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FORM 10-K

(Mark One)

		ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

For the fiscal year ended December 31, 2000

OR

		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

For the transition period from              to               .

Commission File Number: 0-20981

DOCUMENT SCIENCES CORPORATION

Registrant’s telephone number, including area code: (760) 602-1400

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:

     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    No 

      Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  

      As of March 30, 2001, there were 10,858,384 shares of the Registrant’s common stock outstanding and the aggregate market value of such shares held by non-affiliates of the Registrant (based upon the closing sale price of such shares on The Nasdaq National Market on March 30, 2001) was approximately $5,689,717. Shares of common stock held by each executive officer and director and by each entity that owns 5% or more of the outstanding common stock have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

DOCUMENTS INCORPORATED BY REFERENCE

      Part III incorporates certain information by reference from Registrant’s definitive proxy statement pursuant to Schedule 14A for its 2001 Annual Meeting of Stockholders to be held on May 30, 2001, which proxy statement will be filed no later than 120 days after the close of Registrant’s fiscal year ended December 31, 2000.

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A WARNING ABOUT FORWARD-LOOKING STATEMENTS

      We make forward-looking statements in this Annual Report that are subject to risks and uncertainties. These forward-looking statements include information about possible or assumed future results of our financial condition, operations, plans, objectives and performance. Additionally, when we use the words “believe,” “expect,” “anticipate,” “estimate” or similar expressions, we are making forward-looking statements. Many possible events or factors could affect our future financial results and performance. This could cause our results or performance to differ materially from those expressed in our forward-looking statements. You should consider these risks when you review this document, along with the following possible events or factors:

	•	national, international, regional and local economic, competitive and regulatory conditions and developments;
	•	the market for document automation software;
	•	market acceptance of our existing products and introduction of new products and enhancements to existing products;
	•	continued expansion of our professional services;
	•	maintaining our relationships with Xerox;
	•	possible transfer of our listing of our shares to the NASDAQ SmallCap Market; and
	•	other uncertainties, all of which are difficult to predict and many of which are beyond our control.

      Foreseeable risks and uncertainties are described elsewhere in this report and in detail under “Item 1. Business — Risk Factors.” You are cautioned not to place undue reliance on these forward-looking statements, which reflect management’s analysis only as of the date of this Annual Report. We undertake no obligation to publicly release the results of any revision of the forward-looking statements.

PART I

Item 1. Business

      Document Sciences Corporation develops, markets and supports a family of document automation software used in high volume print and transactional electronic publishing applications. Document automation has become increasingly important as more companies realize the benefits of producing individually customized documents that require the precise layout of regulated content, personal financial data and in-context one-to-one marketing information. Our document automation software, the Document Sciences Autograph family of products, enables personalized publishing solutions for many industries including insurance, managed healthcare, financial services, commercial print services, government, telecommunications and manufacturing. Our products facilitate an important form of communication between organizations and their customers by employing enterprise database assets to produce high-quality, personalized documents that are ready to print on demand, email or distribute over the web using HTML or Adobe Systems’ (Adobe) PDF® technology. Document Sciences Autograph is licensed to approximately 600 customers worldwide who collectively produce over one billion customized pages per month. Our highly portable Document Sciences Autograph software platform enables cost-effective, just-in-time, on demand, high volume or transactional publishing that is high quality and fully automated. Our software products are used across a wide array of computing environments from client/server PC and Unix configurations to large mainframe computer systems.

Company Formation

      We were incorporated in Delaware in October 1991 as a wholly owned subsidiary of Xerox Corporation. Following our initial public offering of stock in September 1996, Xerox ownership was reduced to approximately 62%. After the completion of our tender offer to purchase 6,000,000 shares of our outstanding stock, which expired on March 23, 2001, and the likely exercise of our option to purchase additional shares

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Products

      The Document Sciences Autograph family of products currently addresses three major functional areas within the enterprise document automation arena: Document Composition and Assembly, Variable Content Management and Electronic Document Viewing, as described below. All of our software products can be complemented by our professional services organization.

      Historically, we have licensed our products for one year, for an initial license fee, after which an annual renewal fee, usually 15% of the initial license fee, is required for continued use. We have augmented this approach with new licensing models whereby we offer perpetual licenses for our products, as well as three-year term licenses, after which the license may be renewed for additional three-year terms, or converted for perpetual use. We also provide three-year maintenance agreements that are usually in an amount equal to 15%, per year, of the initial license fee. The list price for a three-year license fee for CompuSet, our core product, is currently $80,000 for a mainframe installation and ranges down to $40,000 for a PC NT server installation. Options currently range from $2,000 to $50,000. A typical new account sale through our direct channel is currently about $100,000 for software licenses and approximately $75,000 for professional services.

  Document Composition and Assembly

      Composition and Assembly. CompuSet software automates document assembly and composition using corporate data and variable content. CompuSet consists of a rule-based language and a composition engine that provides high-speed content assembly and composition of complex personalized documents at a high level of quality. The corporate data and variable content are marked with CompuSet tags which, in turn, are defined in logically separate CompuSet style specifications. The CompuSet tags are conceptually and syntactically similar to HTML or XML tags, the current web standards for content tagging, and the CompuSet style specification is conceptually similar to CSS and XSL, the current web standards for style definition. Without requiring any real-time user interaction, CompuSet transforms the tagged data and variable content into high-quality electronic documents that can be composed and assembled at rates in excess of 50 pages per second, depending on computing configuration and complexity of the document. Document composition features are rich and extensive, including the generation of multi-dimensional dynamic data driven graphics, and the support of full color text and images. The assembly and composition process can be optimized for print, email and/or web presentation media.

      Data and Variable Content Capture. Corporate data and variable content capture products include the Data Preparation Tool, or DPT, as well as a number of variable content Importers. These tools map corporate data and prepare variable content for subsequent assembly and composition. DPT is an optional product that enables users to capture and tag corporate data and variable content from a wide variety of sources, including flat files and relational databases, for subsequent CompuSet processing. It provides an easy-to-use Graphical User Interface, or GUI, that describes the data environment and the related data processing and tagging instructions for CompuSet. It then automatically generates a data-tagging program in COBOL that is compatible with mainframe COBOL compilers and Acucorp’s AcuCobol® runtime products. The content Importers accept externally generated document objects, including text, static graphics and scanned images, and converts them into CompuSet compatible formats. The content Importers currently support merge objects in Xerox Corporation’s (Xerox) Metacode®, Adobe’s PostScript® and EPS®, and in the TIFF and JPEG standards for scanned images. This part of the Autograph architecture is extensible and new content Importers can be developed for supplemental print, email and web media, as required.

      Document Output and Merge. The Emitters transform CompuSet output into a number of popular Page Description Languages, or PDLs, for subsequent printing and/or archive viewing. The PDLs provide device-specific instructions for rendering text, forms, images and graphics into finished documents. The Emitters also condition the PDLs for transport over a variety of high-speed printing interfaces and for support of various

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      Rapid Application Development Tools. The Visual CompuSet application development tools run on Microsoft Corporation’s (Microsoft) Windows® and simplify variable document application design and prototyping. Visual CompuSet incorporates support for the optional DPT product, for a variety of Importer, Merge, Font and Emitter tools, as well as for the CompuSeries II design environment and JetForm Corporation’s JetForm Design Tool®. Visual CompuSet uses a Windows version of CompuSet and supports all of the dynamic functions and features of the NT, Unix and mainframe CompuSet production engines.

      Visual CompuSet Professional Edition. Visual CompuSet Professional Edition, or VCPro, significantly augments the capabilities of the basic Visual CompuSet product. An interactive Document Designer component is tightly integrated with the graphical DPT user interface. Users can define their existing data environment with DPT and can directly associate their data and variable content elements with CompuSet style objects such as sections, paragraphs, tabular elements, images, photographs and 2 and 3-D data-driven graphics. The DPT and Document Designer GUI interactions feature WYSIWYG interaction and Drag-and-Drop operability. The feature set is rich and general-purpose and the design centerline is the generation of complex high-value investment and other financial statements. Existing Visual CompuSet users can upgrade to the new Professional Edition product, released November 2000. Additional VCPro enhancements, including integrated web application support, are planned for introduction during 2001.

  Variable Content Management

      Variable Content Management products provide client/server solutions for the creation, revision and management of document components used in several types of document automation solutions. They consist of the Document Library Service, or DLS, Server and Client products, DLS Web Express, DLS eCor and DLSCOM.

      DLS Server and Clients. The DLS Server manages the document component creation process required by complex variable and text-intensive documents, such as contracts, policies and customer correspondence. In addition to component creation, DLS also supports the definition of complex assembly rules required for interactive or fully automated document composition and assembly using Microsoft Word and/or CompuSet. DLS uses a client server architecture for accessing data and files on a mainframe or NT network server. The DLS Client product manages text objects created with Microsoft Word, and stored in HTML. The DLS text objects are tracked and managed in a multi-authoring environment that supports access security, content searching, revision control and approval workflow. DLS also provides a criteria-based document text object selection capability for customized or personalized documents. These criteria are then used by DLS to select the text objects and generate a Microsoft Word document or a CompuSet-ready tagged file, based on application volume requirements. The customized or personalized document assembly can be directed to occur in a high volume fashion on the server or in a just-in-time, on-demand fashion on the local DLS Client PC.

      DLS Web Express. DLS Web Express augments the flexibility of our DLS product line by incorporating Internet support. DLS Web Express enables the dynamic creation and fulfillment of web-ready documents using HTML and/or Adobe’s PDF. These documents can be created on-demand through Advanced Server Page (ASP), or other web server applications. Dynamic web browser form input is routed to the DLS Web Express Server to automatically assemble and generate a customized web-ready document for local browser viewing or printing. Target applications include insurance agent and sales proposal automation. Existing DLS users can upgrade to the new DLS Web Express product. Additional features and enhancements to DLS Web Express are planned for 2001.

      DLS eCor and DLSCOM. The recent introduction of DLS eCor and DLSCOM in December 2000 further augments the DLS technology capabilities by providing a rich feature-set that is targeted at enterprise-

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Electronic Document Viewing

      Electronic Document Viewing enables on-line viewing and archiving of electronic documents produced by Autograph applications. It consists of a proprietary viewing architecture using the CCF Emitter and CompuView, as well as an open viewing architecture using the PDF Emitter for supporting Adobe’s popular Portable Document Format. The CCF Emitter is available for a variety of mainframe, Unix, and PC NT servers. The electronic document files are generated in the Composite Container Format, or CCF, which is optimized for fast, memory-efficient viewing, transport and storage of variable document streams, and these can be searched and viewed using CompuView. CCF files consist of three major components: an internal rendition of the pages for WYSIWYG viewing, various indices for locating documents and reusable document elements. The view of the document is virtually identical to the printed document. CCF files can be distributed, archived or printed through document distribution and archiving systems offered by third party software developers that integrate CCF and CompuView. The PDF Emitter can also be used to support archiving and viewing using third party archiving products. Lastly, indexed support of IBM’s AFPDS document format is provided for compatibility with IBM’s On-Demand offering.

      We are developing a variety of Internet extensions, as well as considering additional possible future extensions, some of which are not currently under active development. We believe that our core technology can be extended to the Internet and we are continuing our development activities in this area, although there can be no assurance that such development activities will result in commercially successful products. See “Business — Research and Development.”

Professional Services

      In addition to our software products, we provide a comprehensive suite of professional services that can assist customers in the implementation of mission-critical document automation applications. Professional services include on-site software installation, customer training programs, telephone support programs and consulting services. Our consulting services are currently focused on assisting in the sale of high margin initial software licenses by providing project management, requirements analysis, application design and application development services. In addition to consulting services, we provide introductory and advanced-level education classes in CompuSet, Visual CompuSet, DPT and DLS at our headquarters in San Diego, our offices in Milwaukee and Washington DC and at customer sites. We believe that the use of our professional services enables customers to deploy our document automation products more rapidly and effectively. The professional services and support organizations employed a staff of 42 as of December 31, 2000.

Sales and Marketing

      Our sales and marketing organization targets vertical industry markets that require document automation and high volume, high quality document customization. We currently license our products using a combination of direct sales and alternative channels. In the United States, we market our products primarily through a direct sales force that manages our existing base of corporate accounts, as well as targets new accounts in select market segments. Our sales account executives are grouped into industry focused teams and are provided with pre-sales technical support by qualified solution analysts. Account executives and solution analysts are located throughout the United States to provide optimal coverage. Outside of the United States, we distribute our software products through value added resellers, or VARs, such as Xerox Canada, Ltd. in Canada, Fuji Xerox Co., Ltd. in Australia and Xerox Brazil, Ltd. in Brazil. Our subsidiary, Document Sciences Europe, markets our products in Europe, Africa and the Middle East by providing VAR channel

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      We intend to increase both our product offerings and markets through joint marketing, sales and distribution and development relationships with other major companies. Current relationships include formal and informal marketing and sales alliances with IBM, Xerox, American Management Systems Inc., Siebel Systems, Inc., Sybase, Inc. and Cardiff Software. These relationships provide sales leads for our products and extend our sales coverage and networking capabilities.

Research and Development

      We are continuing to enhance our World Wide Web functionality across all of our major product offerings. We engage customers in a formal requirements analysis that is based on the Quality Function Deployment (QFD) process, which is a formal procedure for interviewing customers, identifying their needs and prioritizing specific product features. As a result, we have identified a number of customer requirements for regulated, electronic documents of the future. Our major product initiatives in 2001 address several of the key requirements brought to our attention through the QFD process.

      In general, our product development strategy is based on delivering document automation solutions for specific types of documents in one or more industries. A cross-functional team that includes a representative from each discipline in the company is responsible for delivering each focused offering. We use a documented business planning and product delivery process to guide our product development and delivery activities.

      Our new product offerings build on Document Sciences Autograph family of products. These established products are maintained by teams that respond to customer requests for defect corrections and feature enhancements. By building on our existing products, we maximize our reuse of existing software and expertise and enable our customers to purchase new offerings as upgrades.

      New product offerings are increasingly being delivered as components that adhere to open standards for large-scale systems integration. Furthermore, new products are increasingly supporting open tagged data and content standards such as HTML and XML. By developing with open standards we can expand the delivery of our products through large systems integrators.

      We can make no assurance that we will be successful in developing, introducing and marketing new products on a timely and cost-effective basis, if at all, or that new products will achieve market acceptance. See “— Risk Factors — Our growth depends on market acceptance of our existing products and our introduction of new products and enhancements to existing products.”

      We expect to continue to enhance our existing products and to develop new products, particularly as they relate to electronic document automation applications. Our research and development expenditures have grown substantially since our inception. Such expenditures, not including amounts capitalized, were $4.3 million, $4.7 million and $4.2 million in 1998, 1999 and 2000, respectively. Our development organization employed a staff of 46 as of December 31, 2000. We also employ independent contractors as needed to supplement our permanent development staff.

Competition

      The market for document automation products is intensely competitive, subject to rapid change and significantly affected by new product introductions and other market activities of industry participants. Our software products are targeted at document intensive organizations that require the ability to produce large quantities of customized and personalized documents in paper or electronic form. We face direct and indirect competition from a broad range of competitors who offer a variety of products and solutions to our current and potential customers. Our principal competition currently comes from systems developed in-house by the internal MIS departments of large organizations where there is a reluctance to commit the time and effort necessary to convert their document automation processes to our document automation software. We also face

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      It is also possible that we will face competition from new competitors. These include large independent software companies offering personal computer-based application software solutions, such as Microsoft and Adobe, and from large corporations providing database management software solutions, such as Oracle Corporation. In addition, Xerox, either directly or through affiliated entities, could become a large competitor. Moreover, as the market for document automation software develops, a number of these or other companies with significantly greater resources than we do could attempt to enter or increase their presence in the document automation market by either acquiring or forming strategic alliances with our competitors or by increasing their focus on the industry. In addition, current and potential competitors have established or may establish cooperative relationships among themselves or with third parties to increase the ability of their products to address the needs of our current and prospective customers. It is possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share. Increased competition may result in price reductions, reduced gross margins and loss of market share, any of which could have a material adverse effect on our business, operating results and financial condition.

Patents and Proprietary Rights

      Our success is dependent, in part, on our ability to protect our proprietary technology. We rely primarily on a combination of copyright and trademark laws, trade secrets, confidentiality procedures and contractual provisions to protect our proprietary rights. We seek to protect our software, documentation and other written materials under trade secret and copyright laws, which afford only limited protection. We presently have no patents or patent applications pending. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain and use information that we regard as proprietary. See “— Risk Factors — Our growth is dependent upon successfully protecting our proprietary rights.”

      In addition, we also rely on certain software that we license from third parties, including software that is integrated with internally developed software and used in our products to perform key functions. There can be no assurances that such firms will remain in business, that they will continue to support their products or that their products will otherwise continue to be available to us on commercially reasonable terms. The loss or inability to maintain any of these software licenses could result in delays or reductions in product shipments until equivalent software can be developed, identified, licensed and integrated, which would adversely affect our business, operating results and financial condition.

Customers

      We derived 23% of our revenues through Xerox in 2000. As a result, discontinuation of agreements and other business transactions that may adversely impact our relationship with Xerox could have a material adverse effect on our business, operating results and financial condition.

Employees

      As of December 31, 2000, we had 148 employees including 42 in professional services, 41 in sales and marketing, 46 in research and development and 19 in finance and administration. None of our employees are represented by a labor union. We have experienced no work stoppages and believe our relationship with our employees is good. Competition for qualified personnel in the industry in which we compete is intense. We believe that our future success will depend in part on our continued ability to attract, hire and retain qualified personnel.

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Financial Information about Segments and Geographic Areas

      The information regarding revenues and operating profit by reportable segments and revenues from unaffiliated customers by geographic region is set forth at the end of the Annual Report under the heading “Notes to Consolidated Financial Statements — 3. Segment Information,” and is incorporated herein by reference.

Risk Factors

      The following is a discussion of certain factors which currently impact or may impact our business, operating results and/or financial condition. Anyone making an investment decision with respect to our common stock or other securities is cautioned to carefully consider these factors. If any of the following risks actually occur, our business, future operating results and financial condition could be materially adversely affected. In such case, the trading price of our common stock could decline and you may lose all or part of your investment.

Our quarterly results fluctuate significantly and we may not be able to grow our business.

      Our total revenues and operating results can vary, sometimes substantially, from quarter to quarter and we expect them to vary significantly in the future. Our revenues and operating results are difficult to forecast; and our future results will depend upon many factors, including the following:

	•	the demand for our products;
	•	the level of product and price competition we face;
	•	the length of our sales cycle;
	•	the size and timing of individual license transactions;
	•	the delay or deferral of customer implementations;
	•	the budget cycles of our customers;
	•	our success in expanding our direct sales force or indirect distribution channels;
	•	the timing of our new product introductions and enhancements, as well as those of our competitors;
	•	our mix of products and services;
	•	our level of international sales;
	•	the activities of and acquisitions by our competitors;
	•	our timing of new hires;
	•	changes in foreign currency exchange rates;
	•	our ability to develop and market new products and to control costs; and
	•	general domestic and international economic conditions.

      Our initial license fee revenue mainly depends on when orders are received and shipped. However, because of our sales model, our customers’ implementation schedule and the complexity of the implementation process, revenue from some software shipments may not be recognized in the same quarter as when a shipment occurs. Our operating expenses are primarily based on anticipated revenue levels. Since a high percentage of those expenses are relatively fixed, a delay in the recognition of revenue from license transactions could cause significant variations in operating results from quarter to quarter and we may sustain losses as a result. If such expenses precede increased revenues, our operating results would be materially adversely affected.

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      As a result of these factors, results from operations for any quarter are subject to significant variation, and we believe that period-to-period comparisons of our results of operations are not necessarily meaningful and you should not rely upon them as an indication of our future performance. Furthermore, our operating results in some future quarter may fall below the expectations of public market analysts and investors. If this occurs, the price of our common stock would likely be materially adversely affected.

We are substantially controlled by Xerox.

      Xerox owns approximately 62% of the outstanding shares of our common stock. Consequently, Xerox controls Document Sciences, is able to elect our entire board of directors and could have significant input into our operations. In addition, Xerox is able to determine the outcome of all corporate actions requiring stockholder approval, including potential mergers, acquisitions, consolidations and sales of all or substantially all of our assets. Xerox’s voting power could delay or prevent a change in control of Document Sciences and may prevent or discourage tender offers for our common stock at a premium price by another person or entity. Xerox affiliates currently hold one of the five seats on our board of directors.

      As discussed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Overview and Recent Developments,” our tender offer for up to 6,000,000 shares of our outstanding common stock expired on March 23, 2001. The offer was oversubscribed. Xerox tendered all of its shares of Document Sciences in that offer, but will be subject to proration. Xerox also gave us an option to purchase up to 2,000,000 additional shares of our common stock that it owns at the tender offer price under the condition that they would hold at least 19.9% of our common stock outstanding after the exercise of the option. After the conclusion of the tender offer and our likely exercise of the option, we expect Xerox to own approximately 19.9% of our common stock outstanding.

We currently derive a significant portion of our revenues through Xerox.

      We currently have a variety of contractual and informal relationships with Xerox and affiliates of Xerox, including a cooperative marketing agreement, a transfer and license agreement and various distribution agreements. We rely on these relationships and agreements for a significant portion of our total revenues.

	•	In 2000, revenues derived from relationships with Xerox and affiliates of Xerox accounted for approximately $5.2 million, representing 23% of our total revenues;
	•	In 1999, revenues derived from relationships with Xerox and affiliates of Xerox accounted for approximately $5.2 million, representing 21% of our total revenues; and
	•	In 1998, revenues derived from relationships with Xerox and affiliates of Xerox accounted for approximately $5.4 million, representing 27% of our total revenues.

      Included above were commissions that we received from sales of Xerox printers under our strategic marketing alliance with Xerox. These commissions were:

	•	2000: $0;
	•	1999: $287,000; and
	•	1998: $344,000.

      These commissions have little or no associated costs and have contributed a substantial portion of our income from operations for certain prior operating periods. This commission arrangement was terminated as of September 30, 1999.

      Furthermore, there can be no assurance that existing and potential customers will continue to do business with us because of these relationships or our historical ties with Xerox and its affiliates. Although we intend to continue our existing business relationships with Xerox, our strategy is to lessen our dependence on Xerox. However, there can be no assurance that we will be able to do so and, because of our current level of dependence on Xerox, there can be no assurance that our move to become more independent will not adversely affect our business, operating results and financial condition. Our failure to maintain these

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      Xerox has strategic alliances and other business relationships with other companies who supply software and services used in high volume electronic publishing applications and who now or in the future may be our competitors. There can be no assurance that Xerox or one of its affiliated companies will not engage in business that directly competes with us. In addition, Xerox has ongoing internal development activities that could in the future lead to products that compete with us. Xerox could in the future expand these relationships or enter into additional ones, and as a result our business could be materially adversely affected.

Our growth is dependent upon successfully protecting our proprietary rights.

      We rely on a combination of copyright and trademark laws, trade secrets, confidentiality procedures and contractual provisions to protect our proprietary rights. Despite these precautions, it may be possible for unauthorized third-parties to copy portions of our products or use information we consider proprietary. Policing unauthorized use of our products is difficult, and while we are unable to determine the extent to which piracy of our software products exists, software piracy can be expected to be a persistent problem. In addition, the laws of some foreign countries do not protect our proprietary rights to as great an extent as do the laws of the United States. We can not assure you that our means of protecting our proprietary rights will be adequate or that our competitors will not independently develop similar technology. We are not aware that any of our products infringe upon the proprietary rights of third parties. We can not assure you, however, that third parties will not claim infringement by us with respect to current or future products. We expect that software product developers will increasingly be subject to infringement claims as the number of products and competitors in our industry segment grows and the functionality of products in different industry segments overlaps. Any such claims, with or without merit, could be time consuming, result in costly litigation, cause product shipment delays or require us to enter into royalty or licensing agreements. Such royalty or licensing agreements, if required, may not be available on terms acceptable to us or at all, which could have a material adverse effect upon our business, operating results and financial condition.

Our growth is dependent upon successfully focusing our distribution channels.

      We intend to streamline our worldwide sales and distribution channels by focusing on key target industry market segments where our current and planned products enjoy a significant competitive advantage and a current, high market demand. We also plan on leveraging our existing relationships with Xerox, IBM and their channels and affiliates by launching targeted joint marketing and value added reseller programs and by introducing new product offerings that are optimized for selected target markets and marketing channels. In addition, we intend to form additional partnerships with system integrators and consultants in order to broaden our capacity to deliver complete document automation solutions that incorporate significant services content, while also maintaining our core domain expertise. We cannot assure you that we will be able to successfully streamline and focus our worldwide channels, leverage our existing relationships or form new alliances. If we fail to do so, it will have a material adverse effect on our business, operating results and financial condition.

Maintaining our professional services expertise is necessary for our future growth.

      We are continuing our focus on the consulting services component of our professional services to assist customers in the planning and implementation of enterprise-wide, mission-critical document automation applications. This strategy is dependent on retaining and hiring professionals to perform these consulting services. Should we be unable to maintain the necessary services workforce, our business and financial condition could be materially adversely affected.

Our growth depends on our ability to compete successfully against current and future competitors.

      The market for our document automation products is intensely competitive. We face competition from a broad range of competitors, many of whom have greater financial, technical, and marketing resources than we do. Our principal competition currently comes from systems developed in-house by the internal MIS

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Our growth depends on market acceptance of our existing products and our introduction of new products and enhancements to existing products.

      Our future business, operating results and financial condition will depend upon market acceptance of our existing products, as well as our ability to develop new products that address the future needs of our target markets and to respond to emerging industry standards and practices. Our Document Sciences Autograph family of products has been applied mainly to document automation applications producing paper-based documents. We believe that our core technology can be extended to the Internet, intranets and commercial on-line services, and we have begun development activity and released some products in these areas. We cannot assure you that we will be successful in developing, introducing and marketing new products or product enhancements, including new products or the extension of existing products for the Internet, intranets and commercial on-line services, on a timely and cost effective basis, if at all. In addition, we cannot assure you that our new products and product enhancements will adequately meet the requirements of the marketplace or achieve market acceptance. Delays in our commercial shipments of new products or enhancements may result in client dissatisfaction and a delay or loss of product revenues.

      If we are unable, for technological or other reasons, to develop and introduce new products or enhancements of existing products in a timely manner in response to changing market conditions or client requirements, then our business, operating results and financial condition would be materially adversely affected. In addition, we cannot assure you that our existing products, new products or new versions of our existing products will achieve market acceptance. In order to provide our customers with integrated product solutions, our future success will also depend in part upon our ability to maintain and enhance relationships with our technology partners.

A longer than expected sales cycle may affect our revenues and operating results.

      The licensing of our software products is often an enterprise-wide decision by prospective customers and generally involves a sales cycle of three to twelve months in order to educate them regarding the use and benefits of our products. In addition, the implementation of our products by customers involves a significant commitment of their resources over an extended period of time, and is commonly associated with substantial customer business process reengineering efforts. For these and other reasons, our sales and customer implementation cycles are subject to a number of significant delays over which we have little or no control. Any delay in the sale or customer implementation of a limited number of license transactions could have a material adverse effect on our business and financial condition and cause our operating results to vary significantly from quarter to quarter.

Our operating results are substantially dependent on sales of a small number of products in highly concentrated industries.

      We derived 72% of our initial license revenue from CompuSet and related CompuSet option products in 2000. Our initial license fees from DLS and Electronic Document Viewing products comprised 24% and 4%, respectively, in 2000. As a result, factors that may adversely impact the pricing of or demand for CompuSet and related products, such as competition from other products, negative publicity or obsolescence of the hardware or software environments in which our products run, could have a material adverse effect on our business, operating results and financial condition. Our financial performance will continue to depend

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      Our revenues are derived from sales to a small number of industries as follows:

	•	Licenses to end users in the insurance, finance and commercial print services industries for 2000 accounted for 90% of initial license revenues;
	•	Licenses to end users in these industries for 1999 accounted for 82% of initial license revenues; and
	•	Licenses to end users in these industries for 1998 accounted for 72% of initial license revenues.

      Our future success will depend on our ability to continue to successfully market our products in these and other industries. We cannot assure you that we will continue to be successful in developing and marketing CompuSet products and related services. Our failure to do so would have a material adverse effect on our business, operating results and financial condition.

We may be exposed to risks associated with international operations.

      Our revenues from export sales, including sales through our foreign subsidiary, accounted for the following:

	•	28% of our total revenues in 2000;
	•	25% of our total revenues in 1999; and
	•	31% of our total revenues in 1998.

      Our wholly owned subsidiary, Document Sciences Europe, markets and supports our products in Europe. We license our products in Europe through value added resellers and to a lesser extent, direct sales. Our VARs are principally Xerox affiliates who re-market our products. Revenues generated through European resellers were $4.5 million, $3.7 million and $3.9 million in 1998, 1999 and 2000, respectively. In Canada, Australia and Brazil we distribute our products through Xerox Canada, Ltd., Fuji Xerox Co., Ltd. and Xerox Brazil, Ltd., respectively. Revenues generated by these Xerox affiliates were $1.7 million, $2.4 million and $2.4 million in 1998, 1999 and 2000, respectively. In order to successfully expand export sales, we may need to establish additional foreign operations, hire additional personnel and develop relationships with additional international resellers. If we are unable to do so in a timely manner, our growth in international export sales could be limited, and our business, operating results and financial condition could be materially adversely affected. In addition, we cannot assure you that we will be able to maintain or increase international market demand for our products.

      Additional risks inherent in our international business activities include:

	•	currency fluctuations;
	•	unexpected changes in regulatory requirements;
	•	tariffs and other trade barriers;
	•	our limited experience in localizing products for foreign countries;
	•	lack of acceptance of our localized products in foreign countries;
	•	longer accounts receivable payment cycles;
	•	difficulties in managing our international operations;
	•	potentially adverse tax consequences including restrictions on the repatriation of earnings; and
	•	the burdens of complying with a wide variety of foreign laws.

      A portion of our business is conducted in currencies other than the U.S. Dollar, primarily the French Franc and Euro. Although exchange rate fluctuations have not had a significant impact on us, fluctuations in

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Our business is dependent on the market for document automation software.

      The market for document automation software is intensely competitive, highly fragmented, under-developed and subject to rapid change. Marketing and sales techniques in the document automation software marketplace, as well as the bases for competition, are not well established. We cannot assure you that the market for document automation software will develop or that, if it does develop, organizations will adopt our products. We have spent, and intend to continue to spend, significant resources educating potential customers about the benefits of our products. However, we cannot assure you that such expenditures will enable our products to achieve further market acceptance. Furthermore, if the document automation software market fails to develop or develops more slowly than we currently anticipate, our business, operating results and financial condition would be materially adversely affected.

      In addition, the commercial market for document automation of electronic documents designed for use with the Internet, intranets and commercial on-line services has only recently begun to develop, and the success of our products designed for these markets will depend in part on their compatibility with such services. It is difficult to predict whether the Internet, intranets and commercial on-line services will be viable commercial marketplaces or whether the demand for related products and services will increase or decrease in the future. Since the increased commercial use of the Internet, intranets and commercial on-line services could require substantial modification and customization of certain of our products and services as well as the introduction of new products and services, we cannot assure you that we will be able to effectively or successfully compete in this market.

Our ability to manage future change will affect our business.

      Our ability to compete effectively and to manage future change will require us to continue to improve our financial and management controls, reporting systems and procedures on a timely basis and to expand, train and manage our work force. We cannot assure you that we will be able to do so successfully. Our failure to do so could have a material adverse effect on our business, operating results and financial condition.

Our executive officers and certain key personnel are critical to our business, and these officers and key personnel may not remain with us in the future.

      Our future performance depends in significant part upon the continued service of our key technical, sales and senior management personnel. Only our president and chief executive officer and our chief scientist have signed employment agreements with us. The loss of the services of one or more of our executive officers or key personnel could have a material adverse effect on our business, operating results and financial condition. Our future success also depends on our continuing ability to attract and retain highly qualified product development, sales and management personnel. Competition for such personnel is intense, and there can be no assurance that we will be able to retain our key employees or that we will be able to attract, assimilate or retain other highly qualified product development, sales and managerial personnel in the future.

Our failure to adequately limit our exposure to product liability claims may adversely affect us.

      Our license agreements with our customers typically contain provisions designed to limit our exposure to potential product liability claims. However, it is possible that the limitation of liability provisions contained in our license agreements may not be effective under the laws of certain jurisdictions. Although we have not experienced any product liability claims to date, sale and support of our products may entail the risk of such claims in the future. A successful product liability claim brought against us or a claim arising as a result of our professional services could have a material adverse effect upon our business, operating results and financial condition.

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Our products may suffer from defects or errors.

      Software products as complex as those we offer, may contain undetected defects or errors when first introduced or as new versions are released. As a result, we could in the future lose or delay recognition of revenues as a result of software errors or defects. In addition, our products are typically intended for use in applications that may be critical to a customer’s business. As a result, we expect that our customers and potential customers have a greater sensitivity to product defects than the general market for software products. Although our business has not been adversely affected by any such errors to date, we cannot assure you that, despite our testing and testing by current and potential customers, errors will not be found in our new products or releases. If these errors are discovered after the commencement of commercial shipments, it could result in any of the following:

	•	loss of revenue or delay in market acceptance;
	•	diversion of our development resources;
	•	damage to our reputation; or
	•	increased service and warranty costs.

      If any of these events occur, it would have a material adverse effect upon our business, operating results and financial condition.

We may face risks from the Euro.

      In January 1999, a new currency called the “Euro” was introduced in certain Economic and Monetary Union, or EMU, countries. During 2002, all EMU countries are expected to be operating with the Euro as their single currency. Uncertainty exists as to the effects the Euro will have on the marketplace. Additionally, all of the final rules and regulations have not yet been defined and finalized by the European Commission with regard to the Euro. We are still assessing the impact the EMU formation will have on our internal systems and the sale of our products. We expect to take appropriate actions based on the results of such assessment. We have not yet determined any potential costs.

Item 2. Properties

      We lease approximately 27,300 square feet for our principal administrative, sales, marketing, training and research and development facilities in Carlsbad, California. These leases expire on October 14, 2001 and February 28, 2005. Our subsidiary in France occupies approximately 2,200 square feet of office space with a renewable lease expiring on April 15, 2004. In addition, our regional office in Milwaukee, Wisconsin occupies approximately 7,500 square feet of office space pursuant to a lease expiring on March 31, 2003. Sales representatives and field technical support personnel operate from their homes.

Item 3. Legal Proceedings

      In the ordinary course of business, we may become involved in legal proceedings from time to time. As of March 15, 2001, we were not a party, nor was our property subject, to any material pending legal proceedings.

Item 4. Submission of Matters to a Vote of Security Holders

      No matters were submitted to a vote of security holders during the fourth quarter of fiscal year 2000.

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PART II

Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters

      Our common stock is traded on The Nasdaq National Market under the symbol “DOCX.” The following table sets forth the range of high and low sales prices of our common stock for the periods indicated, as reported on The Nasdaq National Market System. Such quotations represent inter-dealer prices without retail markup, markdown or commission and may not necessarily represent actual transactions.

      We had 10,835,139 shares outstanding and 107 record holders of our common stock as of December 31, 2000. We did not make any sales of unregistered stock in 2000. We have not paid dividends on our common stock and do not anticipate paying dividends in the foreseeable future.

Item 6. Selected Financial Data

      The following table presents selected financial data of Document Sciences Corporation. This historical data should be read in conjunction with the Consolidated Financial Statements and the related notes thereto in Item 8 and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7.

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview and Recent Developments

      Document Sciences Corporation develops, markets and supports a family of document automation software used in high volume electronic publishing applications. We were incorporated in Delaware in October 1991 as a wholly owned subsidiary of Xerox Corporation. Following our initial public offering of stock in September 1996, Xerox ownership was reduced to approximately 62%.

      On February 16, 2001, we made a self tender offer for 6,000,000 shares of our outstanding common stock. Xerox tendered all of its shares of Document Sciences common stock in the offer. The tender offer expired on March 23, 2001 and was oversubscribed. We are currently calculating the proration factors and will close the tender offer shortly. Xerox also granted us an option to purchase up to 2,000,000 additional shares of our stock it owned after completion of the tender offer at the tender offer price so long as its ownership after the exercise of the option is at least 19.9% of our outstanding common stock. We currently expect to exercise the option to the extent required to reduce Xerox’s ownership to 19.9% of our stock. The purchase would be financed with a promissory note.

Results of Operations for the Years Ended December 31, 1998, 1999 and 2000

  Revenues

      Total revenues were $20.1 million, $24.3 million and $22.6 million in 1998, 1999 and 2000, respectively, representing an increase of 21% from 1998 to 1999 and a decrease of 7% from 1999 to 2000. Our revenues are divided into three categories based upon the sources from which they are derived: initial license fees, annual renewal license and support fees, and services and other revenues. Initial license fees are comprised primarily of license fees for the first year of use of our products. Annual renewal license and support fees are comprised of license fees for the continued use and support of our licensed products. Services and other revenues are comprised of fees for consulting, application development and training services performed by us as well as miscellaneous other operational revenues. We recognize revenue in accordance with AICPA Statement of Position (SOP) 97-2, Software Revenue Recognition and Staff Accounting Bulletin (SAB) No. 101, Revenue Recognition in Financial Statements. Initial license fees are recognized when a contract exists, the fee is fixed or determinable, software delivery has occurred and collection of the receivable is deemed probable. Any portion of the initial license fee representing the software support for the first year is deferred and recognized ratably over the contract period. Annual renewal license and support fees are recognized ratably over the contract period. Revenues generated from consulting services are recognized as the related services are performed. However, when such consulting services are deemed to be essential to the functionality of the delivered software product, revenue from the entire arrangement is recognized in accordance with SOP 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts, and Accounting Research Bulletin (ARB) No. 45, Long-Term Construction-Type Contracts.

      We sell our products principally through our direct sales force domestically, and internationally through distributors and value added resellers, or VARs. Revenues from export sales and sales through our foreign subsidiary were $6.2 million, $6.1 million and $6.3 million in 1998, 1999 and 2000, respectively, representing a decrease of 2% from 1998 to 1999 and an increase of 3% from 1999 to 2000. Revenue from export sales were 31%, 25% and 28% of total revenues in 1998, 1999 and 2000, respectively. The increase from 1999 to 2000 is primarily the result of increased revenues through our Xerox affiliates in Australia and Europe. The decrease from 1998 to 1999 is primarily the result of decreased activity associated with an internal realignment of our foreign subsidiary.

      Until September 30, 1999, we had a strategic marketing alliance with Xerox under which both parties agreed to pay each other fees on referrals that lead to the successful sale or licensing of each other’s products. Our revenues from this strategic marketing alliance were $344,000, $287,000 and $0 in 1998, 1999 and 2000, respectively. These commissions were 2%, 1% and 0% of total revenues in 1998, 1999 and 2000, respectively. No commissions were paid relating to referrals from Xerox in 1998, 1999 and 2000.

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      We have entered into distributorship agreements with various Xerox foreign affiliates to remarket our products internationally. Our revenues from these agreements were $4.1 million, $4.6 million and $4.7 million in 1998, 1999 and 2000, respectively. The increase from 1999 to 2000 is primarily the result of increased revenues through our Xerox affiliates in Australia and Europe. The increase from 1998 to 1999 is primarily the result of increased revenues through our Xerox affiliate in Brazil.

      Initial license fees. Initial license fees were $7.2 million, $10.4 million and $10.3 million in 1998, 1999 and 2000, respectively, representing an increase of 44% from 1998 to 1999 and a decrease of 1% from 1999 to 2000. The decrease in 2000 was mainly the result of decreased revenues from our foreign resellers. The increase in 1999 was mainly due to increased sales by our direct sales force in the United States. Initial license revenues were 36%, 43% and 46% of total revenues in 1998, 1999 and 2000, respectively.

      Annual renewal license and support fees. Annual renewal license fees were $5.9 million, $7.6 million and $8.6 million in 1998, 1999 and 2000, respectively, representing increases of 29% from 1998 to 1999 and 13% from 1999 to 2000. These increases were principally due to an increase in the installed base of users of our software products. Annual license fees were 29%, 31% and 38% of total revenues in 1998, 1999 and 2000, respectively.

      Services and other. Revenues from services and other were $7.0 million, $6.3 million and $3.7 million in 1998, 1999 and 2000, respectively, representing decreases of 10% from 1998 to 1999 and 41% from 1999 to 2000. These decreases were principally due to the mix of software being sold, much of which did not require as much consulting services in order to be implemented. Revenues from services and other were 35%, 26% and 16% of total revenues in 1998, 1999 and 2000, respectively.

  Cost of Revenues and Operating Expenses

      Cost of initial license fees. Costs of initial license fees were $1.4 million, $1.4 million and $1.6 million in 1998, 1999 and 2000, respectively, representing 19%, 13% and 16% of initial license fees in 1998, 1999 and 2000, respectively. Cost of initial license fees includes documentation, reproduction costs, product packaging and media, employment costs for installation and distribution personnel, the cost of third party software and amortization of previously capitalized software development costs. The increase as a percentage of revenue in 2000 from 1999 was primarily the result of expensing the remainder of the capitalized software costs of Visual CompuSet Professional Edition 2.0 due to the 4th quarter release of Visual CompuSet Professional Edition 3.0. The decrease as a percentage of revenue in 1999 from 1998 was primarily due to savings realized from our restructuring.

      Cost of annual renewal license and support fees. Costs of annual license fees were $862,000, $947,000 and $1.3 million 1998, 1999 and 2000, respectively, representing 15%, 13% and 15% of annual license fees in 1998, 1999 and 2000, respectively. Costs of annual renewal license fees consist principally of the employment-related costs for our technical support staff. The increase in cost in 2000 from 1999 is due to the implementation of a new technical support database and additional technical support personnel necessary to support our increasing customer base. The increase in cost in 1999 from 1998 is due to additional technical support personnel necessary to support our increasing customer base.

      Cost of services and other. Costs of services and other were $4.3 million, $3.6 million and $2.5 million in 1998, 1999 and 2000, respectively, representing 62%, 58% and 68% of services and other revenue in 1998, 1999 and 2000, respectively. Costs of services and other consist principally of the employment-related costs of our consulting and training staff. The decrease in 2000 was primarily due to attrition and transferring underutilized personnel to other departments. The decrease in 1999 was primarily due to savings realized from our restructuring.

      Research and development. Research and development expenses were $4.3 million, $4.7 million and $4.2 million in 1998, 1999 and 2000, respectively, representing an increase of 9% from 1998 to 1999 and a decrease of 11% from 1999 to 2000. Research and development expenses consist primarily of the employment-related costs of personnel associated with developing new products, enhancing existing products, testing software products and developing product documentation. As a percentage of total revenue, research and

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      We expense all costs for research and development of new products until technological feasibility has been assured. Thereafter, costs of software development are capitalized until general release of the product. The capitalized costs of software development are amortized using the greater of the amount computed using the ratio of current product revenues to estimated total product revenues or the straight-line method over the remaining estimated economic life of the product. We capitalized software development costs of $644,000, $643,000 and $1.2 million in 1998, 1999 and 2000, respectively. The increase in 2000 is due to the release of two major products, Visual CompuSet Professional Edition 3.0 and DLS 6.0 and related components. The amount of software development costs to be capitalized in the future may change if the time between the establishment of technological feasibility of a product and its general release changes.

      Selling and marketing. Selling and marketing expenses were $11.4 million, $7.7 million and $8.4 million in 1998, 1999 and 2000, respectively, representing a decrease of 32% from 1998 to 1999 and an increase of 9% from 1999 to 2000. Selling and marketing expenses consist primarily of salaries, commissions, marketing programs and related costs for pre- and post-sales activity. The increase in 2000 was primarily due to increased marketing expenditures on advertising, promotion activities and trade shows. The decrease in 1999 was primarily the result of savings realized from our restructuring and the aligning of our commission structure with our recognition of revenue. Selling and marketing expenses were 56%, 32% and 37% of total revenues in 1998, 1999 and 2000, respectively.

      General and administrative. General and administrative expenses were $6.2 million, $4.6 million and $5.0 million in 1998, 1999 and 2000, respectively, representing a decrease of 26% from 1998 to 1999 and an increase of 9% from 1999 to 2000. General and administrative expenses consist of employment-related costs for finance, administration and human resources and general corporate management expenses, including legal and audit fees. The increase in 2000 was primarily due to an increase in the allowance for doubtful accounts and higher professional fees. The decrease in 1999 was the result of savings realized from our restructuring. General and administrative expenses were 31%, 19% and 22% of total revenues in 1998, 1999 and 2000, respectively.

      Restructuring charges. In connection with a restructuring plan adopted in the fourth quarter of fiscal 1998, we recorded a $2.0 million restructuring charge associated with our actions to reduce our overall cost structure that had become inconsistent with our revenue base. This charge included the termination of 46 employees, the write off of impaired assets and a reduction in our leased facilities.

      Interest, net. Interest, net is composed of interest income from cash and cash equivalents and short-term investments offset by finance charges related to equipment leases. Interest, net was $901,000, $745,000 and $961,000 in 1998, 1999 and 2000, respectively. The increase in 2000 is from higher cash balances. The decrease in 1999 is from lower cash balances due to payments made toward the restructuring charges.

      Provision for income taxes. Effective tax rates were approximately 3%, 0% and 3% in 1998, 1999 and 2000, respectively. These rates differs from the federal statutory rate primarily due to valuation allowances offsetting deferred tax assets.

Factors That May Affect Future Operating Results

      Our total revenues and operating results can vary, sometimes substantially, from quarter to quarter and are expected to vary significantly in the future. Our revenues and operating results are difficult to forecast. Future results will depend upon many factors, including the demand for our products, the level of product and price competition, the length of our sales cycle, the size and timing of individual license transactions, the delay or deferral of customer implementations, the budget cycles of our customers, our success in expanding our direct sales force and indirect distribution channels, the timing of new product introductions and product enhancements by us and our competitors, the mix of products and services sold, levels of international sales, activities of and acquisitions by competitors, the timing of new hires, changes in foreign currency exchange rates, our ability to develop and market new products, controlling costs and general domestic and international

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