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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 and content management software solutions, such as Oracle Corporation. In addition, Xerox or IBM, either directly or through affiliated entities, could become a large competitor.competitors. 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, whichlaws. However, these 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 “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%19% of our revenues through Xerox and its affiliates in 2000.2001. 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, 2000,2001, we had 148130 employees including 4241 in professional services, 4136 in sales and marketing, 4640 in research and development and 1913 in finance and administration. None of our employees are represented by a labor union.unions. 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

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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 FactorsRISK 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;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

7

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 its 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, In 2001, 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 costsaccounted for approximately $5.2 million, $5.2 million and have contributed a substantial portion$4.1 million in 1999, 2000 and 2001, respectively, representing 21%, 23% and 19% of our income from operations for certain prior operating periods. This commission arrangement was terminated as of September 30, 1999.total revenues, respectively.

     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-partiesthird 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 notcannot 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 thatof any infringement of our products infringe upon the proprietary rights of third parties. We can notHowever, we cannot 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

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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 enhancements to 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 respond to emerging industry standards and practices and to develop new products that address the future needs of our target markets and to respond to emerging industry standards and practices.markets. OurDocument Sciences Autographfamily of products has been applied mainly to document automation applications producing paper-based documents. We believe thathave started to extend our core technology can be extended to the Internet, intranets and commercial on-line services, andservices. However, 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 we are unable 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 wouldwill 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.

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

     The licensing of our software products is often involves an enterprise-wide decision making process by prospective customers andpotential customers. Sales cycles generally involves a sales cycle ofrange from three to twelve months in order to educate thempotential customers 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%66% of our initial license revenue from CompuSet and related CompuSet option products in 2000. Our2001. In 2001, our initial license fees from DLS and Electronic Document Viewing products comprised 24%33% and 4%1%, respectively, in 2000.respectively. 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. Licenses to end users in the insurance, finance and commercial print services 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.

accounted for 82%, 90% and 97% of initial license revenues in 1999, 2000 and 2001, respectively.

     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.

25%, 28% and 21% of our total revenues in 1999, 2000 and 2001, respectively.

     Our wholly owned subsidiary, Document Sciences Europe, markets and supports our products in Europe. We license our products in Europe through value added resellersVAR’s and to a much 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 and $2.7 million in 1998, 1999, 2000 and 2000,2001, respectively. In Canada, Australia and Brazil, we distribute our products through Xerox Canada, Ltd., Fuji Xerox Co., Ltd. and Xerox do Brazil, Ltd., respectively. Revenues generated by these Xerox affiliates were $1.7$2.4 million, $2.4 million and $2.4$2.1 million in 1998, 1999, 2000 and 2000,2001, 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;

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	•	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 developgrow or that, if it does develop,grow, 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,Moreover, if the document automation software market fails to developgrow or developsgrows 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 theirthe compatibility of our products 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 partsignificantly upon the continued service of our key technical, sales and senior management personnel. Only our presidentPresident and chief executive officerChief Executive Officer and our chief scientistChief 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.

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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.

     SoftwareOur software products asare complex as those we offer,and 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 by us 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 27,30021,300 square feet for our principal administrative, sales, marketing, training and research and development facilitiesfacility in Carlsbad, California. These leases expireThis lease expires 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,February 22, 2002, 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 2000.2001.

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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 10,835,1393,867,906 shares outstanding and 107103 record holders of our common stock as of December 31, 2000.February 27, 2002. We did not make any sales of unregistered stock in 2000.1999, 2000 or 2001. 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, marketsWe develop, market and supportssupport 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 As a selfresult of our tender offer for 6,000,000 sharesand our exercise 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 reducefrom Xerox in April 2001, Xerox’s ownership interest has been reduced to 19.9% of.

Critical Accounting Policies

     We believe the following represent our stock. The purchase would be financed with a promissory note.

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

  Revenuescritical accounting policies:

     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. Revenue Recognition.We recognize revenue in accordance with AICPA Statement of Position (SOP)SOP 97-2,Software Revenue Recognitionand Staff Accounting Bulletin (SAB)SAB No. 101,Revenue Recognition in Financial StatementsStatements.. Initial license fees are recognized when a contract exists, the fee is fixed orand 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 on a percentage of completion method or not until the contract is completed in accordance with SOP 81-1,Accounting for Performance of Construction-Type and Certain Production-Type Contracts, and Accounting Research Bulletin (ARB)ARB No. 45,Long-Term Construction-Type ContractsContracts..

     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. Since revenue may not be recognized in the same quarter as when shipment occurs and if such fixed expenses precede these revenues, our operating results would be materially adversely affected.

Computer Software Costs.In accordance with SFAS No. 86,Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed, costs incurred in the research and development of new software products and significant enhancements to existing software products are expensed as incurred until the technological feasibility of the product has been established. After technological feasibility has been established, direct production costs, including programming and testing, are capitalized until general release of the product.

     Capitalized costs of software to be sold, licensed or otherwise marketed are amortized using the greater of the amount computed using the ratio of current period product revenues to estimated total product revenues or the straight-line method over the remaining estimated economic lives of the products. It is possible that estimated total product revenues, the estimated economic life of the product, or both, will be reduced in the future. As a result, the carrying amount of capitalized software costs may be reduced in the future, which could cause our operating results in future periods to be adversely affected.

Results of Operations for the Years Ended December 31, 1999, 2000 and 2001

Revenues

     Total revenues were $24.3 million, $22.6 million and $22.1 million in 1999, 2000 and 2001, respectively, representing decreases of 7% from 1999 to 2000 and 2% from 2000 to 2001. 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 consist primarily of license fees for the first year of use of our products. Annual renewal license and support fees consist of license fees for the continued use and support of our licensed products. Services and other revenues consist of fees for consulting, application development and training services performed by us as well as miscellaneous other operational revenues.

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     We sell our products principally through our direct sales force domestically, and internationally through distributors and value added resellers or VARs.(VARs). Revenues from export sales and sales through our foreign subsidiary were $6.2 million, $6.1 million, and $6.3 million and $4.7 million in 1998, 1999, 2000 and 2000,2001, respectively, representing a decrease of 2% from 1998 to 1999 and an increase of 3% from 1999 to 2000.2000 and a decrease of 25% from 2000 to 2001. Revenue from export sales were 31%25%, 25%28% and 28%21% of total revenues in 1998, 1999, 2000 and 2001, respectively. The decrease from 2000 respectively.to 2001 was the result of lower initial license fees in all regions. The increase from 1999 to 2000 iswas 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 and $3.7 million in 1998, 1999, 2000 and 2001, respectively. The decrease from 2000 respectively.to 2001 was the result of lower initial license fees in all regions. The increase from 1999 to 2000 iswas 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 and $8.2 million in 1998, 1999, 2000 and 2000,2001, respectively, representing an increase of 44% from 1998 to 1999 and a decreasedecreases of 1% from 1999 to 2000.2000 and 20% from 2000 to 2001. The decreasedecreases in 2001 and 2000 was mainlywere largely the result of decreased revenuesfewer sales and fewer new customers 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%, 43%46% and 46%37% of total revenues in 1998, 1999, 2000 and 2000,2001, respectively.

     Annual renewal license and support fees.Annual renewal license fees were $5.9 million, $7.6 million, and $8.6 million and $8.7 million in 1998, 1999, 2000 and 2000,2001, respectively, representing increases of 29% from 1998 to 1999 and 13% from 1999 to 2000.2000 and 1% from 2000 to 2001. The increase in 2001 was largely offset by the impact of discontinuing support for certain products and platforms. These increases in license renewal and support fees were principally due to an increase in the installed base of users of our software products. Annual license fees were 29%31%, 31%38% and 38%39% of total revenues in 1998, 1999, 2000 and 2000,2001, respectively.

     Services and other.Revenues from services and other were $7.0 million, $6.3 million, and $3.7 million and $5.2 million in 1998, 1999, 2000 and 2000,2001, respectively, representing decreasesa decrease of 10% from 1998 to 1999 and 41% from 1999 to 2000. These decreases were2000 and an increase of 41% from 2000 to 2001. The increase in 2001 is due to the delivery of consulting services needed to implement new product sales made since the fourth quarter of 2000 as well as significant services to existing customers. The decrease in 2000 was principally due to the mix of software being sold, much of which did not require as muchonly required minimal consulting services in order to be implemented.at implementation. Revenues from services and other were 35%26%, 26%16% and 16%24% of total revenues in 1998, 1999, 2000 and 2000,2001, respectively.

Cost of Revenues and Operating Expenses

     Cost of initial license fees.Costs of initial license fees were $1.4 million, $1.4$1.6 million and $1.6$1.5 million in 1998, 1999, 2000 and 2000,2001, respectively, representing 19%13%, 13%16% and 16%18% of initial license fees in 1998, 1999, 2000 and 2000,2001, 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 asdecrease in 2001 compared to 2000 was due to lower sales and a percentagedecrease in the amortization of revenuesoftware. The increase in 2000 fromcompared to 1999 was primarily the result of expensing the remainder of the capitalized software costs of Visual CompuSet Professional EditionVCPro 2.0 due to the 4th quarter 2000 release of Visual CompuSet Professional EditionVCPro 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,and $1.5 million 1999, 2000 and 2000,2001, respectively, representing 15%13%, 13%15% and 15%17% of annual license fees in 1998, 1999, 2000 and 2000,2001, respectively. Costs of annual renewal license fees consist principally of the employment-related costs for our technical support staff. The increase in cost2001 compared to 2000 was due to additional technical support personnel necessary to support our increasing customer base. The increase in 2000 fromcompared to 1999 iswas 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 and $3.0 million in 1998, 1999, 2000 and 2000,2001, respectively, representing 62%58%, 58%68% and 68%58% of services and other revenue in 1998, 1999, 2000

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     Research and development.Research and development expenses were $4.3 million, $4.7 million, and $4.2 million and $5.2 million in 1998, 1999, 2000 and 2000,2001, respectively, representing an increase of 9% from 1998 to 1999 and a decrease of 11% from 1999 to 2000.2000 and an increase of 24% from 2000 to 2001. 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 and $717,000 in 1998, 1999, 2000 and 2000,2001, respectively. The increaseSome of the new products started in 2000 is due2001 have yet to the release of two major products, Visual CompuSet Professional Edition 3.0 and DLS 6.0 and related components.reach technological feasibility. 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 and $7.2 million in 1998, 1999, 2000 and 2000,2001, respectively, representing a decrease of 32% from 1998 to 1999 and an increase of 9% from 1999 to 2000.2000 and a decrease of 14% from 2000 to 2001. Selling and marketing expenses consist primarily of salaries, commissions, marketing programs and related costs for pre- and post-sales activity. The decrease in 2001 was primarily due to fewer personnel and decreased commissions due to decreased initial license fees. 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%, 32%37% and 37%32% of total revenues in 1998, 1999, 2000 and 2000,2001, respectively.

     General and administrative.General and administrative expenses were $6.2 million, $4.6 million, and $5.0 million and $3.4 million in 1998, 1999, 2000 and 2000,2001, respectively, representing a decrease of 26% from 1998 to 1999 and an increase of 9% from 1999 to 2000.2000 and a decrease of 32% from 2000 to 2001. General and administrative expenses consist of employment-related costs for finance, administration and human resources, allowance for doubtful accounts and general corporate management expenses, including legal and audit fees. The decrease in 2001 was primarily due to decreased personnel and outside consultant costs. 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%, 19%22% and 22%15% of total revenues in 1998, 1999, 2000 and 2000,2001, respectively.

     Restructuring charges.Other income (expense).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, netOther income (expense) is composed of interest income from cash and cash equivalents and short-term investments offset by finance chargesinterest expense related to equipment leases. Interest, netnotes to Xerox and losses on disposal of fixed assets. Other income was $901,000, $745,000, $961,000 and $961,000$281,000 in 1998, 1999, 2000 and 2000,2001, respectively. The decrease in 2001 was the result of less interest income following a large decrease in our cash balances as a result of our tender offer which was completed in April 2001. The increase in 2000 iswas from higher cash balances. The decrease in 1999 is from lower cash balances due to payments made toward the restructuring charges.which generated higher interest income.

     Provision for income taxes.The provision for income taxes in 2000 and 2001 was for taxes under the alternative minimum tax. Effective tax rates were approximately 3%0%, 3% and 0% in 1999, 2000 and 3% in 1998, 1999 and 2000,2001, respectively. These rates differsdiffer from the federal statutory rate primarily due to the change in the 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

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