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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

Commission file number 000-29335

WITNESS SYSTEMS, INC.
(Exact Name of Registrant as Specified in its Charter)

Registrant's telephone number, including area code 770-754-1900

        Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý    No o

        Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.

WITNESS SYSTEMS, INC.

FORM 10-Q

INDEX

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PART I.
FINANCIAL INFORMATION

Item 1. Financial Statements

WITNESS SYSTEMS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
(unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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WITNESS SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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WITNESS SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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WITNESS SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2002

(unaudited)

1. General and Basis of Presentation

        Witness Systems, Inc. and subsidiaries (the "Company") provide an integrated performance optimization software suite to help companies capture customer intelligence and optimize workforce performance. Comprised of business-driven multimedia recording, performance analysis and e-learning management applications, the browser-based software solution is designed to enhance the quality of customer interactions across multiple communications media, including the telephone, e-mail and Web. The closed-loop suite enables companies to record, evaluate and analyze customer contacts, and then launch e-learning to develop staff, generate additional revenue, and achieve greater customer retention and loyalty. The Company is headquartered in Roswell, Georgia with other offices in the United States, Canada, Mexico, Brazil, the United Kingdom, the Netherlands, Japan, Australia and Singapore. The Company was originally incorporated in 1988 in Georgia and was reincorporated in Delaware on March 13, 1997.

        The unaudited interim condensed consolidated financial statements include the accounts of Witness Systems, Inc. and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. Certain prior year amounts have been reclassified to conform with the current year presentation.

        The financial statements herein have been prepared in accordance with the requirements of Form 10-Q and, therefore, do not include certain information and footnotes required by generally accepted accounting principles in the United States. However, in the opinion of management, all adjustments (which, except as disclosed elsewhere herein, consist only of normal recurring accruals) necessary for a fair presentation of the results of operations for the relevant periods have been made. Results for the interim periods are not necessarily indicative of the results to be expected for the year. These financial statements should be read in conjunction with the summary of significant accounting policies and the notes to the consolidated financial statements included in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2001, filed with the U.S. Securities and Exchange Commission.

2. Significant Accounting Policies

        Revenue Recognition and Deferred Revenue.    The Company recognizes revenue in accordance with Statement of Position ("SOP") 97-2, Software Revenue Recognition, and SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions. Revenue is derived from licensing software and providing related services including maintenance. Revenue is allocated to each element of the arrangement based on its relative fair value, which is established by the price charged when the respective element is sold separately.

        Revenue from license fees is recognized when persuasive evidence of an agreement exists, delivery of the product has occurred, the fee is fixed or determinable and collection is probable. Services revenue includes installation, training, consulting, maintenance and reimbursable travel expenses. Revenue from installation, training and consulting services are recognized upon performance of the related services and are offered and billed as separate elements of contracts. Reimbursable travel expenses revenue is recognized upon incurrence of the related expenses. The functionality of the software is not dependent on installation and training services. Maintenance is offered as a separate element and includes the right to unspecified upgrades on a when-and-if available basis. Maintenance revenue, which is generally billed in advance, is deferred and recognized ratably over the term of the related contract. Specified upgrades are not typically offered to customers.

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3. Net Income (Loss) Per Share

        The following table presents the computation of basic and diluted net income (loss) per share for the three and six months ended June 30, 2002 and 2001:

        For the three and six months ended June 30, 2001, the Company has excluded the weighted-average number of all outstanding stock options from the calculation of diluted net loss per common share because all such securities were anti-dilutive. The total number of shares excluded from the calculation of diluted net loss per common share for the three and six months ended June 30, 2001 was 1,614,368 and 1,691,348, respectively.

4. Comprehensive Income (Loss)

        The following table presents the components of total comprehensive income (loss), net of income tax, and accumulated other comprehensive loss:

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5. Line of Credit and Restricted Cash

        In April 2002, the Company secured a $7.5 million revolving line of credit from a bank which matures on April 2, 2003. All borrowings under the line of credit bear interest at the bank's prime rate, which was 4.75% on June 30, 2002. The revolving line of credit is secured by all assets of the Company and requires compliance with various covenants, including liquidity ratios and tangible net worth requirements, among others. Borrowings under the revolving line of credit are limited to 80% of eligible accounts receivable, as defined by the agreement. In June 2002, the Company reissued its three irrevocable standby letters of credit by the same bank in the aggregate amount of $4.3 million as of June 30, 2002, which secure the corporate headquarters facility and furniture leases. The Company's line of credit serves as collateral on the reissued letters of credit, which relieved its restricted cash of $4.8 million as of June 30, 2002. The letters of credit have decreasing schedules that ultimately expire in 2002 and 2007. The amount available under the line of credit at June 30, 2002 was $3.2 million which was net of the outstanding letters of credit. To date, the Company has not borrowed any funds under the line of credit.

6. Notes Receivable for Stock

        In 1999, the Company issued 879,763 shares of restricted common stock to the CEO of the Company in exchange for a note receivable of $1.5 million. Also in 1999, the CEO was granted and exercised options to acquire 112,230 shares of the Company's common stock in exchange for a note receivable of $334,000. Under the terms of such arrangements, the underlying restricted stock was fully vested and the maturity dates of the notes were February 2002 as a result of the Company's initial public offering ("IPO") in February 2000. During the first quarter of 2002, the Company refinanced the $1.8 million notes in part with a full recourse note for approximately $1.5 million and the remaining balance was satisfied by delivering, at current fair market value, mature shares of common stock to the Company, which were retired immediately. The $1.5 million note receivable has floating monthly interest of 325 basis points over the Federal Funds Rate and is payable in three equal payments of principal and interest due annually through February 2005.

        In 1999, the Company issued 269,195 shares of common stock from treasury shares to certain officers and directors of the Company in exchange for individual notes receivable aggregating $800,000 which were due in February 2002 as a result of the Company's IPO. Certain officers paid their notes in full prior to maturity totaling $273,000. During the first quarter of 2002, the remaining notes totaling $527,000 were satisfied by delivering, at current fair market value, mature shares of the Company's common stock to the Company, which were retired immediately.

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7. Acquired In-process Research and Development and Related Charges

        During 2000, the Company entered into an option agreement to purchase in-process research and development ("IPR&D") technology that had a carrying value of $650,000. In March 2001, the Company paid $2.0 million to exercise this option to purchase the underlying technology. Also, during the first quarter of 2001, the Company purchased additional IPR&D technology for $1.1 million relating to similar development projects. At the time of the purchases, the Company estimated that it would take up to a year to complete these development projects and estimated that it would incur at least an additional $3 million to complete these projects. These projects were successfully completed by the end of 2001.

        During the second quarter of 2001, the Company purchased software-based IPR&D technology relating to the development of on-line analytical processing and multi-dimensional analysis capabilities for $1.1 million. At that time, the Company estimated that it would take up to a year to complete the development of this technology and that it would cost at least an additional $1 million. This project was successfully completed by June 30, 2002.

        At the date of the aforementioned transactions, the acquired IPR&D technologies had not progressed to a stage where they met technological feasibility as defined by Statement of Financial Accounting Standards ("SFAS") No. 86, Accounting for the Costs of Computer Software to Be Sold, Leased or Otherwise Marketed. At the time of each transaction, the Company estimated the stage of completion of the project and the time and resources required to complete the project by creating a product design plan and evaluating the progress of the acquired technology towards this plan. A significant amount of uncertainty existed as to the Company's ability to complete the development projects within a timeframe acceptable to the market, and failure to do so would have caused the Company's competitive position in the market to erode. Additionally, the amount of development required to enable the acquired technology to integrate with the Company's primary product was estimated to be significant, which increased the uncertainty surrounding its successful development. The acquired technologies did not have alternative future uses. As a result of the above, the Company recorded charges totaling $1.1 million and $4.8 million during the three and six months ended June 30, 2001, respectively, as acquired IPR&D.

8. Relocation of Corporate Headquarters

        During 2000, the Company adopted a plan to relocate its corporate headquarters to a larger facility within the Atlanta metropolitan area. In accordance with the Emerging Issues Task Force's ("EITF") abstract No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring), the Company estimated that the net costs associated with its then existing facilities, which were under noncancellable leases expiring on June 30, 2002, would be approximately $525,000. The Company recorded this obligation during the second quarter of 2000. During 2001, two of the sublessees were unable to fulfill their obligations and the subleases were terminated. As a result, the Company recorded an additional obligation of $155,000 in the second quarter of 2001 for the additional estimated loss. As of June 30, 2002, there were no remaining obligations.

9. Geographic Information

        The Company's international revenue derived from customers outside North America, which includes the United States and Canada, was $2.8 million and $5.2 million for the three and six months ended June 30, 2002, respectively; and $1.4 million and $2.7 million for the three and six months ended June 30, 2001, respectively. International revenue was derived from customers in Europe, Latin America and the Asia-Pacific.

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10. Recent Accounting Pronouncements

        In June 2002, the Financial Accounting Standards Board ("FASB") issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. Under the new rules, a liability for a cost associated with an exit or disposal activity must only be recognized when the liability is incurred. Under the previous guidance of EITF No. 94-3, a liability for an exit costs was recognized at the date of an entity's commitment to an exit plan. This SFAS is effective for fiscal years beginning after December 15, 2002. The Company does not anticipate that the adoption of this SFAS will have a material impact on its results of operations or financial position.

        In April 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections. Previous to the issuance of SFAS No. 145, SFAS No. 4 had required that all gains and losses from extinguishment of debt were to be aggregated and, if material, classified as an extraordinary item, net of related income tax effect. SFAS No. 145 rescinds SFAS No. 4 and the related required classification of extraordinary items. This SFAS is effective for fiscal years beginning after May 15, 2002. The Company does not anticipate that the adoption of this SFAS will have a material impact on its results of operations or financial position.

        Effective January 1, 2002, we adopted EITF No. 01-14, Income Statement Characterization of Reimbursements Received for "Out-of-Pocket" Expenses Incurred, which requires companies to characterize reimbursements received for travel expenses incurred as revenue in the statement of operations. The Company had historically recorded reimbursements as a reduction of services cost of revenue. In accordance with the EITF No. 01-14, the Company reclassified $192,000 and $318,000 of reimbursed travel expenses to services revenue and cost of services revenue leaving gross profit unchanged for the three and six months ended June 30, 2001, respectively. Gross profit margins decreased to 81% from 82% for the three and six months ended June 30, 2001 after the effect of EITF No. 01-14.

        In October 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-lived Assets, which supersedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of, and Accounting Principles Board ("APB") Opinion No. 30, Reporting the Results of Operations —Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions. SFAS No. 144 amends accounting and reporting standards for the disposal of segments of a business and addresses various issues related to the accounting for impairments or disposals of long-lived assets. This SFAS is effective for fiscal years beginning after December 15, 2001. The adoption of this SFAS did not have a material impact on the Company's results of operations or financial position.

        In August 2001, the FASB issued SFAS No. 143, Accounting for Asset Retirement Obligations, which addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. This SFAS is effective for fiscal years beginning after June 15, 2002. The Company does not anticipate that the adoption of this SFAS will have a material impact on its results of operations or financial position.

        In July 2001, the FASB issued SFAS No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets, effective for fiscal years beginning after December 15, 2001. Under the new rules, the pooling-of-interests method is no longer permitted, and goodwill and other intangible assets that have indefinite useful lives will no longer be amortized but will be subject to annual impairment tests in accordance with the statements. Most other intangible assets will continue to be amortized over their useful lives. Goodwill and intangible assets acquired after June 30, 2001 are subject to the new rules. The adoption of this SFAS did not have a material impact on the Company's results of operations or financial position.

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Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

        This quarterly report on Form 10-Q contains forward-looking statements that are not historical facts but rather are based on current expectations, estimates and projections about our business and industry, and our beliefs and assumptions. Words such as "anticipates", "expects", "intends", "plans", "believes", "seeks", "estimates" and variations of these words and similar expressions are intended to identify forward-looking statements. These statements are not guarantees of future performance and are subject to risks, uncertainties and other factors, some of which are beyond our control, are difficult to predict and could cause actual results to differ materially from those expressed or forecasted in the forward- looking statements. Forward-looking statements that were true at the time made may ultimately prove to be incorrect or false. Readers are cautioned not to place undue reliance on forward-looking statements, which reflect our management's view only as of the date of this report. Except as required by law, we undertake no obligation to update any forward-looking statement, whether as a result of new information, future events or otherwise.

        The following Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Condensed Consolidated Financial Statements and Notes thereto included elsewhere in this report.

Overview

        We provide an integrated performance optimization software suite to help global enterprises capture customer intelligence and optimize workforce performance. Comprised of business-driven multimedia recording, performance analysis and e-learning management applications, the browser-based software solution is designed to enhance the quality of customer interactions across multiple communications media, including the telephone, e-mail and Web. The closed-loop suite enables companies to record, evaluate and analyze customer contacts, and then launch e-learning to develop staff, generate additional revenue, and achieve greater customer retention and loyalty. An integrated business consulting, implementation and training methodology provides services to support an effective, rapid deployment of our software that enables organizations to maximize their return on investment. Our software is designed to integrate with a variety of third-party software applications, such as customer relationship management and enterprise resource planning applications, and with existing telephony and computer network hardware and software. The majority of our customers are companies with one or more contact centers that handle voice and data customer interactions for outbound sales and marketing operations, inbound service/support lines, or both.

        During the first half of 2002, many of our prospects and customers deferred projects and/or extended their software purchasing processes, which decreased our visibility into the sales cycle and resulted in our first half of 2002 license revenue being less than our license revenue for the first half of 2001. While the economy continues to impact the sales cycle, we feel that we have improved our visibility into the second half of 2002 and we currently expect to see a sequential improvement in our license revenue beginning in the third quarter of 2002. However, a deterioration in the economy, a reduction in the level of corporate spending for information technology or other matters may cause us to experience a material adverse effect on our business, financial condition and results of operations. Although historically more than 95% of our active customers sites have renewed their annual maintenance contracts, we expect maintenance revenue may be impacted in future quarters by the current economic conditions as an increasing number of customers reevaluate their spending plans due to their own budget uncertainties in addition to increased pricing pressures for renewal amounts.

Sources of Revenue and Revenue Recognition Policy

        We derive our revenue from licensing our software and providing related services. We primarily utilize a direct sales organization, select resellers and a variety of strategic marketing alliances to reach our target customer base. Prior to 2002, less than 10% of our license revenue had been derived from resellers rather than from our direct sales force. For the six months ended June 30, 2002, 20% of our license revenue was derived from resellers. We expect this proportion of license revenue derived from resellers to continue throughout 2002.

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        Revenue is allocated to each element of the arrangement based on its relative fair value, which is established by the price charged when the respective element is sold separately. License revenue is recognized when persuasive evidence of an agreement exists, delivery of the product has occurred, the fee is fixed or determinable and collection is probable. Services revenue includes installation, training, consulting, maintenance and reimbursable travel expenses revenue. Revenue from installation, training and consulting services is recognized upon performance of the related services. Reimbursable travel expenses revenue is recognized upon incurrence of the related expenses.

        Services are traditionally offered and billed as separate elements of contracts on either a fixed service fee plus travel expenses or a time-and-material basis. The functionality of the software is not dependent on these services. Maintenance is offered as a separate element and includes the right to unspecified upgrades on an if-and-when available basis. Maintenance revenue, which is generally billed annually in advance, is deferred and recognized ratably over the term of the related contract. Specified upgrades are not typically offered to customers. Historically, all customers have purchased an initial maintenance contract for each newly licensed site. During the first half of 2002, 97% of active customer installation sites renewed their annual maintenance contracts.

        During the three and six months ended June 30, 2002, approximately 17% and 15%, respectively, of revenue was derived from customers outside North America, which includes the United States and Canada. Approximately 10% and 9% of revenue was derived from customers outside North America during the three and six months ended June 30, 2001, respectively. We expect that a greater proportion of future revenue will be derived from international markets and may be denominated in the currency of the applicable market.

        Our license agreements generally provide that customers pay a software license fee for one or more software products for a specified number of users. The amount of the license fee varies based on which product is licensed, the number of software products licensed, the number of installation sites and the number of users licensed. Customers can subsequently pay additional license fees to allow additional users to use previously licensed software products or to license additional software products. Each software product contains common components, allowing for easy integration of additional software products as they are licensed from us. Customers that license our software products usually receive the software on compact disc.

Cost of Revenue and Operating Expenses

        Cost of license revenue primarily consists of royalties due to third parties and packaging costs. Cost of services revenue for installation, training, consulting and maintenance services includes personnel costs and related expenses and allocations of facilities, communications and depreciation expense. Personnel costs include salaries, benefits, stock-based compensation and travel expenses. We classify all charges to the operating expense categories based on the nature of the expenditures. We allocate the costs for facilities, communications and depreciation to each of the functional areas based on use. These allocated charges include rent for corporate offices and furniture, communication charges and depreciation and amortization expenses for office equipment and leasehold improvements.

        Operating expenses are classified into three general categories: sales and marketing, research and development and general and administrative. Sales and marketing expenses consist primarily of personnel costs, sales commissions, promotional expenses, public relations, and tradeshows, as well as allocations of facilities, communications and depreciation expense. Research and development expenses consist primarily of personnel and consulting costs to support product development, as well as allocations of facilities, communications and depreciation expense. Research and development costs are expensed as incurred. Costs incurred subsequent to establishing technological feasibility are capitalized and amortized over their estimated useful lives. To date, software development costs incurred after technological feasibility has been established have not been material. General and administrative expenses consist primarily of personnel costs for accounting and finance, information technology, human resources, legal and facilities, as well as provisions for allowance for doubtful accounts and allocations of facilities, communications and depreciation expense.

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        We had 364 full-time employees at June 30, 2002, up from 327 at December 31, 2001 and 297 at June 30, 2001. We anticipate that operating expenses will increase over time as we increase sales and marketing operations, develop new distribution channels, fund ongoing research and development, broaden professional services offerings, improve operational and financial systems and support our growth internationally.

Critical Accounting Policies and Estimates

        The discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect our reported assets, liabilities, revenues and expenses, and our related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to revenue recognition, allowance for doubtful accounts, property and equipment, intangible assets, research and development and software development costs and provision for income taxes. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. This forms the basis of judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

        Factors that could affect our future operating results and cause actual results to vary materially from expectations include, but are not limited to, lower than anticipated growth from existing customers, an inability to attract new customers and grow internationally, our ability or inability to grow through acquisitions and to successfully integrate acquisitions, the availability and cost of debt and equity financing, technology changes, or a decline in the financial stability of our customers. Negative developments in these or other risk factors could have a material adverse effect on our financial position and results of operations. A summary of our critical accounting policies follows.

        Revenue Recognition.    Our revenue recognition policy is significant because our revenues are a key component of our results of operations. We follow very specific and detailed guidelines, discussed above, in measurin