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Table of Contents
 
 
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
 
 
FORM 10-Q
 
x
 
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
  
 
SECURITIES EXCHANGE ACT OF 1934.
 
  
 
  For the quarterly period ended September 30, 2002
 
OR
 
¨
 
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
  
 
SECURITIES EXCHANGE ACT OF 1934
 
  
 
  For the transition period from                                    to                                   
 
Commission File Number: 000-32417
 
 
VERISITY LTD.
(Exact name of registrant as specified in its charter)
 
Israel
  
Not Applicable
(State or other Jurisdiction of
Incorporation or Organization)
  
(I.R.S. Employer
Identification No.)
 
2041 Landings Drive, Mountain View, California
  
94043
(Address of principal US executive offices)
  
(Zip Code)
 
(650) 934-6800
(Registrant’s telephone number, including area code)
 
 
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  x  No  ¨
 
As of September 30, 2002, there were 19,471,740 of registrant’s ordinary shares, par value NIS 0.01 per share, outstanding.
 

Table of Contents
VERISITY LTD.
 
Quarterly Report on Form 10-Q
For the Quarter Ended September 30, 2002
 
Index
 
         
Page
Part I – Financial Information
     
Item 1.
   
Condensed Consolidated Financial Statements (Unaudited):
     
       
1
       
2
       
3
       
4-6
Item 2.
      
7-11
Item 3.
      
11-12
Item 4.
      
12
Part II – Other Information
     
Item 1.
      
12
Item 2.
      
13
Item 3.
      
13
Item 4.
      
13
Item 5.
      
13
Item 6.
      
14
    
    

Table of Contents
 
PART I — FINANCIAL INFORMATION
 
Item 1.    Condensed Consolidated Financial Statements
 
VERISITY LTD.
 
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)
 
    
September 30,
2002
     
December 31,
2001
  
    
Unaudited
         
ASSETS
                  
Current assets:
                  
Cash and cash equivalents
   
$
71,119
 
   
$
58,488
 
Accounts receivable
   
 
12,523
 
   
 
8,498
 
Prepaid expenses and other current assets
   
 
2,543
 
   
 
2,511
 
    
  
Total current assets
   
 
86,185
 
   
 
69,497
 
Property and equipment, net
   
 
2,185
 
   
 
2,112
 
Other assets
   
 
535
 
   
 
229
 
    
  
Total assets
   
$
88,905
 
   
$
71,838
 
    
  
LIABILITIES AND SHAREHOLDERS’ EQUITY
                  
Current liabilities:
                  
Accounts payable
   
$
741
 
   
$
468
 
Accrued compensation
   
 
4,461
 
   
 
4,574
 
Deferred revenues
   
 
24,989
 
   
 
26,694
 
Other current liabilities
   
 
4,609
 
   
 
2,991
 
    
  
Total current liabilities
   
 
34,800
 
   
 
34,727
 
Long-term portion of deferred revenues
   
 
7,712
 
   
 
2,397
 
Long-term portion of capital lease obligations
   
 
5
 
   
 
13
 
Other long-term liabilities
   
 
473
 
   
 
184
 
    
  
Total long-term liabilities
   
 
8,190
 
   
 
2,594
 
Shareholders’ equity:
                  
Ordinary shares and additional paid-in capital
   
 
54,101
 
   
 
52,501
 
Deferred compensation
   
 
(199
)
   
 
(470
)
Shareholder’s loan
   
 
—  
 
   
 
(202
)
Accumulated deficit
   
 
(7,987
)
   
 
(17,312
)
    
  
Total shareholders’ equity
   
 
45,915
 
   
 
34,517
 
    
  
Total liabilities and shareholders’ equity
   
$
88,905
 
   
$
71,838
 
    
  
 
The accompanying notes are an integral part of these condensed consolidated financial statements.
 

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Table of Contents
 
VERISITY LTD.
 
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
 
    
Three Months Ended
September 30,
     
Nine Months Ended
September 30,
  
    
2002
   
2001
     
2002
   
2001
  
    
Unaudited
     
Unaudited
  
Revenue:
                                
License
   
$
8,939
   
$
6,525
 
   
$
23,629
   
$
17,918
 
Maintenance
   
 
4,664
   
 
2,956
 
   
 
13,046
   
 
7,903
 
Other services
   
 
351
   
 
308
 
   
 
1,249
   
 
1,539
 
    
  
  
  
Total revenue
   
 
13,954
   
 
9,789
 
   
 
37,924
   
 
27,360
 
Cost of revenue:
                                
License
   
 
45
   
 
179
 
   
 
118
   
 
557
 
Maintenance
   
 
514
   
 
478
 
   
 
1,515
   
 
1,292
 
Other services(1)
   
 
195
   
 
226
 
   
 
564
   
 
924
 
    
  
  
  
Total cost of revenue
   
 
754
   
 
883
 
   
 
2,197
   
 
2,773
 
    
  
  
  
Gross profit
   
 
13,200
   
 
8,906
 
   
 
35,727
   
 
24,587
 
    
  
  
  
Operating expenses:
                                
Research and development
   
 
2,291
   
 
2,216
 
   
 
6,724
   
 
6,392
 
Sales and marketing
   
 
5,275
   
 
4,352
 
   
 
14,683
   
 
12,198
 
General and administrative
   
 
1,487
   
 
1,306
 
   
 
4,168
   
 
3,661
 
Non-cash charges related to equity issuances(1)
   
 
34
   
 
110
 
   
 
243
   
 
492
 
    
  
  
  
Total operating expenses
   
 
9,087
   
 
7,984
 
   
 
25,818
   
 
22,743
 
    
  
  
  
Operating income
   
 
4,113
   
 
922
 
   
 
9,909
   
 
1,844
 
Interest income
   
 
259
   
 
420
 
   
 
659
   
 
1,142
 
Interest expense and other income,net
   
 
15
   
 
(11
)
   
 
29
   
 
(12
)
    
  
  
  
Net income before income taxes
   
 
4,387
   
 
1,331
 
   
 
10,597
   
 
2,974
 
Provision for income taxes
   
 
527
   
 
66
 
   
 
1,272
   
 
151
 
    
  
  
  
Net income
   
$
3,860
   
$
1,265
 
   
$
9,325
   
$
2,823
 
    
  
  
  
Basic earnings per share:
                                
Basic net income per ordinary share
   
$
0.20
   
$
0.07
 
   
$
0.50
   
$
0.20
 
    
  
  
  
Shares used in per share calculation
   
 
18,983
   
 
17,563
 
   
 
18,798
   
 
14,424
 
    
  
  
  
Diluted earnings per share:
                                
Diluted net income per ordinary share
   
$
0.18
   
$
0.06
 
   
$
0.44
   
$
0.15
 
    
  
  
  
Shares used in per share calculation
   
 
21,102
   
 
20,668
 
   
 
21,205
   
 
19,294
 
    
  
  
  
(1)
 
Non-cash charges related to equity issuances include the following :
 
      
Three Months Ended
September 30
       
Nine Months Ended
September 30,
      
2002
     
2001
       
2002
   
2001
Cost of other services revenue
     
$
2
 
   
$
3
 
     
$
6
   
$
12
      
  
    
  
Research and development
     
$
15
 
   
$
55
 
     
$
55
   
$
156
Sales and marketing
     
 
(18
)
   
 
(2
)
     
 
54
   
 
164
General and administrative
     
 
37
 
   
 
57
 
     
 
134
   
 
172
      
  
    
  
Total included in operating expenses
     
$
34
 
   
$
110
 
     
$
243
   
$
492
      
  
    
  
 
 
The accompanying notes are integral part of these condensed consolidated financial statements.
 

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Table of Contents
 
VERISITY LTD.
 
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
 
    
    Nine Months Ended    
September 30,
  
    
2002
     
2001
  
    
Unaudited
  
Cash flows from operating activities:
                  
Net income
   
$
9,325
 
   
$
2,823
 
Adjustments to reconcile net income to net cash provided by operating activities:
                  
Depreciation
   
 
661
 
   
 
660
 
Non-cash charges related to equity issuances
   
 
191
 
   
 
544
 
Changes in operating assets and liabilities:
                  
Accounts receivable
   
 
(4,025
)
   
 
(1,571
)
Prepaid expenses and other assets
   
 
(348
)
   
 
832
 
Accounts payable
   
 
273
 
   
 
(337
)
Other liabilities and accrued compensation
   
 
1,821
 
   
 
1,188
 
Other long-term liabilities
   
 
(27
)
   
 
30
 
Deferred revenues
   
 
3,610
 
   
 
8,160
 
    
  
Net cash provided by operating activities
   
 
11,481
 
   
 
12,329
 
Cash flows from investing activities:
                  
Purchases of property and equipment
   
 
(734
)
   
 
(1,177
)
Sales of short-term investments
   
 
—  
 
   
 
287
 
Other assets
   
 
10
 
   
 
(45
)
    
  
Net cash used in investing activities
   
 
(724
)
   
 
(935
)
Cash flows from financing activities:
                  
Net proceeds from issuance of ordinary shares
   
 
1,680
 
   
 
22,816
 
Proceeds from repayment of shareholder’s loan
   
 
202
 
   
 
—  
 
Repayment of bank loan
   
 
—  
 
   
 
(265
)
Payments under capital lease obligations
   
 
(8
)
   
 
(8
)
    
  
Net cash provided by financing activities
   
 
1,874
 
   
 
22,543
 
Net increase in cash and cash equivalents
   
 
12,631
 
   
 
33,937
 
Cash and cash equivalents at beginning of the period
   
 
58,488
 
   
 
18,388
 
    
  
Cash and cash equivalents at end of the period
   
$
71,119
 
   
$
52,325
 
    
  
 
 
 
The accompanying notes are integral part of these condensed consolidated financial statements.
 

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Table of Contents
 
VERISITY LTD.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 
1.
 
Basis of Presentation
 
The Company
 
These unaudited interim condensed consolidated financial statements reflect the Company’s position as of September 30, 2002. The statements also show the Company’s statements of operations for the three and nine month periods ended September 30, 2002 and 2001, and the statements of cash flow for the nine month periods ended September 30, 2002 and 2001. These interim condensed consolidated financial statements include all normal recurring adjustments, which the Company believes are necessary to fairly present the Company’s financial position. All material intercompany balances have been eliminated. Because all of the disclosures required by accounting principles generally accepted in the United States are not included, these interim condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements for the year ended December 31, 2001, included in the Company’s annual report on Form 10-K filed with the Securities and Exchange Commission on March 26, 2002. The December 31, 2001 condensed consolidated balance sheet data was derived from the Company’s audited consolidated financial statements and does not include all of the disclosures required by accounting principles generally accepted in the United States. The statements of operations for the periods presented are not necessarily indicative of results for any future period, nor for the entire year.
 
Use of Estimates
 
The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making 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.
 
2.
 
Basic and Diluted Net Income Per Share
 
Basic net income per share is computed based on the weighted average number of ordinary shares outstanding during each period. Diluted net income per share is computed based on the weighted average number of ordinary shares outstanding during each period, plus dilutive potential ordinary shares considered outstanding during the period, in accordance with Financial Accounting Standards Board (“FASB”) Statement No. 128, “Earnings per Share.”

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Table of Contents
 
The following table presents the calculation of unaudited basic and diluted net income per share (in thousands, except per share data):
 
    
Three Months Ended September 30,
   
Nine Months Ended September 30,
    
2002
   
2001
   
2002
   
2001
    
Unaudited
   
Unaudited
Net income
   
$
3,860
   
$
1,265
   
$
9,325
   
$
2,823
    
  
  
  
Shares used in computing basic net income per ordinary share
   
 
18,983
   
 
17,563
   
 
18,798
   
 
14,424
    
  
  
  
Effect of conversion of preferred shares prior to the IPO
   
 
—  
   
 
—  
   
 
—  
   
 
1,775
Weighted average number of ordinary shares under the treasury method
   
 
2,119
   
 
3,007
   
 
2,402
   
 
2,955
Weighted average number of ordinary shares subject to repurchase
   
 
—  
   
 
98
   
 
5
   
 
140
    
  
  
  
Shares used in computing diluted net income per ordinary share
   
 
21,102
   
 
20,668
   
 
21,205
   
 
19,294
    
  
  
  
Diluted net income per ordinary share
   
$
0.18
   
$
0.06
   
$
0.44
   
$
0.15
    
  
  
  
 
3.
 
Segment, Customers and Geographic Information
 
The Company operates in one industry segment and develops, markets and supports software products, which provide systems and semiconductor companies with the ability to automate the functional verification of system and integrated circuit designs. Operations in Israel and in the United States include research and development, sales and marketing and general administration. Operations in Europe include sales and marketing.
 
The following is a summary of operations within geographic areas based on the location of the entity making the sales and the location of the long-lived assets (in thousands):
 
    
Three Months Ended
September 30,
   
Nine Months Ended September 30,
    
2002
   
2001
   
2002
   
2001
    
Unaudited
   
Unaudited
Revenue from sales to unaffiliated customers:
                            
United States
   
$
10,536
   
$
6,666
   
$
27,745
   
$
21,397
Israel
   
 
847
   
 
1,482
   
 
2,838
   
 
2,432
Europe
   
 
2,571
   
 
1,641
   
 
7,341
   
 
3,531
    
  
  
  
    
$
13,954
   
$
9,789
   
$
37,924
   
$
27,360
    
  
  
  
    
 
September 30, 2002
   
December 31, 2001
          
    
Unaudited
               
Long lived assets:
                            
United States
   
$
1,119
   
$
1,075
              
Israel
   
 
1,005
   
 
971
              
Europe
   
 
61
   
 
66
              
    
  
             
    
$
2,185
   
$
2,112
              
    
  
             

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Table of Contents
 
4.
 
Recently Issued Accounting Standards
 
In July 2001, the FASB issued SFAS No. 141, “Business Combinations,” and SFAS No. 142, “Goodwill and Other Intangible Assets” (SFAS No. 142). The new rules require business combinations initiated after June 30, 2001 to be accounted for using the purchase method of accounting and goodwill acquired after this date will no longer be amortized, but will be subject to annual impairment tests. All other intangible assets will continue to be amortized over their estimated useful lives. Companies are required to adopt SFAS No. 142 for fiscal years beginning after December 15, 2001. The Company adopted SFAS No. 142 in the quarter ended March 31, 2002. The adoption of SFAS No. 142 did not have a material effect on the Company’s financial position, operating results or cash flows.
 
In August 2001, the FASB issued Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (SFAS 144). This statement addresses financial accounting and reporting for the impairment or disposal of long-lived assets. SFAS 144 supersedes SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of, “ and provides guidance on classification and accounting for such assets when held for sale or abandonment. SFAS 144 is effective for fiscal years beginning after December 15, 2001. The Company adopted SFAS No. 144 in the quarter ended March 31, 2002. The adoption of SFAS No. 144 did not have a material effect on the Company’s financial position, operating results or cash flows.
 
In June 2002, the FASB issued SFAS No.146 “Accounting for Costs Associated with Exit or Disposal Activities “ (SFAS 146), effective for exit or disposal activities that are initiated after December 31,2002.Under SFAS 146,a liability for the cost associated with an exit or disposal activity is recognized when the liability is incurred. Under prior guidance, a liability for such costs could be recognized at the date of commitment to an exit plan. The effect of adoption of SFAS 146 is dependent on the Company’s related activities subsequent to the date of adoption.

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Table of Contents
 
Item 2.     Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and the related notes included elsewhere in this Quarterly Report on Form 10-Q. Some of the statements contained in this Form 10-Q are forward looking statements, including but not limited to those specifically identified as such, that involve risks and uncertainties. The statements contained in this Form 10-Q that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”) and Section 21E of the Exchange Act of 1934, as amended, including, without limitation, statements regarding our expectations, beliefs, intentions or strategies regarding the future. All forward-looking statements included in this Form 10-Q are based on information available to us on the date hereof, and we assume no obligation to update any such forward-looking statements. These statements involve known and unknown risks, uncertainties and other factors, which may cause our actual results to differ materially from those implied by the forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” or “continue,” or the negative of these terms or other comparable terminology. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Important factors that may cause actual results to differ from expectations include those discussed in “Risk Factors” in our annual report on Form 10-K filed with the Securities and Exchange Commission on March 26, 2002 and elsewhere in this quarterly report on Form 10-Q.
 
Description of Business
 
We provide proprietary technologies and software products used to efficiently verify designs of electronic systems and complex integrated circuits (ICs) that are essential to a broad and growing range of applications within the electronics industry. Our products automate the process of detecting flaws in the designs of electronic systems and ICs and enable our customers to deliver higher quality electronic products, accelerate time-to-market and reduce overall product development costs. We were founded in September 1995 and commenced operations in January 1996. In November 1999, we acquired SureFire Verification, Inc. by merging it into our wholly-owned subsidiary, Verisity Design, Inc., a California corporation. The SureFire acquisition was accounted for under the pooling-of-interests method.
 
In 1996, we released our original Specman functional verification software product. In the second quarter of 1998, SureFire released our SureCov software product. In the fourth quarter of 1998, we released Specman Elite, an enhanced version of our original Specman product. In the fourth quarter of 1999, we released our SureLint software product. In the second quarter of 2002, we released version 4.0 of Specman Elite, a further enhanced version of our Specman Elite product. We have also introduced several other products and support programs, which enhance the use of our products in the functional verification process.
 

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Three and Nine Months Ended September 30, 2002 Compared to Three and Nine Months Ended September 30, 2001
 
Total Revenue
 
Our revenue consists of license revenue, maintenance revenue and other services revenue. License revenue consists of fees paid by our customers to license our software products. Maintenance revenue consists of fees for technical support and product updates. Other services revenue consists of training and consulting fees. Our total revenue was $14.0 million for the three months ended September 30, 2002, and $9.8 million for the comparable quarter of 2001, representing an increase of $4.2 million, or 42.5%, and was $37.9 million for the nine months ended September 30, 2002, and $27.4 million for the comparable period of 2001, representing an increase of $10.5 million, or 38.6%. Approximately 63% of the increase in each period was attributable to additional sales to our existing customers with the balance coming from new customers.
 
License revenue.    Our license revenue was $8.9 million for the three months ended September 30, 2002, and $6.5 million for the comparable quarter of 2001, representing an increase of $2.4 million, or 37.0%, and was $23.6 million for the nine months ended September 30, 2002, and $17.9 million for the comparable period of 2001, representing an increase of $5.7 million, or 31.9%. Approximately 56% of these increases were attributable to sales to new license customers, with the balance of the increase representing sales to our existing customers. These increases resulted from the increased sales of time-based licenses partially offset by slightly lower sales of perpetual licenses.
 
Maintenance revenue.    Our maintenance revenue was $4.7 million for the three months ended September 30, 2002, and $3.0 million for the comparable quarter of 2001, representing an increase of $1.7 million, or 57.8%, and was $13.0 million for the nine months ended September 30, 2002, and $7.9 million for the comparable period of 2001, representing an increase of $5.1 million, or 65.1%. These increases were primarily attributable to the recognition of maintenance revenue derived in connection with the sale of new licenses.
 
Other services revenue.    Our other services revenue was $351,000 for the three months ended September 30, 2002, and $308,000 for the comparable quarter of 2001, representing an increase of $43,000, or 14.0%, which was attributable approximately equally to higher training and consulting services. Other services revenue was $1.2 million for the nine months ended September 30, 2002, and $1.5 million for the comparable period of 2001, representing a decrease of $0.3 million, or 18.8%. This decrease was primarily attributable to fewer training services being requested by our customers, which we believe resulted from reduced travel for security and budgetary purposes.
 
Cost of Revenue
 
Cost of revenue consists of costs associated with generating license, maintenance and other services revenue. Cost of revenue was $754,000 for the three months ended September 30, 2002, and $883,000 for the comparable quarter of 2001, representing a decrease of $129,000, or 14.6%, and was $2.2 million for the nine months ended September 30, 2002, and $2.8 million for the comparable period of 2001, representing a decrease of $0.6 million, or 20.8%. Cost of revenue as a percentage of total revenue was 5.4% for the three months ended September 30, 2002, and 9.0% for the comparable quarter of 2001, and was 5.8% for the nine months ended September 30, 2002, and 10.1% for the comparable period of 2001.
 
Cost of license revenue.    Cost of license revenue was $45,000 for the three months ended September 30, 2002, and $179,000 for the comparable quarter of 2001, representing a decrease of $134,000, or 74.9%, and was $118,000 for the nine months ended September 30, 2002, and $557,000 for the comparable period of 2001, representing a decrease of $439,000, or 78.8%. As a percent of license revenue, the cost of license revenue decreased from 2.7% for the three months ended September 30, 2001, to 0.5% for the comparable quarter of 2002, and decreased from 3.1% for the nine months ended September 30, 2001, to 0.5% for the comparable period of 2002. These decreases were primarily due to the
 

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Table of Contents
 
fact that in the three- and nine-month periods ended September 30, 2001, we accrued for royalties due to the Office of Chief Scientist in Israel (OCS), for which all obligations were fully repaid during the fourth quarter of 2001, resulting in no royalties being due to the OCS during the first nine months of 2002.
 
Cost of maintenance revenue.    Cost of maintenance revenue was $514,000 for the three months ended September 30, 2002, and $478,000 for the comparable quarter of 2001, representing an increase of $36,000, or 7.5%, and was $1.5 million for the nine months ended September 30, 2002, and $1.3 million for the comparable period of 2001, representing an increase of $0.2 million, or 17.3%. As a percent of maintenance revenue, the cost of maintenance revenue decreased from 16.2% for the three months ended September 30, 2001, to 11.0% for the comparable quarter of 2002, and from 16.3% for the nine months ended September 30, 2001, to 11.6% for the comparable period of 2002. These decreases were a result of an increased volume of maintenance renewals and continued improvements in product quality. These improvements related primarily to the introduction of upgraded versions of our software products that improved functionality and ease of use. These improvements contributed to the overall operating efficiency of our software and our customer support personnel.
 
Cost of other services revenue.    Cost of other services revenue consists primarily of internal and contracted personnel and other expenses related to providing training and consulting services to our customers. Cost of other services revenue was $195,000 for the three months ended September 30, 2002, and $226,000 for the comparable quarter of 2001, representing a decrease of $31,000, or 13.7%, and was $564,000 for the nine months ended September 30, 2002, and $924,000 for the comparable period of 2001, representing a decrease of $360,000, or 39.0%. These decreases were primarily attributable to the decrease in externally contracted training services. As a percent of other services revenue, the cost of other services revenue decreased from 73.4% for the three months ended September 30, 2001, to 55.6% for the comparable quarter of 2002, and from 60.0% for the nine months ended September 30, 2001, to 45.2% for the comparable period of 2002.
 
Operating Expenses
 
Research and development.    Research and development expenses consist primarily of costs related to research and development personnel, including salaries and other personnel-related expenses, sub-contracting fees, facilities and computer equipment used in our product and technology development. Research and development expenses were $2.3 million for the three months ended September 30, 2002, and $2.2 million for the comparable quarter of 2001, representing an increase of $0.1 million, or 3.4%, and were $6.7 million for the nine months ended September 30, 2002, and $6.4 million for the comparable period of 2001, representing an increase of $0.3 million, or 5.2%. These increases were primarily related to the increase in the number of software developers employed in the continuing enhancement of our software products and partially offset by a reduction of $0.1 million and $0.5 million for the three and nine month periods ended September 30, 2002, respectively, due to currency exchange as a somewhat weaker New Israeli Shekel affected the costs in our Israeli operations. Research and development expenses as a percentage of total revenues were 16.4% for the three months ended September 30, 2002, and 22.6% for the comparable quarter of 2001 and were 17.7% for the nine months ended September 30, 2002, and 23.4% for the comparable period of 2001. We believe that significant investment in research and development has been and will continue to be required to develop new products and enhance existing products to allow us to further penetrate our target markets. We anticipate that the absolute dollar amount of research and development expenses will increase in the future.
 
Sales and marketing.    Sales and marketing expenses consist primarily of salaries, commissions, travel for sales and marketing personnel and promotional and advertising costs. Sales and marketing expenses were $5.3 million for the three months ended September 30, 2002, and $4.4 million for the comparable quarter of 2001, representing an increase of $0.9 million, or 21.2%, and were $14.7 million for the nine months ended September 30, 2002, and $12.2 million for the comparable period of 2001, representing an increase of $2.5 million, or 20.4%. These increases were primarily attributable to the hiring of additional sales and marketing personnel, including related travel and office expenses, for an increase of approximately $0.4 million and $1.5 million in the three and nine months periods, respectively.
 

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The balances of the increases were primarily due to higher commission expenses resulting from higher revenue levels. Sales and marketing expenses as a percentage of total revenues were 37.8% for the three months ended September 30, 2002, and 44.5% for the comparable period of 2001, and were 38.7% for the nine months ended September 30, 2002, and 44.6% for the comparable period of 2001. We expect sales and marketing expenses to increase as we expand our geographic reach, hire additional personnel and expand our strategic programs.
 
General and administrative.    General and administrative expenses consist primarily of salaries and other personnel-related expenses for our administrative, legal, human resources, investor relations and finance personnel and expenses for facilities, insurance, and professional services fees. General and administrative expenses were $1.5 million for the three months ended September 30, 2002, and $1.3 million for the comparable quarter of 2001, representing an increase of $0.2 million, or 13.9%, and were $4.2 million for the nine months ended September 30, 2002, and $3.7 million for the comparable period of 2001, representing an increase of $0.5 million, or 13.8%. These increases were primarily attributable to the increased personnel in our finance, legal and investor relations’ functions and an increase in insurance expenses. General and administrative expenses as a percentage of total revenue were 10.7% for the three months ended September 30, 2002, and 13.3% for the comparable quarter in 2001, and were 11.0% for the nine months ended September 30, 2002, and 13.4% for the comparable period of 2001. We expect general and administrative expenses to increase for the foreseeable future as we expand our administrative staff and incur expenses associated with being a public company, including the costs of annual and periodic reporting, investor relations programs and insurance.
 
Non-cash charges related to equity issuance.    Non-cash charges related to equity issuances reflect the amortization of the deferred share-based compensation, representing the difference between the fair value of the ordinary shares for financial reporting purposes and the exercise price of the underlying options at the date of grant, as well as the measurement of the fair value of the non-employee share options. Our share-based compensation expenses, reported in operating expenses, were $34,000 for the three months ended September 30, 2002, and $110,000 for the comparable quarter of 2001, and were $243,000 for the nine months ended September 30, 2002, and $492,000 for the comparable period of 2001. In addition, $2,000 was reported in cost of other services for the three months ended September 30, 2002, and $6,000 for the nine months ended September 30, 2002. The deferred share-based compensation is amortized over the vesting schedule of the underlying options, generally four years.
 
Interest income, interest expenses and other income, net
 
Interest income, interest expenses and other income, net consists of interest income on our cash and cash equivalents, net of interest expense on our obligations under capital lease and other miscellaneous expenses. Our interest income, interest expenses and other income, net decreased from $409,000 for the three months ended September 30, 2001, to $274,000 for the comparable quarter of 2002, and from $1.1 million for the nine months ended September 30, 2001, to $688,000 for the comparable period of 2002. These decreases were primarily due to lower interest rates received on cash and cash equivalents balances. As a percent of total revenue, interest income, interest expenses and other income, net decreased from 4.2% for the three months ended September 30, 2001, to 2.0% for the comparable quarter of 2002, and from 4.1% for the nine months ended September 30, 2001, to 1.8% for the comparable period of 2002.
 
Income taxes
 
We recorded provisions for income taxes of $527,000 in the three months ended September 30, 2002, and $66,000 for the comparable quarter of 2001, and $1.3 million in the nine months ended September 30, 2002, and $151,000 for the comparable period of 2001. The provisions for income taxes in these related periods are primarily due to U.S. alternative minimum taxes.

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We have not recognized any benefit from the future use of loss carryforwards for these periods or for any other period since inception because of uncertainty surrounding their realization. The amount of net operating losses that we can utilize may be limited under tax regulations in some circumstances including acquisition activities.
 
Liquidity And Capital Resources
 
Since our inception, we have financed our operations primarily through the private sale of convertible preferred shares and the public offering of ordinary shares. We have also financed our operations through the sale of ordinary shares, pursuant to our equity incentive plans, equipment financing and cash generated from the sale of our products and services. As of September 30, 2002, we had cash and cash equivalents of $71.1 million, an accumulated deficit of $8.0 million and working capital of $51.4 million.
 
On March 26, 2001, we completed our initial public offering (“IPO”) of ordinary shares in which we sold 3,335,000 shares at a price of $7.00 per share. In April 2001 our underwriters exercised their over-allotment option for an additional 500,250 ordinary shares at the same price set in the IPO. Total net proceeds, including the exercise of the over-allotment option, less underwriting discounts, were approximately $25.0 million.
 
Net cash provided by operating activities was $11.5 million for the nine months ended September 30, 2002, and $12.3 million for the comparable period of 2001. Cash provided by operating activities for each period resulted primarily from the net income and increases in deferred revenue in those periods.
 
Net cash used in investing activities was $724,000 for the nine months ended September 30, 2002, and $935,000 for the comparable period of 2001. Investing activities in the nine months ended September 30, 2002, consisted primarily of $734,000 in capital expenditures. Investing activities in the nine months ended September 30, 2001, consisted primarily of $1.2 million in capital expenditures, partially offset by net sales of $287,000 of short-term investments.
 
Net cash provided by financing activities was $1.9 million for the nine months ended September 30, 2002, resulting primarily from exercise of share options by employees and the purchase of shares under our equity incentives plans. Net cash provided by financing activities was $22.5 million for the nine months ended September 30, 2001, resulting primarily from our IPO, partially offset by the repayment in full of our bank term loan balance of $265,000.
 
We believe that cash flow from operations will continue to be positive, and together with our current cash and cash equivalents balances and current credit facilities will be sufficient to meet our operating requirements for at least the next 12 months, including increased operating expenses and purchases of property and equipment.
 
Although we currently have no plans, commitments or agreements with respect to any acquisitions or investments, it is possible that we may decide to undertake those activities during the next 12 months to an extent that could require additional financial resources. In that case, we may be required to raise additional financing through public or private financings, strategic relationships or other arrangements. However, we cannot be certain that this funding, if needed, will be available on terms attractive to us, or at all. Furthermore, any additional equity financing may be dilutive to shareholders, and debt financing, if available, may involve restrictive covenants.
 
Item 3.   Quantitative And Qualitative Disclosure About Market Risk
 
We develop products primarily in Israel, and also in North America, and sell those products primarily in North America, Israel, Europe and Eastern Asia. As a result, our financial results could be

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affected by factors such as changes in foreign currency exchange rates or weak economic conditions in foreign markets. As substantially all of our sales are currently made in United States dollars, a strengthening of the United States dollar could make our products less competitive in foreign markets.
 
We incur expenses denominated in the local currencies in Israel and Europe. As exchange rates vary, these expenses, when translated into United States dollars, may vary from expectations and adversely affect overall profitability.
 
Our exposure to market risk for changes in interest rates relates primarily to our cash and cash equivalents. We maintain a conservative investment policy, which intends to ensure the safety and preservation of our invested funds by limiting default risk, market risk and reinvestment risk. Our cash and cash equivalents as of September 30, 2002, consists primarily of short-term U.S. government securities, demand deposits and money market funds held by institutions in the United States.
 
Management’s intent and current practice is to invest funds in excess of current operating requirements in:
 
 
•
 
obligations of the United States government and its agencies;
 
 
•
 
investment grade state and local government obligations;
 
 
•
 
securities of corporations in the United States rated A1 or P1 by Standard & Poors’ or Moody’s Ratings; or
 
 
•
 
money market funds, deposits or notes issued or guaranteed by commercial banks meeting certain credit rating and net worth requirements with maturities of less than two years.
 
These investments, included in our cash and cash equivalents, are exposed to short-term fluctuations in interest rates. Should interest rates fall, our cash equivalents may produce less income than expected. During the period ended September 30, 2002, decreases in interest rates did not have a material impact on our operating results. Our long-term liabilities, largely composed of deferred revenues, are not subject to interest rate risk. Given the liquid nature of our cash and cash equivalents and the non-exposed nature of our long-term liabilities, we have concluded that we do not have material market risk exposure due to changes in interest rates.
 
Item 4.     Controls and Procedures
 
Under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, the Company has evaluated the effectiveness of the design and operation of its disclosure controls and procedures, as such term is defined under Rule 13a-14(c) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), within 90 days of the filing date of this quarterly report, and, based on their evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective. There were no significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation.
 
PART II.    OTHER INFORMATION
 
Item 1.     Legal Proceedings
 
None.

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Item 2.     Changes In Securities and Use of Proceeds
 
During the three months ended September 30, 2002, we issued an additional 68,806 ordinary shares as a result of the exercise of share option grants. The aggregate net consideration received by the Company for the issuance of the ordinary shares was $259,000. Certain of the ordinary shares were issued pursuant to compensatory plans registered by registration statements, filed with the SEC on Form S-8. Other ordinary shares were issued pursuant to compensatory plans of the Company that are compliant with Rule 701 promulgated under the Securities Act and in reliance on the exemption from the registration requirements of the Securities Act provided by such rule.
 
On March 26, 2001, we completed our initial public offering in which we sold 3,335,000 ordinary shares at $7.00 per share. The net proceeds we received from this offering after deducting underwriting discounts were approximately $21.7 million.
 
In April 2001, the underwriters of the initial public offering exercised their over-allotment option to purchase an additional 500,250 ordinary shares at $7.00 per share, the initial public offering price of the ordinary shares. The net proceeds received after deducting underwriting discounts were approximately $3.3 million.
 
We intend to use the aggregate net proceeds from our initial public offering, share purchases pursuant to equity incentives plans and cash generated from operation activities for general corporate purposes, capital expenditures and potential acquisitions of complementary businesses, products and technologies. Pending these uses, these cash balances have been and will continue to be invested in interest bearing, investment grade securities.
 
Item 3.     Default Upon Senior Securities.
 
None.
 
Item 4.     Submission of Matters to a Vote of Security Holders.
 
None.
 
Item 5.     Other Information
 
In accord with Section 10A(i)(2) of the Securities Exchange Act of 1934, as added by Section 202 of the Sarbanes-Oxley Act of 2002, the Company is responsible for listing the non-audit services approved in the third quarter by the company’s Audit Committee to be performed by Ernst & Young, the Company’s independent auditor. Non-audit services are defined in the law as services other than those provided in connection with an audit or a review of the financial statements of the Company. The non-audit services approved by the Audit Committee in the third quarter are each considered by the company to be either audit-related services which are closely related to the financial audit process or related to taxation matters.

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Item 6.      Exhibits and Reports on Form 8-K.
 
(a)  See Exhibit Index on Page 18.
(b)  No report on Form 8-K was filed during the quarter ended September 30, 2002.
 

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SIGNATURES
 
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
           
VERSITY LTD.
    (Registrant)
Date:
  
November 12, 2002
      
By:
  
/s/  Charles G. Alvarez
           
Charles G. Alvarez
Vice President of Finance and
Administration and Chief Financial
Officer (Principal Accounting Officer)
 

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Certification under Section 302(a) of the Sarbanes-Oxley Act of 2002
 
I, Moshe Gavrielov, certify that:
 
1.
 
I have reviewed this quarterly report on Form 10-Q of Verisity Ltd.;
 
2.
 
Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;
 
3.
 
Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;
 
4.
 
The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant, and we have:
 
 
a)
 
designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;
 
 
b)
 
evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and
 
 
c)
 
presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
 
5.
 
The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors:
 
 
a)
 
all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
 
 
b)
 
any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls;
 
6.
 
The registrant’s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
 
Date: November 12, 2002
          
/s/    Moshe Gavrielov         
               
Chief Executive Officer     

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I, Charles Alvarez, certify that:
 
1.
 
I have reviewed this quarterly report on Form 10-Q of Verisity Ltd;
 
2.
 
Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;
 
3.
 
Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;
 
4.
 
The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant, and we have:
 
 
a)
 
designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;
 
 
b)
 
evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and
 
 
c)
 
presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
 
5.
 
The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors:
 
 
a)
 
all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
 
 
b)
 
any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls;
 
6.
 
The registrant’s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
 
Date: November 12, 2002
          
/s/    Charles Alvarez         
               
Vice President of Finance and Administration and Chief Financial Officer     

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EXHIBIT INDEX
 
Number
   
Description
3.1*
   
Articles of Association, as amended.
3.2*
   
Amendment to the Articles of Association
3.3*
   
Form of Amended and Restated Articles of Association.
3.4*
   
Memorandum of Association, as amended.
4.1*
   
Form of Share Certificate.
4.3*
   
Warrant to Purchase up to an aggregate of 45,618 Series D Preferred Shares.
4.4*
   
Warrant to Purchase up to an Aggregate of 19,551 Series D Preferred Shares.
10.1*
   
Loan Modification Agreement dated as of December 30, 1999, by and between Verisity Design, Inc. and Silicon Valley Bank.
10.2*
   
Amended and Restated Loan and Security Agreement by and between Silicon Valley Bank and Verisity Design, Inc., dated as of December 31, 1998.
10.3*
   
Unconditional Guaranty (Verisity Ltd.) dated as of December 31, 1998.
10.4*
   
Lease Agreement dated as of July 29, 1997 by and between Mifalei Locky, 1’Bniya Ltd. and Verisity Ltd.
10.5*
   
Rental Agreement by and between Verisity Design, EURL and IOM Business Center GmbH, dated as of October 1, 1999.
10.6*
   
Rental Agreement by and between Verisity Design, EURL and IOM Business Center GmbH, dated May 8, 2000.
10.7*
   
License by and between Chancery Court Business Center Ltd. And Verisity Design, EURL, effective as of August 1, 2000.
10.8*
   
Office Services Agreement by and between Verisity Design, EURL and Vantas, effective as of November 1, 1999.
10.9*
   
Domiciliation Agreement by and between Verisity Design, EURL and “BURO Club,” dated May 11, 1999.
10.10*
   
Landmark Office Center Lease by and between Landmark Investments Limited and Verisity Design, Inc., dated August 10, 1998.
10.11*
   
Landmark Office Center Lease by and between Landmark Investments Limited and Verisity Design, Inc., dated August 10, 1998.
10.12**
   
Lease Agreement dated as of November 28, 2000, by and between W9/TIB Real Estate Limited Partnership and Verisity Design, Inc.
10.13*
   
Office Service Agreement effective as of October 1, 2000 by and between Austin Mopac d/b/a/ Vantos and Verisity Design, Inc.
10.14*
   
Office Service Agreement dated as of November 8, 1999 by and between Plano Executive Suite, Inc. d/b/a HQ Plano, Managing Partner and Verisity Design, Inc.
10.15*
   
Letter Distributor Agreement dated as of December 1, 1998 by and between Verisity Design, Inc. and Integrated Systems Scandinavia AB.
10.16*
   
International Distributor Agreement by and between Verisity Design, Inc. and Cybertec Yugen Kaisha, effective as of January 1, 1999.
10.17*
   
International Distributor Agreement by and between Verisity Design, Inc. and Davan Tech Company, Ltd., dated as of November 10, 1999.
10.18*
   
Employment Agreement effective as of October 26, 1999 by and between Verisity Design, Inc. and Michael McNamara.
10.19*
   
Employment Agreement effective as of March 23, 1998 by and among Verisity Ltd., Verisity Design, Inc. and Moshe Gavrielov.
10.20*
   
Secured Promissory Note from Moshe Gavrielov to Verisity Design, Inc. dated March 23, 1998.
10.21*
   
Form Software License Agreement.
10.23*
   
Share Restriction Agreement effective as of March 23, 1998 by and between Verisity Ltd. and Moshe Gavrielov.
10.24*
   
Stock Option Agreement effective as of December 1, 1999 by and between Verisity Ltd. and Moshe Gavrielov.

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10.25*
   
Amended and Restated Verisity Ltd. 2000 U.S. Share Incentive Plan, form of Option Agreement for Amended and Restated 2000 U.S. Share Incentive Plan and form of Option Agreement for outside directors under Amended and Restated 2000 U.S. Share Incentive Plan.
10.26*
   
Verisity Ltd. 1999 Israeli Share Option Plan and form of Option Agreement for 1999 Israeli Share Option Plan.
10.27*
   
Verisity Ltd. 1999 Share Incentive Plan and form of Option Agreement for 1999 Share Incentive Plan.
10.28*
   
Sub-Plan for the Issuance of Options to the Company’s Employees created within the framework of the 1997 Israel Share and Option Incentive Plan and form of Option Agreement for Sub-Plan.
10.29*
   
1997 Israel Share and Stock Option Incentive Plan.
10.30*
   
1996 U.S. Stock Option Plan, as amended October 1999, form of Option Agreement for 1996 U.S. Stock Option Plan and form of Amended Option Agreement.
10.31*
   
Verisity Ltd. 2000 Employee Share Purchase Plan.
10.32*
   
Amendment to Amended and Restated Investor Rights Agreement dated as of July 21, 1999 by and among Verisity Ltd., Yoav Hollander, Avishai Silvershatz, Moshe Gavrielov and certain investors.
10.33*
   
Amended and Restated Investors Rights Agreement dated as of February 26, 1999 by and among Verisity Ltd., Yoav Hollander, Avishai Silvershatz, Moshe Gavrielov and certain investors.
10.34*
   
Technology Exchange Agreement, Addendum to Software License and Volume Purchase Agreement effective as of January 1, 2000 by and between LSI Logic Corporation and Verisity Design, Inc.
10.35*
   
Software License and Volume Purchase Agreement effective as of December 11, 1998 by and between Verisity Design, Inc. and LSI Logic Corporation.
10.36*
   
Software License Agreement by and between Intel Corporation and Verisity Design, Inc., effective as of January 18, 1999.
10.37*
   
Amendment No. 1 to Software and Related Services Agreement, effective as of May 5, 2000 and Intel Corporation Purchase Agreement, Software and Related Services, by and between Intel Corporation and Verisity Design, Inc., effective as of June 21, 1999.
10.38*
   
Verisity Ltd. 2000 Israeli Share Option Plan and form of Option Agreement for 2000 Israeli Share Option Plan.
10.39*
   
Verisity Ltd. 2000 Directed Share Plan.
10.40*
   
International Representative Agreement between Verisity Design, EURL and Integrated Systems Scandinavia EDA AB, effective as of June 15, 2000.
10.41*
   
First Amendment to Verisity Ltd. 1999 Israeli Share Option Plan.
10.42*
   
First Amendment to Verisity Ltd. 2000 Employee Share Purchase Plan.
10.43**
   
Sublease Agreement dated as of February 20, 2002, between Lakewood Property Trust, I/O of Austin Inc. and Verisity Design, Inc.
21.1*
   
List of subsidiaries.
99.2
   
Certification pursuant to 18.U.S.C. Section 1350 for the current period.
99.3
   
Certification pursuant to 18.U.S.C. Section 1350 for the current period.
*
 
Incorporated by reference from the like-numbered exhibit filed with the Registrant’s registration statement on Form S-1 (No. 333-45440) filed on September 8, 2000, as subsequently amended.
**
 
Incorporated by reference from the like-numbered exhibit filed with the annual report on Form 10-K (No. 000-32417) filed on March 26, 2002.

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