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SCO's February 11 SEC S-3 Filing
Sunday, February 15 2004 @ 06:50 PM EST

SCO's got a new SEC filing, an S-3 dated February 11. There are some interesting elements. What leaps off the page, to me, is that they seem to be gearing up to sue end users soon, and they are expecting serious backlash from their DMCA strategy. The feeling I get is they are suiting up for battle, and soon. McBride said in the Harvard appearance they'd file against some users around February 18, and after reading the S-3 financials, I now believe they actually will.

Note the foreshadowing here:

"Additionally, we have begun notifying selected Linux end users in writing of violations we allege under the Digital Millennium Copyright Act related to our copyrights contained in Linux.

"As a result of our action against IBM and our SCOsource initiatives to protect our intellectual property rights, several participants in the Linux industry and others affiliated with IBM or sympathetic to the Linux movement have taken actions attempting to negatively affect our business and our SCOsource efforts. Linux proponents have taken a broad range of actions against us, including, for example, attempting to influence participants in the markets in which we sell our products to reduce or eliminate the amount of our products and services they purchase from us. We expect that similar efforts likely will continue. There is a risk that participants in our marketplace will negatively view our action against IBM and our SCOsource initiatives, and we may lose support from such participants.

"The success of our UNIX business will depend on the level of commitment and certification we receive from industry partners and developers. In recent years, we have seen hardware and software vendors as well as software developers turn their certification and application development efforts toward Linux and elect not to continue to support or certify to our UNIX operating system products. If this trend continues, our competitive position will be adversely impacted and our future revenue from our UNIX business will decline. The decline in our UNIX business may be accelerated if industry partners withdraw their support from us as a result of our SCOsource initiatives and in particular any lawsuit against end users violating our intellectual property and contractual rights."
[emphasis added]

The S-3 is mainly about the stock and the various risks you should be aware of. It sounds to me like a company committing suicide by trial. Or maybe a company giving it all they've got in one final push, do or die. They mention all the court battles they are involved in, including IBM, Red Hat, Novell, the proposed actions against end users, the Germany matter, complaints filed in Australia, Austria and Poland. There seems to be a lot of talk about "liquidation events". Of course, this is the risks section, where you are supposed to list all the possibilities, but liquidation?

I checked Novell's most recent 10K, and liquidation isn't a risk even mentioned. They don't sound too worried about the SCO lawsuit, either. Here is how they describe the lawsuit with SCO:

"In January 2004, the SCO Group, Inc. (“SCO”) filed suit against us in the Third Judicial District Court of Salt Lake County, State of Utah. . . . We believe that we have meritorious defenses to these claims and intend to vigorously defend ourselves in this suit. Although there can be no assurance as to the ultimate disposition of the suit, we do not believe that the resolution of this litigation will have a material adverse effect on our financial position, results of operations or cash flows. . . .

"SCO filed legal action in March 2003 against IBM alleging misappropriation of trade secrets, tortious interference, unfair competition and breach of contract relating to IBM’s sale of products based on the Linux operating system. . . . It is possible that SCO’s actions may reduce general demand for Linux and Linux related products and services. In this event, demand for our Linux products and services could decrease, thereby reducing revenue."
[emphasis added]

In contrast, here's how dire SCO's worst case scenario is in the IBM lawsuit:

"If we do not prevail in our action against IBM, or if IBM is successful in its counterclaim against us, our business and results of operations could be materially harmed. The litigation with IBM and potentially others could be costly, and our costs for legal fees may be substantial and in excess of amounts for which we have budgeted. Additionally, the market price of our common stock may be negatively affected as a result of developments in our legal action against IBM that may be, or may be perceived to be, adverse to us." [emphasis added]

And as for the Novell case, here is SCO's sum up of that potential:

"Notwithstanding our assertions of full ownership of UNIX-related intellectual property rights, as set forth above, including copyrights, and even if we are successful in our legal action against Novell, the efforts of Novell and the other Linux proponents described above may cause Linux end users to be less willing to purchase from us our SCO IP licenses authorizing their use of our intellectual property contained in the Linux operating system, which may adversely affect our revenue from our SCOsource initiatives. These efforts also may increase the negative view some participants in our marketplace have regarding our legal actions against IBM and Novell and our SCOsource initiatives and may contribute to creating confusion in the marketplace about the validity of our claim that the unauthorized use of our UNIX source code and derivative works in Linux infringes on our copyrights. Increased negative perception and potential confusion about our claims in our marketplace could impede our continued pursuit of our SCOsource initiatives and negatively impact our business. Additionally, if we fail in our lawsuit against Novell, the negative perception and confusion in our marketplace about our intellectual property claims likely would increase significantly, and the effectiveness of our SCOsource initiatives could be materially harmed."[emphasis added]

As for the end user lawsuits, those too, they acknowledge, could send their UNIX business tanking even further:

"We may lose the support of industry partners leading to an accelerated decline in our UNIX products and services revenue.

"Our SCOsource initiatives, particularly lawsuits against end users violating our intellectual property and contractual rights, may cause industry partners, developers and hardware and software vendors to choose not to support or certify to our UNIX operating system products. This would lead to an accelerated decline in our UNIX products and services revenue and would adversely impact our results of operations and liquidity."
[emphasis added]

The Red Hat case could harm them too they say:

"If Red Hat is successful in its claim against us, our business and results of operations could be materially harmed. "[emphasis added]

Then there is the Australia info, not that it seems up-to-date:

"The Australian Competition and Consumer Commission ('ACCC') contacted us in August 2003 regarding complaints it has received concerning our intellectual property claims and our statements regarding the need for commercial Linux users to obtain a UNIX license. The ACCC further informed us that it has not made any decision to pursue the complaints it has received or determined what, if any, action it will take. We have hired counsel in Australia and responded to the ACCC's request for information. We have not heard from the ACCC and it is unknown if future action will be taken." [emphasis added]

Oh, don't forget Germany:

"Several entities in Germany have obtained temporary restraining orders in Germany precluding our German subsidiary, from making statements in Germany that, in substance, disparage Linux, or entities involved in the Linux industry, or implicate Linux as infringing our intellectual property rights. SCO GmbH has received an administrative fine of 10,000 Euros for a technical violation of one of the temporary restraining orders. We are currently negotiating with the various claimants in Germany over the temporary restraining orders and are evaluating whether we will appeal the administrative fine. Informal complaints similar to those raised in Germany have been received from companies in Austria and Poland. We have responded to those complaints. It is not known if those complainants will take future action." [emphasis added]

If that isn't enough, what about this sentence?

"In addition to these above-mentioned actions, other regulators or others in the Linux community may initiate legal actions against us, all of which may negatively impact our operations or future operating performance."

If it's hurting your business so badly and has the capability to finish it off, why are they doing all this, pray tell?

I thought it would be useful to look at some other companies and see if maybe I was reading too much into this language. Did others describe their risks in such apocalyptic terms? Maybe this is normal in the risks section, I thought. So, next I checked Red Hat. No liquidation event is even listed as a possibility. Here is what they say about their lawsuit against SCO in their most recent 10-Q:

"Commencing August 4, 2003, the Company filed suit against The SCO Group, Inc. ('SCO') in the U.S. District Court for the District of Delaware (Civil Action No. 03-722 SLR) (the 'Action') seeking a declaratory judgment that the Company is not infringing any of SCO’s intellectual property rights. In addition, the Company has asserted claims against SCO under Delaware and federal law, including deceptive trade practices, unfair competition, tortious interference with prospective business opportunities, trade libel and violations of the Lanham Act. The Company contends that SCO has made false and misleading public statements alleging that software code, in which SCO claims to own copyrights and trade secrets, was misappropriated and incorporated into the Company’s product and has threatened legal action. On September 15, 2003, SCO filed a Motion to Dismiss contending, among other things, that there exists no actual controversy that would warrant the declaratory judgment the Company seeks. The Company filed an opposition to the Motion to Dismiss and intends to vigorously prosecute the Action. At this early stage of the proceedings no assurance can be given as to the outcome." [emphasis added]

See the difference in the tone? In contrast, SCO's filing sounds like a letter by a soldier about to enter a war zone. He hopes to make it, but no guarantees, and just in case, here's where the key to the safe is kept and you'll find the will in the middle drawer at the office.

Meanwhile, how about IBM? IBM had this to say in their most recent 8K about Linux:

"Linux also continued to drive zSeries demand.

"As an example, the City University of New York, the biggest urban university in the US, recently purchased a high-end z990 with 15 processors dedicated to Linux—the Linux equivalent of nearly 5,000 MIPS. The Linux workload will include e-mail, voice mail, calendaring and wireless support for two hundred and sixty thousand handheld devices.

"IBM's zSeries are an integral part in our customers' restructuring into an on demand environment. . . .

And Linux revenue on iSeries had strong growth, up 10% sequentially from the 3rd quarter."

Their UNIX business is doing well too, they report. In contrast, here is SCO's gloomy report on their UNIX business:

"Our UNIX products and services revenue has declined in each of the last four years. In our results of operations, we recognize revenue from agreements for support and maintenance contracts and other long-term contracts that have been previously invoiced and are included in deferred revenue. Our deferred revenue balance has declined from $10,056,000 as of October 31, 2002 to $5,501,000 as of October 31, 2003, and this decline in deferred revenue may continue into future quarters, which may have a negative impact on our operating system platform products revenue. . . .

We initiated the SCOsource licensing effort in January 2003 to review the status of UNIX licensing and sublicensing agreements. This effort resulted in the execution of two significant vendor license agreements during fiscal year 2003 and generated $25,846,000 in revenue."
[emphasis added]

Despite bringing in $25,846,000 in SCOsource revenue and only $5,501,000 in Unix "deferred revenue," a steep decline from the year before (this would be customers running for the hills when their contracts end, maybe?), SCO describes their "core" business as being sales of Unix, not SCOsource:

"Our profitability in fiscal year 2003 resulted primarily from our SCOsource licensing initiative. If we do not receive SCOsource licensing revenue in future quarters and our revenue from the sale of our operating system platform products and services continues to decline, we will need to further reduce operating expenses to maintain profitability or generate positive cash flow. . . .

"We generate revenue from two sources: sales of our UNIX-based products and services and licenses of our UNIX technology through our SCOsource initiatives. Our core business is to sell and service our UNIX operating system and related software products to small-to-medium sized businesses and branch offices and franchisees of Fortune 1000 businesses. Our main products that drive the majority of our UNIX revenue are OpenServer and UnixWare."
[emphasis added]

So their core business is selling Unix? But they don't make most of their money from their core business? Why not just say that SCOsource is now their core business? By the time you get to the financials, it sounds to me like they are going for broke with the DMCA end user lawsuits. If it works, fine. In any case, here's the setup:

"Risks associated with the potential exercise of our options outstanding.

        "As of February 1, 2004, we have issued and outstanding options to purchase up to approximately 3,504,800 shares of common stock with exercise prices ranging from $0.66 to $28.00 per share. The existence of such rights to acquire common stock at fixed prices may prove a hindrance to our efforts to raise future equity and debt funding, and the exercise of such rights will dilute the percentage ownership interest of our stockholders and may dilute the value of their ownership. The possible future sale of shares issuable on the exercise of outstanding options could adversely affect the prevailing market price for our common stock. Further, the holders of the outstanding rights may exercise them at a time when we would otherwise be able to obtain additional equity capital on terms more favorable to us.

"The holders of shares of Series A-1 Convertible Preferred Stock have preferential redemption rights and rights upon liquidation that could adversely affect the holders of our common stock.

        "If the selling stockholders choose not to convert shares of Series A-1 Convertible Preferred Stock, then, as holders of shares of Series A-1 Convertible Preferred Stock, among other rights, they will be entitled to require us to repurchase for cash all the shares of Series A-1 Convertible Preferred Stock held by them at a premium price if any of several redemption trigger events occurs. Our redemption obligation may be triggered by events that are beyond our control. These redemption provisions, if triggered, would require us to redeem the then-issued and outstanding shares of our Series A-1 Convertible Preferred Stock for cash.

"Additionally, as stated elsewhere in the registration statement, the Certificate of Designation for the Series A-1 Convertible Preferred Stock provides that the number of shares of our common stock issuable upon the conversion of shares of Series A-1 Convertible Preferred Stock is limited to 2,863,135 shares in the aggregate, notwithstanding that the holders of shares of Series A-1 Convertible Preferred Stock may otherwise be entitled to receive more shares of common stock upon conversion based on the applicable conversion price. If the number of shares of common stock issuable to the holders of shares of Series A-1 Convertible Preferred Stock upon conversion is limited in this manner, then we may be required by the holders of such shares to redeem for cash the number of shares of Series A-1 Convertible Preferred Stock that were not issuable upon conversion as a result of such limits on conversion. If we were required to pay cash to the holders of shares of our Series A-1 Convertible Preferred Stock for any reason, it could have a material impact on our liquidity, which may require us to obtain additional sources of cash to sustain operations and may negatively impact the holders of our common stock.

"Further, the holders of shares of our Series A-1 Convertible Preferred Stock will be entitled to receive a preferential distribution of our assets prior to any distribution to our holders of common stock upon a liquidation, dissolution, winding up or other change in control transaction in which we sell all or substantially all our assets or merge or consolidate or otherwise combine with another company or entity. Upon the occurrence of a liquidation event, the holders of Series A-1 Convertible Preferred Stock will be entitled to receive the greater of:
  • the value of the shares of Series A-1 Convertible Preferred Stock held by them determined by multiplying the closing sale price of our common stock on the Nasdaq SmallCap Market on the date of the liquidation event by the number of shares of common stock into which the preferred shares could be converted at the time of the liquidation event; or
  • up to $50,000,000, the aggregate purchase price paid by the selling stockholders in our October 2003 private placement, plus eight percent of that amount less the amount of any dividends paid to the preferred stockholders in the calendar year in which the liquidation event occurs.
    "Depending on the amount of assets we have available for distribution to stockholders upon a liquidation event when shares of Series A-1 Convertible Preferred Stock remain outstanding, we may be required to distribute all such assets or a portion of such assets that exceeds the preferred stockholders' pro rata ownership of our common stock assuming full conversion of their preferred shares into common stock, which could eliminate or limit the assets available for distribution to our common stockholders. Our potential obligation to pay to the law firms representing us in our efforts to establish our intellectual property rights a contingent fee of 20 percent of the proceeds we receive from a sale of our company, subject to certain limitations, could also contribute to eliminating or limiting the assets available for distribution to our common stockholders."
[emphasis added]

I'm not a financial expert. Far from it. I don't even invest, or gamble, so I'm probably missing plenty, but all I see is risk, risk and more risk. I see what's in it for holders of Series A-1 Convertible Preferred Stock, but what's in it for the common shareholders?

With such bleak financials from their "core" business, it seems logical that they will have to go forward to try to get money from end users or try to inspire someone to acquire them. So, when they say they really will sue end users on February 18, I now believe them.

Some have suggested that this whole lawsuit thing was conceived as just an exit strategy, that the goal was to be acquired, and the strategy to be so annoying, someone would buy them:

"On the other hand, he [Moglen] says, the suit against Novell is also a tacit admission by SCO that ownership of the code is uncertain. Thus, the firm's demand from Linux users to pay license fees has no teeth and that keeps the door open for continued Linux adoption.

"There is no question that SCO is fighting for its life, especially in terms of the value of SCO's stock. Moglen suggests an erosion of revenue will catch up with SCO on Wall Street. Even techies like Bruce Perens assert that SCO's original suit against IBM was related to an investor exit strategy. 'Here's a company that was at 60 cents stock price. As a result of the suit, ... their stock price [climbed] to over 10 dollars,' he said.

"Legal experts tend to agree with Moglen. And the industry perception of Linux users is not consistent with the notion that they are conniving freeloaders with eyes the size of pie plates once they see they can get away with using pieces of Unix code, within Linux, for free.

"Even if SCO prevails in court, it is unlikely the company will win large punitive damages. Software experts predict that any offending Unix code would be replaced in a matter of a day and released weeks later, leaving SCO right where it started."

That is from NewsFactor's Top Tech News. You might find this article about the poor sad sack small investor of interest as well.

So. February 18, then.

If I were a commercial end user, being sued by SCO, I believe I'd instruct my attorneys to stall, in hopes SCO might just keel over dead from insufficient cash flow to the head.

That's a joke, folks. If you really get sued, ask your lawyer what to do.

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