Filed Pursuant to Rule 424(b)(1)
Registration No. 333-138313

PROSPECTUS

 

6,500,000 Shares

 

 

Ordinary Shares

 

 

 

 

We are offering 6,500,000 ordinary shares. No public market currently exists for our ordinary shares.

 

Our ordinary shares have been approved for quotation on The Nasdaq Global Market under the symbol “ALLT.”

 

Investing in our ordinary shares involves risks. See “Risk Factors” beginning on page 8.

 

 

We have granted the underwriters a 30-day option to purchase up to an additional 975,000 ordinary shares on the same terms and conditions as set forth above if the underwriters sell more than 6,500,000 ordinary shares in this offering.

 

Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense.

 

Lehman Brothers, on behalf of the underwriters, expects to deliver the ordinary shares on or about November 21, 2006.

 

 

 

 

 

 

 

November 15, 2006

TABLE OF CONTENTS

 

 

Until December 10, 2006, 25 days after the date of this prospectus, all dealers that buy, sell or trade our ordinary shares, whether or not participating in this offering, may be required to deliver a prospectus. This is in addition to the dealers’ obligation to deliver a prospectus when acting as underwriters and with respect to their unsold allotments or subscriptions.

 

You should rely only on the information contained in this prospectus and any free writing prospectus prepared by or on our behalf. We have not authorized anyone to provide you with information different from that contained in this prospectus. This prospectus is not an offer to sell or a solicitation of an offer to buy our ordinary shares in any jurisdiction where it is unlawful. The information contained in this prospectus is accurate only as of the date of this prospectus, regardless of the time of delivery of this prospectus or of any sale of ordinary shares.

 

PROSPECTUS SUMMARY

	•	Network visibility.  Our intelligent network solutions enable our end-customers to generate detailed real-time and historical reports by identifying bandwidth usage by application, subscriber usage patterns, network performance, long- and short-term usage trends and abnormal events, such as denial-of-service attacks and worms.
	•	Application management and control.  Service providers and enterprises apply our intelligent network application management technology to improve service quality by optimizing available bandwidth usage for different applications. For example, P2P applications that consume large amounts of network bandwidth can be de-prioritized to enhance the performance of applications, such as VoIP or Internet video, that are more sensitive to delay. Intelligent application controls can ensure the delivery of mission-critical applications by deprioritizing non-critical, bandwidth-intensive applications, discourage the use of non-business or recreational applications, and warn and protect against security threats.
	•	Subscriber and service management.  Our offerings enable service providers to increase total revenue, ARPU and customer loyalty by offering tiered service plans and differentiated content offerings to better meet varying subscriber needs. Using our systems, service providers can tailor and price service plans based on customer needs and demands, such as plans that guarantee performance of certain applications, the ability to purchase bandwidth on demand or bandwidth for prioritized content delivery. Content providers can also contract with service providers to guarantee high quality service to their customers over the service provider’s infrastructure, thereby enabling content providers to differentiate their offerings.

	•	Market-leading DPI technology and analytical capabilities.  Our focus on developing the most efficient means to search for hundreds of different applications, combined with our extensive database of algorithms that detect network applications, provide us with a significant competitive advantage. We believe that our NetEnforcer AC-2500, is currently the only commercially deployed solution with its level of functionality capable of supporting 5 gigabits/second performance and 2 million simultaneous connections.
	•	Broad product portfolio.  We believe that our broad product portfolio with offerings targeted at small, midsize and large service providers and enterprises enables us to compete in, and our channel partners to serve, a wider range of profitable markets than our competitors.
	•	Independence from underlying network infrastructure.  Our independent solutions are designed for easy deployment and to be less disruptive to existing networks than embedded solutions, which require changes or upgrades to the network infrastructure. In addition, independent solutions can be upgraded easily to respond to rapid changes in application behavior and subscriber demands, and offer end-customers flexibility in choosing any infrastructure equipment vendor.
	•	Global sales and marketing channels.  Our global network of over 300 distributors, resellers and systems integrators, through which we make substantially all of our sales, have enabled us to achieve a diverse customer base. We also rely on these third parties to install and provide basic technical support for our systems. To date, we have deployed over 9,000 NetEnforcer systems in 118 countries.
	•	Focus on service optimization solutions.  We believe that our dedicated focus on DPI solutions differentiates the level of service and support that we provide to our channel partners and end-customers. This includes our responsiveness to the introduction of new applications and effective integration of our products into our customers’ existing billing, customer care and other business systems.

	•	Further our technological advantage.  We intend to continue investing in the development of market leading broadband service optimization technologies and new broadband applications and services. Our next generation product, which is designed to support multiple channels of 10 gigabit/second full performance throughput rates, will utilize the new Advanced Telecom Computing Architecture standards, or ATCA, since it better enables the integration of additional third-party services into our product offerings.
	•	Continue to expand our sales and marketing channels.  We intend to expand our world-wide sales and marketing channels to further address small and medium-sized service providers and enterprises, including the government and education sectors. We intend to seek channel partners in new geographical territories, as well as in vertical markets in countries where we have already established a presence.
	•	Focus on larger service providers.  We intend to target larger service providers in response to increased demand from them for the ability to differentiate their service offerings. We believe that sales to these end-customers are more likely to result in sustained demand for our NetEnforcer systems as they deploy our products throughout their networks and as their networks grow. We intend to supplement these efforts by expanding our relationships with system integrators and OEMs who have existing relationships with larger service providers.

	•	Selectively pursue strategic partnerships and acquisitions. We intend to selectively pursue partnerships and acquisitions that will provide us access to complementary technologies and accelerate our penetration into new markets, including mobile networks, security applications and subscriber management.

Ordinary shares offered by us		6,500,000 shares.
Ordinary shares to be outstanding after this offering		20,889,931 shares.
Use of proceeds		We intend to use the net proceeds of this offering to fund our research and development activities, business development and marketing activities, and for general corporate purposes and working capital. We also may use a portion of the net proceeds to acquire or invest in complementary companies, products or technologies although we currently do not have any acquisition or investment planned.
Proposed Nasdaq Global Market symbol		“ALLT.”

	•	reflects the issuance upon the closing of this offering of 284,349 ordinary shares upon the exercise of warrants to purchase Series B preferred shares on a cashless and non-cashless basis, and the receipt of $1,128 by us from such exercise;
	•	reflects the issuance upon the closing of this offering of 14,094 ordinary shares upon the exercise of an option to purchase Series B preferred shares and the receipt of NIS 620, representing approximately $145, from such exercise, held by Mr. Jacoby;
	•	reflects the conversion upon the closing of this offering of (1) all of our issued and outstanding Series A, B, C, D and E preferred shares into 10,931,110 ordinary shares, including 236,492 ordinary shares resulting from an anti-dilution adjustment for price protection granted to holders of our Series C preferred shares in connection with prior financings and this offering, and (2) all of our Series A ordinary shares into 611,349 ordinary shares;
	•	reflects the initial public offering price of $12.00 per ordinary share;
	•	assumes no exercise of the underwriters’ option to purchase from us up to 975,000 additional ordinary shares; and
	•	reflects a 1-for-100 share split effected on February 5, 1998, a share dividend effected on September 12, 2000 of three shares for each outstanding share, and a 4.3962-for-1 reverse share split effected on October 29, 2006. Such reverse share split was effected through a 10-for-1 consolidation of each series of our ordinary and preferred shares, followed by a share dividend of approximately 1.275 ordinary shares for each ordinary share outstanding and an adjustment to the ordinary share conversion ratio of our preferred shares and Series A ordinary shares. We effected the reverse share split in this manner in order to maintain a round par value per share and to give our board of directors maximum flexibility under Israeli law to determine the amount of the share dividend prior to printing preliminary prospectuses for this offering.

														Nine Months Ended
		Year Ended December 31,												September 30,
		2003				2004				2005				2005				2006
														(unaudited)
		(in thousands, except share and per share data)
Consolidated statements of operations data:
Revenues:
Products		$	13,122			$	14,638			$	18,498			$	12,576			$	20,718
Services			1,653				3,447				4,474				3,317				3,859
Total revenues			14,775				18,085				22,972				15,893				24,577
Cost of revenues(1):
Products			3,229				3,942				4,481				3,237				4,562
Services			362				679				938				699				845
Total cost of revenues			3,591				4,621				5,419				3,936				5,407
Gross profit			11,184				13,464				17,553				11,957				19,170
Operating expenses:
Research and development, gross			4,053				4,851				6,652				4,964				6,737
Less royalty-bearing participation			1,094				894				727				582				1,095
Research and development, net(1)			2,959				3,957				5,925				4,382				5,642
Sales and marketing(1)			8,164				10,104				11,887				8,797				10,859
General and administrative(1)			1,832				2,081				2,380				1,709				2,260
Impairment of intangible assets			—				366				—				—				—
Total operating expenses			12,955				16,508				20,192				14,888				18,761
Operating income (loss)			(1,771	)			(3,044	)			(2,639	)			(2,931	)			409
Financing and other income (expenses), net			(507	)			(241	)			45				36				229
Income (loss) before income tax expenses (benefit)			(2,278	)			(3,285	)			(2,594	)			(2,895	)			638
Income tax expenses (benefit)			2				3				(218	)			(178	)			75
Net income (loss)		$	(2,280	)		$	(3,288	)		$	(2,376	)		$	(2,717	)		$	563
Basic net earnings (loss) per share		$	(0.82	)		$	(1.18	)		$	(0.81	)		$	(0.94	)		$	0.04
Diluted net earnings (loss) per share		$	(0.82	)		$	(1.18	)		$	(0.81	)		$	(0.94	)		$	0.04
Weighted average number of shares used in computing basic net earnings (loss) per share			2,774,639				2,787,554				2,943,500				2,903,356				13,310,355
Weighted average number of shares used in computing diluted net earnings (loss) per share			2,774,639				2,787,554				2,943,500				2,903,356				15,501,698
Pro forma basic and diluted net earning (loss) per share of ordinary shares (unaudited)(2)										$	(0.18	)						$	0.04

(1)		Includes stock-based compensation expense related to options granted to employees and others as follows:

														Nine Months Ended
		Year Ended December 31,												September 30,
		2003				2004				2005				2005				2006
														(unaudited)
		(in thousands)
Cost of revenues		$	—			$	—			$	—			$	—			$	8
Research and development, net			22				17				12				10				97
Sales and marketing			40				25				251				240				330
General and administrative			235				116				42				27				247
Total		$	297			$	158			$	305			$	277			$	682

(2)		Pro forma basic and diluted loss per ordinary share gives effect to the conversion upon the closing of this offering, assuming such closing occurred on September 30, 2006, of (1) all of our issued and outstanding preferred shares into 10,931,155 ordinary shares, and (2) all of our Series A ordinary shares into 611,349 ordinary shares. See Note 2r to our consolidated financial statements for an explanation of the number of shares used in computing per share data.

		As of September 30, 2006
						Pro Forma as
		Actual				Adjusted
		(unaudited)
		(in thousands)
Consolidated balance sheet data:
Cash and cash equivalents		$	4,547			$	75,587
Marketable securities			8,897				8,897
Working capital			5,048				75,588
Total assets			27,524				98,064
Total liabilities			14,686				14,686
Accumulated deficit			(37,321	)			(37,321	)
Total shareholders’ equity			12,838				83,378

 

This offering and an investment in our ordinary shares involve a high degree of risk. You should consider carefully the risks described below, together with the financial and other information contained in this prospectus, before you decide to buy our ordinary shares. If any of the following risks actually occurs, our business, financial condition and results of operations would suffer. In this case, the trading price of our ordinary shares would likely decline and you might lose all or part of your investment. The risks described below are not the only ones we face. Additional risks that we currently do not know about or that we currently believe to be immaterial may also impair our business operations.

 

Risks Relating to Our Business

 

We have a history of losses, may incur future losses and may not achieve profitability.

 

We have incurred net losses in each fiscal year since we commenced operations in 1997. We incurred net losses of $2.4 million in 2005, $3.3 million in 2004 and $2.3 million in 2003. As of September 30, 2006, our accumulated deficit was $37.3 million. Our losses could continue for the next several years as we expand our sales and marketing activities and continue to invest in research and development. We may incur losses in the future and may not generate sufficient revenues in the future to achieve profitability.

 

We are dependent on our NetEnforcer traffic management system and NetXplorer network management application suite for all of our revenue.

 

Our revenues are currently derived solely from sales of our NetEnforcer traffic management system and NetXplorer network management application suite, and from maintenance and support contracts related to these products. We currently expect that our revenues from these products will continue to account for all or substantially all of our revenues for the foreseeable future. As a result, any factor adversely affecting our ability to sell, or the pricing of or demand for, these products would severely harm our ability to generate revenues.

 

We may be unable to compete effectively with other companies in our market who offer, or may in the future offer, competing technologies.

 

We compete in a rapidly evolving and highly competitive sector of the networking technology market. Our principal competitors are Cisco Systems, Inc. (through its acquisition of P-Cube, Inc.), Sandvine Inc. and Ellacoya Networks, Inc. in the service provider market, and Packeteer Inc. in the enterprise market. We also compete in particular geographic areas with a number of smaller local competitors and we compete indirectly with router and switch infrastructure companies with features that address some of the problems that our products address. We also face competition from companies that offer partial solutions addressing only one aspect of the challenges facing broadband providers, such as network monitoring or security. Our competitors may announce new products, services or enhancements that better meet the needs of customers or changing industry requirements, or may offer alternative methods to achieve customer objectives. One of our direct competitors, Cisco Systems, is substantially larger than we are and has significantly greater financial, sales and marketing, technical, manufacturing and other resources. The entry of new competitors into our market and acquisitions of our existing competitors by companies with significant resources and established relationships with our potential customers could result in increased competition and harm our business. Increased competition may cause price reductions, reduced gross margins and loss of market share, any of which could have a material adverse effect on our business, financial condition or result of operations.

 

Demand for our products depends in part on the rate of adoption of bandwidth-intensive broadband applications, such as peer-to-peer (P2P), and latency-sensitive applications, such as voice-over-Internet protocol (VoIP), Internet video and online video gaming applications.

 

Our products are used by service providers and enterprises to monitor and manage bandwidth-intensive applications that cause congestion in broadband networks and impact the quality of experience of users. In addition to the general increase in applications delivered over broadband networks that require large amounts

of bandwidth, such as P2P applications, demand for our products is driven particularly by the growth in applications which are highly sensitive to network delays and therefore require efficient network management. These applications include VoIP, Internet video and online video gaming applications. If the rapid growth in adoption of VoIP and in the popularity of Internet video and online video gaming applications does not continue, the demand for our products may not grow as anticipated.

 

We depend on third parties to market, sell, install, and provide initial technical support for our products.

 

We market and sell our products to end-customers through third party channel partners, such as distributors, resellers, OEMs and system integrators. Our channel partners are also responsible for installing our products and providing initial customer support for them. As a result, we depend on the ability of our channel partners to market and sell our products successfully to end-customers. If any significant channel partners fail, individually or in the aggregate, to perform as we expect, our sales may suffer. We also depend on our ability to maintain our relationships with existing channel partners and develop relationships in key markets with new channel partners. We cannot assure you that our channel partners will market our products effectively, receive and fulfill customer orders of our products on a timely basis or continue to devote the resources necessary to provide us with effective sales, marketing and technical support. Our products are complex and it takes time for a new channel partner to gain experience in their operation and installation. Therefore, it may take a period of time before a new channel partner can successfully market, sell and support our products if an existing channel partner ceases to sell our products.

 

Our channel partners install our products and provide initial customer support to end-customers of our products. Any failure by our channel partners to provide adequate support to end-customers could result in customer dissatisfaction with us or our products, which could result in a loss of customers, harm our reputation and delay or limit market acceptance of our products.

 

Our agreements with channel partners are generally not exclusive and our channel partners may market and sell products that compete with our products. Our agreements with our distributors and resellers are usually for an initial one year term and following the expiration of this term, they can be terminated by either party. We can give no assurance that these agreements will not be terminated upon proper notice and any such termination may adversely affect our profitability and results of operations.

 

The market for our products in the service provider market is still emerging and our growth may be harmed if carriers do not adopt DPI solutions.

 

The market for DPI technology is still emerging and the majority of our sales to date have been to small and midsize service providers and enterprises. We believe that the largest service providers, referred to as Tier 1 carriers, as well as cable and mobile operators, present a significant market opportunity and are an important element of our long term strategy, but they are still in the early stages of evaluating the benefits and applications of DPI technology. Carriers may decide that full visibility into their networks or highly granular control over content based applications is not critical to their business. They may also determine that certain applications, such as VoIP or video, can be adequately prioritized in their networks by using router and switch infrastructure products without the use of DPI technology. They may also, in some instances, face regulatory constraints that could change the characteristics of the markets. Furthermore, widespread adoption of our products by carriers will require that they migrate to a new business model based on offering subscriber and application-based tiered services and market these new services successfully to consumers. If carriers decide not to adopt DPI technology, our market opportunity would be reduced and our growth rate may be harmed.

 

Demand for our products may be impacted by government regulation of the telecommunications industry.

 

Carriers are subject to government regulation in jurisdictions in which we sell our products. For example, there has been a series of draft bills introduced to the U.S. Congress in the first half of 2006 that would prohibit service providers from prioritizing applications from content providers who are prepared to pay for such service. To date, none of these bills has been adopted; however, some of these bills may still be raised for consideration and other jurisdictions in which we operate may adopt similar legislation. Advocates for the

legislation claim that collecting premium fees from certain “preferred” customers would distort the market for Internet applications in favor of larger and better-funded content providers and would impact end users who purchased broadband access only to experience differing response times in interacting with various content providers. Opponents of the legislation believe that content providers who support bandwidth-intensive applications should be required to pay service providers a premium in order to support further network investments. Demand from carriers for the traffic management and subscriber management features of our products could be adversely affected if regulations prohibit, or limit, service providers from managing traffic on their networks. A decrease in demand for these features could adversely impact sales of our products.

 

Sales of our products to large service providers can involve a lengthy sales cycle, which may impact the timing of our revenues and result in us expending significant resources without making any sales.

 

The length of our sales cycles to large service providers, including carriers and cable and mobile operators, is generally lengthy, as these end-customers undertake significant testing to assess the performance of our products within their networks. As a result, we may invest significant time from initial contact with a large service provider until that end-customer decides to incorporate our products in its network. We may also expend significant resources attempting to persuade large service providers to incorporate our products into their networks without success. Even after deciding to purchase our products, initial network deployment of our products by a large service provider may last up to three years. Carriers, especially in North America, often require that products they purchase meet Network Equipment Building System (NEBS) certification requirements, which relate the reliability of telecommunications equipment. Our NetEnforcer AC-1000 and AC-2500 are designed to meet NEBS certification requirements and are currently undergoing the certification process, but carriers may not choose to use our systems until we receive the certification. If a competitor succeeds in convincing a large service provider to adopt that competitor’s product, it may be difficult for us to displace the competitor because of the cost, time, effort and perceived risk to network stability involved in changing solutions. As a result we may incur significant expense without generating any sales.

 

Our revenues and business will be harmed if we do not keep pace with changes in broadband applications and with advances in technology.

 

We will need to invest heavily in developing our DPI technology in order to keep pace with rapid changes in applications, increased broadband network speeds and with our competitors’ efforts to advance their technology. Designers of broadband applications that our products are designed to identify and manage are using increasingly sophisticated methods to avoid detection and management by network operators. Even if our products successfully identify a particular application, it is sometimes necessary to distinguish between different types of traffic belonging to a single application. Accordingly, we face significant challenges in ensuring that we identify new applications as they are introduced without impacting network performance, especially as networks become faster. This challenge is increased as we seek to expand sales of our products in new geographic territories because the applications vary from country to country and region to region. If we fail to address the needs of customers in particular geographic markets and if we fail to develop enhancements to our products in order to keep pace with advances in technology, our business and revenues will be adversely affected.

 

We currently depend on a single subcontractor, R.H. Electronics Ltd., to manufacture and provide hardware warranty support for our NetEnforcer traffic management system and if it experiences delays, disruptions, quality control problems or a loss in capacity, it could materially adversely affect our operating results.

 

We currently depend on a single subcontractor, R.H. Electronics Ltd., to manufacture, assemble, test, package and provide hardware warranty support for all of our NetEnforcer traffic management systems, although we are negotiating with candidates for an additional third-party manufacturer. In addition, our agreement with R.H. Electronics requires it to procure and store key components for the NetEnforcer at its facilities. If R.H. Electronics experiences delays, disruptions or quality control problems in manufacturing our products, or if we fail to effectively manage the relationship with R.H. Electronics, shipments of products to our customers may be delayed and our ability to deliver products to customers could be materially adversely

affected. Our agreement with R.H. Electronics is automatically renewed annually for additional one-year terms, unless R.H. Electronics elects not to renew by giving us at least 90 days prior notice to the expiration of any such term. Furthermore, R.H. Electronics may terminate our agreement at any time during the term upon 120 days prior notice. We expect that it would take approximately six months to transition manufacturing of our products to an alternate manufacturer and our inventory of completed products may not be sufficient for us to continue delivering products to our customers on a timely basis during any such transition. Therefore, the loss of R.H. Electronics would adversely affect our sales and operating results, and harm our reputation.

 

R.H. Electronics’ facilities are located in northern Israel and are in range of rockets that were fired recently from Lebanon into Israel. In the event that the facilities of R.H. Electronics are damaged as a result of hostile action, our ability to deliver products to customers could be materially adversely affected. See also “Risk Factors — Conditions in Israel could adversely affect our business, and — Our operations may be disrupted by the obligations of personnel to perform military service.”

 

Certain components for our NetEnforcer traffic management systems come from single or limited sources, and we could lose sales if these sources fail to satisfy our supply requirements.

 

Certain components used in our NetEnforcer systems are obtained from single or limited sources. Since our NetEnforcer systems have been designed to incorporate these specific components, any change in these components due to an interruption in supply or our inability to obtain such components on a timely basis would require engineering changes to our products before we could incorporate substitute components. Such changes could be costly and result in lost sales. In particular, the central processing unit for our NetEnforcer AC-400 and our NetEnforcer AC-800 is from Intel Corporation and the network processor for our NetEnforcer AC-1000 and our NetEnforcer AC-2500 is from Hifn Inc.

 

If we or our contract manufacturer fail to obtain components in sufficient quantities when required, our business could be harmed. Our suppliers also sell products to our competitors. Our suppliers may enter into exclusive arrangements with our competitors, stop selling their products or components to us at commercially reasonable prices or refuse to sell their products or components to us at any price. Our inability to obtain sufficient quantities of single-source or limited-sourced components, or to develop alternative sources for components or products would harm our ability to maintain and expand our business.

 

The slowdown in capital expenditures by telecommunications service providers in prior years had a material adverse effect on our results of operations. Another down turn in technology spending could have a material adverse effect on our results of operations.

 

A deterioration of economies around the world and economic uncertainty in the telecommunications market began in 2000 and continued through 2003. There was a curtailment of capital investment by telecommunications carriers and service providers as well as by businesses that use our products, referred to as the enterprise market. Recent increased expenditures in the telecommunications industry in general or in the broadband portion of the market in particular may not continue. Since a substantial portion of our operating expenses consist of salaries, we may not be able to reduce our operating expenses in line with any reduction in revenues or may elect not to do so for business reasons. We will need to continue to generate increased revenues and manage our costs to maintain profitability. Any future industry downturn may increase our inventories, decrease our revenues, result in additional pressure on the price of our products and prolong the time until we are paid, all of which would have a material adverse effect on the results of our operations and on our cash flow from operations.

 

We use certain “open-source” software tools that carry the risk of being subject to intellectual property infringement claims, the assertion of which could impair our product development plans, interfere with our ability to support our customers or require us to pay licensing fees.

 

Our NetEnforcer traffic management systems and NetXplorer management application suite contain software from open source code sources. Open source code is software that is accessible, usable and modifiable by anyone, provided that users and modifiers abide by certain licensing requirements. The original

developers of the open source code provide no warranties on such code. Our products include, for example, open source code such as the Linux kernel and the GNU/Linux operating system. The Linux kernel and the GNU/Linux operating system have been developed under a license (known as a General Public License or GPL), which permits them to be liberally copied, modified and distributed.

 

Under certain conditions, the use of some open source code to create derivative code may obligate us to make the resulting derivative code available to others at no cost. The circumstances under which our use of open source code would compel us to offer derivative code at no cost are subject to different interpretations. While we have periodically undertaken reviews of our use of open source code in an effort to avoid situations that would require us to make parts of our core proprietary technology freely available as open source code, we cannot guarantee that such circumstances will not occur or that a court would not conclude that, under a different interpretation of an open source license, certain of our core technology must be made available as open source code. The use of such open source code may also ultimately require us to take remedial action, such as replacing certain code used in our products, paying a royalty to use some open source code, making certain proprietary source code available to others or discontinuing certain products, that may divert resources away from our development efforts.

 

The license under which we licensed the Linux kernel and GNU/Linux operating system, is currently the subject of litigation in the case of The SCO Group, Inc. v. International Business Machines Corp., pending in the United States District Court for the District of Utah. SCO filed its complaint in 2003. According to the current schedule, the parties will complete summary judgment briefing by December 8, 2006 and the court has postponed the jury-trial date of February 26, 2007, pending the outcome of the motions. SCO has alleged that certain versions of the Linux kernel and GNU/Linux operating system contributed by IBM contain unauthorized UNIX code or derivative works of UNIX code, which SCO claims it owns. If the court were to rule in SCO’s favor and find, for example, that GNU/Linux-based products, or significant portions of them, may not be liberally copied, modified or distributed, we may have to modify our products and/or seek a license to use the code in question, which may or may not be available on commercially reasonable terms, and this could have a material adverse effect on our business. Regardless of the merit of SCO’s allegations, uncertainty concerning SCO’s allegations could adversely affect our products and customer relationships.

 

If we are unable to successfully protect the intellectual property embodied in our technology, our business could be harmed significantly.

 

Know-how relating to networking protocols, building carrier-grade systems and identifying applications is an important aspect of our intellectual property. To protect our know-how, we customarily require our employees, distributors, resellers, software testers and contractors to execute confidentiality agreements or agree to confidentiality undertakings when their relationship with us begins. Typically, our employment contracts also include the following clauses: assignment of intellectual property rights for all inventions developed by employees, non-disclosure of all confidential information, and non-compete clauses for six months following termination of employment. The enforceability of non-compete clauses in Israel is limited. We cannot provide any assurance that the terms of these agreements are being observed and will be observed in the future. Because our product designs and software are stored electronically and thus are highly portable, we attempt to reduce the portability of our designs and software by physically protecting our servers through the use of closed networks, which prevent external access to our servers. We cannot be certain, however, that such protection will adequately deter individuals or groups from wrongful access to our technology. Monitoring unauthorized use of intellectual property is difficult, and some foreign laws do not protect proprietary rights to the same extent as the law of the United States. We cannot be certain that the steps we have taken to protect our proprietary information will be sufficient. In addition, to protect our intellectual property, we may become involved in litigation, which could result in substantial expenses, divert the attention of management, cause significant delays, materially disrupt the conduct of our business or adversely affect our revenue, financial condition and results of operations.

 

As of September 30, 2006, we had a limited patent portfolio. We had two issued U.S. patents and four pending U.S. patent applications. We also have one pending counterpart application outside of the United

States, filed pursuant to the Patent Cooperation Treaty. While we plan to protect our intellectual property with, among other things, patent protection, there can be no assurance that:

 

 

The failure to obtain patents, inability to obtain patents with claims of a scope necessary to cover our technology, or the invalidation of our patents, may weaken our competitive position and may adversely affect our revenues.

 

We may be subject to claims of intellectual property infringement by third parties that, regardless of merit, could result in litigation and our business, operating results or financial condition could be materially adversely affected.

 

There can be no assurance that we will not receive communications from third parties asserting that our products and other intellectual property infringe, or may infringe their proprietary rights. We are not currently subject to any proceedings for infringement of patents or other intellectual property rights and are not aware of any parties that intend to pursue such claims against us. Any such claims, regardless of merit, could result in litigation, which could result in substantial expenses, divert the attention of management, cause significant delays and materially disrupt the conduct of our business. As a consequence of such claims, we could be required to pay a substantial damage award, develop non-infringing technology, enter into royalty-bearing licensing agreements, stop selling our products or re-brand our products. If it appears necessary, we may seek to license intellectual property that we are alleged to infringe. Such licensing agreements may not be available on terms acceptable to us or at all. Litigation is inherently uncertain and any adverse decision could result in a loss of our proprietary rights, subject us to significant liabilities, require us to seek licenses from others and otherwise negatively affect our business. In the event of a successful claim of infringement against us and our failure or inability to develop non-infringing technology or license the infringed or similar technology, our business, operating results or financial condition could be materially adversely affected.

 

Our products are highly technical, and any undetected software or hardware errors in our products could have a material adverse effect on our operating results.

 

Our products are complex and are incorporated into broadband networks which are a major source of revenue for service providers and which support critical applications for subscribers and enterprises. Due to the complexity of our products and variations among customers’ network environments, we may not detect product defects until full deployment in our customers’ networks. Regardless of whether warranty coverage exists for a product, we may be required to dedicate significant technical resources to resolve any defects. If we encounter significant product problems, we could experience, among other things, loss of major customers, cancellation of product orders, increased costs, delay in recognizing revenue, and damage to our reputation. In addition, we could face claims for product liability, tort, or breach of warranty. Defending a lawsuit, regardless of its merit, is costly and may divert management’s attention. In addition, if our business liability insurance is inadequate or future coverage is unavailable on acceptable terms or at all, our financial condition could be harmed.

We need to increase the functionality of our products and offer additional features in order to maintain or increase our profitability.

 

The market in which we operate is highly competitive and unless we continue to enhance the functionality of our products and add additional features, our competitiveness may be harmed and the average selling prices for our products may decrease over time. Such a decrease would generally result from the introduction by competitors of competing products and from the standardization of DPI technology. To counter this trend, we endeavor to enhance our products by offering higher system speeds, and additional features, such as additional security functions, supporting additional applications and enhanced reporting tools. We may also need to reduce our per unit manufacturing costs at a rate equal to or faster than the rate at which selling prices decline. If we are unable to reduce these costs or to offer increased functionally and features, our profitability may be adversely affected.

 

If we fail to attract and retain skilled employees, we may not be able to timely develop, sell or support our products.

 

Our success depends in large part on the continued contribution of our research and development, sales and marketing and managerial personnel. If our business continues to grow, we will need to hire additional qualified research and development, sales and marketing and managerial personnel to succeed. The process of hiring, training and successfully integrating qualified personnel into our operation is a lengthy and expensive one. The market for qualified personnel is very competitive because of the limited number of people available with the necessary technical skills, sales skills and understanding of our products and technology. This is particularly true in Israel, where competition for qualified personnel is intense. Our failure to hire and retain qualified personnel could cause our revenues to decline and impair our ability to meet our research and development and sales objectives.

 

The European Union has issued directives relating to the sale in member countries of electrical and electronic equipment, including products sold by us. If our products fail to comply with these directives, we could be subject to penalties and sanctions that could materially adversely affect our business.

 

A directive issued by the European Union, or EU, on the Restriction of the Use of Certain Hazardous Substances in Electrical and Electronic Equipment, referred to as RoHS, came into effect on July 1, 2006. The RoHS directive, lists a number of substances, including lead, mercury, cadmium and hexavalent chromium, which must either be removed, or reduced to maximum permitted concentrations, in any products containing electrical or electronic components that are sold within the EU. Our products fall within the scope of the RoHS directive. We believe that our products are currently compliant with the RoHS directive. There can, however, be no assurance that we will continue to comply with the RoHS directive or any similar directives in other jurisdictions in the future.

 

In 2003, the EU approved a directive on Waste Electrical and Electronic Equipment, or WEEE, which promotes waste recovery with a view to reducing the quantity of waste for disposal and saving natural resources, in particular by reuse, recycling, composting and recovering energy from waste. The WEEE directive covers all electrical and electronic equipment used by consumers and electronic equipment intended for professional use. The directive, which went into effect in August 2005, requires that all new electrical and electronic equipment placed for sale in the EU be appropriately labeled regarding waste disposal and contains other obligations regarding the collection and recycling of waste electrical and electronic equipment. Our products fall within the scope of the WEEE directive, with which we believe we are compliant and are taking all requisite steps to ensure continued compliance.

 

The countries of the EU form the largest single market for our products. If our products fail to comply with WEEE or RoHS directives, we could be subject to heavy penalties and other sanctions that could have a material adverse affect on our results of operations and financial condition.

Our international operations expose us to the risk of fluctuation in currency exchange rates.

 

In 2005, we derived our revenues principally in U.S. dollars and to a lesser extent in euros and shekels. Although a majority of our expenses were denominated in U.S. dollars, a significant portion of our expenses were denominated in shekels and to a lesser extent in euros and yen. Our shekel-denominated expenses consist principally of salaries and related personnel expenses. We anticipate that a material portion of our expenses will continue to be denominated in shekels. If the U.S. dollar weakens against the shekel, there will be a negative impact on our profit margins. We currently do not hedge our currency exposure through financial instruments. In addition, if we wish to maintain the dollar-denominated value of our products in non-U.S. markets, devaluation in the local currencies of our customers relative to the U.S. dollar could cause our customers to cancel or decrease orders or default on payment.

 

We may expand our business or enhance our technology through acquisitions that could result in diversion of resources and extra expenses. This could disrupt our business and adversely affect our financial condition.

 

Part of our strategy is to selectively pursue partnerships and acquisitions that provide us access to complementary technologies and accelerate our penetration into new markets. For example, in 2002 we acquired the assets of NetReality, an Israeli manufacturer of traffic management solutions, which increased our customers base and enhanced our engineering capabilities and technology. The negotiation of acquisitions, investments or joint ventures, as well as the integration of acquired or jointly developed businesses or technologies, could divert our management’s time and resources. Acquired businesses, technologies or joint ventures may not be successfully integrated with our products and operations. We may not realize the intended benefits of any acquisition, investment or joint venture and we may incur future losses from any acquisition, investment or joint venture.

 

In addition, acquisitions could result in:

 

 

If acquisitions disrupt our operations, our business may suffer.

 

Under current U.S. and Israeli law, we may not be able to enforce employees’ covenants not to compete and therefore may be unable to prevent our competitors from benefiting from the expertise of some of our former employees.

 

It is our practice to have our employees sign appropriate non-compete agreements. These agreements prohibit our employees, if they cease working for us, from competing directly with us or working for our competitors for a limited period. Under current U.S. and Israeli law, we may be unable to enforce these agreements and it may be difficult for us to restrict our competitors from gaining the expertise our former employees gained while working for us. If we cannot enforce our employees’ non-compete agreements, we may be unable to prevent our competitors from benefiting from the expertise of our former employees.

 

We have not yet evaluated our internal controls over financial reporting in compliance with Section 404 of the Sarbanes-Oxley Act.

 

We are required to comply with the internal control evaluation and certification requirements of Section 404 of the Sarbanes-Oxley Act by no later than the end of our 2007 fiscal year. We are in the process of determining whether our existing internal controls over financial reporting systems are compliant with

Section 404. This process may divert internal resources and will take a significant amount of time and effort to complete. If it is determined that we are not in compliance with Section 404, we may be required to implement new internal control procedures and reevaluate our financial reporting. We may experience higher than anticipated operating expenses as well as higher independent auditor fees during the implementation of these changes and thereafter. Further, we may need to hire additional qualified personnel in order for us to comply with Section 404. If we are unable to implement these changes effectively or efficiently, it could harm our operations, financial reporting or financial results and could result in our being unable to obtain an unqualified report on internal controls from our independent auditors.

 

Risks Related to this Offering

 

There has been no prior market for our ordinary shares and our share price may be volatile.

 

Prior to this offering there has been no public market for our ordinary shares. We cannot predict the extent to which investor interest will lead to the development of an active trading market in our ordinary shares or whether such a market will be sustained. The market price of our ordinary shares may be volatile and could fluctuate substantially due to many factors, including:

 

 

Share price fluctuations may be exaggerated if the trading volume of our ordinary shares is too low. The lack of a trading market may result in the loss of research coverage by securities analysts. Moreover, we cannot assure you that any securities analysts will initiate or maintain research coverage of our company and our ordinary shares. If our future quarterly operating results are below the expectations of securities analysts or investors, the price of our ordinary shares would likely decline. Securities class action litigation has often been brought against companies following periods of volatility. Any securities litigation claims brought against us could result in substantial expense and divert management’s attention from our business.

 

Following the closing of this offering, a small number of significant beneficial owners of our shares acting together will have a controlling influence over matters requiring shareholder approval, which could delay or prevent a change of control.

 

Following the closing of this offering, the largest beneficial owners of our shares, entities and individuals affiliated with Tamir Fishman Ventures, the Gemini Group, Genesis Partners, and Odem Rotem Holdings Ltd., a company owned and controlled by our Chairman, Yigal Jacoby, each of which currently beneficially owns more than 10.0% of our outstanding shares, will beneficially own in the aggregate 38.6% of our ordinary shares or 36.9% if the underwriters exercise their option to purchase additional shares. As a result, these shareholders, acting together, could exercise a controlling influence over our operations and business strategy and will have sufficient voting power to control the outcome of matters requiring shareholder approval. These matters may include:

 

	•	raising future capital; and
	•	amending our articles of association which govern the rights attached to our ordinary shares.

Number of Shares/
Percentage of Total
Outstanding		Date of Availability for Resale Into the Public Market
218,864/1.0%		Upon the date of this prospectus.
161,302/0.8%		90 days after the date of this prospectus.
13,899,972/66.5%		180 days after the date of this prospectus of which 9,828,102, or 47.0%, are subject to volume limitations under Rule 144.
109,793/0.5%		More than 180 days after the date of this prospectus.

are held for the production of, or produce, passive income we may use the market capitalization method for certain periods. Under the market capitalization method, the total asset value of the Company would be considered to equal the fair market value of its outstanding shares plus outstanding indebtedness on a relevant testing date. Because the market price of our ordinary shares is likely to fluctuate after this offering, the market price of the shares of technology companies has been especially volatile, and the market price may affect the determination of whether we will be considered a passive foreign investment company, there can be no assurance that we will not be considered a passive foreign investment company for any taxable year. If we are characterized as a passive foreign investment company, our U.S. shareholders may suffer adverse tax consequences, including having gains realized on the sale of our ordinary shares treated as ordinary income, rather than capital gain, the loss of the preferential rate applicable to dividends received on our ordinary shares by individuals who are U.S. holders, and having potentially punitive interest charges apply to the proceeds of share sales. See “Taxation and Government Programs — United States Federal Income Taxation — Distributions — Passive Foreign Investment Company Considerations.”

 

You will experience immediate and substantial dilution in the net tangible book value of the ordinary shares you purchase in this offering.

 

The initial public offering price of our ordinary shares is expected to exceed substantially the net tangible book value per share of our ordinary shares immediately after this offering. Therefore, based on the initial public offering price of $12.00 per share, if you purchase our ordinary shares in this offering, you will suffer immediate dilution of $8.01 per share or $7.69 if the underwriters exercise their option to purchase additional ordinary shares. As a result of this dilution, investors purchasing 6,500,000 ordinary shares from us will have contributed 64.3% of the total amount of our total funding to date but will only own 31.1% of our equity. If outstanding options and warrants to purchase our ordinary shares are exercised in the future, you will experience additional dilution.

 

Our management will have broad discretion over the use of proceeds from this offering and may not obtain a favorable return on the use of these proceeds.

 

Our management will have broad discretion in determining how to spend the net proceeds from this offering and may spend the proceeds in a manner that our shareholders may not deem desirable. We currently intend to use the net proceeds from this offering to fund our research and development activities, expand our business development and marketing activities, and other general corporate purposes and working capital. We may also use a portion of the net proceeds to acquire or invest in complementary companies, products or technologies. We cannot assure you that these uses or any other use of the net proceeds of this offering will yield favorable returns or results.

 

Risks Relating to our Location in Israel

 

Conditions in Israel could adversely affect our business.

 

We are incorporated under Israeli law and our principal offices, and research and development facilities are located in Israel. In addition, the subcontractor for our products is located in Israel. Accordingly, political, economic and military conditions in Israel directly affect our business. Since the State of Israel was established in 1948, a number of armed conflicts have occurred between Israel and its Arab neighbors. Although Israel has entered into various agreements with Egypt, Jordan and the Palestinian Authority, there has been an increase in unrest and terrorist activity, which began in September 2000 and has continued with varying levels of severity into 2006. The recent election of representatives of the Hamas movement to a majority of seats in the Palestinian Legislative Council has resulted in an escalation in violence and among Israel, the Palestinian Authority and other groups. In July and August 2006, significant fighting took place between Israel and Hezbollah in Lebanon, resulting in rockets being fired from Lebanon up to 50 miles into Israel. Furthermore, several countries, principally in the Middle East, still restrict doing business with Israel and Israeli companies, and additional countries may impose restrictions on doing business with Israel and Israeli companies if hostilities in Israel continue or increase. These restrictions may limit materially our ability to sell our solutions to companies in these countries. Any hostilities involving Israel or the interruption or curtailment of trade

between Israel and its present trading partners, or a significant downturn in the economic or financial condition of Israel, could adversely affect our operations and product development, cause our revenues to decrease and adversely affect the share price of publicly traded companies having operations in Israel, such as us. Additionally, any hostilities involving Israel may have a material adverse effect on R.H. Electronics and its facilities in which event, all or a portion of our inventory may be damaged, and our ability to deliver products to customers may be materially adversely affected.

 

Our operations may be disrupted by the obligations of personnel to perform military service.

 

As of September 30, 2006, we had 232 employees of whom 170 were based in Israel. Our employees in Israel, including three executive officers, may be called upon to perform up to one month (in some cases more) of annual military reserve duty until they reach age 45 and, in emergency circumstances, could be called to active duty. In response to increased tension and hostilities, there have been since September 2000 occasional call-ups of military reservists, including in connection with recent hostilities in Lebanon, and it is possible that there will be additional call-ups in the future. Our operations could be disrupted by the absence of a significant number of our employees related to military service or the absence for extended periods of one or more of our key employees for military service. Such disruption could materially adversely affect our business and results of operations. Additionally, the absence of a significant number of the employees of R.H. Electronics related to military service or the absence for extended periods of one or more of R.H. Electronics’ key employees for military service may disrupt its operations in which event our ability to deliver products to customers may be materially adversely affected.

 

The tax benefits that are available to us require us to meet several conditions and may be terminated or reduced in the future, which would increase our costs and taxes.

 

Our investment program in equipment at our facility in Hod-Hasharon, Israel has been granted approved enterprise status and we are therefore eligible for tax benefits under the Israeli Law for the Encouragement of Capital Investments, 1959, referred to as the Investment Law. We expect to utilize these tax benefits after we utilize our net operating loss carry forwards. As of December 31, 2005, the end of our last fiscal year, our net operating loss carry forwards for Israeli tax purposes amounted to approximately $20.5 million. To remain eligible for these tax benefits, we must continue to meet certain conditions stipulated in the Investment Law and its regulations and the criteria set forth in the specific certificate of approval, including, among other conditions, that the approved enterprise be operated over a seven-year period and that at least 30% of our investment in fixed assets of the approved enterprise be funded by additional paid-up ordinary share capital. If we do not meet the conditions stipulated in the Investment Law and its regulations and the criteria set forth in the specific certificate of approval in the future, the tax benefits would be canceled and we could be required to refund any tax benefits that we have received. These tax benefits may not be continued in the future at their current levels or at any level.

 

Effective April 1, 2005, the Israeli Law for the Encouragement of Capital Investments was amended. As a result, the criteria for new investments qualified to receive tax benefits were revised. No assurance can be given that we will, in the future, be eligible to receive additional tax benefits under this law. The termination or reduction of these tax benefits would increase our tax liability in the future, which would reduce our profits or increase our losses. Additionally, if we increase our activities outside of Israel, for example, by future acquisitions, our increased activities might not be eligible for inclusion in Israeli tax benefit programs.

 

See “Taxation and Government Programs — Israeli Tax Considerations and Government Programs — Law for the Encouragement of Capital Investments, 1959.”

 

The government grants we have received for research and development expenditures restrict our ability to manufacture products and transfer technologies outside of Israel and require us to satisfy specified conditions. If we fail to comply with such restrictions or these conditions, we may be required to refund grants previously received together with interest and penalties, and may be subject to criminal charges.

 

We have received grants from the government of Israel through the Office of the Chief Scientist of the Ministry of Industry, Trade and Labor, for the financing of a portion of our research and development

expenditures in Israel, pursuant to the provisions of The Encouragement of Industrial Research and Development Law, 1984, referred to as the Research and Development Law. In 2003, 2004 and 2005, we received and accrued grants totaling $2.7 million from the Office of the Chief Scientist, representing 27.0%, 18.4% and 10.9%, respectively, of our gross research and development expenditures in these periods. We may not receive future grants from the Office of the Chief Scientist and our failure to receive additional grants in the future could adversely affect our profitability.

 

The terms of the grants prohibit us from manufacturing products outside of Israel or transferring intellectual property rights in technologies developed using these grants inside or outside of Israel without special approvals. Even if we receive approval to manufacture our products outside of Israel, we may be required to pay an increased total amount of royalties, which may be up to 300% of the grant amount plus interest, depending on the manufacturing volume that is performed outside of Israel. This restriction may impair our ability to outsource manufacturing or engage in similar arrangements for those products or technologies. Know-how developed under an approved research and development program may not be transferred to any third parties, except in certain circumstances and subject to prior approval. In addition, if we fail to comply with any of the conditions and restrictions imposed by the Research and Development Law or by the specific terms of under which we received the grants, we may be required to refund any grants previously received together with interest and penalties, and may be subject to criminal charges. In recent years, the government of Israel has accelerated the rate of repayment of the Office of Chief Scientist grants and may further accelerate them in the future.

 

It may be difficult to enforce a U.S. judgment against us, our officers and directors and the Israeli experts named in this prospectus in Israel or the United States, or to assert U.S. securities laws claims in Israel or serve process on our officers and directors and these experts.

 

We are incorporated in Israel. The majority of our executive officers and directors and the Israeli experts named in this prospectus are not residents of the United States, and the majority of our assets and the assets of these persons are located outside the United States. Therefore, it may be difficult for an investor, or any other person or entity, to enforce a U.S. court judgment based upon the civil liability provisions of the U.S. federal securities laws against us or any of these persons in a U.S. or Israeli court, or to effect service of process upon these persons in the United States. Additionally, it may be difficult for an investor, or any other person or entity, to assert U.S. securities law claims in original actions instituted in Israel. Israeli courts may refuse to hear a claim based on a violation of U.S. securities laws on the grounds that Israel is not the most appropriate forum in which to bring such a claim. Even if an Israeli court agrees to hear a claim, it may determine that Israeli law and not U.S. law is applicable to the claim. If U.S. law is found to be applicable, the content of applicable U.S. law must be proved as a fact which can be a time-consuming and costly process. Certain matters of procedure will also be governed by Israeli law. There is little binding case law in Israel addressing the matters described above. See “Enforceability of Civil Liabilities.”

 

Provisions of Israeli law and our articles of association may delay, prevent or make undesirable an acquisition of all or a significant portion of our shares or assets.

 

Our articles of association contain certain provisions that may delay or prevent a change of control, including a classified board of directors. In addition, Israeli corporate law regulates acquisitions of shares through tender offers and mergers, requires special approvals for transactions involving significant shareholders and regulates other matters that may be relevant to these types of transactions. These provisions of Israeli law could have the effect of delaying or preventing a change in control and may make it more difficult for a third party to acquire us, even if doing so would be beneficial to our shareholders, and may limit the price that investors may be willing to pay in the future for our ordinary shares. Furthermore, Israeli tax considerations may make potential transactions undesirable to us or to some of our shareholders. See “Description of Ordinary Shares — Anti-Takeover Provisions under Israeli Law” and “Acquisitions under Israeli Law.”

 

This prospectus contains forward-looking statements. We have based these forward-looking statements on our current expectations and projections about future events. These statements include but are not limited to:

 

 

These statements may be found in the sections of this prospectus entitled “Prospectus Summary,” “Risk Factors,” “Use of Proceeds,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Business” and in this prospectus generally, including the section of this prospectus entitled “Business — Overview” and “Business — Industry Overview,” which contains information obtained from independent industry sources. Actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including all the risks discussed in “Risk Factors” and elsewhere in this prospectus.

 

In addition, statements that use the terms “believe,” “expect,” “plan,” “intend,” “estimate,” “anticipate” and similar expressions are intended to identify forward-looking statements. All forward-looking statements in this prospectus reflect our current views about future events and are based on assumptions and are subject to risks and uncertainties that could cause our actual results to differ materially from future results expressed or implied by the forward-looking statements. Many of these factors are beyond our ability to control or predict. You should not put undue reliance on any forward-looking statements. Unless we are required to do so under U.S. federal securities laws or other applicable laws, we do not intend to update or revise any forward-looking statements.

 

The forward looking statements contained in this prospectus are excluded from the safe harbor protection provided by the Private Securities Litigation Reform Act of 1995 and Section 27A of the Securities Act of 1933, as amended.

 

Based on the initial public offering price of $12.00 per share, we estimate that we will receive total net proceeds from this offering of $70.5 million, after deducting the underwriting discount and estimated offering expenses payable by us.

 

If the underwriters exercise their option to purchase additional ordinary shares, we estimate that we will receive an additional $10.9 million in net proceeds.

 

We intend to use the net proceeds of this offering for research and development activities, expand our business development and marketing activities, and the remaining proceeds for general corporate purposes and working capital. We may also use a portion of the net proceeds to acquire or invest in complementary companies, products or technologies, although we currently do not have any acquisitions or investments planned.

 

We will have broad discretion in the way that we use the net proceeds of this offering. The amounts that we actually spend for the purposes described above may vary significantly and will depend, in part, on the timing and amount of our future revenues.

 

Pending use of the net proceeds as described above, we intend to invest the net proceeds in interest-bearing, investment-grade instruments with maturities of less than one year or deposit the net proceeds in bank accounts in Israel or outside of Israel.

 

We have never declared or paid any cash dividends on our ordinary shares and we do not anticipate paying any cash dividends on our ordinary shares in the future. We currently intend to retain all future earnings to finance our operations and to expand our business. Any future determination relating to our dividend policy will be made at the discretion of our board of directors and will depend on a number of factors, including future earnings, capital requirements, financial condition and future prospects and other factors our board of directors may deem relevant.

 

The following table presents our capitalization as of September 30, 2006, assuming the closing of this offering on such date:

 

 

 

You should read this table in conjunction with “Selected Consolidated Financial Data,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and related notes included elsewhere in this prospectus.

 

 

The preceding table excludes (1) 3,543,522 ordinary shares reserved for issuance under our share option plans as of September 30, 2006, of which options to purchase 3,470,318 ordinary shares at a weighted average exercise price of $2.26 per share have been granted, (2) except to the extent stated in the preceding table, 246,479 ordinary shares that had been issued, but are held in trust for the benefit of Mr. Jacoby pending his payment of the full purchase price of such shares, and (3) up to 163,705 ordinary shares issuable upon the exercise of warrants granted to two Israeli banks and an Israeli non-profit organization at a weighted average exercise price of $3.37 per share.

 

Our pro forma consolidated net tangible book value as of September 30, 2006 was $12.7 million, or $0.90 per ordinary share. Pro forma consolidated net tangible book value per share represents consolidated tangible net assets less consolidated liabilities divided by the number of ordinary shares outstanding on a pro forma basis after giving effect to the conversion of all outstanding preferred and Series A ordinary shares into ordinary shares. Our pro forma as adjusted consolidated net tangible book value as of September 30, 2006 would have been $83.3 million or $3.99 per ordinary share assuming the closing of this offering on such date after giving effect to:

 

 

This represents an immediate increase in pro forma consolidated net tangible book value of $3.09 per ordinary share to existing shareholders and an immediate dilution of $8.01 per ordinary share to new investors purchasing ordinary shares in this offering. Dilution per share represents the difference between the price per share to be paid by new investors for the ordinary shares sold in this offering and the pro forma consolidated net tangible book value per share immediately after this offering. The following table illustrates this per share dilution:

 

The following table presents the differences between the total consideration paid to us and the average price per share paid by existing shareholders and by new investors purchasing ordinary shares in this offering, before deducting the estimated underwriting discounts and estimated offering expenses payable by us:

 

 

The preceding table excludes (1) 3,543,522 ordinary shares reserved for issuance under our share option plans as of September 30, 2006, of which options to purchase 3,470,318 ordinary shares at a weighted average exercise price of $2.26 per share had been granted, (2) 246,479 ordinary shares that have been issued, but are held in trust for the benefit of Mr. Jacoby pending his payment of the purchase price of such shares, and (3) up to 163,705 ordinary shares issuable upon the exercise of warrants granted to two Israeli banks and an Israeli non-profit organization at a weighted average exercise price of $3.37 per share.

 

Assuming the exercise in full of the underwriters’ option to purchase 975,000 ordinary shares to cover over-allotments, the pro forma net tangible book value after giving effect to this offering would be $4.31 per share, and the dilution in pro forma net tangible book value per share to investors in this offering would be $7.69 per share.

 

You should read the following selected consolidated financial data in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the related notes included elsewhere in this prospectus. The consolidated statements of operations data for the years ended December 31, 2003, 2004 and 2005 and the consolidated balance sheet data as of December 31, 2004 and 2005 are derived from our audited consolidated financial statements included elsewhere in this prospectus, which have been prepared in accordance with generally accepted accounting principles in the United States. The consolidated statements of operations for the years ended December 31, 2001 and 2002 and the consolidated balance sheet data as of December 31, 2001, 2002 and 2003 have been derived from our audited consolidated financial statements which are not included in this prospectus. The consolidated statements of operations data for the nine months ended September 30, 2005 and 2006 and the consolidated balance sheet data as of September 30, 2006 are derived from our unaudited consolidated financial statements that are included elsewhere in this prospectus. In the opinion of management, these unaudited interim consolidated financial statements include all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of our financial position and operating results for these periods. Results for interim periods are not necessarily indicative of the results that may be expected for the entire year.

 

 

 

 

MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The following management’s discussion and analysis of financial condition and results of operations contains forward-looking statements which involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forth under “Risk Factors” and elsewhere in this prospectus. We assume no obligation to update forward-looking statements or the risk factors. You should read the following discussion in conjunction with our consolidated financial statements and related notes included elsewhere in this prospectus.

 

Overview

 

We are a leading designer and developer of broadband service optimization solutions using advanced deep packet inspection, or DPI, technology. Our solutions provide broadband service providers and enterprises with real-time, highly granular visibility into, and control of, network traffic, and enable them to efficiently and effectively manage and optimize their networks. End-customers use our solutions to create sophisticated policies to monitor network applications, enforce quality of service policies that guarantee mission-critical application performance, mitigate security risks and leverage network infrastructure investments. Our carrier-class products are used by service providers to offer subscriber-based and application-based tiered services that enable them to optimize their service offerings, reduce churn rates and increase ARPU.

 

We were incorporated in late 1996 and commenced operations in 1997. Between 1998 and 2000, we focused primarily on developing our technology and products. In 1998, we shipped our first traffic management product. Between 2000 and 2003, we continued to develop our technology, including through our acquisition of the assets of NetReality, an Israeli manufacturer of traffic management solutions, which increased our customer base and resulted in an enhancement of our engineering capabilities. In 2003, we introduced our NetEnforcer AC-1000 product, which was the first commercially available network traffic management system operating above 1 gigabit full duplex throughput per second. In 2004, we increased our sales and marketing efforts to the service provider market and in late 2004 and in 2005 we accelerated sales to large service providers. In late 2005, we introduced our NetXplorer management application suite, which complements our NetEnforcer system, by adding a centralized management capability, and monitoring and reporting capabilities. In 2006, we introduced the NetEnforcer AC-2500, which supports up to 5 gigabit throughput per second, and our Subscriber Management Platform, which enhances our NetXplorer management application suite to include subscriber management.

 

We market and sell our products through our channel partners, which include distributors, resellers, OEMs and system integrators. End customers of our products include carriers, cable operators, wireless and wireline Internet service providers, educational institutions, governments and enterprises.

 

Revenues

 

We generate revenues from two sources: (1) sales of our NetEnforcer network traffic management system and our application suites, including our NetXplorer management application suite, and (2) maintenance and support services, including installation and training. We provide maintenance and support services pursuant to a one- or three-year maintenance and support program, which may be purchased by customers at the time of product purchase or on a renewal basis.

 

We recognize revenues from product sales when persuasive evidence of an agreement exists, delivery of the product has occurred, no significant obligations with respect to implementation remain, the fee is fixed or determinable, and collection is probable. We grant a one-year hardware warranty and a three-month software warranty on all of our products and take a reserve against revenues on account of possible warranty claims based on our historical experience. Warranty claims have to date been immaterial to our results of operations. We recognize revenues associated with our maintenance and support programs on a straight-line basis over the term of the maintenance and support agreement. See “Critical Accounting Policies and Estimates — Revenue Recognition.”

Customer concentration.  We derived approximately 13% of our revenues in 2003, 12% of our revenues in 2004 and 9% of our revenues in 2005 from a single U.S. distributor of our products to other resellers and system integrators in the United States. We derived 16% of our revenues in 2005 and 27% in the first nine months of 2006 from a single system integrator for our products in the United Kingdom, primarily in connection with the deployment of our products by NTL Group Limited, a leading United Kingdom cable operator. During these periods no other end-customer accounted for more than 5% of our revenues. We expect that sales attributable to NTL will decline significantly as a percentage of revenue in the last quarter of 2006 and in 2007 as deployment of a majority of our products by NTL is completed and as sales to other customers increase.

 

Geographical breakdown.  The following table sets forth the geographic breakdown of our revenues for the periods indicated:

 

 

The increase in our revenues in the United Kingdom in 2005 and the first nine months of 2006 compared to our revenues in the other areas for the same periods is mainly attributable to sales to a local system integrator, primarily in connection with the deployment of our products by NTL. We expect that the percentage of our revenues from the United Kingdom will return to historical levels in the last quarter of 2006 and in 2007, as deployment of a majority of our products by NTL is completed and as sales in other geographic areas increase.

 

Cost of revenues

 

Our product cost of revenues consists primarily of costs of materials, manufacturing services and overhead, warehousing, testing and royalties paid to the Office of the Chief Scientist of the Israeli Ministry of Industry, Trade and Labor. Our services cost of revenues consist primarily of salaries and related personnel costs for our help desk staff. We expect cost of revenues to increase primarily as a result of the increase in our product and service revenues, although we expect our gross margins to approximate current levels.

 

Operating expenses

 

Research and development.  Our research and development expenses consist primarily of salaries and related personnel costs, costs for subcontractor services, depreciation, rent and costs of materials consumed in connection with the design and development of our products. We expense all of our research and development costs as they are incurred. Our net research and development expenses are our gross research and development expenses offset by financing through royalty-bearing grants from the Office of the Chief Scientist. Such participation grants are recognized at the time at which we are entitled to such grants on the basis of the costs incurred and included as a deduction of research and development expenses (See “— Government Grants” below). We believe significant investment in research and development is essential to our future success and expect that in future periods our research and development expenses will increase on an absolute basis but decrease as a percentage of revenues as sales increase.

 

Sales and marketing.  Our sales and marketing expenses consist primarily of salaries and related personnel costs, travel expenses, costs associated with promotional activities such as public relations, conventions and exhibitions, rental expenses, depreciation and commissions paid to third parties. We intend to

continue our activities to target the service provider market and therefore we expect that sales and marketing expenses will increase on an absolute basis in the future as we hire additional sales, marketing and engineering personnel, continue to promote our brand and establish marketing channels and sales offices in additional U.S. and international locations. We expect that our sales and marketing expenses will decrease as a percentage of revenues as sales increase.

 

General and administrative.  Our general and administrative expenses consist primarily of salaries and related personnel costs, rental expenses, costs for professional services and depreciation. We expect these expenses to increase on an absolute basis as we hire additional personnel and incur additional costs related to the growth of our business as well as the costs associated with being a public company, including corporate governance compliance under the Sarbanes-Oxley Act of 2002 and rules implemented by the U.S. Securities and Exchange Commission and Nasdaq, as well as director and officer liability insurance.

 

Amortization of deferred stock-based compensation.  We have granted options to purchase our ordinary shares to our employees and consultants at prices below the fair market value of the underlying ordinary shares on the grant date. These options were considered compensatory because the deemed fair market value of the underlying ordinary shares was greater than the exercise prices determined by our board of directors on the option grant date. The determination of the fair market value of the underlying ordinary shares prior to this offering involved subjective judgment, third party valuations and the consideration by our board of directors of a variety of factors. Because there has been no public market for our ordinary shares prior to this offering, the amount of the compensatory charge was not based on an objective measure, such as the trading price of our ordinary shares. We discuss in detail the factors affecting our determination of the deemed fair value of the underlying ordinary shares below in “Critical Accounting Policies and Estimates — Accounting for Stock-Based Compensation.” As of January 1, 2006, we adopted Statement of Financial Accounting Standards No. 123(R) “Share Based Payment”, or SFAS No. 123(R), which requires us to expense the fair value of employee stock options. We adopted the fair value recognition provisions of SFAS No. 123(R), using the modified prospective method for grants that were measured using the fair value method and adopted SFAS No. 123(R) using the prospective-transition method for grants that were measured using the Minimum Value method in SFAS No. 123 for either recognition or pro forma disclosures. The fair value of stock-based awards granted after January 1, 2006, was estimated using the binominal model. As a result of adopting SFAS No. 123(R) on January 1, 2006, our net income for the nine month period ended September 30, 2006, is $252,000 lower with a negative effect of $0.01 on basic or diluted earnings per share, than if it had continued to account for stock based compensation under Accounting Principles Board Opinion 25 “Accounting for Stock Issued to Employees”, or APB 25.

 

In connection with the grant of options, we recorded total stock-based compensation expenses of $297,000 in 2003, $158,000 in 2004 and $305,000 in 2005. We also recorded a total stock-based compensation expense of $682,000 in the nine months ended September 30, 2006, of which $8,000, $97,000, $330,000 and $247,000 resulted from cost of revenue, research and development expenses, sales and marketing expenses and general and administrative expenses, respectively, based on the division in which the recipient of the option grant was employed. As of September 30, 2006, we had an aggregate of $3.1 million of deferred unrecognized stock-based compensation remaining to be recognized. We estimate that this deferred unrecognized stock-based compensation balance will be amortized as follows: approximately $0.4 million during the remainder of 2006, approximately $1.0 million in 2007 and approximately $0.8 million in 2008 and approximately $0.9 million in 2009 and thereafter.

 

Financial income (expenses), net

 

Financial income consists primarily of interest earned on our cash balances and other financial investments, foreign currency exchange gains and, to a lesser extent, interest accrued on loans made to employees. Financing expenses consist primarily of amortization of discounts on bank-credit lines, bank fees, foreign currency exchange losses and interest accrued on banks loans.

Corporate Tax

 

Israeli companies are generally subject to corporate tax at the rate of 31% of their taxable income in 2006. The rate is scheduled to decline to 29% in 2007, 27% in 2008, 26% in 2009 and 25% in 2010 and thereafter. However, the effective tax rate payable by a company that derives income from an Approved Enterprise designated as such under the Law for the Encouragement of Capital Investments, 1959 (the “Investment Law”) may be considerably less. Our investment programs in equipment at our facilities in Hod-Hasharon, Israel have been granted Approved Enterprise status under the Investment Law and enjoys certain tax benefits. We expect to utilize these tax benefits after we utilize our net operating loss carry forwards. As of December 31, 2005, the end of our last fiscal year, our net operating loss carry forwards for Israeli tax purposes amounted to approximately $20.5 million. Income derived from other sources, other than the “Approved Enterprise,” during the benefit period will be subject to tax at the regular corporate tax rate. For more information about the tax benefits available to us as an Approved Enterprise see “Taxation and Government Programs — Law for the Encouragement of Capital Investments, 1959.”

 

NetReality

 

In September 2002, we acquired the assets of NetReality, from a receiver pursuant to a court ruling. In consideration for the assets acquired, we granted to NetReality’s receiver a fully-vested warrant to purchase 48,267 Series B preferred shares (with an exercise price of NIS 0.10 per share) and undertook to pay the receiver a minimum of $1 million and maximum of $2.5 million in royalties over a period of five years from the date of the acquisition at the rate of the higher of (1) 7% of sales of the NetReality products and (2) 1% of our total sales. The purchase price was valued at approximately $1.3 million, based on the fair value of the warrant granted, and the minimum commitment of such royalties. We also assumed the commitment to pay royalties to the Office of the Chief Scientist as discussed under the subheading “Government Grants” below. The acquisition increased our customer base and resulted in an enhancement of our engineering capabilities. In the fourth quarter of 2004, we decided to cease sales of the NetReality product line, although we continue selling maintenance and support programs relating to the NetReality products. Consequently, an impairment of intangible assets relating to the NetReality acquisition of $0.4 million was recorded to operating expenses at the end of 2004. We do not expect our ongoing sales of maintenance and support programs relating to the NetReality products to be a significant source of revenue in the future.

 

Government Grants

 

Our research and development efforts have been financed, in part, through grants from the Office of the Chief Scientist under our approved plans in accordance with the Israeli Law for Encouragement of Research and Development in the Industry, 1984, or the R&D Law. Through September 30, 2006, we had applied and received approval for grants totaling $9.4 million from the Office of the Chief Scientist. Under Israeli law and the approved plans, royalties on the revenues derived from sales of all of our products are payable to the Israeli government, generally at the rate of 3.0% during the first three years and 3.5% beginning with the fourth year, up to the amount of the received grants as adjusted for fluctuation in the U.S. dollar/shekel exchange rate. The amounts received after January 1, 1999 bear interest equal to the 12-month London Interbank Offered Rate applicable to dollar deposits that is published on the first business day of each calendar year. Royalties are paid on our consolidated revenues.

 

The government of Israel does not own proprietary rights in knowledge developed using its funding and there is no restriction related to such funding on the export of products manufactured using the know-how. The know-how is, however, subject to other legal restrictions, including the obligation to manufacture the product based on the know-how in Israel and to obtain the Office of the Chief Scientist’s consent to transfer the know-how to a third party, whether in or outside Israel. These restrictions may impair our ability to outsource manufacturing or enter into similar arrangements for those products or technologies and they continue to apply even after we have paid the full amount of royalties payable for the grants.

 

If the Office of the Chief Scientist consents to the manufacture of the products outside Israel, the regulations allow the Office of the Chief Scientist to require the payment of increased royalties, ranging from

120% to 300% of the amount of the grant plus interest, depending on the percentage of foreign manufacture. If the manufacturing is performed outside of Israel by us, the rate of royalties payable by us on revenues from the sale of products manufactured outside of Israel will increase by 1% over the regular rates. If the manufacturing is performed outside of Israel by a third party, the rate of royalties payable by us on those revenues will be a percentage equal to the percentage of our total investment in our products that was funded by grants. The R&D Law further permits the Office of the Chief Scientist, among other things, to approve the transfer of manufacturing or manufacturing rights outside Israel in exchange for an import of certain manufacturing or manufacturing rights into Israel as a substitute, in lieu of the increased royalties.

 

The R&D Law provides that the consent of the Office of the Chief Scientist for the transfer outside of Israel of know-how derived out of an approved plan may only be granted under special circumstances and subject to fulfillment of certain conditions specified in the R&D Law as follows: (a) the grant recipient pays to the Office of the Chief Scientist a portion of the sale price paid in consideration for such Office of the Chief Scientist-funded know-how (according to certain formulas), except if the grantee receives from the transferee of the know-how an exclusive, irrevocable, perpetual unlimited license to fully utilize the know-how and all related rights; (b) the grant recipient receives know-how from a third party in exchange for its Office of the Chief Scientist funded know-how; or (c) such transfer of Office of the Chief Scientist funded know-how arises in connection with certain types of cooperation in research and development activities.

 

In connection with the NetReality acquisition, we assumed a commitment to pay royalties to the Office of the Chief Scientist up to the amount of the contingent liabilities derived from the grants that had been received by NetReality prior to the acquisition.

 

As of September 30, 2006, we had an outstanding contingent obligation to pay royalties in the amount of approximately $11.7 million, including obligations assumed in connection with the purchase of the operations of NetReality.

 

Factors Affecting Our Performance

 

Our business, financial position and results of operations, as well as the period-to-period comparability of our financial results, are significantly affected by a number of factors, some of which are beyond our control, including:

 

 

Mix between product and service revenues.  The following table sets forth information for the periods presented regarding the percentage of our revenues derived from product and service:

 

 

During the period from 2003 to 2005, we increased the percentage of our service revenues compared to product revenues both as a result of the increase in the installed base of our NetEnforcer and NetReality systems and also as a result of increased efforts to drive service contract renewals among end-customers. However, for the nine months ended September 30, 2006, the percentage of our service revenues was lower than in the nine months ended September 30, 2005, primarily as a result of product sales to a system integrator in the United Kingdom, as part of the deployment of our systems by NTL. In addition, such decrease in the

percentage of our service revenues was also due in part to the decrease in sales of maintenance and support services relating to the NetReality products. We are targeting our service revenues to remain at approximately the percentage levels of 2004 and 2005. Our service gross margins have historically been slightly higher than our product gross margins and we believe that our service activities can be scaled to address a larger installed basis without a proportionate increase in cost of services.

 

Size of end-customers and sales cycles.  We believe that our growth can be accelerated by increasing sales to large service providers and have hired additional sales and marketing personnel in recent years in order to achieve this goal. The deployment of our products by small and midsize enterprises and service providers can be completed relatively quickly with a limited number of NetEnforcer systems compared to the number required by large service providers. Design wins with large service providers, including carriers, are more likely to result in sustained demand for additional NetEnforcer systems as they deploy our products throughout their networks and as their networks grow. The increased deployment of our products in carriers’ networks also enhances our reputation and name recognition in the market. We, therefore, expect that significant customer wins in the carrier market will positively impact future performance. However, our performance is also influenced by sales cycles for our products, which typically fluctuate based upon the size and needs of end-customers that purchase our products. Generally, large service providers take longer to plan the integration of DPI solutions into their existing networks and to set goals for the implementation of the technology. The varying length of our sales cycles creates unpredictability regarding the timing of our sales and may cause our quarterly operating results to fluctuate if a significant customer defers an order from one quarter to another. Furthermore, longer sales cycles may result in delays from the time we increase our operating expenses and make investments in inventory, until the time that we generate revenue from related product sales.

 

Average selling prices.  Our performance is affected by the selling price of our products. We price our products based on several factors, including manufacturing costs, the stage of the product’s life cycle, competition, technical complexity of the product, discounts given to channel partners in certain territories, customization and other special considerations in connection with larger projects. We typically are able to charge the highest price for a product when it is first introduced to the market. We expect that the average selling prices for our products will decrease over the product’s life cycle as our competitors introduce new products and DPI technology becomes more standardized. In order to maintain or increase our current price, we expect that we will need to enhance the functionality of our products by offering higher system speeds, and additional features, such as additional security functions, supporting additional applications and enhanced reporting tools. For example, we sell additional software packages as part of the NetXplorer management application suite, and optional upgrade application suites to the NetEnforcer network traffic management system. We also from time to time introduce higher end models that typically increase our average selling price. To further offset such declines, we sell maintenance and support programs on our products, and as our customer base and number of field installations grows our related service revenues are expected to increase.

 

Cost of revenues and cost reductions.  We strive to control our cost of revenues in order to maintain and increase our gross margins. Our cost of revenues as a percentage of total revenues was 24.3% for 2003, 25.6% for 2004, 23.6% for 2005 and 22.0% for the nine months ended September 30, 2006. Our products use off-the-shelf components and typically the prices of such components decline over time. In addition, we make an effort to identify cheaper components of comparable performance and quality, as well as making engineering improvements in our products that will reduce costs. Since our cost of revenues also include royalties paid to the Office of the Chief Scientist, our cost of sales may be impacted positively or negatively by actions of the Israeli government changing the royalty rate. In addition, we may in the future incorporate features into our products that require payment of royalties to third parties.

 

Critical Accounting Policies and Estimates

 

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. These estimates and

judgments are subject to an inherent degree of uncertainty and actual results may differ. Our significant accounting policies are more fully described in Note 2 to our consolidated financial statements included elsewhere in this prospectus. Certain of our accounting policies are particularly important to the portrayal of our financial position and results of operations. In applying these critical accounting policies, our management uses its judgment to determine the appropriate assumptions to be used in making certain estimates. Those estimates are based on our historical experience, the terms of existing contracts, our observance of trends in our industry, information provided by our customers and information available from other outside sources, as appropriate. With respect to our policies on revenue recognition and warranty costs, our historical experience is based principally on our operations since we commenced selling our products in 1998. Our estimates are guided by observing the following critical accounting policies:

 

Revenue recognition.  We recognize revenues from sales of our products in accordance with the American Institute of Certified Public Accountants’ Statement of Position, or SOP, 97-2, “Software Revenue Recognition”, as modified by SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition, with Respect to Certain Transactions”. When an arrangement does not require significant production, modification or customization of software or does not contain services considered to be essential to the functionality of the software, revenue is recognized when the following four criteria are met:

 

 

We exercise judgment and use estimates in connection with the determination of the amount of product software license and services revenues to be recognized in each accounting period. If collection is not considered probable, revenue is recognized when the fee is collected. We record provisions against revenue for estimated sales returns, sales incentives and warranty allowances on product and service-related sales in the same period as the related revenue is recorded. We also record a provision to operating expenses for bad debts resulting from customers’ inability to pay for the products or services they have received. These estimates are based on historical sales returns, sale incentives, warranty related expenses, and bad debt expense, analyses of credit memo data, and other known factors, such as bankruptcy. If the historical data we use to calculate these estimates do not accurately reflect actual or future returns, sales incentives, warranty related expenses or bad debts, adjustments to these reserves may be required that would increase or decrease revenue or net income.

 

Many of our product sales include multiple elements. Such elements typically include several or all of the following: hardware appliance, software licenses, hardware and software maintenance, technical support and training services. For multiple-element arrangements that do not involve significant modification or customization of the software and do not involve services that are considered essential to the functionality of the software, we allocate value to each element based on its relative fair value, if sufficient specific objective evidence of fair value exists for each element of the arrangement. Specific objective evidence of fair value is determined based on the price charged when each element is sold separately. If sufficient specific objective evidence exists for all undelivered elements, but does not exist for the delivered element, typically the hardware appliance and software license, then the residual method is used to allocate value to each element. Under the residual method, each undelivered element is allocated value based on customer specific objective evidence of fair value for that element, as described above, and the remainder of the total arrangement fee is

allocated to the delivered element(s). If sufficient customer specific objective evidence does not exist for all undelivered elements and the arrangement involves rights to unspecified additional software products, all revenue is recognized ratably over the term of the arrangement. If the arrangement does not involve rights to unspecified additional software products, all revenue is initially deferred until typically the only remaining undelivered element is software maintenance or technical support, at which time the entire fee is recognized ratably over the remaining maintenance or support term.

 

Accounting for Stock-Based Compensation.  Through December 31, 2005, we elected to follow the intrinsic value-based method prescribed by APB 25 and related interpretations in accounting for employee stock options rather than adopting the alternative fair value accounting provided under Statement of Financial Accounting Standards No. 123, or SFAS No. 123, “Accounting for Stock Based Compensation.” Therefore, we have not recorded any compensation expense for stock options we granted to our employees where the exercise price equals the fair market value of the stock on the date of grant and the exercise price, number of shares eligible for issuance under the options and vesting period are fixed. However, where the exercise price is less than the fair market value of the stock on the date of grant, compensation expense was recognized. Deferred compensation is amortized to compensation expense over the vesting period of the options, which is generally four years, on a straight-line method.

 

We comply with the disclosure requirements of SFAS No. 123 and Statement of Financial Accounting Standards No. 148 “Accounting for Stock-Based Compensation — Transition and Disclosure”, or SFAS No. 148, which require that we disclose our pro forma net income or loss and net income or loss per ordinary share as if we had expensed the fair value of the options. In calculating such fair value, there are certain assumptions that we use, as disclosed in Note 2 of our consolidated financial statements included elsewhere in this prospectus. For purposes of this pro forma disclosure, we estimate the fair value of stock options issued to employees using the minimum value valuation model through December 31, 2005. Option valuation models require the input of highly subjective assumptions, including the expected life of options and our expected stock price volatility. Therefore, the estimated fair value of our employee stock options may vary significantly as a result of changes in the assumptions used.

 

In December 2004, the Financial Accounting Standards Board, or FASB, issued SFAS 123(R), which requires companies to expense the fair value of employee stock options and other forms of share-based compensation. SFAS 123(R) requires nonpublic companies that used the Minimum Value method in SFAS 123 for either recognition or pro forma disclosures to apply SFAS 123(R) using the prospective-transition method. As such, we will continue to apply APB 25 in future periods to equity awards outstanding at the date of SFAS 123(R)adoption that were measured using the Minimum Value method.

 

We adopted SFAS 123(R) using the prospective transition method for grants that were measured for pro forma purposes using the Minimum Value Method. Under SFAS 123(R), we are required to determine the appropriate fair value model to be used for valuing share-based payments, the amortization method for compensation cost and the transition method to be used at date of adoption. We use the Minimum Value valuation model to value options for pro forma financial statement disclosure purposes. The use of a different model to value options may have resulted in a different fair value. We adopted SFAS 123(R) commencing January 1, 2006 and recognized a compensation expense of $682,000 in the nine months ended September 30, 2006. The fair value of stock-based awards, granted after January 1, 2006, was estimated using the Binominal model.

 

With respect to each option grant date, we determine the deemed fair value of our ordinary shares. As there is no public market for our ordinary shares, this determination was necessarily subjective. In making this determination, we considered a number of factors, including:

 

 

 

We have reviewed the methodologies used in making these determinations in light of the AICPA’s Practice Aid Valuation of Privately-Held-Company Equity Securities Issued as Compensation, which we refer to as the practice aid. We took into consideration the market and income approaches to valuation as set forth in the practice aid. We believe that the valuation methodologies that we have used are consistent with the practice aid.

 

In connection with the preparation of our financial statements for the years ended December 31, 2004 and 2005, and the nine months ended September 30, 2006, we assessed the valuations of our ordinary shares as of the applicable grant dates and engaged an independent valuation firm, BDO Ziv Haft Consulting & Management Ltd.

 

We also assessed our estimate of the fair value for financial reporting purposes of our ordinary shares based on the subjective factors mentioned above, the various approaches to valuation set forth in the practice aid, the independent valuation studies and an assessment of market considerations, including the overall economic marketplace, factors affecting our industry as well as the likelihood of an initial public offering, the uncertainties inherent in an initial public offering and the enterprise value of our company.

 

The valuation methodologies employed in connection with our 2004, 2005 and 2006 independent valuation studies were based upon various generally accepted valuation methods but relied primarily on the discounted cash flow and market approach models. Determining the fair value of our ordinary shares involves complex and subjective judgments involving estimates of revenues, earnings, assumed market growth rates and estimated costs, as well as appropriate discount rates. At the time of each valuation, the significant estimates used in the income approach included estimates of revenues for 2006 and revenues growth rates for the following years.

 

Inventories.  We value our inventories at the lower of cost or estimated market value, cost being determined on the basis of the average cost method for raw materials, manufacturing costs and indirect allocable costs. We estimate market value based on our current pricing, market conditions and specific customer information. We write off inventory for slow-moving items or technological obsolescence. We also assess our inventories for obsolescence based upon assumptions about future demand and market conditions. Once inventory is written off, a new cost basis for these assets is established for future periods. Inventory write offs totaled $0.2 million in 2003, $0.4 million in 2004 and $0.2 million in 2005.

Results of Operations

 

The following table sets forth our statements of operations as a percentage of revenues for the periods indicated:

 

 

Nine Months Ended September 30, 2006 Compared to Nine Months Ended September 30, 2005

 

Revenues

 

Products.  Product revenues increased by $8.1 million, or 65%, to $20.7 million in the nine months ended September 30, 2006 from $12.6 million in the nine months ended September 30, 2005. The majority of our product revenues in the nine months ended September 30, 2006 were derived from sales of the NetEnforcer AC-1000. We continued to increase our concentration in the service provider market during this period. Product revenues for the nine months ended September 30, 2006 also include $6.8 million of sales of our products to a single system integrator for our products in the United Kingdom relating primarily to deployment of our systems by NTL compared to $2.5 million of sales to the same system integrator in relation to the same project for in the nine months ended September 30, 2005.

 

Services.  Service revenues increased by $0.6 million, or 16%, to $3.9 million in the nine months ended September 30, 2006 from $3.3 million in the nine months ended September 30, 2005. The increase in service revenues resulted primarily from a larger product base covered by maintenance and support contracts. The increase in service revenues was partially offset by a decrease of sales of maintenance and support programs related to NetReality’s legacy products in the nine months ended September 30, 2006 compared to the nine months ended September 30, 2005. Service revenues as a percentage of sales decreased in part due to sales to NTL, which, as of September 30, 2006, had not included maintenance and support contracts typically associated with our product sales.

 

Cost of revenues and gross margin

 

Products.  Cost of product revenues increased by $1.4 million, or 41%, to $4.6 million in the nine months ended September 30, 2006, from $3.2 million in the nine months ended September 30, 2005. This

increase resulted primarily from increased expenditure of $0.6 million on materials due to an increased number of units sold, and an increase of $0.3 million in royalty expense accrued or paid to the Office of the Chief Scientist. Product gross margin was 78.0% in the nine months ended September 30, 2006 compared to 74.3% in the nine months ended September 30, 2005. This increase resulted from higher priced modules accounting for a greater proportion of total sales and, to a lesser degree, cost reduction efforts.

 

Services.  Service cost of revenues increased by $0.1 million, or 21%, to $0.8 million in the nine months ended September 30, 2006 from $0.7 million in the nine months ended September 30, 2005. This increase resulted primarily from post-sales support expenses as a result of salary increases. Services gross margin was 78.1% in the nine months ended September 2006 compared to 78.9% in the nine months ended September 30, 2005.

 

Total gross margin was 78.0% in the nine months ended September 30, 2006 compared to 75.2% in the nine months ended September 30, 2005.

 

Operating expenses

 

Research and development.  Gross research and development expenses increased by $1.7 million, or 36%, to $6.7 million in the nine months ended September 30, 2006 from $5.0 million in the nine months ended September 30, 2005. This increase resulted from an increase of $1.5 million due primarily to the hiring of additional research and development staff in connection with development of our ATCA-based 10G platform, as well as salary increases.

 

Research and development expenses as a percentage of revenues decreased to 27% in the nine months ended September 30, 2006 from 31% in the nine months ended September 30, 2005.

 

Research and development expenses, net of received and accrued royalty-bearing grants from the Office of the Chief Scientist increased by $1.2 million, or 29%, to $5.6 million in the nine months ended September 30, 2006 from $4.4 million in the nine months ended September 30, 2005. Grants received and accrued increased by $0.5 million, or 88%, to $1.1 million in the nine months ended September 30, 2006 from $0.6 million in the nine months ended September 30, 2005, due to a larger grant approved by the Office of the Chief Scientist.

 

Sales and marketing.  Sales and marketing expenses increased by $2.1 million, or 23%, to $10.9 million in the nine months ended September 30, 2006 from $8.8 million in the nine months ended September 30, 2005. This increase resulted from an increase of $1.3 million due primarily to the hiring of additional sales, marketing and engineering personnel to provide broader geographical coverage and increased focus on the service provider and carrier markets, an increase of $0.3 million in expenses relating to resellers and end-customers events and an increase of $0.2 million in rental costs related to our offices. Sales and marketing expenses as a percentage of revenues decreased to 44% in the nine months ended September 30, 2006 from 55% in the nine months ended September 30, 2005.

 

General and administrative.  General and administrative expenses increased by $0.6 million, or 32%, to $2.3 million in the nine months ended September 30, 2006 from $1.7 million in the nine months ended September 30, 2005. This increase resulted from an increase of $0.3 million due primarily to the hiring of additional personnel, as well as salary increases and increased stock-based-compensation costs, and an increase of $0.1 million in professional services rendered. General and administrative expenses as a percentage of revenues decreased to 9% in the nine months ended September 30, 2006 from 11% in the nine months ended September 30, 2005.

 

Financial and other income (expenses), net

 

Financial and other income was $229,000 in the nine months ended September 30, 2006 compared to financial and other income of $36,000 in the nine months ended September 30, 2005. The increase in financial income resulted from interest received on cash balances and decrease of amortization of discount on bank credit line.

Income tax benefit (expense)

 

Income tax expense was $75,000 in the nine months ended September 30, 2006 compared to income tax benefit of $178,000 in the nine months ended September 30, 2005. The income tax benefit in the nine months ended September 30, 2005 was attributable to deferred income tax asset recorded by our U.S. subsidiary.

 

Year Ended December 31, 2005 Compared to Year Ended December 31, 2004

 

Revenues

 

Products.  Product revenues increased by $3.9 million, or 26%, to $18.5 million in 2005 from $14.6 million in 2004. The majority of our product revenues in 2005 was derived from sales of the NetEnforcer AC-1000, which is targeted primarily at service providers, and the balance from sales of the NetEnforcer AC-400 and AC-800. While we experienced growth in sales from all NetEnforcer models, the rate of growth of the NetEnforcer AC-400 and AC-800 was slower than in previous years as we shifted our focus to the service provider market. Products revenues for 2005 also include $3.7 million of sales to a single system integrator compared to $0.6 million of sales to the same system integrator in 2004.

 

The increase in NetEnforcer sales was partially offset by a decrease of sales of NetReality’s legacy products which accounted for sales of $1.0 million in 2004 compared to $0.1 million of sales in 2005. At the end of 2004, we decided to cease selling NetReality’s product line, although we continue selling maintenance and support programs relating to the NetReality products.

 

Services.  Service revenues increased by $1.1 million, or 30%, to $4.5 million in 2005 from $3.4 million in 2004. The increase in service revenues resulted primarily from a larger product base covered by maintenance and support contracts. The increase in service revenues was partially offset by a decrease of sales of maintenance and support programs related to NetReality’s legacy products in 2004 compared to 2005.

 

Cost of revenues and gross margin

 

Products.  Cost of product revenues increased by $0.5 million, or 14%, to $4.5 million in 2005 from $4.0 million in 2004. This increase resulted primarily from increased expenditure of $0.5 million on materials which was partially offset by a write off of $0.2 million primarily related to NetReality inventories, and an increase of $0.2 million in royalties paid to the Office of the Chief Scientist. Product gross margin was 75.8% in 2005 compared to 73.1% in 2004. This increase resulted from higher priced modules accounting for a greater proportion of total sales, as well as lower relative fixed costs and decreased inventory write-offs compared to 2004.

 

Services.  Service cost of revenues increased by $0.2 million, or 38%, to $0.9 million in 2005 from $0.7 million in 2004. This increase resulted from an increase of $0.2 million in post-sales support expenses as a result of employing additional post-sale support engineers and salary increases. Services gross margin was 79.0% in 2005 compared to 80.3% in 2004.

 

Total gross margin was 76.4% in 2005 compared to 74.4% in 2004.

 

Operating expenses

 

Research and development.  Gross research and development expenses increased by $1.8 million, or 37%, to $6.7 million in 2005 from $4.9 million in 2004. This increase resulted from an increase of $1.4 million due primarily to the hiring of additional research and development staff as well as increased salaries, an increase of $0.2 million due to additional materials consumed and an increase of $0.1 million due to additional subcontractor work. These increases were driven by the development of new products, such as our NetXplorer management application suite and the initial development of our new ATCA-based 10G platform.

 

Research and development expenses, net of received and accrued grants from the Office of the Chief Scientist, increased by $1.9 million, or 50%, to $5.9 million in 2005 from $4.0 million in 2004. Grants totaled $0.7 million in 2005 compared to $0.9 million in 2004. The decrease in the size of grants received and accrued in 2005 compared to 2004 was primarily due to unfavorable changes in the currency exchange rates

between the shekel and the U.S. dollar as well as an adjustment in 2005 of the grant allowance for 2004. Research and development expenses as a percentage of revenues increased to 26% in 2005 from 22% in 2004.

 

Sales and marketing.  Sales and marketing expenses increased by $1.8 million in 2005, or 18%, to $11.9 million in 2005 from $10.1 million in 2004. This increase resulted from an increase of $1.1 million due primarily to the hiring of additional sales, marketing and engineering personnel to provide broader geographical coverage and increased focus on the service provider market, an increase of $0.2 million in commissions paid to third parties, an increase of $0.2 million in amortization of stock-based compensation and an increase of $0.1 million in expenses relating to cooperative advertising expenses, public relations and advertising. Sales and marketing expenses as a percentage of revenues decreased to 52% in 2005 from 56% in 2004.

 

General and administrative.  General and administrative expenses increased by $0.3 million, or 14%, to $2.4 million in 2005 from $2.1 million in 2004. This increase resulted from an increase of $0.1 million due primarily to the hiring of additional personnel as well as salary increases and an increase of $0.1 million in expenses related to professional services. General and administrative expenses as a percentage of revenues decreased to 10% in 2005 from 12% in 2004.

 

Impairment of intangible assets

 

Impairment of intangible assets was $0.4 million in 2004 and zero in 2005. This decrease resulted from the impairment at the end 2004 of most of the intangible assets acquired in connection with our acquisition of the assets of NetReality in 2002.

 

Financial and other income (expenses), net

 

Financial and other income, net was $45,000 in 2005 compared to financial and other expenses, net of $241,000 in 2004. The increase in financial and other income resulted from an increase of $0.1 million related to interest received on cash balances and decrease of $0.3 million related to amortization of discount on bank credit-lines.

 

Income tax benefit (expense)

 

Income tax benefit was $218,000 in 2005 compared to income tax expense of $3,000 in 2004. The income tax benefit in 2005 was attributable to deferred income tax asset recognized by our U.S. subsidiary.

 

Year Ended December 31, 2004 Compared to Year Ended December 31, 2003

 

Revenues

 

Products.  Product revenues increased by $1.5 million, or 12%, to $14.6 million in 2004 from $13.1 million in 2003. The increase in product revenues resulted primarily from an increase in sales of our NetEnforcer product, partially offset by a decrease of $1.8 million in sales of our NetReality legacy products. At the end of 2004, we decided to cease selling NetReality’s product line, although we continue selling maintenance and support programs relating to the NetReality products.

 

Services.  Revenues increased by $1.7 million, or 109%, to $3.4 million in 2004 from $1.7 million in 2003. The increase in service revenues resulted from an increased emphasis on selling maintenance and support programs.

 

Cost of revenues and gross margin

 

Products.  Cost of product revenues increased by $0.7 million, or 22%, to $3.9 million in 2004 from $3.2 million in 2003. This increase resulted from a write off of $0.4 million primarily related to NetReality inventories and from increased product sales. Products gross margin was 73.1% in 2004 compared to 75.4% in 2003.

Services.  Cost of service revenues increase by $317,000, or 88%, to $679,000 in 2004 from $362,000 in 2003. Services gross margin was 80.3% in 2004 compared to 78.1% in 2003. This increase resulted from employing additional post-sales support engineers.

 

Total gross margin was 74.4% in 2004 compared to 75.7% in 2003.

 

Operating expenses

 

Research and development.  Gross research and development expenses increased by $0.8 million, or 20%, to $4.9 million in 2004 from $4.1 million in 2003. This increase resulted from an increase of $0.7 million due primarily to the hiring of additional research and development staff for the development of new products. Research and development expenses as a percentage of revenues were 27% in both 2004 and 2003.

 

Research and development expenses, net of received and accrued grants from the Office of the Chief Scientist, increased by $1.0 million, or 34%, to $4.0 million in 2004 from $3.0 million in 2003. Grants totaled $0.9 million in 2004 compared to $1.1 million in 2003. The decrease in the size of grants received and accrued in 2004 compared to 2003 was primarily due to budget constraints imposed by the Israeli government that led to a reduction in participation rates from 50% to 40%, as well as unfavorable changes in the currency exchange rates between the shekel and the U.S. dollar.

 

Sales and marketing.  Sales and marketing expenses increased by $1.9 million in 2004, or 24%, to $10.1 million in 2004 from $8.2 million in 2003. This increase resulted from an increase of $1.3 million due primarily to the hiring of additional sales and marketing personnel in our sales, support and marketing departments and expansion to new territories, an increase of $0.4 million in travel expenses and an increase of $0.2 million related to conventions and exhibitions. Sales and marketing expenses as a percentage of revenues increased to 56% in 2004 from 55% in 2003.

 

General and administrative.  General and administrative expenses increased by $0.3 million, or 11%, to $2.1 million in 2004 from $1.8 million in 2003. This increase resulted primarily from an increase of $0.2 million in expenses related to professional services and $0.1 million due primarily to the hiring of additional personnel as well as salary increases. General and administrative expenses as a percentage of revenues decreased to 11.5% in 2004 from 12.4% in 2003.

 

Impairment of intangible assets

 

Impairment of intangible assets was $0.4 million in 2004 and zero in 2003. This increase resulted from the impairment at the end 2004 of most of the intangible assets acquired in connection with our acquisition of the assets of NetReality in 2002.

 

Financial and other income (expenses), net

 

Financial and other income (expenses), net decreased to $0.2 million in 2004 from $0.5 million in 2003. This decrease was primarily a result of higher interest expenses in 2003 relating to bank loans and foreign exchange gains from and increased interest income on cash balances in 2004.

 

Income tax benefit (expense)

 

Income tax expense was $3,000 in 2004 compared to $2,000 in 2003.

 

Quarterly Results of Operations

 

The table below sets forth unaudited consolidated statements of operations data in dollars for each of the seven consecutive quarters ended September 30, 2006. In management’s opinion, the unaudited consolidated financial statements have been prepared on the same basis as our audited consolidated financial statements contained elsewhere in this prospectus and include all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of such financial information. This information should be read in conjunction with the audited consolidated financial statements and notes thereto appearing elsewhere in this prospectus.