibles and impairment of goodwill in connection with acquisitions;
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changes in availability of tax credits, tax holidays, and tax deductions;
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changes in share-based compensation; and
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changes in tax laws or the interpretation of such tax laws and changes in generally accepted accounting principles.
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On December 22, 2017, the President signed into law new legislation that significantly revises the Internal Revenue Code of 1986, as amended. The newly enacted federal income tax law, among other things, contains significant changes to corporate taxation, including reduction of the corporate tax rate from a top marginal rate of 35% to a flat rate of 21% beginning in 2018, limitation of the tax deduction for interest expense to 30% of adjusted earnings, limitation of the deduction for net operating losses to 80% of current year taxable income and elimination of net operating loss carrybacks, one time taxation of offshore earnings at
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reduced rates regardless of whether they are repatriated, immediate deductions for certain new investments instead of deductions
for depreciation expense over time, and modifying or repealing many business deductions and credits (including reducing the business tax credit for certain clinical testing expenses incurred in the testing of certain drugs for rare diseases or conditions)
. Notwithstanding the reduction in the corporate income tax rate, the overall impact of the new federal tax law is uncertain and our business and financial condition could be adversely affected. In addition, it is uncertain if and to what extent various st
ates will conform to the newly enacted federal tax law. The impact of this tax reform on holders of our common stock is also uncertain and could be adverse.
We urge our stockholders to
consult with their legal and tax advisors with respect to this legislat
ion and the potential tax consequences of investing in or holding our common stock.
Intellectual Property-Related Risk Factors
Our software and service offerings could infringe the intellectual property rights of third parties, which could expose us to additional costs and litigation and could adversely affect our ability to sell our products and services or cause shipment delays or stoppages.
It is difficult to determine whether our software products, including DataV, and engineering services infringe third-party intellectual property rights, particularly in a rapidly evolving technological environment in which technologies often overlap and where there may be numerous patent applications pending, many of which are confidential when filed. If we were to discover that one of our software products or service offerings, or a product based on one of our reference designs, violated a third party’s proprietary rights, we may not be able to obtain a license on commercially reasonable terms, or at all, to continue offering that product or service. Similarly, third parties may claim that our current or future software products and services infringe their proprietary rights, regardless of whether such claims have merit. Any such claims could increase our costs and negatively impact our business and operating results. In certain cases, we have been unable to obtain indemnification against claims that third-party technology incorporated into our software products and services infringe the proprietary rights of others. However, any indemnification we do obtain may be limited in scope or amount. Even if we receive broad third-party indemnification, these entities may not have the financial capability to indemnify us in the event of infringement. In addition, in some circumstances we are required to indemnify our customers for claims made against them that are based on our software products or services. There can be no assurance that infringement or invalidity claims related to the software products and services we provide, or arising from the incorporation by us of third-party technology, and claims for indemnification from our customers resulting from such claims, will not be asserted or prosecuted against us. Some of our competitors have, or are affiliated with companies with, substantially greater resources than we have, and these competitors may be able to sustain the costs of complex intellectual property litigation to a greater degree and for longer periods of time than we could. In addition, we expect that software developers will be increasingly subject to infringement claims as the number of products and competitors in the software industry grows, and as the functionality of products in different industry segments increasingly overlap. Such claims, even if not meritorious, could result in the expenditure of significant financial and managerial resources in addition to potential product redevelopment costs and delays. Furthermore, if we were unsuccessful in resolving a patent or other intellectual property infringement action claim against us, we may be prohibited from developing or commercializing certain of our technologies and products, or delivering services based on the infringing technology, unless we obtain a license from the holder of the patent or other intellectual property rights. There can be no assurance that we would be able to obtain any such license on commercially favorable terms, or at all. If such license were not obtained, we would be required to cease these related business operations, which could negatively impact our business, revenue and operating results.
If we fail to adequately protect our intellectual property rights, competitors may be able to use our technology or trademarks, which could weaken our competitive position, reduce our revenue and increase our costs.
If we fail to adequately protect our intellectual property, our competitive position could be weakened and our revenue and operating results adversely affected. We rely primarily on confidentiality policies and procedures and contractual provisions as well as a combination of patent, copyright, trade secret and trademark laws, to protect our intellectual property. These laws, policies and procedures provide only limited protection. It is possible that another party could obtain patents that block our use of some, or all, of our software products and services, including DataV. If that occurred, we would need to obtain a license from the patent holder or design around those patents. The patent holder may or may not choose to make a license available to us on acceptable terms, or at all. Similarly, it may not be possible to design around a blocking patent. In general, there can be no assurance that our efforts to protect our intellectual property rights through patent, copyright, trade secret and trademark laws will be effective to prevent misappropriation of our technology, or to prevent the development and design by others of products or technologies similar to or competitive with those developed by us.
We frequently license our computer source code to customers. There can be no assurance that customers with access to our source code will comply with the license terms or that we will discover any violations of the license terms or, in the event of discovery of violations, that we will be able to successfully enforce the license terms and/or recover the economic value lost from
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such violations. To license some of our software products, we rely in part on “shrink-wrap” and “click wrap” licenses that are not signed by the end user and, theref
ore, may be unenforceable under the laws of certain jurisdictions. As with other software, our software products are susceptible to unauthorized copying and uses that may go undetected, and policing such unauthorized use is difficult. A significant portion
of our marks include the word “BSQUARE.” Other companies use forms of “BSQUARE” in their marks alone, or in combination with other words, and we cannot prevent all such third-party uses. We license certain trademark rights to third parties. Such licensees
may not abide by our compliance and quality control guidelines with respect to such trademark rights. Any of these outcomes could negatively impact our brand, dilute its recognition in the marketplace, or confuse potential customers, all of which could ha
rm our business.
The computer software market is characterized by frequent and substantial intellectual property litigation, which is often complex and expensive, and involves a significant diversion of resources and uncertainty of outcome. Litigation may be necessary in the future to enforce our intellectual property or to defend against a claim of infringement or invalidity. Litigation could result in substantial costs and the diversion of resources and could negatively impact our business and operating results.
Our software or hardware products or the third-party hardware or software integrated with our products or delivered as part of our service offerings may suffer from defects or errors that could impair our ability to sell our products and services.
Software and hardware components as complex as those needed for dedicated purpose intelligent systems frequently contain errors or defects, especially when first introduced or when new versions are released. We have had to delay commercial release of certain versions of our products until problems were corrected and, in some cases, have provided product enhancements to correct errors in released products. Some of our contracts require us to repair or replace products that fail to work. To the extent that we repair or replace products, our expenses may increase. In addition, it is possible that by the time defects are fixed, the market opportunity may decline which may result in lost revenue. Moreover, to the extent that we provide increasingly complex and comprehensive products and services, particularly those focused on IIoT hardware, and rely on third-party manufacturers and suppliers to manufacture these products, we will be dependent on the ability of such third-party manufacturers and suppliers to correct, identify and prevent manufacturing errors or defects. Errors or defects that are discovered after commercial release could result in loss of revenue or delay in market acceptance, diversion of development resources, damage to our reputation and increased service and warranty costs, all of which could negatively impact our business and operating results.
If we are unable to license key software from third parties, our business could be harmed.
We sometimes integrate third-party software with our proprietary software and engineering service offerings or sell such third-party software offerings on a standalone basis (e.g. Microsoft Windows Embedded and Mobile operating systems under our ODAs with Microsoft). If our relationships with these third-party software vendors were to deteriorate, or be eliminated in their entirety, we might be unable to obtain licenses on commercially reasonable terms, if at all. In the event that we are unable to obtain these third-party software offerings, we would be unable to continue to generate revenue from our reseller relationships or, with respect to our proprietary software and engineering services offerings, we would be required to develop this technology internally, assuming it was economically or technically feasible, or seek similar software offerings from other third parties assuming there were competing offerings in the marketplace, which could delay or limit our ability to introduce enhancements or new products, or to continue to sell existing products and engineering services, thereby negatively impacting our revenue and operating results.
Governance-Related Risk Factors
It might be difficult for a third party to acquire us even if doing so would be beneficial to our shareholders.
Certain provisions of our articles of incorporation, bylaws and Washington law may discourage, delay or prevent a change in the control of us or a change in our management, even if doing so would be beneficial to our shareholders. Our Board of Directors has the authority under our articles of incorporation to issue preferred stock with rights superior to the rights of the holders of common stock. As a result, preferred stock could be issued quickly and easily with terms calculated to delay or prevent a change in control of our company or make removal of our management more difficult. In addition, our Board of Directors is divided into three classes. The directors in each class serve for three-year terms, one class being elected each year by our shareholders. This system of electing and removing directors may discourage a third party from making a tender offer or otherwise attempting to obtain control of our company because it generally makes it more difficult for shareholders to replace a majority of our directors. In addition, Chapter 19 of the Washington Business Corporation Act generally prohibits a “target corporation” from engaging in certain significant business transactions with a defined “acquiring person” for a period of five years after the acquisition, unless the transaction or acquisition of shares is approved by a majority of the members of the target corporation’s Board of Directors prior to the time of acquisition. This provision may have the effect of delaying, deterring or preventing a change in control of our company. The existence of these anti-takeover provisions could also limit the price that investors might be willing to pay in the future for shares of our common stock.
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International Operations-Related Risk Factors
Our international operations expose us to greater intellectual property, management, collections, regulatory and other risks.
Customers outside of North America generated 6% of our total revenue in 2017 and 5% in 2016. We currently have sizable operations outside of North America in Taiwan and the United Kingdom (“U.K.”). Our international activities and operations expose us to a number of risks, including the following:
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Greater difficulty in protecting intellectual property due to less stringent foreign intellectual property laws and enforcement policies;
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Longer collection cycles than we typically experience in North America;
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Unfavorable changes in regulatory practices and tariffs;
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Compliance with complex regulatory regimes or restrictions on import and export of our goods and services;
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Complex and/or adverse tax laws and/or changes thereto. Additionally, we may be subject to income, withholding and other taxes for which we may realize no current benefit despite the existence of significant net operating loss and tax credit carryforwards in the U.S.;
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Loss or reduction of withholding tax exemptions;
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The impact of fluctuating exchange rates between the U.S. dollar and foreign currencies;
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General economic and political conditions in international markets which may differ from those in the U.S.;
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Increased exposure to potential liability under the Foreign Corrupt Practices Act;
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Added cost and administrative burden associated with creating and operating business structures in other jurisdictions;
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Potential labor costs and risks associated with employees and labor laws in other geographies; and
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The inherent risks of working in a certain highly regulated and/or controlled economies where relationships between company management and government officials is critical to timely processing of approvals required to conduct business.
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In addition, on June 23, 2016, the U.K. held a referendum in which voters approved an exit from the E.U., commonly referred to as “Brexit”. Because of the referendum, it is expected that the British government will begin negotiating the terms of the U.K.’s future relationship with the E.U. Although it is unknown what those terms will be, it is possible that there will be greater restrictions on imports and exports between the U.K. and E.U. countries and increased regulatory complexities, which could adversely impact our operations and business in both the U.K. and the E.U.
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These risks could have a material adverse effect on the financial and managerial resources required to operate our foreign offices, as well as on our future international revenue, which could negatively impact our business and operating results.
As our customers seek more cost-effective locations to develop and manufacture their products, particularly overseas locations, our ability to continue to sell our software products and services to these customers could be adversely affected, which could negatively impact our revenue and operating results.
Due to competitive and other pressures, some of our customers have moved, and others may seek to move, the development and manufacturing of their smart, connected systems to overseas locations, which may limit our ability to sell our software and services to these customers. As an example, under our ODAs with Microsoft, we are currently only able to sell Microsoft Windows Embedded operating systems to our customers in the United States, Canada, the Caribbean (excluding Cuba), Mexico, the E.U. and the European Free Trade Association. If our customers, or potential customers, move their manufacturing overseas to locations in which our business may be limited, we may be less able to remain competitive, which could negatively impact our revenue and operating results.